- going financial crisis ” bis central bankers ’ speeches crisis. further, the regulatory gaps which led to proliferation of shadow banking entities have also been significantly instrumental in exacerbating the crisis. there were lapses in the supervisory framework also. in the run - up to the crisis, it was observed that the supervisors were staying on the sidelines and not intruding sufficiently into the affairs of participants. they were not being proactive in dealing with the emerging risks and in adapting to changing environment. there was a lack of capacity to identify, or to act on identification. for example, supervisors could not see the risks building up when banks started dealing in very complex products or when banks started relying excessively on short term funding sources for their operations. supervision was not comprehensive and even when supervisors found some anomaly, it was not taken to conclusion. b. market governance failure : the prevailing dogma prior to the crisis was that markets were always right and will find their own balance, left to themselves. there was unflinching faith in the invisible hand of markets, despite the well known fat tails in statistical distributions representing herd behaviour of markets signifying irrationality driven by excessive optimism or pessimism. however, the crisis established that markets are indeed fallible. as observed by joseph e. stiglitz, a nobel laureate in economics, when information is imperfect, markets do not often work well and information imperfections are central in finance. c. stakeholder governance failure : the crisis has also highlighted the failure on the part of various stakeholders who did not have active involvement in corporate governance. d. internal governance failure : it is observed that the lapses in internal systems and controls such as board oversight, managerial competence, compensation policies, audit etc. were instrumental in exacerbating the crisis let me now briefly touch upon some of the specific internal governance failures in the financial institutions that have contributed to and / or exacerbated the crisis. a. complex and opaque organizational structures : there was a massive growth in the complexity of organizational structures in the pre - crisis period, with a view to taking advantage of regulatory arbitrage and also of gaps in regulations. regulators found it difficult to look through the structures and enforce regulation. many times, such complex structures fell in the gaps between regulatory jurisdictions and escaped regulations. b. inadequate oversight by board : boards were found to be not actively involved in formulating risk appetite framework of firms. incomplete risk information due to gaps in mis coupled with inadequate

understanding of risk due to the lack of expertise among the directors, hampered effective and timely decision making. improper pricing of risk led to suboptimal allocation of capital and inadequate preparation for the tail events eventually leading to the precipitation of the crisis. c. weaknesses in the senior management : senior management failed to adopt and integrate necessary systems to identify, manage and report risk. the misalignment of incentives also resulted in the management pursuing objectives which, at times, were at cross purposes to those of the firm. d. proliferation of complex products : there was a significant spurt in the complexity of financial products in the run - up to the crisis. abundance of cheap liquidity prodded the participants to innovate ways to deploy the funds and earn a return. complexity and opacity led to inadequate understanding and mispricing of risk. the long chain of transactions also obfuscated the true risks inherent in the transactions and led to a false sense of comfort. e. flawed remuneration policies : compensation structures which focussed excessively on short term performance incentivised managers to take excessive risks in order to bis central bankers ’ speeches meet the short term objectives at the expense of long term sustainability of the firm. further, the framework where the participants get to keep the gains while the losses are assured to be borne by the society ( either explicitly by the government guarantee or implicitly due to the inevitable governments ’ intervention to bail out due to systemic concerns ), was an incentive for participants to take - up risky activities. equity incentives, put in place with the objective to align managers ’ incentives with those of shareholders, may also have induced managers to take excessive risks. f. weak risk management systems and internal controls : with significant developments in technology, risk management in the run up to the crisis became highly quantitative on the lines of an exact science. models proliferated with a false assurance to capture and measure every kind of risk. it is said that economists suffered from a syndrome of physics envy. the models tried to anticipate the future based on assumptions of normality and on the basis of past data. in their exuberance, quants, however, forgot that the assumption of normality does not correspond to reality, particularly, in highly stressed situations. for example, the probability of a 5 - sigma loss on any given day would mean that such an occurrence should happen once in about 14, 000 years ( assuming 250 trading days in a year ) that is much longer