We see this in the speed and complexity of capital flows, we see it in the complexity of many classes of financial instruments (some of which contain significant embedded leverage), and we see it in the extraordinary complexity faced by individual financial institutions in their day-to-day risk management activities and in their policies and practices related to valuation and price verification for some classes of financial instruments. Needless to say, the complexity factor is an issue as it pertains to the capacity of the international community of supervisors and regulators to discharge their responsibilities.

The key issue here is not complexity per se but rather the extent to which complexity feeds on itself thereby helping to create or magnify contagion risk “hot spots” that may have systematic implications. Thus, we are faced with the pressing need to find better ways to manage and mitigate the risk associated with complexity, a subject that will continue to challenge the best and the brightest among us.

(Ahem. I seem to recall regulators, policymakers and financial industry executives claiming for years that "the best and the brightest" on Wall Street knew just what they were doing. Was that a lie? Or was it simply another layer of incoherence and incompetence?)

Fourth: reflecting in part the forces described above, the current crisis has witnessed patterns of contagion the speed and reach of which are different in degree, if not kind, from that which we have witnessed in earlier periods of financial instability. The list is long: asset-backed commercial paper, conduits, structured investment vehicles (SIVs), collateralized debt obligations (CDOs), quantitative funds, auction rate securities, monolines, and hedge funds. To a considerable extent, the “hot spots” where contagion forces have emerged share at least three common denominators: (1) the contraction in market liquidity, which has been largely driven by a huge shift from risk taking to risk aversion, was itself driven by the fear of the unknown and a limited ability to anticipate with confidence the sensitivity to loss in many financial instruments; (2) greater leverage in balance sheet terms and in the use of off-balance sheet vehicles and the presence of embedded leverage in certain classes of financial instruments; and (3) risk mitigation cushions which were either too thin or were at least partially neutralized by basis risk developments.

(Weren't most, if not all, of these shortcomings known in advance? If so, why didn't anybody do something about it before the bubble burst? If not, what the heck were these "senior executives" and "risk managers" doing while leverage was increasing and "risk mitigation cushions" were being compressed? Counting bonuses?)

Fifth: it is likely that flaws in the design and workings of the systems of incentives within the financial sector have inadvertently produced patterns of behavior and allocations of resources that are not always consistent with the basic goal of financial stability. Often, when the issue of incentives is discussed, the focus is on compensation and, especially, executive compensation. Consistent with the priorities of this Report noted earlier, the Policy Group has chosen not go into the subject of executive compensation in any detail. Having said that, the Policy Group recognizes that more can be done to ensure that incentives associated with compensation are better aligned with risk taking and risk tolerance across broad classes of senior and executive management. Accordingly, and respecting the role and responsibilities of the board of directors in matters relating to executive compensation, the Policy Group believes that compensation practices as they apply to senior and executive management should be (1) based heavily on the performance of the firm as a whole and (2) heavily stock-based with such stockbased compensation vesting over an extended period of time. The long vesting period is particularly important for high risk, high volatility lines of business where short run surges in revenues and profits can be offset if not reversed in the longer term. In broad terms, the Policy Group recognizes that this philosophy of compensation is hardly new, but its importance looms especially large given the events of the past twelve months.

While the linkage between incentives and compensation is obvious for large integrated financial intermediaries, the incentive question has much broader – and no less important – implications. For example, the framework of incentives at the level of individual firms should help to balance business imperatives by ensuring that the resource base and the recognition/reward system for the support and control functions are such that critical tasks, such as risk monitoring and price verification, are performed in a manner that protects the financial integrity and professional reputation of the institution.

(Go on. Admit it. Stop with the euphemistic talk already. When you say "incentives," you actually mean pure, unbridled greed. Otherwise, my question is: What are the incentives that led to the writing of this report? Might the letters "CYA" have something to do with it?)

There's much more, but I have a headache.