Annexure II

For Internal Circulation Only

Model Validation Policy

Financial Year 2024

Small Industries Development Bank of India

Risk Management Vertical, Mumbai
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Model Validation Policy-Version 3.0
 Model Validation Policy-Version 3.0

Document Control

Version Revision Date Revision Description

1.0 August 2021 Introduction of Policy
2.0 February 2022 Annual review and model inventory updation
3.0 February 2023  Annual review and model inventory updation
 Updation of roles of ERMC and RiMC

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Model Validation Policy-Version 3.0
Contents
1. Introduction .......................................................................................... 4
2. Policy objectives ................................................................................... 4
3. Governance and control ......................................................................... 5
4. Organization structure for Model Validation ............................................. 5
4.1. Board ................................................................................................... 5
4.2. Risk Management Committee of the Board .............................................. 5
4.3. Product Innovation and Review Committee .............................................. 6
4.4. Enterprise Risk Management Committee ................................................. 6
4.5. Risk Management Vertical ...................................................................... 6
4.6. Digital Initiatives Vertical ....................................................................... 7
5. Regulatory Framework........................................................................... 7
6. Scope of the Policy ................................................................................ 7
7. Appropriate use of models ..................................................................... 7
8. Model Development and implementation................................................. 8
9. Qualitative Validation & Quantitative Validation ....................................... 8
9.1. Qualitative Validation ............................................................................ 8
9.2. Quantitative validation .......................................................................... 9
10. Frequency of validation........................................................................ 10
11. Mode of validation ............................................................................... 10
12. Internal validation by officers of RiMV ................................................... 11
13. External validation by Consultants ........................................................ 11
14. Outcome of the validation exercise ....................................................... 12
15. Validity of the Policy ............................................................................ 12
16. Policy Custodian .................................................................................. 12

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Model Validation Policy-Version 3.0
 Model Validation Policy – FY 2024

1. Introduction
As a part of the strategy for managing risks in the credit portfolio, the
Bank uses internal risk rating models (‘Models’ or ‘Rating models’) to measure
credit risk for majority of the customer categories. The Model Validation Policy
elucidates the guiding principles, objectives and overall framework for
undertaking validation of Rating Models adopted by the Small Industries
Development Bank of India (‘SIDBI’ or the ‘Bank’).

2. Policy objectives
The Rating models categorise different dimensions of credit risk into
management risk, financial risk, business risk and industry risk. With a view to
facilitating credit related decision-making in a consistent manner, the risk
rating reveals the underlying risk of lending, critical input for setting pricing as
also non-price terms of loan and presents meaningful information for
management of loan portfolio. Further, they facilitate informed decision
making by providing predictive outcomes or likelihood of default.
A model developed using some initial sample may not hold well as the
portfolio composition changes over time. Therefore, the accuracy of a model
needs to be tracked on a regular basis. A significant fall in the accuracy over
a period of time indicates that the model may no longer be valid for scoring or
rating a customer. This could be on account of various reasons viz. some risk
parameters becoming irrelevant, some new risks having emerged, the score
ranges/ value statement requiring modification due to changing scenario, lack
of clarity in parameter resulting in scores generally in mid-range which do not
act as differentiators, etc. Since the estimated score is an important input in
credit appraisal and in future would be used in capital computation, poor
model performance will lead to inaccurate credit appraisal and estimation of
capital. Periodic Validation ensures that the Bank’s models are operating as
intended when they were developed.

The main objectives of the Policy are:

 To maintain model inventory.

 To adopt an effective governance framework, procedures and controls
to ensure appropriate and timely use of models.
 To outline a model development and implementation process.
 To undertake appropriate model validation to ensure consistent model
performance and better understanding of inherent uncertainties.
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Model Validation Policy-Version 3.0
3. Governance and control
Model governance would be based on the following principles:
 The roles and responsibilities of each of the stakeholders would
be clearly established, to ensure clear reporting lines, avoid
conflict of interests and adequate segregation of duties.
 Business users of models should generally not form a part of the
model development team & model validation team and have no
role other than providing inputs in the model development
process and testing.
 Each new rating model should be properly documented at
development and implementation stage to ensure control and
monitoring.
 Ensure all models are adequately back tested and approved prior
to implementation in the live environment.
 Periodic validation is carried out through a combination of
Internal Validation by officers of the Bank and Validation by
external Consultant.

