Regulatory capital and internal capital targets: An examination of the Australian banking industry

Using a unique but confidential database, this study examines the capital management practices of Australian banks under the Basel regulatory framework. We find evidence of a significantly negative relationship between the internally targeted capital buffers of banks and the state of the business cycle. This finding supports the view that the capital conservation buffer and countercyclical capital buffer under the Basel III rules are necessary reforms to address the tendency of banks to manage their capital buffers in a pro-cyclical fashion. However, we also find evidence of forward-looking behaviour by bank managers that is likely to dampen the impact of fluctuations in credit market conditions on their lending activities: Banks set higher capital targets when economic activity is gathering momentum and the demand for loanable funds is increasing