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The banks’ response to the RBA’s latest rate cut pushed Australia’s political debate into uncharted waters. The fact that 3.75 per cent of the 4 per cent worth of previous cuts had been passed on to home owners (businesses only got 2.7 per cent) had differentiated the RBA from its counterparts in the US, Britain and NZ. For a variety of reasons central banks in these countries had been unable to exert much influence over the cost of borrowing, which had exacerbated the crisis.

The RBA has highlighted how effectively monetary policy in Australia had been working with its much vaunted 'transmission mechanism' delivering a 40 per cent reduction in costs for the bulk of homebuyers who have a variable rate loan. Sure the banks had boosted mortgage rates by 0.55 per cent more than the RBA’s hikes during 2007-08, and pocketed a further 0.25 per cent as the RBA started bringing rates back down in mid-2008. But it was argued that this allowed them to preserve their profitability and willingness to lend.

Now the game has taken a dangerous turn. An intensely debated RBA Board meeting yielded a critical 0.25 per cent cut to its target rate. Yet three of the four majors passed on just 0.10 per cent to homebuyers while another ignored it altogether. Some speculated that perhaps the banks were saving their generosity for businesses. But here again there was no loving with only Westpac disclosing a cut.

It appears that the RBA’s ability to manage Australia’s economy may have deteriorated substantially with the link between its target rate and the cost of borrowing slowly evaporating. In an environment where Australia’s real economy has only started to feel the effects of the global contagion, and with the risk of a protracted downturn, the notion that monetary policy is being suffocated in this way is disturbing. Certainly one frequently noted strength of Australia’s economic station – the assumption that there was much interest rate ‘ammunition’ left to deploy – looks to have been eviscerated.

Against this backdrop, the government’s attempts to shore up the banking system have unwittingly made it harder for smaller banks, like Bendigo & Adelaide Bank and the Bank of Queensland, to compete. Whereas they had previously been able to source funding on terms not dissimilar to the major banks, the pricing of the government’s guarantees (of funding not deposits), which are based on credit ratings, puts them at a competitive disadvantage.

An additional risk the government now faces is that the four ‘too-big-to-fail’ banks that Australia’s economy relies so heavily on, and which have de-facto control over monetary policy, will not employ their taxpayer-guaranteed funding in the manner required. It is, for example, well known that one of the majors is limiting housing credit to bolster its balance-sheet to buy banks in China. This seems to be a questionable decision in the midst of a credit crisis. And given the poor track-record Australian banks have with overseas investments (think NAB in the US and AMP in the UK) there is a compelling case that these taxpayer-supported utilities should stick to their knitting—drawing in savings and lending them out to businesses and households (in Australia and overseas) rather than burning capital pursuing Asian expansion plans.

The disciplining influence of competition, which would have helped maintain the mortgage rate pass-through, has dissipated due to the closure of the securitisation markets (which were key sources of finance for alternative lenders) combined with the fact that many rival institutions like St. George, BankWest, RAMS, Aussie, and Wizard have been acquired by the majors. So what can policymakers do?

One simple, low-cost and tactically efficient solution would be for the government to extend the guarantees from the institutions to the assets they lend (and thus also include the non-banks). This would directly vouchsafe liquidity rather than relying on bank CEOs bending to the policymakers’ will. By applying the guarantees to AAA-rated home loans and, interestingly, AAA-rated commercial property loans, the government could help reopen the securitisation markets, which have been further decimated by the bank’s funding guarantees. This could create a level playing field amongst all lenders irrespective of size, who would pay the same low fee (0.3 per cent based on recent AAA-rated state government precedents) when lending the same assets in contrast to the current situation where the big banks get preferential funding terms with uncertain lending outcomes.

It could also help enhance the monetary policy transmission mechanism by stimulating competition on rates, save taxpayers the $4 billion that has yet to be spent buying home loans directly through the Treasury, generate revenues through the fees government would receive, and possibly eliminate the need for RuddBank and the billions of dollars of taxpayer cash that it will use propping up commercial property values.

Insuring 'conforming' AAA-rated residential and commercial property loans is, by definition, less risky for taxpayers than guaranteeing the liabilities of more poorly rated banks over which they have little control. Importantly, guarantees are also easier to remove once conditions stabilise than newly created institutions.

One unanticipated consequence of the funding guarantee was that it created a new super-class of taxpayer-backed AAA-rated securities that has reduced liquidity for, and raised the cost of, other safer and more highly rated instruments. This in turn undermined existing government policies. For example, the Treasury’s commitment to buy $8 billion of AAA-rated home loans was supposed to reduce “spreads” and give smaller lenders access to cheaper finance. Yet since the government announced the guarantees, the spreads on AAA-rated residential mortgages have exploded from 1.3 per cent over the benchmark rate to more than 4 per cent over according to the RBA.

Importantly, there is a successful precedent for this solution. Canada’s banking system was recently judged by the World Economic Forum to be the world’s safest and was advocated by the G20 as a model for others. Like Australia, Canada has had no bank failures and is dominated by five major institutions. Canadian home loans actually have lower default rates than Australia’s. Unlike Australia, Canada’s mortgage securitisation markets have remained liquid and functional throughout the crisis and continue to provide lenders with a viable source of finance. Canada has also avoided the credit rationing experienced by Australia’s businesses with normal growth throughout 2008.

Canada’ success is in large part due to their government’s willingness to explicitly guarantee the creditworthiness of conforming Canadian home loans on a commercial basis. As a condition of this guarantee, the government requires lenders to invest directly in their securitisation pools, which creates the alignment of interests (i.e., low default rates) that was missing in the US. Australian policymakers should urgently consider similar measure to support liquidity in a manner that does not discriminate among lenders.