Based on the principles and process as outlined above, the following

roles and responsibilities are identified for the management of model risk.
4. Organization structure for Model Validation
4.1. Board
The Board of Directors is the apex entity for risk management. The Board
shall approve the Model Validation Policy as a part of credit risk management.
4.2. Risk Management Committee of the Board
The Risk Management Committee of the Board (RiMC), which is a Board
level Committee, is responsible for risk management in the Bank. The RiMC
shall:
 Assist the Board in management of risks and will be responsible for
reviewing the implementation of the Model Validation Policy.
 Carry out annual review of the Model validation Policy and suggest /
recommend modifications in the Policy to the Board to address the risks
emanating from emerging business environment and availability of
digital risk mitigants tools from the digital eco-system.

 Approve introduction of new Models for credit risk assessment on the

recommendation of the ERMC.
 Approve roll out of rating models launched on pilot basis under new
products approved by Product Innovation and Review Committee
[PIRC]..
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  Approve discontinuance / re-introduction of the model on the
recommendation of ERMC.

4.3. Product Innovation and Review Committee

PIRC shall accord approvals for launching of new models as part of

launch of new product on test basis. On satisfactory performance of the test
product and its rating model, PIRC shall recommend to RiMC for approval of
the roll out of the product along with the rating model.
4.4. Enterprise Risk Management Committee

The responsibilities of the Enterprise Risk Management Committee

[ERMC] regarding the implementation of the Model Validation Policy are:
 Approve operational guidelines for Internal validation.
 Accept / approve the model validation findings.
 Recommend additional validation, either internal or external to be
carried out in addition to periodic validation, if required.
 Recommend discontinuation/ reintroduction of a model to RiMC.
 Approve upgradation, improvement, re-calibration of existing rating /
scoring models, tools, applications, software etc.

4.5. Risk Management Vertical

The Risk Management Vertical [RiMV] shall be responsible for co-
ordinating all activities of the Bank in connection with model validation and
shall:
 Ensure periodic validation of the models as per the frequency and mode
defined in this Policy.
 Ensure selection of Consultant for carrying out validation and
compliance to guidelines for external validation.
 Ensure that Internal Validation is not undertaken by individuals who
were involved in the development of any of the models they are
validating.
 Present the results of each independent validation to the ERMC for
approval.
 Co-ordinate with Digital Initiatives Vertical [DIV] / vendor [for externally
developed models] to ensure implementation of the modification /
model enhancement approved by the ERMC / RiMC.

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  Ensure corrective measures and remedial actions taken based on review
and validation results as approved by ERMC /RiMC-.

4.6. Digital Initiatives Vertical

DIV shall carry out the modification / enhancements prescribed in the
model validation results as advised by RiMV.
5. Regulatory Framework
The Basel II framework provides two broad methodologies to banks to
calculate capital requirements for credit risk, namely, Standardised Approach
(SA) and Internal Rating Based (IRB) Approach. The IRB Approach allows
banks, subject to the approval of RBI, to use their own internal estimates for
some or all of the credit risk components [Probability of Default (PD), Loss
Given Default (LGD), etc. in determining the capital requirement for a given
credit exposure.
As per Basel Committee on Banking Supervision (BCBS) / RBI guidelines,
Banks employing IRB for regulatory capital must have a robust, documented
system in place to validate on an ongoing basis the accuracy of rating systems,
associated risk estimates (quantitative validation), and operational integrity
and consistency of those systems and estimates (process validation).
RBI had, on October 22, 2021, released the Draft Master Direction, 2021
- Prudential Regulations on BASEL III Capital Framework, Exposure Norms,
Significant Investments, Classification, Valuation and Operation of Investment
Portfolio Norms and Resource Raising Norms for All India Financial Institutions
(AIFIs) for feedback from the stakeholders. As per the draft direction, for credit
risk, AIFIs shall adopt the Standardised Approach. Applicability of Basel III
norms for AIFI has not yet been introduced by the RBI.
6. Scope of the Policy
The Policy covers all internal rating models of the Bank. Presently, rating
is carried out in
a) Risk Assessment Model [RAM],
b) SIDBI Multifunctional Appraisal and Rating Tool [SMART] and
c) Score Card [hosted on SMART platform].

