A disruption to these flows would have not only stalled the domestic financial markets but left the capital account unfunded, precipitating a big fall in the exchange rate. This guarantee should not be confused with that on domestic deposits, designed to prevent an old-style bank run.

This is a good time to ask some important questions: Was the bank guarantee warranted? Was it effective? Is now the right time to lift it? What are the lessons for the future?

The Treasurer repeatedly commended the policy. ‘There’s no doubt the bank guarantee, along with fiscal stimulus, certainly averted a catastrophic impact on the Australian economy from the global financial crisis,’ he told ABC Radio. Without ever knowing the counterfactual, we cannot be sure how right he is. But rumours abound in Canberra that in late 2008 the big four banks, as well as some smaller financial institutions, were edging closer towards the precipice. With international markets drying up, there was little prospect of Australian banks rolling over their short-term foreign debt, which makes up some 40 percent of their overall liabilities. If one assumes that the bankers and politicians had more information about the precariousness of the situation than was publicly acknowledged, the bank guarantee made good sense, especially since many other advanced countries extended guarantees to their own banks.

Did it work? Probably. The absence of a banking crisis is a pretty strong argument in favour of the policy’s efficacy. But the policy had some unpleasant side effects too. Because the guarantee allowed banks to rely on Australia’s AAA sovereign credit rating when issuing debt (adjusted for a small fee, based on their individual credit rating), it was overly generous to the banks. Their continual reliance on the scheme while talking up the strength of their balance sheets suggests that the guarantee was no longer needed to avert insolvency but to fatten the hip pockets of the banks’ shareholders.

Moreover, even though Swan professed that, ‘the guarantee has been critical in helping to support competition in the banking sector throughout the global financial crisis,’ the Australian banking sector is more concentrated now than it was before the crisis. It did not create a level playing field, rather favouring the big four banks who managed to increase their market share of home loans, small business loans, credit cards and deposits. These banks now hold more than three quarters of all outstanding mortgages, up 20 percent from a couple of years ago. Several take-overs in the industry have underscored their dominance.

Is now the right time to withdraw the guarantee? ‘I find it a most curious decision to withdraw the guarantee given the current risk aversion in financial markets,’ Mark Bayley of Aquasia said recently. He added he was, ‘far from convinced that those financial institutions outside the top four will be able to access the debt markets at acceptable funding levels without the Commonwealth government guarantee.’ This analysis is correct: while the wild gyrations of the interbank market two years ago have subsided, credit markets remain tight. Tapping the international credit markets will prove more costly going forward, as it should.

The worry is that the global economy is still very fragile, with a sovereign debt crisis looming in Europe and elsewhere. Private balance sheets are still scarred from the global financial crisis and the ability and desirability of governments to fill the demand gap is being seriously questioned. China’s economic armour is showing some chinks in the form of a home-made credit and asset price bubble that could yet prove painful for the world’s third largest economy and its trading partners.

Australia remains particularly vulnerable to the health of the global economy. Its economic strength relies in no small measure on global demand for its natural resources, and its financial system depends on cheap capital from overseas. Disruptions to either will easily nip the nascent recovery in the bud.

At the same time current economic indicators point to an accelerating expansion, prompting the Reserve Bank of Australia to raise the cash rate by 100 basis points since October 2009. Such apparent strength is sufficient reason to do away with the bank guarantee. What Swan did not mention—because the market already knows—is that a bank guarantee would likely be swiftly re-instated should global financial markets once again go into a deep-freeze.

This raises the more general question of whether bank guarantees are the right policy to safeguard against the vagaries of financial markets. Deposit guarantees create a moral hazard problem, reducing the incentive for bank managers to invest prudently and for depositors and shareholders to adequately monitor the bank’s activities. They lead to an inefficient allocation of capital whose costs are borne by taxpayers. Wholesale guarantees, such as the one being phased out now, preserve a country’s reliance on cheap foreign capital. If growing external indebtedness is a problem, then so is a policy that artificially perpetuates it.

These side effects notwithstanding, the systemic nature of the banking system and its salience to the wider economy dictate that there must exist some degree of protection to allow the financial wheels to keep turning even when the economy is heading South.

The road to more stability ought to follow a two-pronged approach. The first is better regulation of the financial industry, based on types of institutions, and targeting specific sources of risk. Dynamic provisioning, softened marking-to-market procedures, and variable margin and liquidity requirements also belong in the mix. Second, there is a strong case for a clearly differentiated banking system that separates those banking activities worthy of protection (such as retail deposit banking) from those unworthy of protection (such as speculative investment banking). The moral hazard would be severely curtailed because retail deposit banks would not be allowed to invest their liabilities in highly speculative projects, but the economy’s core banking functions would remain protected. The key to such a banking structure is transparency, clarity, and strong communication, with an unambiguous caveat emptor attached to the risky, unprotected functions. Such a demarcation will preserve one of the key lessons from Finance 101, namely that the higher the expected yield, the greater the risk.

Timo Henckel is a Research Fellow at the Centre for Applied Macroeconomic Analysis at the Australian National University.