The credit crisis would not have been as bad if investment banks' risk management systems worked well. But the systems rely on sophisticated mathematical models that have a fundamental flaw: they grossly underestimate a factor called "tail risk." This problem can be solved fairly easily.
In a way, this is a highly technical dispute about the arcane details of the calculation of Value at Risk, the prime measure of the riskiness of trading books. To nonmathematicians, the possible answers sound daunting: Gaussian, Cauchy and Pareto-Levy. But the underlying question is straightforward: how often and how badly do markets blow up?
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