Complete list of the models is furnished in Model list inventory – Annexure I.

While the above models are used primarily for credit risk assessment,
some of the models are also being used for investment proposals, co-lending
proposals and for other similar arrangements.
7. Appropriate use of models
Internal credit assessment is carried out through Score Card, SMART or
RAM. All proposals eligible for rating under SMART or any of the Score Cards

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 as per guidelines shall be rated in SMART / respective Score Card model. All
other proposals are required to be rated in RAM. The guidelines for selection
of the appropriate rating model viz. RAM/ SMART / Score Card is furnished in
Annexure II.
8. Model Development and implementation
Models may be developed in-house or through external agencies. The
model can be built based on expert judgment or statistical models or it can be
a hybrid model.
The following key points should be considered during development and
implementation of models internally:
 The intended portfolio/ segment / borrower profile for which the model
is being built should be clearly defined.
 Back testing shall be carried out using statistical tools as approved by
ERMC for internal validation.
 The procedure for selection of risk parameter in the model should be
clearly documented.
 The calibration to grade the borrowers in several rating classes and
assign PD to each of the grades should be clearly defined. In case of
model using ‘Go / No Go’ criteria only i.e. without PD is proposed, it may
be ensured that separate suitable model is available for annual re-rating
which captures associated PD for such ratings.
 The following shall be properly documented viz:
o Need for the new/modification in existing model [e.g. why existing
models do not meet the present requirement etc.];
o Purpose of the model [in terms of scheme, exposure, target
customer etc. as applicable];
o Rationale for key parameters and assumptions behind the model;
o Back testing and its adequacy;
o Users of the model i.e.BO / ELSC/ HO verticals etc.;
o Process flow i.e. rating validation by BO or RiMV, etc.;
o If override available, the user level for such override access;
o Whether the model would be applicable for credit decision and
pricing and if so, the investment grade and mapping for interest
rate.
 Implementation of the model with review of the business requirements,
functional requirement specifications and software requirements
through DIV support.

9. Qualitative Validation & Quantitative Validation

9.1. Qualitative Validation

Qualitative validation refers to a broad-ranging assessment of various
model dimensions and is designed to evaluate and certify that a model has
been built properly, is adequately embedded in the business processes,

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contains adequate controls and governance oversight, and is sufficiently
documented. Qualitative validation is a core requirement in periodic
validation. Qualitative validation is performed to check the applicability and
diligence of the quantitative methods. A careful review of all the assumptions,
methodologies and documentation is performed at this stage. If the model is
developed under wrong or invalid assumptions according to qualitative
validation, the same shall not be acceptable even if having positive
assessments in quantitative validation.

Qualitative validation involves testing the model usage environment for

factors such as model design objectives, biases in model performance, data
quality, governance failures. Fundamentals of Qualitative validation include
questioning the model for objective outcomes including:

o Model design objectives - Determination of model objectives being

achieved through the validation exercise along with completeness
of the model schema
o Model parameters – Determination of the need for selected model
parameters, their reasonableness and exhaustiveness.
o Output validation – Determination of the adequacy of model
outputs in decision making, risk categories and action points
defined for each category.
o Data quality – Determination of whether the data available for risk
modelling is adequate to provide accurate results, data quality
and consistency as well as exceptions.
o Governance failures – Determination of past outcomes where
controls in place proved insufficient to avoid or mitigate credit risk.

9.2. Quantitative validation

Quantitative Validation includes employing statistical methods to test
the model performance. The validation process can test each individual model
factor to identify biases, concentrations or skewness; pinpoint components
that contribute little to no information to the model; test effectiveness in
ranking against benchmark; identify redundancies and unacceptable factor
correlations; etc. and measure the ability to discriminate between good and
bad obligors.

Quantitative validation involves a number of defined statistical tests and

evaluative measures that are used to assess the power of the models to
consistently predict risks of a borrower at timeline of a loan lifecycle.

