Joe Hockey has waded into dangerous territory with his reported call for the Reserve Bank to referee the banks on interest rates.

”I would like to see the RBA take on a greater role as a referee and in their statement include whether the banks should pass [rate cuts] on in full or in part,” Fairfax reports him as saying this morning. “Competition had to be respected so the Reserve Bank’s views would not be binding, he said. But it would be independent and allow public debate about rate cuts to be factually based.”

Hockey’s proposal would see the RBA wasting its “jawboning” power on the banks. It has to protect that for the tough decisions on interest rates, such as putting them up to prick an asset bubble, or not cutting them (today week?) because it sees no need to do so for the domestic economy. More importantly, Joe’s idea would potentially politicise the RBA, pitching it straight into domestic political debates. The RBA already comes under enough pressure to comment on fiscal policy as governments and oppositions try to score points off each other.

Hockey’s not the only one wandering into this territory. The Prime Minister last week introduced an unwelcome note of political pressure on the RBA when she said there was plenty of room to cut rates. Wayne Swan said the same thing a day or two later. Remember, his head of Treasury sits on the RBA board. Swan and Gillard have to be careful in not appearing to give Martin Parkinson riding instructions.

But most of all, what does it mean to say “cuts should be passed on”? The word “should” is a dead giveaway — it’s a subjective judgment. What the RBA can and does do already is keep track of bank funding costs. That’s what Ian Verrender used in his must-read analysis of the bank’s myths about rising funding costs in the Fairfax press today.

Whether banks should pass on rate cuts (or rate rises) depends on whether you think their current profit margins are merely adequate or bordering on superprofits from the cartel-like conditions in which they operate.

But the banks have successfully framed the debate not in terms of their extraordinary profits, but in terms of funding costs, a far more complex and perplexing issue for the average punter. Framed thus, the debate assumes bank profits should be maintained at their current levels no matter what, so if there’s any rise in funding costs, that automatically justifies not passing on rate cuts, or even lifting rates “out of cycle”.

ANZ, which, under Mike Smith, is the nearest thing we have to a rogue institution, has reinforced this framing by piously declaring it would no longer react to the RBA, but decide its rates according to its own timetable. Westpac has joined the ANZ in trying to unhook itself. Both have form in being self-interested when it comes to making unsubstantiated claims about higher funding costs and ignoring what they have already done on the lending side.

It’s all a distraction from the real issue — their superprofits obtained from anti-competitive market conditions.

Fitch Ratings bought into this issue overnight with its threat to downgrade the Australian banks because of the claimed high level of offshore funding. ”Specifically, the RWN (ratings watch negative) for the four major Australian banks largely reflects Fitch’s view that despite significant improvements, these banks continue to have a weaker funding profile than other similarly rated peers,” it said.

But Fitch knows that there has been a turnaround in the level of offshore funding: domestic deposits from individuals and companies used to be less than 40% in 2007, now it’s more than 60% and rising slowly as the Australian savings rate runs at about 10% of national income a year. Offshore borrowings have fallen from about 32% in 2007 to less than 20% now. Longer-term debt has risen sharply in the same period. Fitch is only heading down the track that Standard & Poor’s wandered off onto late last week when it trimmed the AA 2 ratings of the big four Australian banks.

The banks do have a lot of offshore money to replace this year because they boosted their borrowings in 2009 thanks to the government guarantee. That no longer applies, so the loans will either be rolled over at higher cost, allowed to mature and repaid, or replaced with domestic borrowings, which is what they are doing with covered bond issues (backed by mortgages).

The banks will no doubt use the Fitch Ratings examination to bolster their case for higher rates (i.e. not passing on the next RBA rate cut, whenever that happens). But Verrender nailed this furphy. “For despite all their protestations, and their claims of the rising cost of funds, the simple fact is that our banks are in rude good health and are more concerned about protecting record profits than they are about ensuring their survival … Remember, too, that since 2008, our banks have added the equivalent of five official rate rises either by not passing on cuts or by increasing rates beyond official rate rises.”

That’s an excellent point: that’s an extra 1.25% added to bank lending rates in three years that went straight into those record profits the big four reported in the 2011 financial year.

Let’s all hope that business journalists read Verrender’s column and start asking informed questions about bank profits, instead of merely parroting the special interest moans from highly paid bankers who want to protect not only the bank’s profits, but their own earnings (especially bonuses and meet short-term performance measures) as well.