Regulatory Capital and Internal Capital Targets: An Examination of the Australian Banking Industry☆

Abstract In this study, we examine the capital management of Australian banks before the introduction of the capital conservation and countercyclical capital buffers of Basel III. We find evidence of a negative relationship between the internally targeted capital buffers of banks and the current state of the economic cycle. This finding supports the view that the capital conservation and countercyclical capital buffers under Basel III 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 capital management: Banks set higher target capital buffers when the economic outlook improves and the loan demand increases. We find unambiguous evidence that banks adjust their actual capital buffers to align them with their pre-defined target capital buffers.