The federal government's announcement that it would be withdrawing the banking guarantee scheme for large deposits and wholesale funding set off chatter within the financial services industry this week.

However, according to some media reports, there was an even more interesting story going on in the background.

Age columnist Adele Ferguson said some smaller banks and non-bank lenders were attempting to convince Treasury and the government to introduce legislation that allowed the creation of a covered bond market, which means that bonds could be backed by residential mortgages.

This would be a boon for smaller banks, building societies and credit unions as according to Ferguson many of these so-called second-tier financial institutions have found it difficult to compete in the credit markets due to their lower credit rating.

"Even with the government guarantee, most smaller banks couldn't afford to use it because they had to pay a higher fee to the government to compensate for their lower credit rating," Ferguson wrote

Members Equity Bank (ME Bank) chief financial officer Nick Vamvakas said that the government guarantee withdrawal will make it more difficult for smaller banks to access longer term funding.

"The covered bonds idea may be a means by which smaller banks could fulfil their longer term funding requirements," he said.

However ME Bank has not investigated [covered bonds] at present.

Meanwhile, the bank which is owned by 35 industry superannuation funds which have over 5 million members has priced a government guaranteed transaction following the government's withdrawal announcement.

The transaction was a four-year, $500 million guaranteed deal which priced at 38 basis points (BP) over the swap rate plus the cost of the government guarantee which is 150 BP

Joint managers on this deal are the Commonwealth Bank of Australia, Credit Suisse and Westpac Institutional Bank.

According to Vamvakas securitisation markets are gradually reopening with some smaller banks accessing these markets in recent weeks.

"This source of funding combined with guaranteed bonds has assisted smaller banks with their overall funding requirements," Vamvakas said.

So with smaller banks making moves to compete with the big boys, the industry will wait and see what Treasurer Wayne Swan does next.