The measurement of risks inherent in trading assets is prone to a significant “model risk”; the risk that the model used in risk measurement is itself inaccurate. The severity of model risk stems largely from the presence of “tail risks” in trading assets. These are risks that cause catastrophic losses but that materialize with a very low probability.
Moreover, tail risks are intertwined with the severe liquidity shortages that occur in systemic crises. Hence, almost by definition, tail risks are difficult to model and measure. The mandatory separation of the riskiest trading activities from deposit banking is a key step for limiting the impact of these risks. Robust capital requirements which do not heavily rely on models are another.