'Four pillars' policy could topple in the flurry set off by the credit crisis

THE notion that Australia's banks are somehow quarantined from the global credit meltdown is under challenge amid a wave of consolidation in the banking sector.

Our banks are surely better capitalised than their counterparts in the US and Britain, yet the freeze in wholesale funding markets is forcing a round of emergency negotiations, both regulatory and corporate.

Already, Commonwealth Bank has agreed to swallow BankWest after parent HBOS fell to the funding squeeze in Britain, Westpac has committed to take over St George, and Suncorp has hoisted the "for sale" flag.

Don't be surprised to find the big bank chiefs have beaten a path to the Treasurer's door this week to pave the way for the jettisoning of the "four pillars" policy.

And don't be surprised to learn that ANZ and National Australia Bank have been chewing over a merger.

Both have been left out of the play for BankWest and St George, and both are in the field with CBA to buy the distressed Suncorp. But both are susceptible to ratings agency downgrades were they to strike a deal for the Brisbane-based bank.

The preservation of confidence in the banking system now overrides the four pillars policy.

ANZ and NAB are the two banks of the Big Four with the greatest problem exposures to derivatives such as credit default swaps and collateralised debt obligations.

Indeed, it's still unclear how much Australian banks are exposed to the CDS imbroglio arising from the collapse of Lehman Brothers.

Over the past month, interbank rates have shot to record levels as US and European banks have refused to lend to each other and turnover has ped away sharply. This means there is no access, unless at prohibitively expensive rates, to wholesale funding.

ANZ and NAB rely on wholesale funding for roughly one-third of their respective mortgage books.

Their plight, however, is enviable compared with the second-tier players.

Although Bank of Queensland has just handed down an admirable result this week, it is highly dependent on offshore markets functioning efficiently to fund its book.

CBA has pulled off a cracker. It raised $2 billion this week to finance the acquisition of BankWest. But BankWest was acquired at below net asset value so the vendor proceeds were less than the assets received.

In fact, Ralph Norris and co. will now book a profit on the purchase because of the discount to net assets.

They may require a modest amount to cover the Australian Prudential Regulation Authority's tier-one capital obligations but only about $600 million maximum, less the discount amount of $200 million.

The plunge in the Australian dollar has exacerbated the big banks' woes, driving up their cost of capital sharply.

While successive governments have boasted of the fact that they run surpluses and there is no national debt, deregulation and the explosion in credit over the past two decades have ensured a blow-out in our private sector debt.

The 25% in the currency will have hurt. (Wholesale funding programs average five-year duration versus the 15-to-30-year duration of mortgages - this borrow short/lend long caper is a trap when the currency s.)

The Reserve Bank figures do not reveal the quantum of the foreign currency exposure, nor who picks up the tab, but it is a big number.

Banking sources estimate the banks are taking a loss at 0.2% margin over a five-year term. The banks are nervous, they have been testing the market for mortgage and loan defaults.

Then there is interbank lending.

The collapse of Lehman Brothers has all the banks fretting over their counterparty risks and the regulators trying to evaluate the landscape on all large, single-name exposures.

The reason for the freeze in offshore markets is the banks simply don't trust each other on counterparty risks to the likes of Lehman, and this contagion has now swept across the Pacific.

Our economy relies on what is termed "money velocity" - that is, how quickly a dollar moves through the economy and is recycled (respent or invested).

Roughly two-thirds of Australia's economic activity, or GDP (and the world's GDP), comes down to consumers spending and spending quickly.

Contrary to current thinking it's not all about the mining boom, which accounts for only about 15% of Australian GDP in boom times.

Hence the emphasis on consumer spending patterns.

When Gerry Harvey came out and said Harvey Norman could see a trend developing towards a 5% reduction in consumer sales by Christmas, it was a clear signal to the RBA and the banks that 1.5%-plus in interest rate easing would be needed within the next 12 months to slow this rate to 1%-2 %.

While 5% may not sound like much but extrapolated across the broad economy it equates to billions of dollars not being recycled throughout the economy.

Retailers in Australia are shedding jobs, the banks are watching a sharp reduction in client transaction volumes, and settlements are said to be slowing. Velocity is beginning to stall.

mwest@fairfax.com