We have our eye on two major points to begin the week. The first is that the most interesting election in the world this year may be in a communist country. A political drama is playing out that could have a much greater impact on Australia's future prosperity than anything that happens in America. We'll introduce you to the main players in this drama tomorrow.

Today, we need to talk about how the never-ending European debt crisis is making Australian banks more deposit dependent and prone to taking risks that don't look like risks but are. The end result of this change in Australian bank behaviour will be lower loan growth (and lower house prices) and more bad investment decisions. This is how a debt crisis on the other side of the world has an everyday impact here.

As usual, this chain of analysis begins with the managed failure of the common currency in Europe. Take Thursday's failed Italian bond auction. The Italians sold €4.9 billion in three-year government bonds paying 3.89%. That interest rate was 41% higher than the 2.76% they had to pay for a similar bond issue last month.

Still, 3.89% doesn't seem like so much, does it? If there were an imminent debt crisis in Italy, short-term interest rates would soar. In fact, in a real crisis, the government would have to pay double-digit interest rates just to borrow. And that's assuming anyone would lend them money.

It's a good thing (and probably not an accident) an Italian now runs the European Central Bank (ECB). Italy must borrow a grand total of €450 billion this year. You read that correctly. €450 billion. There's only one place the Italians can get that kind of money on short notice.

Italian officials said they declined to sell the whole €5 billion issue on Thursday because they didn't want to pay higher interest rates. "We made the choice not to take all of the demand because we do not have the urgency to raise funding at rates that we do not believe are right," said economics minister Vittorio Grilli.

Poor Mr Grilli had better realise that what government ministers think are the "right" interest rates and what investors are going to demand are very different things. Our guess is the only way the Italians can sell €450 billion in new bonds this year is if the ECB buys them. Private investors know that any investment in the European Welfare State is suicide.

Now let's connect this with ANZ's decision to raise the interest rate on its variable mortgage loans six basis points to 7.42%. Six basis points isn't a lot. It's just six. But ANZ is really doing this to establish the principle that it can set interest rates independently of the Reserve Bank of Australia (RBA).

It will probably come as quite a surprise to some people (like Wayne Swan) that the RBA doesn't determine the price of money. But Aussie banks aren't surprised. Australian banks borrow abroad to loan at home. When they borrow abroad in, say, Europe, they pay the market rate. What the RBA says about interest rates doesn't affect the price of money in the European banking system.

The debt crisis that began in 2007 has already forced Australian banks to rely more on local deposits. Westpac is a good example. It wants to raise its share of the deposit market and expand its business into "wealth management", according to Eric Johnston in today's Age. That's exactly the sort of thing you'd do if you were preparing your business for many years of much lower credit growth. You'd try to make money in more traditional and conventional ways (instead of blowing up a housing bubble with money you borrowed overseas).

This could take us directly to a discussion of how Australian house prices will behave in an era of lower credit growth. But we'll side step that issue for today. We merely wanted to say that morons who suggest Australia was unaffected by the GFC in Europe simply aren't paying attention. The GFC has been here all along. The result is lower bank lending and more focus on "wealth management".

But "wealth management" isn't nearly as safe and respectable as it sounds. You shouldn't expect Aussie banks to take less risk in the future just because they can't afford to blow up house prices anymore. What's happening with pension funds could be a good predictor of what will happen in the "wealth management" arms of Australian banks.

Regards,

Dan Denning

for The Daily Reckoning Australia

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