Mumbai: A Reserve Bank of India (RBI) panel on Monday suggested that banks maintain up to 2.5% of their assets as a capital buffer above the mandatory capital requirement of 9%. The extra capital can be used during financial difficulties, the panel said.

The final recommendations of the panel are essentially same as those in a draft report the group had put out on 2 December. The report is based on the Basel III international banking norms.

According to the Basel committee on risk supervisions, excessive credit growth builds up a system-wide risk and it had been observed that the credit-to-gross domestic product (GDP) ratio tends to rise during an economic boom and fall during a downturn.

The theoretical approach behind such a capital buffer had been that “banking sector profits are high in good times and lower during the times of stress". Banks should set aside more capital in the good times, goes the argument.

The RBI panel, headed by executive director B. Mahapatra, decided that for India, the benchmark will be the credit-to-GDP gap, which is the difference of the credit-to-GDP ratio and its long-term trend.

The panel said the counter-cyclical capital buffer (CCCB) should increase gradually from 0 to 2.5% of the risk weighted assets of the banks, progressively as the credit-to-GDP gap increases. A widening of the credit-to-GDP gap “indicates the build-up of excessive credit growth in an economy and system-wide risk as a precursor to the crisis".

When credit growth outpaces the GDP growth rate, it leads to overheating of the economy. To prevent the banking system from a crisis, a capital buffer needs to be maintained.

The Mahapatra committee recommended that for India, the buffer should increase in a non-linear fashion when the credit-to-GDP gap reaches 3-15%.

If the credit-to-GDP gap exceeds 15%, the buffer continues at 2.5% of banks’ risk-weighted assets. “If the credit-to-GDP gap is below 3 percentage points then there will not be any CCCB requirement," the guidelines said.

However, other factors such as level of gross bad debt should also be considered as a trigger for CCCB, the committee said.

Similarly, the supplementary indicators should include the incremental credit-deposit ratio, the industry outlook assessment index and the interest coverage ratio.

“In due course, indices like House Price Index/RESIDEX and Credit Condition Survey may also form a part of the supplementary indicators for CCCB decision," the committee recommended.

The buffer has to be maintained as equity capital, which constitutes a bank’s core capital.