Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

The Formula That Killed Wall Street is Alive and Well

The Gaussian Copula which used to be the standard model for valuing CDOs has been described as the The Formula That Killed Wall Street. After the crisis, several alternatives to the Gaussian copula have become popular for CDO valuation.

But there are many other areas where Gaussian copulas still hold sway. Last month, the Basle Committee on Banking Supervision published Operational Risk Supervisory Guidelines for the Advanced Measurement Approaches. The paper notes that the most common method of dealing with dependence in modelling operational risk is by use of copulas; and “Of the banks using Copulas, most (83%) use a Gaussian copula.” In addition about 17% of banks, used a correlation matrix which is even worse than a Gaussian copula.

Faced with this clearly unsatisfactory situation, the BCBS pushes back against this in the mildest possible way:

Assumptions regarding dependence should be conservative given the uncertainties surrounding dependence modelling for operational risk. Consequently, the dependence structures considered should not be limited to those based on Normal or Normal-like (eg T- Student distributions with many degrees of freedom) distributions, as normality may underestimate the amount of dependence between tail events. (para 229)

Not only is the Gaussian copula alive and well, the regulators do not seem to feel any sense of urgency in changing this state of affairs.

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