question : what are the potential challenges in implementing the countercyclical capital buffer? 51. as we noted earlier, a critical component of the basel iii package is a countercyclical capital buffer which mandates banks to build up a higher level of capital in good times that could be run down in times of economic contraction, consistent with safety and soundness considerations. this is conceptually neat, but is challenging in operational terms, as indeed evidenced by spain ’ s recent experience. the foremost challenge is identifying the inflexion point in an economic cycle which should trigger the release of the buffer. it is quite evident that both tightening too early or too late can be costly in macroeconomic terms. the identification of the inflexion point therefore needs to be based on objective and observable criteria. it also needs long series data on economic cycles. so, what we need is both a better database and more refined statistical skills in analyzing economic cycles. 52. the countercyclical capital buffer as prescribed in basel iii was initially based on the credit / gdp metric. is this a good economic indicator from the indian perspective? a study undertaken by the reserve bank shows that the credit to gdp ratio has not historically been a good indicator of build up of systemic risk in our banking system. 53. furthermore, some economic sectors such as real estate, housing, micro finance and consumer credit are relatively new in india, and banks have only recently begun financing them in a big way. the risk build up in such sectors cannot accurately be captured by the aggregate credit to gdp ratio. the reserve bank has so far calibrated countercyclical policies at the sectoral level, and i believe we need to continue to use that approach. the basel committee also has now recognized that no single variable can fully capture the dynamics of the economic cycle. appropriate calibration of the buffer requires country specific judgement backed by a broad range of other simple indicators used in financial stability assessments. 9th question : what are d - sibs? will any indian bank be classified as a d - sib? 54. the moral hazard relating to too - big - to - fail institutions which encourages risky behaviour by larger banks has been a huge issue on the post - crisis reform agenda. basel iii seeks to mitigate this externality by identifying global systemically important banks ( g - sibs ) and mandating them to maintain a higher level of capital dependent on their level of systemic bis central bankers ’ speeches importance. the

virtually every bank that came under stress in the depth of the crisis. 10. finally, basel ii was also seen to be guilty of focusing exclusively on individual financial institutions, ignoring the systemic risk arising from the interconnectedness across institutions which, as we now know with the benefit of hindsight, was the culprit for ferociously spreading the crisis across financial markets. 11. is all this criticism against basel ii valid? as i said before, only partly valid. note that basel ii, which became operational in june 2006, was still largely work in progress as the crisis began unfolding in august 2007. it is possible that the failure of the market risk framework underlying basel ii may have abetted the crisis, but to claim that the risk sensitivity of basel ii caused the crisis would be extreme. 2nd question : how is basel iii an improvement over basel ii? 12. basel iii represents an effort to fix the gaps and lacunae in basel ii that came to light during the crisis as also to reflect other lessons of the crisis. what is important though is that basel iii does not jettison basel ii ; on the contrary, it builds on the essence of basel ii – the link between the risk profiles and capital requirements of individual banks. in that sense, basel iii is not a negation, but an enhancement of basel ii. 13. the enhancements of basel iii over basel ii come primarily in four areas : ( i ) augmentation in the level and quality of capital ; ( ii ) introduction of liquidity standards ; ( iii ) modifications in provisioning norms ; and ( iv ) better and more comprehensive disclosures. let me discuss each of these briefly. higher capital requirement 14. as can be seen from the comparative data in table 1, basel iii requires higher and better quality capital. the minimum total capital remains unchanged at 8 per cent of risk weighted assets ( rwa ). however, basel iii introduces a capital conservation buffer of 2. 5 per cent of rwa over and above the minimum capital requirement, raising the total capital requirement to 10. 5 per cent against 8. 0 per cent under basel ii. this buffer is intended to ensure that banks are able to absorb losses without breaching the minimum capital requirement, and are able to carry on business even in a downturn without deleveraging. this buffer is not part of the regulatory minimum ; however, the level of the buffer will determine the dividend distributed to shareholders and the bonus paid to staff. 15.