A primary concern was, and, is whether Basel II’s capital requirement is adequate. In a structural sense this concern has two parts: should Basel II maintain the 8 per cent capital ratio and are the new risk weights in Pillar 1 (subject to any action under Pillar 2) adequate? The historical record in developed economies over the last 30 years is that 90 per cent of failed institutions reported capital ratios at or near the regulatory minimum just prior to failure (BCBS 2004a). This raises the question of the requirement’s adequacy, if the purpose of the capital requirement is to prevent bank insolvencies.

Gup (2004a) argued that the amount of regulatory capital implied by Basel II is too low for banks in the United States. Gup reasoned that the operational profile of US banks (in 2004) was much more risky than it was in 1988 on account of three sources of their altered risk profile: increased exposure of US banks to commercial property loans; an increased proportion of bank portfolios dedicated to sub-prime lending; and greater exposure to derivatives markets. Gup’s concerns about bank’s sub-prime assets and credit derivatives were well founded and imply that the risk weights attached to these loans and contracts were inadequate.

On the other hand, Altman, Bharath & Saunders (2002: 917–20) challenged the credit-risk weights for the standardised approach in an earlier version of the framework as well as the range of proposed risk categories for corporate loans. They found using the default experience of US corporate bonds over the period 1981–99 that the capital requirements on highly rated borrowers (A and BBB/BB classes) were significantly higher under the 2001 version of Basel II than is justified by the default experience of such high-grade bonds (that is, borrowers), while for more poorly rated borrowers (below BB) the risk weight was about right. These findings held also for the 1989–92 recession; but clearly the findings are not representative of the recent experience with securities backed by US sub-prime housing loans or with similarly rated corporate bonds.

APRA estimated that Basel II’s introduction may marginally reduce the Australian banking system’s required amount of capital and has advised that it will take a cautious approach toward reductions in regulatory capital during the initial years under Basel II (Egan 2007).

Australia’s 20-year experience with the Capital Accord suggests the amount of regulatory capital has been adequate. Over this period there had been a recession in the early 1990s (accompanied significantly by a collapse in the commercial property market) when substantial losses were incurred at two large Australian banks (Westpac and ANZ). The capital held by these banks absorbed these losses and allowed them time to restore their capital ratios (Gizycki & Lowe 2000: 181–6). The results of the stress tests of the Australian financial system conducted by the IMF in early 2006 — that the banking system would cope (with reduced profits) under its macroeconomic shock scenarios — imply that the banking system was holding adequate capital in the tested scenarios (RBA 2006: 46).

Moreover, Australia’s banks have maintained capital ratios well above the regulatory minimum. As a group, the Australian-owned banks have maintained a capital ratio of between 10 and 12 per cent and credit unions and building societies have maintained higher ratios since the introduction of Basel I, and these capital ratios increased in 2008 (RBA 2008b: 26). Such ratios reflect each bank’s judgement of the amount of capital it should use in its financing. These judgements would depend on each bank’s calculations of its economic capital requirement. Economic capital is the amount of capital a bank holds to protect its solvency from unexpected losses (and from inadequate provisions against expected losses). Its purpose is to ensure the bank is able to continue operating (that is, remain solvent) should it incur unexpected losses. Since banks have liabilities in addition to their deposits, a bank’s economic capital is likely to exceed the regulatory requirement.

The evidence as at the end of 2008 (putting aside the Government’s recent guarantee of bank liabilities) supports the conclusion that the capital requirement under Basel II as applied by APRA has been adequate given the approach of Australia’s ADIs toward risk taking and risk management and APRA’s approach to prudential supervision.

An important criticism of Basel II is its pro-cyclical effects on economic activity that could amplify and prolong macroeconomic fluctuations. A substantial literature has analysed the cyclical nature of probabilities of default, exposure at time of default and losses given default and the consequences of capital requirements that are adjusted for these cyclical risk factors (such as Resti 2002; Kashyap & Stein 2004; Goodhart, Hofmann & Segoviano 2004; Illing & Paulin 2005; Altman et al. 2005). It is clear that regulatory capital under Basel II would increase during recessions and decrease during periods of strong economic growth. This view holds for each of the different methods for setting ratings even though, as Altman and Saunders (2001) argue, changes in corporate security ratings (by the major ratings agencies) tend to lag the changes in credit conditions.

The pro-cyclical criticism assumes that bank capital is varied according to movements in the minimum capital requirement. Banks in Australia have consistently held capital well above their required minimum and thus have always held a capital buffer. Consequently, proposals for Basel II’s capital requirement to be set as an average risk across the cycle (Goodhart, Hofmann & Segoviano 2004: 599) and that regulators embed a counter-cyclical capital buffer in Pillar 2 during periods of economic growth that could be drawn upon during an economic downturn may not seriously distort banks’ actual capital levels. Implementation of the latter proposal, though, would need to harmonise with monetary policy and so require close cooperation (in Australia) between APRA and the RBA.

While actual capital ratios may be less pro-cyclical than regulatory capital, there is a good case for banks to hold a counter-cyclical capital buffer to improve their financial stability (that is, capacity to absorb lower earnings and even losses). Since the required return on equity falls as share prices increase (and vice versa), the capital buffer would be raised when the cost of equity capital is lower than if banks had to increase their capital when their share prices are depressed.

