Bank 'guarantee' distorts system: Treasury

The removal of a so-called implicit guarantee supporting Australia's major banks would see their credit ratings lowered and funding costs rise, which would likely be passed on to borrowers, the Department of Treasury has warned.

In its submission to the federal government's financial system inquiry, Treasury says the perception that Australia's four major banks - ANZ, Commonwealth Bank of Australia, National Australia Bank and Westpac - are too big to fail because the government would step in, is distorting the financial system.

These banks argue there is no such guarantee.

But Treasury points out the perceived guarantee in commentary by one of the world's major credit agencies, Standard & Poor's, which said ANZ's rating "reflects our view of a high likelihood of extraordinary government support in a crisis".

Similar comments are made about the other major banks, Treasury says.

Treasury says these perceptions have two major consequences for the efficiency and stability of the financial system.

There is a moral hazard because risks taken by the major banks and their investors are shifted to the government.

There is also inefficiency from the mis-pricing of risk, with the funding costs of the major banks lower than that of smaller financial institutions.

Treasury said part of the G20's policy response to the problem was a so-called "bail-in regime" which would allow the government to write down the value of bank debt or convert debt securities into equity if a bank fails.

The department put forward other possible options such as a tax on the major banks, although it said if this was incorrectly set, it risked creating new distortions.

However, Treasury recognised how difficult it was for governments not to support a single large, interconnected, failing bank, particularly in a more widespread financial distress situation.

"During crises there is considerable pressure on government to minimise the losses to shareholders and bondholders to prevent a shock to the broader financial system and economy," it said.

The report was one of more than 200 submitted to the inquiry.

The inquiry will report back by mid-year with a final report due in November.