One of the most striking aspects of the final report from the Australian Financial System Inquiry (AFSI), chaired by David Murray, is the proposal that the future capital requirements for Australian banks should be linked to international developments rather than domestic circumstances.

Specifically, the Murray Report says that the capital position of Australian banks needs to be unquestionably strong so that they can deal with potential future crises. In practical terms, this means they should be in the top quartile of international banks when it comes to capital levels. 

The initial response to the Murray Report has focused on the practical implications for Australian banks if they have to increase their capital levels (particularly equity capital). Their funding costs will rise which will mean either increased borrowing rates and/or lower bank profits.

But perhaps more attention should be given to the appropriateness of having a 'relative requirement' for the amount of capital Australian banks should hold. There are practical and logical problems in linking the capital position of Australian banks to that of the top quartile of international banks.

One practical problem recognised in the AFSI report is the difficulty of comparing bank capital positions across jurisdictions. As the report notes, 'no benchmark of international practice exists for comparing capital ratios'. Why? Because while there is an international minimum for bank capital (the Basel capital framework), all countries adjust the minimum requirement to meet their own circumstances.

For example, the Australian Prudential and Regulation Authority (APRA) has adjusted Australian bank capital requirements, based on the Basel capital framework, to meet domestic needs. This means that in some areas, the capital requirements on Australian banks are more stringent than those applied to overseas banks, while in other areas they are less so.

While the AFSI says that it 'has not sought to determine the exact capital position of Australian banks on a consistent basis compared with banks in other countries', it also says that it is in Australia's interest for such comparisons to be made, and it recommends that APRA should develop a common reporting framework for the purpose. Yet despite not making formal comparisons of its own, AFSI still concludes that Australian bank capital ratios are not in the top quartile of international banks.

The major Australian banks dispute the AFSI's conclusion. The Inquiry's report notes that the Australian Bankers Association's argument that that the major Australian banks are at or above the 75th percentile of their identified international peers in terms of capital levels.

There is a three-month consultation period on the AFSI report before the Government releases its response. The nature of the report and the reaction of the banks suggests that the key issue in the consultation period may be the technicalities of comparing the capital position of the major Australian banks with their international peers.

But are international comparisons the right focus of debate, particularly since the AFSI itself notes that APRA's argument that 'it is not practical to compute such comparisons'? It would be more appropriate if the focus of the discussions on the AFSI report were on the most appropriate capital levels for Australian banks given domestic circumstances, rather than arguing the relative merits of international comparisons.

Another practical problem of having a relative measure for the capital position of Australian banks is that it is a moving target. Stephen King from Monash University raises the prospect of what Australia would do if international banks let their standards slip so that their capital holdings fell. Would APRA reduce the capital requirement for Australian banks?

At present, however, the reverse appears to be the case. International banks are increasing their capital position as they progressively implement the Basel requirements. The concern has been raised that by adopting an international 'top quartile' benchmark for capital, Australian banks will be involved in an ongoing global race to increase their capital. 

While there may be good reasons for our banks to increase their capital levels given that Australia is a commodity dependent, capital importing country with a concentrated banking system that has a similar risk profile based on housing assets, the case should be based on Australia's domestic needs rather than on comparisons with international banks.  Australia needs absolute and not relative capital standards for its major banks.

Photo courtesy of Flickr user Nicki Mannix.