There is a confusion in this area of modeling between risk (which is as you say defined as volatility) and ignorance which is incapable of being modeled (by definition). It is the same distinction between “known unknowns” and “unknown unknowns” to quote the philosopher Rumsfield. LTCM was brought down by the UUs, but at the same time they profited greatly using the risk models.

So while risk models are here to stay, my view is that there is a lot more room for wisdom in their application.

The financial crisis appears, based on published reports, to have deeper roots than risk models (though the use of the models also appears to play a role, as Greenspan asserts) as some of the ratings firms apparently issued ratings on products with no understandings of the products, much less the risks or unknown unknowns.

Along these lines improving rgulation of the ratings agencies would seem to be as important as improving regulation of banks.

I’m still curious about your take on a point I made in commenting on a recent post of yours on this topic. The models all use “risk” measures which actually measure market volatility (and the volatility is from ordinary markets, not those in a crisis). The problem with using volatility as a proxy for risk is that it isn’t really the same as risk, especially the risk inherent in crisis. The models are all sophisticated scaffolds atop a fundamentally flawed foundational assumption.

I’d also like to see more commentators focus on the massive hubris underlying the models. A little humility would have gone a long way.

[More on the volatility is not the same as risk -- volatility (as used in the models) is a measure which depends the knowledge of market participants. Actual risk, in the sense of crisis level risk, is always beyond the knowledge of market participants.]