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10. Frequency of validation
The frequency of validation based on the phase of the model shall be as
follows:
#
Model Phase Internal Validation frequency
Back-testing to be carried before roll-out for models developed in house
Before launch
with available data.

The first validation exercise shall be carried out after at least 1 year from
Pilot phase date of launching based on usage of the model.

Existing models Once in two years

# For statistical feasibility, the sample set should contain at least 30 ratings.
Accordingly, models with usage of at least 30 ratings during the year shall be considered for
internal validation as per frequency indicated above.

Additionally, ERMC may recommend validation to be carried in view of

changes in policy by regulatory bodies, Government guidelines, Global, geo-
political and macroeconomic changes affecting the industry, etc. Further,
ERMC may also recommend validation of models within one year and after six
months of roll-out of models in pilot phase depending on usage of the model.

11. Mode of validation

Mode of validation may be internal or external depending on the model
usage. While Internal validation is quicker to carry out and cost effective,
external validation provides an unbiased view and expert judgement.
However, keeping in view the expertise required for qualitative validation, the
internal validation shall comprise of quantitative validation of the rating
models for the time being.

External validation may be carried out in any of the following scenarios:

 Direct Finance:
i. All models developed internally, within 3 years from launch of
the model except where the model has not been frequently
used and does not have adequate usage [say, less than 250
instances (aggregate) in the past 3 years] rated through the
model.
ii. The exposure under the model has increased by 25% during
the previous year provided two years has lapsed since

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 implementation of model enhancements / modification
recommended in the previous external validation.
iii. NPA of the exposure under the model is more than 5% and has
shown an increasing trend of 5% or more provided three years
has elapsed since implementation of model enhancements /
modification recommended in the previous external validation.
iv. 5 years have elapsed since the last external validation i.r.o
models having not less than 20% of the exposure under Direct
Finance.

 Institutional Finance:
For low-default portfolios, where the reliance on the statistical testing of
quantitative validation may be less robust, qualitative validation takes
on even more significance and emphasis. As internal validation
presently covers only quantitative validation and in view of the exposure
under Institutional Finance, external validation may be carried out at
least once in 5 years.

12. Internal validation by officers of RiMV

The model inventory shall be updated annually. Based on the review of
the model inventory, RiMV shall identify the rating models to be taken up for
validation [internal or external validation] during the year. Further, retirement
/ discontinuance of models which are not in use / not relevant may also be
considered based on the review. However, in view of the requirement of
carrying annual re-rating, such models may be allowed to continue for the
purpose of annual re-rating till required.

Internal validation shall be carried out by officers of RiMV to the extent

possible. GM / DGM RiMV shall constitute a team consisting of at least two
officers of which one officer shall not be below the rank of AGM for the purpose.
The team shall submit the validation report to GM / CGM RiMV for submission
to ERMC.

The validation exercise shall be carried out as per operational guidelines

approved by ERMC for the purpose.

13. External validation by Consultants

Validation by external Consultant shall be carried out wherever
applicable. Such validation shall include Quantitative as well as Qualitative
validation. Scope of work for external validation shall be covered in guidelines
for external validation approved by ERMC.
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14. Outcome of the validation exercise
On completion of the validation exercise, the internal validation team
shall submit a report to the RiMV. Outcomes of the validation must contain
suitable recommendations based on objective observations. The report shall,
inter alia, contain the following: Results of the internal validation viz. inference
as per the template.

Recommendation for external validation based on results of the internal

validation as above RiMV shall initiate action based on the report including,
submission to ERMC with its recommendation for acceptance, engagement of
consultant for external validation, etc. as applicable.

Where external validation is carried out, RiMV shall examine the external
validation report and submit to ERMC for its approval.

15. Validity of the Policy

This document would come into effect from such date and year as
approved by the Board and would remain in force until the next review or till
such time as stipulated by the Board.

16. Policy Custodian

The Head of the RiMV will be the custodian of the Policy. In case any
external agencies like consultants, auditors, inspection teams from RBI, etc.
need to refer to the Model Validation Policy, the consent of the Policy custodian
will need to be obtained.

