Illustration: Rocco Fazzari

Illustration: Rocco Fazzari

IT WAS with a silken touch that the government slipped the bank lobby's ''covered bond'' legislation through the Senate a little more than a year ago.

They are not so keen on covered bonds overseas. And while the prudential regulator APRA had protested that they favoured big creditors to the disadvantage of the mums and dads, the Reserve Bank, Treasury and the big banks won the day.

Now the evidence is in. Covered bonds have brought down bank costs even further. In a confidential note to its institutional clients, Westpac describes the fall in wholesale funding costs over the past year as ''extraordinary''.

No longer can the banks rely on that hoary old chestnut of ''high funding costs'' to pass off their failure to match the successive cuts in the official cash rate.

Margins are fatter than ever, veritably bulging, and there is scant proof that borrowers are getting their grimy fingers on a single cent of it. It's a good thing for shareholders though, some cautious at the listless growth in credit.

The story that the banks spin to their big clients, as opposed to the rest of us, is about as similar as the Chinese and Japanese perspective on who owns the Senkaku Islands.

While the public rhetoric has adamantly clung to the line that ''it's tough out there'', Westpac confides to the institutions that, over the past year ''the spread compression has been an extraordinary performance''.

In this month's missive to institutional clients, called Covered Bonds with the Institutional Bank, the cost of wholesale funding has halved over the past 12 months, from 120 to 60 basis points over the swap rate.

Covered bonds with a five-year maturity are fetching a 30-point premium to others. Yet the frustrating bit for borrowers is that, while all wholesale funding spreads ''continued to grind tighter'', the banks, in their habitual lock-step, recoiled from passing on the full cuts in the cash rate. It's down from 4.25 per cent to 3 per cent.

About $40 billion in covered bonds have been issued since October 2011 when the government bestowed the cartel with its latest legislative leg-up (the last of the sovereign guaranteed bonds, another freebie, are pricing 30 points better than the covered bonds).

Of the big four, the CBA leads the way with $15 billion of the roughly $40 billion on issue.

Looking back, in January 2005 the standard variable rate was 7.05 per cent (now 6.5 per cent) and the cash rate 5.25 per cent (now 3 per cent). Add a 30-point funding margin and you get to 5.55 per cent.

For the sake of comparison, then, there was a 1.5 per cent margin eight years ago. Today, the cash rate is 3 per cent, so the banks are paying 3.6 per cent for their money versus the standard variable of 6.5 per cent. This is the undiscounted rate mind you - most borrowers should be forking out 5.6 per cent - but we are comparing apples with apples here.

This 6.5 per cent minus the 3.6 per cent bond rate plus costs constitutes a margin of 2.9 per cent compared with the 1.5 per cent earlier. It is an increase of more than 90 per cent in eight years.

Another interesting point in the wholesale funding game - and now we refer to another document, the Westpac Institutional Bank Floating Rate MBS Revaluation Sheet - is that what the bank is telling its clients appears to diverge quite considerably from actual market prices.

This revaluation sheet assists institutions to price all fixed-interest products including RMBS (residential mortgage-backed securities) issued by the likes of AIM, Firstmac and Pepper.

Something peculiar is going on. According to contract notes that this reporter has seen, there are mortgage bonds, for instance, which Westpac values at $82 (yielding 9.2 per cent or 650 points over swap) that are actually changing hands at $87.

A Macquarie Bank valuation of the very same bond in January was $92.50.

This may be an extreme example, yet there appears to be a pattern of some banks pricing non-bank paper issued by their rivals below market value. Perhaps it's a matter for the ACCC.

The banks will contend, and plausibly, that the discrepancy comes down to liquidity.

It is quirky, though, that a covered bond of the same duration trades at just 60 points over swap versus 250 for its RMBS equivalent.

Both are covered by mortgages, both regulated by APRA, both enjoy a pristine history of default. The difference is that one is issued by a bank and the other by a non-bank lender, enhanced via a trust and insured by the likes of QBE or Genworth.

The bottom line is that, when it comes to the cost of funding, the non-bank lenders still can't compete as they did before the financial crisis.

And while the big banks have grown their market share to well over 90 per cent of new home loans in the past four years, they still command a margin of 2.85 per cent on that exquisite asset called an Australian mortgage.

Nice work if you can get it - but banking licences don't grow on trees.