, accumulates in balance sheets, masked in part by the favourable asset price developments. the trigger for a reversal is essentially unpredictable. it can originate either in the financial sphere ( eg, an asset price correction ) or in the real economy ( eg a spontaneous unwinding of an investment boom ). the process then moves into reverse. ex post, a financial cycle is evident. behind this recurrent pattern are serious difficulties in measuring underlying risk, and a structure of incentives that hinders an appropriate behavioural response to changes in risk, even when these are correctly identified. indicators of risk tend to be at their lowest at or close to the peak of the financial cycle, ie just at the point where, with hindsight, we can see that risk was greatest. asset prices are buoyant, credit spreads are narrow and loan loss provisions low. the tension between the micro - and macro - prudential perspectives is obvious both with respect to the measurement of risk and the behavioural response to it. as regards measurement, economic agents and markets appear reasonably good at assessing the relative risk of instruments, debtors and counterparties. they seem to find it considerably harder to evaluate the absolute, undiversifiable risk associated with the financial cycle. this requires a more sophisticated understanding of correlations and their evolution through time. in turn, a proper evaluation of the robustness of any historical relationship can only be based on some theory about the forces driving the economy and the interaction between the financial and real sectors. and such a theory would need to recognise the impact of the collective behaviour of institutions on financial distress. the contrast between this perspective and current methodologies for assessing market and credit risk is striking. typically, current approaches are based on some form of short - term extrapolation or, at best, time - invariant historical averages. consider, for instance, the mechanical inputs used in calculating var for market risk. at bottom, approaches to measuring credit risk are not very different. this view has important implications for how we think of risk evolving through time. the received wisdom is that risk increases in recessions and falls in booms. in contrast, it may be more helpful to think of risk as increasing during upswings, as financial imbalances build up, and materialising in recessions. the length of the horizon here is crucial. i will return to this point in a moment. as regards behavioural responses, incentive structures in financial markets can compound the problems arising from difficulties

be in such a select group. this implies that the competition and consolidation that has characterised the industry in the past decade still has some way to go. last, but certainly not least, a question hanging over the financial sector is the speed and scope of changes to be brought about by the internet revolution. certain financial activities are being transformed by the new technology quite quickly. this includes securities broking and foreign exchange. in other areas, ( traditional banking is one ), change is occurring more gradually. but this does not mean that its scope could not be significant. in adapting to the changes in the financial landscape, the objective of central banks and other regulatory authorities has been to allow the financial system to be responsive to the needs of the real economy, while preserving a level playing field among financial institutions, and making sure that intermediaries operate in a prudent way. this has required a change in the focus of regulation – away from prohibitions and administrative restraints on balance sheets, and towards prudential requirements that focus on the management of risk. away, that is from regulation, and towards supervision. this journey has been a lengthy one, and it is not yet complete. an early step was the original basel capital accord of 1988, with its focus on the concept of risk - based capital requirements. the latest is the revised accord, with its greater reliance on internal risk measurement, and its emphasis on two additional “ pillars ” for capital adequacy – supervisory review and market discipline. in between these landmark documents, there has been a vast array of official guidance on risk management practices. this is not the place to comment in detail on the latest proposals from the basel committee. but i think it is worthwhile to make two points of a more general nature. one concerns the “ style ” according to which individual institutions are supervised. and the other concerns the balance between the regulation of individual institutions and the goal of systemic stability. concerning the “ style ” of supervision, public authorities have become increasingly aware of the need to make regulation conform to market realities, rather than the other way round. going against the grain of market forces will create or entrench inefficiencies that reduce the capacity of the financial system to serve the needs of its users. it will also be ultimately fruitless, since the ingenuity of financial engineers to avoid burdensome restrictions will always run ahead of the capacity of regulators to close loopholes. the objective of modern prudential regulation is not to control