. the risk identified in the fsr is that market forces could compel banks to maintain higher capital ratios than necessary to guard against the possibility of worse economic outcome. this could lead banks to slow balance sheet growth, which would tighten lending conditions for both households and businesses and weaken the economy. ultimately, the financial institutions themselves would suffer from this self - fulfilling prophecy. given these concerns, the superintendent of financial institutions last month took the welcome step of giving canadian banks more flexibility by allowing them to raise the proportion of preferred shares that comprise their tier 1 capital from 30 per cent to 40 per cent. the lower absolute leverage of canadian institutions and the higher quality of their tier 1 capital should mean that they can expand lending faster than their international peers. the value of this virtually unique advantage of our economy should not be underestimated. the bank is working with its international counterparts to examine how the current regulatory capital framework may amplify fluctuations in economic and financial conditions. 7 under current rules, capital requirements are linked to the credit risk in an institution's portfolio. in an upturn, risk goes down, banks are required to hold less capital, and the growth of credit increases. the problem is that this can amplify swings in financial conditions and lead to the emergence of financial imbalances. recall the link between credit growth and future financial stress that i just mentioned. then, during the downturn when credit risk increases, banks are required to increase capital holdings, thus exacerbating the economic weakness and financial stress. this is the motivation for proposals to have capital requirements move procyclically. banks could be required to build up capital buffers during times of rapid credit expansion. this would strengthen their balance sheets and reduce the risk that financial imbalances will develop from overly easy financial conditions. during a downturn, banks could then draw down these buffers, which would reduce the need to liquidate assets or restrict loan growth at a time when credit conditions and asset prices are already under stress. in this way, capital requirements would moderate the ups and downs of the credit cycle – the reverse of what currently happens – reducing the risk of a future crisis. this macroprudential approach to capital requirements is tremendously important, but it is also complex, with a number of practical and logistical concerns. such a system could be accomplished by linking capital requirements to movements in credit - cycle indicators, such as loan growth and asset prices. for example, our research on the determinants

affects external competitiveness through appreciation of the real exchange rate. finally, as inflation rises beyond a threshold, it has an adverse impact on overall growth. the reserve bank ’ s technical assessment suggests that the threshold level of inflation for india is in the range of 4 to 6 per cent. if inflation persists beyond this level, it could lower economic growth over the medium - term. bis central bankers ’ speeches causes of recent inflation spike let me first identify the high inflation period. the wpi inflation rate accelerated from 7. 1 per cent in december 2009 to a peak of 10. 9 per cent by april 2010, thereafter it remained stubbornly close to double digits till november 2011. thus, we experienced two years of high inflation between january 2010 to december 2011. during this two - year period, wpi inflation averaged 9. 5 per cent per annum. all the major components of inflation contributed to this surge. the trigger for inflation first emanated from the failure of south - west monsoon of 2009, following which food prices rose sharply. concurrently, the global economy made a sharp recovery from the recession of 2009. as a result, global commodity prices including oil rose substantially. india being a net commodity importer, particularly oil, the intermediate prices rose. this quickly spilled over to non - food manufactured products inflation, making the inflation process fairly generalised. in the subsequent one year between january 2012 to december 2012 the average wpi inflation moderated to 7. 5 per cent led by all its major components except fuel and power ( chart 1 ). the high inflation during 2010 and 2011 was a combination of both adverse global and domestic factors as well as supply and demand factors. first, crude oil and other global commodity price trends as well as exchange rate movements are increasingly playing an important role in defining domestic prices. with the gradual external liberalization, the indian economy is much more open and globalised now than ever before. currently, over 85 per cent of demand for crude oil in india is met by imports. the imported indian basket of crude oil price rose from us $ 49 per barrel in april 2009 to an average of us $ 79 per barrel in 2010 and further to us $ 108 per barrel in 2011 and remained high at us $ 110 per barrel in 2012. global metal prices, reflected in the imf index, rose by 48 per cent in 2010 and again by 14 per cent in 2011 before moderating by 17 per cent in 2012. moreover, the rupee depreciated from an