AML/CTF Model Validation
Model validation within AML/CTF should answer if models have the right design for their purpose, methodological approach, and risk coverage. Model validation is a critical key to ensuring that the models used to identify suspicious financial activity are effective, reliable, and compliant with applicable regulations.
Banks and other financial institutions are dedicating more resources to AML/CTF and various action programs than ever before. Efficiency and model validation are therefore highly relevant issues.
The concept of a “model” is very broad. The model creates a framework that financial institutions should follow to ensure regular monitoring of models and systems used for decision-making. Systems used for AML/FCP, particularly for customer risk classification, transaction monitoring, and sanctions screening, will for several reasons need to be assessed more carefully in the future to ensure reliable results. This also means regular model validation as a standard process to ensure continuous improvements and a risk-based approach.
Model risk management often requires a more structured approach to assess all models within a bank, including models for AML and decisions on risk-reducing measures. However, it was only recently that AML models were clearly included in the framework for model risk management, and many banks still have work to do in this area.
The Right Approach – How model validation underpins effective AML processes
Every model involves simplifications of reality and thus a certain degree of uncertainty, the so-called model risk. Model validation is the tool for identifying, understanding, and reducing this risk, and is a clear regulatory requirement in Sweden and most other jurisdictions.
An effectively conducted model validation holds the entire AML/CTF process together from initial risk assessment to suspicious activity reporting and feedback. If the initial models are deficient, the quality of the entire chain suffers.
Moreover, model validation enables more effective interaction between key functions such as FCP/AFC, Compliance, and Risk Control. Many issues are common, especially concerning data quality, stability, and risk modeling, and a common validation framework provides both better governance and higher operational accuracy.
Essential for the Entire AML/CTF Effort
At the same time, substantial investments are being made in AML/CTF programs. Securing the return on these investments is critical to business and the way to do it is by validating that models work and contribute to the operational objective. New technologies such as AI and machine learning add further complexity and demand even higher requirements on the validation process.
Model validation within AML/CTF should answer the question of whether models have the right design for their purpose, methodological approach, and risk coverage. It should also ensure that they deliver outputs in the form of customer risk classes, transaction alerts, or behaviors as intended.
Model validation is a critical key to ensuring that the models used to identify suspicious financial activity are effective, reliable, and compliant with applicable regulations. It verifies that the right data is used, that suspicious behaviors are identified as intended, and that alerts are generated and handled correctly. It strengthens transparency, internal governance, and quality throughout the AML system.
The Value of AML/CTF Model Validation
Financial institutions are increasingly expected to demonstrate a holistic approach with a logical “red thread” through the overall business risk assessment, customer risk classification model, and individual KYC processes.
A common challenge in following up on AML work and model validation is ensuring consistency from risk assessment to Suspicious Activity Reporting/Suspicious Transaction Reporting and feedback. A deficient risk assessment leads to weaknesses throughout the chain, and the quality of the foundational work determines everything else.
Another commonly occurring challenge is the need to strengthen coordination between the FCP/AFC unit, Compliance, and Risk Control. Risk Control often has a tradition of validating models concerning capital adequacy, credit risks, and market risks, data quality, and model stability. Many issues are often common, and the units can also support each other with different competencies.
Supervisory authorities have pointed out several recurring deficiencies that validation helps to detect and address:
- No or insufficient review/adjustment of models
- Ineffective scenarios leading to incorrect resource allocation
- Lack of differentiation in monitoring based on customer risk
- Insufficient coverage of risks and products
- Weak linkage between risk assessment, scenarios, and classification
- Inadequate test environment and major deficiencies in documentation
- Insufficient management follow-up
Current Legal Requirements in the Nordics
The upcoming EU AML Regulation (AMLR), which will enter into force on July 10, 2027, will introduce more specific and binding requirements for model validation for all member states.
Sweden
The legal requirements for validation of models for combating money laundering and terrorist financing (AML models) are regulated in the Money Laundering Act and in the Swedish Financial Supervisory Authority’s regulations on measures against money laundering and terrorist financing (FFFS 2017:11). These require institutions to continuously ensure that the methods and models used to identify and manage risks are effective and adapted to the institution’s risk exposure.
Norway
There is currently no explicit legal requirement for model validation in Norway. However, the Money Laundering Act and the Money Laundering Regulations require reporting entities to have risk-based routines adapted to the nature and scope of the business—including when using automated systems and models for risk classification and transaction monitoring.
During supervision by the Financial Supervisory Authority of Norway, issues related to model design, risk coverage, data quality, and how results are used are often reviewed—even though the term model validation does not explicitly appear in the regulations. The authority expects models to be evaluated, documented, and adjusted based on how well they function in practice.
Finland
In Finland, the Financial Supervisory Authority (FIN-FSA) has recently introduced binding requirements for model validation within AML/CTF. According to regulations and guidelines 2/2023, which entered into force on June 26, 2023, supervised entities are required to carry out risk-based measures to prevent money laundering and terrorist financing. This includes ensuring that internal control systems and models for risk assessment and transaction monitoring are effective and appropriate. Model validation is now an explicit requirement in Finland.
Denmark
In Denmark, there is currently no explicit legal requirement for model validation within AML/CTF. However, the Anti-Money Laundering Act requires businesses to apply risk-based measures and ensure that their systems and methods are effective. In practice, the Danish Financial Supervisory Authority reviews model-related issues during supervision, even though the term model validation is not formally used.
What is the status of model validation in your organisation?
Regardless of whether you are about to validate a new model, streamline an existing process, or obtain an independent review – model validation is a key component.
Contact us to discuss how you can strengthen your AML/CTF work through structured model validation.
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