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 Annexure I

Model Inventory

Instan
ces of Model
S. Model Purpose Model Developme Developmen Model Storage
Model Name Use Versi
No of use Version date nt year t Type Type location
in CY on
22

A. Direct Retail Credit

Green Field Green Field Score

1 45 3 27/01/2020 2019 Internal SMART
Score Card entities Card
Quick evaluation
of machinery
Speed Score Score
2 finance proposal 1828 3 07/12/2021 2019 Internal SMART
Card Card
based on cash
collateral
Secured
Evaluation of
3 Business 37 1 07/10/2015 2015 External RAM RAM
SBL
Loan (SBL)

Evaluation of
5 Asset Light Companies with 0 1 07/10/2015 2015 External RAM RAM
minimal assets
Commercial
6 Real Estate CRE proposals 0 1 07/10/2015 2015 External RAM RAM
Developer
CF based
Contractual
7 contractual 0 1 07/10/2015 2015 External RAM RAM
Cash Flow
evaluation
SMART Till SMAR
8 SMART (<25 L) 6 5 15/01/2021 2014 Internal SMART
25 T

SMART
SMART (25 - 300 SMAR
9 Above 25 to 415 5 15/01/2021 2014 External SMART
L) T
300

Small and
Medium Evaluation of
10 1898 3 04/08/2017 2005 External RAM RAM
Enterprises SME companies
(SME)
Small and
Medium
Evaluation of
Enterprises
11 SME Services 103 3 04/08/2017 2005 External RAM RAM
Services
companies
(SME
Services)
Evaluation of
Large - SME
12 Large Ltd. 359 3 04/08/2017 2005 External RAM RAM
(LSME)
companies

B. Corporate / Refinance Model

Large
Evaluation of
13 Corporate 7 2 09/11/2018 2005 External RAM RAM
LCM
Model

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Model Validation Policy-Version 3.0
 Instan
ces of Model
S. Model Purpose Model Developme Developmen Model Storage
Model Name Use Versi
No of use Version date nt year t Type Type location
in CY on
22

A. Direct Retail Credit

Evaluation of
14 Bank 20 2 27/04/2022 2005 External RAM RAM
Banks
Non-Banking
Financial
15 RAM NBFC 23 3 15/07/2022 2005 External RAM RAM
Companies
model
Micro Finance
16 RAM MFI institutions 11 2 19/05/2022 2015 External RAM RAM
lending model
State Financial
Corporations &
17 SFC State Industrial 0 1 2005 2005 External RAM RAM
Development
Corporations
List of rating models discontinued in FY 22. Models can be re-introduced as and when required with approval and external
validation.
Priority Loans to Score Excel score
1 PRISM 0 1 14/02/2020 2020 Internal
Informal Sector Card card
Retail Loan
Quick evaluation Score Excel score
2 Scheme 0 2 12/12/2019 2019 Internal
of retail entities Card card
Score Card
Quick evaluation
Flipkart Score Excel score
3 of retail entities - 0 1 2018 2018 Internal
Score Card Card card
Flipkart scheme
Commercial
4 Real Estate CRE proposals 0 1 07/10/2015 2015 External RAM RAM
Contractor
Infrastructure
Infrastructur
5 development 0 1 2005 2005 External RAM RAM
e – Port
projects/ SPV
Infrastructure
Infrastructur
6 development 0 1 2005 2005 External RAM RAM
e – Power
projects/ SPV
Infrastructure
Infrastructur
7 development 0 1 2005 2005 External RAM RAM
e – Road
projects/ SPV
Infrastructure
Infrastructur
8 development 0 1 2005 2005 External RAM RAM
e – Telecom
projects/ SPV
RFS limit with
9 RFS-Model 0 1 2005 2005 External RAM RAM
security
RFS- Clean RFS limit without
10 0 1 2005 2005 External RAM RAM
limit security
List of rating models discontinued in FY 23. Models can be re-introduced as and when required with approval and external
validation.
Non-Banking
NBFC Score Financial Score Excel score
11 0 3 31/05/2021 2019 Internal
Card Companies Card card
model
Micro Finance
MFI Score Score Excel score
12 institutions 0 3 09/09/2021 2019 Internal
Card Card card
lending model

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