The effectiveness of disclosure requirements and market discipline is the subject of a lengthy literature.

Bliss & Flannery (2001: 108–9) draw an important distinction between the roles of monitoring and influence in assessing the potential effectiveness for market discipline to enhance bank regulation. Information which is monitored, correctly understood and acted upon by investors, so that it leads to changes in the market prices of debt and equity, will result in effective bank discipline only if management responds to the changed market prices with modified risk-taking behaviour. They further point out monitoring behaviour has two pre-conditions. The first is that participants must have an incentive to monitor. Depositors covered by a perceived safety net are unlikely to have this incentive, while equity holders and holders of debt which ranks below deposits are more likely to have an incentive to monitor. The second is that the suppliers of funds must have the ability to accurately interpret disclosed information. The common answer is that most depositors are unlikely to have this ability while a greater proportion of equity and subordinated debt holders could be expected to have it, especially when they are institutional investors.

Flannery (1998) surveyed the evidence of monitoring and found that investors respond to and correctly interpret changes in bank conditions, that there is little evidence of irrational contagion and that on-site regulatory inspections contribute at least some information that markets use to discipline banks. Esho, Kofman, Kollo & Sharpe (2005) provide similar evidence that accounting risk measures for Australian banks are accurately reflected in the risk spread on bank subordinated debt over the return on Australian Government securities. However, Bliss & Flannery (2001: 141) found little evidence to support the influence dimension of market discipline and argued that it would be dangerous for regulators to rely on a market discipline mechanism in the absence of evidence that supports its existence. For this reason, commentators such as Gup (2004b: 82–4 and 86–8) and Kaufman (2004: 46) argue that Basel II’s Pillar 3 provisions are likely to contribute little to effective bank supervision.

Calomiris & Powell (2001), however, suggest an alternative channel by which market discipline might enhance prudential supervision. They argue that the monitoring effect may impose discipline not on bank managers but on regulatory authorities, overcoming a problem of regulatory forbearance identified by Boot & Thakor (1993). They argue that regulators may delay taking corrective action when banks become financially distressed because of the high cost to taxpayers of closing a troubled institution and, instead, rely on the hope of bank recovery. The forbearance of APRA toward HIH in late 2000 and early 2001 prior to its $5bn insolvency appears to be a case in point. The regulator delayed conducting a formal investigation into HIH’s financial situation that should have been triggered by its failure to submit its quarterly financial statement for December 2000. The HIH case, though, illustrates that the regulator was not influenced by the market’s discipline since HIH’s share price fell sharply (from $1 to $0.20) in late 2000. Presumably APRA will not repeat this mistake and so the introduction of Pillar 3 should mean that the regulator will be influenced by market signals and so place pressure on ADI management to do likewise.

Under Basel II loans to small and medium-sized businesses (SMEs) can be treated as either retail loans or corporate loans. The former are pools of standardised smaller loans whereas the latter are customised larger loans. Under Basel II retail loans attract a lower capital charge (6 per cent); one reason for which is the view that such loans are less sensitive to systemic risk than corporate loans (Jacobson, Lindé and Roszbach 2005: 44). This view has attracted some debate but, irrespective of its validity, Altman and Sabato (2005) argue that (particularly in the US banking system) larger banks are more likely to be able to benefit from the lower charge. Berger (2006), though, concludes otherwise, arguing that the SME loan market is segmented and larger banks are unlikely to enter the segment dominated by smaller banks. Given the dominant role of Australia’s large banks in the SME loan market it seems unlikely that the treatment of retail loans under Basel II will have much influence on small-business lending or on which banks dominate this segment of bank lending.

Under Basel II credit and operating risk weights determined under the standard approach are likely to be higher than under the internal ratings approaches (McDonald & Eastwood 2000; Egan 2004: 4; Egan 2007; BCBS 2003: 4). This raised the concern that the smaller ADIs (the regionals, credit unions and building societies) would be placed at a competitive disadvantage to the larger banks by the different methods for calculating risk factors. Egan (2004: 7) disputed that requiring smaller banks to hold larger amounts of capital represents a distortion of competitive neutrality. Egan argued that small ADIs are inherently riskier than larger banks since they have less-diversified loan portfolios and so face greater risk.

A related concern is the impact that Basel II might have on concentration in the banking industry. Given that the internal-ratings approaches under Basel II imply a lower regulatory capital requirement (than the standard approach) they represent an economy of scale that would encourage consolidation between banks. The merits of this potential impact would depend on the form of consolidation and whether the outcomes are anti-competitive. Mergers between regionals (such as between Bendigo and Adelaide banks) would be less likely to be anti-competitive than mergers with a big bank (such as between Westpac and St George and between the Commonwealth and BankWest). Where mergers enable the new organisation to adopt superior risk-measurement techniques this would be in the public interest. But fewer bigger banks intensifies the ‘too big to fail’ dilemma for APRA and ultimately for the community (through the cost of bail-outs, should they occur). A more concentrated banking industry may also increase contagion risk within the wholesale payment system.