A widening gap was opening up between the requirements of Basel I and the way in which banks, particularly the large, internationally active banks, and some of their unregulated competitors, were thinking about risks. This placed banks at a competitive disadvantage vis-a-vis some of those unregulated competitors, and was leading to extensive capital arbitrage by banks. The sophisticated approaches under Basel II were devised as a solution to this problem. The underlying philosophy of Basel II was simple and sensible: (i)  Where possible, rely on the risk management practices of banks as the basis for setting more risk sensitive capital requirements. (ii)  Provide incentives to banks to continuously improve their risk management practices. As this idea began to take shape, and the Basel Committee began to fall in love with it, we persuaded ourselves that it would lead to a supervisory nirvana, at least for the well-managed institutions, with less work for supervisors and less supervisory intrusion for those deserving banks. But, idea and reality do not always coincide. So far, an immense amount of work has gone into development of Pillar 1 of the framework, which contains the nuts and bolts of Basel II’s risk sensitive capital requirements. The result is a far more complex system than we ever dreamed we would be putting in place. But in the end, we have met the objective of creating a more risk-sensitive supervisory system for measuring capital adequacy of banks, that is better aligned with the way in which banks manage their own risks.

The task set ahead for central banks in emerging markets, therefore, are many. First and foremost is to manage the challenge posed by the new globalization in the pursuit of price stability. Important in this context is the monetary policy framework that addresses the challenge to price stability while at the same time allows central banks to pay closer attention to financial stability. Next is the question on the role that central bank policies can play to support the economy’s transition from export-led growth to a more balanced growth. Such transition will require a redirection of economic incentives from exports to domestic consumption and investment. At a minimum, the transition will require a further strengthening of the economy’s financial system so as to ensure an efficient intermediation of resources into productive investments. Against this backdrop, I want to leave you with a few thoughts on the challenges to macroeconomic policy that will be important for emerging market central banks going forward. The first is monetary policy and the challenge is to have in place a monetary policy framework that can deal effectively with the threat to price stability and the need to oversee the risk of financial imbalance in this era of globalization. In the current crisis, it is clear that no particular monetary policy framework is superior in dealing with such a challenge. Nonetheless, experience of many inflation-targeting emerging economies in this crisis does demonstrate that price stability and financial stability can be preserved even in extreme financial circumstances under a flexible inflation-targeting regime.