The capital ratios of Australia's four largest banks underestimate their capital strengths, but despite this these banks need even more capital, the authors of a working paper by the International Monetary Fund argue.The IMF paper does not spell out how much more additional capital the four banks need, but rather details the effect on capital ratios of lending losses arising from a sharp decline in housing prices.Staff of the Asia and Pacific Department of the IMF modelled the effect on bank's profits and capital from an economic shock paralleling the decline in housing prices in Ireland in the late 2000s.In one scenario, the IMF estimates that the four Australian banks' probability of default would increase sharply to 11 per cent, from two per cent, and the estimated losses would be larger than the banks' total provisions, resulting in a reduction in the banks' capital. It is estimated that the banks' tier one capital ratio would decline by 1.5 percentage points. However, their tier one capital ratio would "remain well above the regulatory minimum ratio of four per cent."In a more severe scenario (which projects a higher risk of "loss given default", and higher risk weights), the IMF said that the total capital ratio of one of the four major banks would decline to below six per cent. The total capital ratio for the other three banks would remain above eight per cent. The IMF notes that this exercise "does not consider shocks to corporate and other lending, which should be considered when banks conduct stress testing."There was no mention of the conclusions of a working paper also published this month by the Bank for International Settlements that say "given current technology, macro stress tests are ill-suited as early warning devices… for identifying vulnerabilities during seemingly tranquil times and for triggering remedial action."