Banks may choose any risk management model commensurate with its risk appetite. But the model chosen should ensure safety and soundness of the bank's financial position. Model Risk is the risk that theoretical models used in pricing, trading, hedging and estimating risk will turn out to produce misleading results. The effect of model risk on the financial performance of the bank can be significant. The loss arising out of the model inaccuracy and consequent model risk can be mitigated if the banks observe certain fundamental principles while making use of the model.

Risk Models have assumed importance in the area of Risk Management because they provide the decision-maker with insight or knowledge that would not otherwise be readily available. They are intended to aid banks in quantifying, aggregating and managing risk across geographical and product lines. The outputs of these models also play an increasingly important role in banks' risk management and performance measurement process, customer profitability analysis and capital structure decisions.

Risk modeling, thanks to Basel Committee, is entering into an era where scientific techniques well established in medical statistics can be used to quantify the Risk with much more sophistication than ever before. This increases the dependence of the bank on the model while making a capital structure decision.

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