So one of the secrets to making this new supervisory approach a success will be the accumulated experience of supervisory staff. That means having staff with a nose for a crisis (like a hedgehog) as well as ears and eyes (like a fox). Therein lies a dilemma. Galbraith observed that: “There can be few fields of human endeavour in which history counts for so little as in the world of finance.” 23 A full crisis cycle might last 20–30 years. A systemic crisis might only occur once or twice a century. Among  22  A number of authors have proposed basing contractual triggers in banks’ debt instruments on market-based measures of capital adequacy (Calomiris and Herring (2011), Flannery (2010)). 23  Galbraith (2008). 16  BIS central bankers’ speeches  risk managers, typical levels of experience are significantly less than a full crisis cycle. The same is true among bank supervisors. Historically, financial supervision has been long foxes and short hedgehogs. Ever-expanding numbers of regulators will not solve this problem – if anything, that may cause average levels of experience to fall, not rise. Nor will ever-expanding amounts of regulatory reporting – if anything, that breeds more complexity, not less. A strong case can be made for a reversal of the historical trajectory in which “more is more”. This strategy has comprehensively, and repeatedly, failed the crisis test. This calls for a different supervisory direction of travel.
Financial intermediaries are provided with sufficient incentives to improve their risk-management techniques. Therefore, the financial system is better able to absorb shocks without increasing the effects of such shocks on the economy. Broadly speaking, this seems correct to me. The financial system has coped with remarkable success and with few signs of instability with the various episodes of financial turmoil and shocks in recent years. Market-functioning difficulties were short-lived. The impact of these episodes on the real economies of industrialised countries was generally limited. However, we want to make sure that financial institutions and markets help to absorb and redistribute the shocks occurring in the real economy. We don't want them, in general, to be an additional source of shocks. In this regard, two specific questions come to the mind of policy makers. The first relates very simply to our ability to understand what is going on in the financial system when innovations permanently introduce additional layers of sophistication and complexity. As is often the case with  BIS Review 64/2006  3  financial innovations, evaluating the risk they entail requires the use of complex techniques that are not always sufficiently tried and tested 6 .The second issue, singled out by Rajan himself, is about incentives, an issue made especially important by the shift from depository intermediation to professional asset management. The system of incentives under which managers operate should be closely and permanently aligned with the interests of investors.