Last week I was at a conference in Zurich, Switzerland, site of the HQs of all those Swiss banks. At Einstein's alma mater, the Swiss Federal University of Technology (ETH) there is a mathematics professor named Paul Embrechts whom I like to think of as being the actual Gnome of Zurich. About a decade ago he succeeded in convincing the leading Swiss banks to use the mathematical entity known as a copula as the basis for measuring risk. They did so, and from them it spread to become the most widely used method in the financial world, displacing the Black-Scholes formula, although one is hard pressed to find a definition of it in any financial economics textbooks. I will say that it is based on a stationary distribution that attempts to take into account more fully covariances among events. It also has the advantage of actually admitting that there are lots more extreme events than does the Gaussian normal that underlies Black-Scholes, which after the 1987 crash most of the practitioners knew was garbage. So, it admits the stylized fact that all asset markets exhibit "fat tails" or kurtosis, those more frequent extreme events.
However, it turns out that the copulas have not proved sufficient to deal with the events of the last year, with most funds and banks and whatnot still getting into trouble. One of the conference participants was an econophysicist colleague of Embrechts, Didier Sornette, who runs an "Observatory of Financial Crises." While he has made some not so accurate public forecasts himself (see my "Econophysics and Economic Complexity," available at http://cob.jmu.edu/rosserjb), Sornette described the problem with the copulas: they do not take into account how herding can happen. So, they can give the right probability that a 10% decline in a market can happen in one day, but will understate the probability that this might happen for three days in a row. This would suggest that Nassim Taleb with his black swans might be right, although anybody trying to follow his "barbell strategy" to make money on really big crashes would probably have lost money over most of the last several years, despite the big crashes that have been going on over the past year.