In a perverse way, sometimes trying to avoid risk can actually lead to far greater loss. For example, someone who is scared of flying may instead choose to drive to their destination, blissfully unaware that the risk of injury is far greater in a car than in a plane (possibly because plane fatalities receive far more publicity than car deaths). Australian banks appear to be taking a similar view — devoting a substantial proportion of their lending capacity to residential property, on the basis that it is less risky than other forms of lending.

Three of the four large banks have more than 60% of their loan books attaching to residential mortgages (NAB’s Joseph Healy noted that in 2000, only 43% of lending was to the residential property sector). This is partially due to Australia’s continued housing strength and also, courtesy of the Basel II capital requirements, which attached less “risk” to residential mortgages compared with lending to business.

But while residential lending is ostensibly “safer” than business lending (householders are more likely to repay their mortgage than business owners are a personally non-recourse business loan), by devoting too many resources to into lending to the so-called less-risky residential sector, this actually leads to an increase in risk, as banks continue to lend to purchasers even while property valuations start to vastly exceed their “intrinsic” values.

One of the main reasons asset bubbles occur is that purchasers are able to obtain easy credit — this is often the result of an economic boom, which leads to relaxed lending standards. When people borrow a large amount of money to buy an asset, the inevitable result is that prices tend to stray from a reasonable correlation to future cash flows (their “intrinsic value”). It is not unreasonable to suggest that this has transpired in the Australian residential property sector, where the ratio of household income to median property around double the historical levels (the ratio is for most capital cities, above six times the level of median household disposable income).

Meanwhile, mortgage debt has risen from 20% of GDP in 1990 to almost 90% today. The Economist also found that compared with rentals, Australian housing is the most overvalued out of 20 nations sampled. That means two things — first, Australians are paying more for dwellings (relative to the nation’s income) than ever before and second, they are using hefty dollops of leverage to do this.

This leads to one of two possible conclusions. Either the rest of the world (and until the past decade, Australia as well) underpaid for houses (relative to income); or Australians are using too much gearing and over-paying for residential dwellings. If the former is true, then a rational investor would sell property in Australia and buy housing in relatively cheaper overseas markets, such as in the United States. If the latter is correct, the banks (and the taxpayers, courtesy of an effective implicit government guarantee) will be in for a spot of bother.

In this regard it is important to consider banks’ funding structure. By using fractional reserves (banks are only required to keep a small amount liquid assets compared with their debts), they are able to generate relatively high rates of return on equity. The problem with maintaining such low levels of liquid assets is that a bank can find itself unable to meet its liabilities very quickly if even a relatively small proportion of its depositor base demands their money back at the same time (a classic “bank run”).

Banks’ balance sheets therefore have a substantial amount of assets, very large levels of liabilities (which are usually depositors’ funds or borrowings from the wholesale market) but only a relatively small sliver of equity. For example, the Commonwealth Bank has $300 billion worth of home loans outstanding (which are assets) but equity of only $33 billion (the bank has almost $600 billion in liabilities). If the ratio of income to house prices fell to its historical levels (similar to what occurred in the United States), this would not only destroy banks’ profitability (by having to write down a large proportion of their housing assets) but also cast serious doubts upon their ability to remain solvent.

By focusing their lending on the residential sector, the banks have been a significant factor in allowing houses prices to appreciate by 211% between 1997 and 2010. Perversely, this appreciation has placed greater risk on the value of the banks’ own collateral.

This is the inevitable problem that results when institutions base forward risk decisions on historical events. Generally, the result is disastrous. The “rocket scientists” or “quants” at investment banks and hedge funds (like Long-Term Capital Management or Bear Sterns) devised complex formulas that sought to virtually erase risk by extrapolating past events and ended up causing enormous economic damage.

The difficulty is the past is not always an accurate guide of the future (it may hold true for a period of time, but eventually, unexpected or “black swan” events will transpire). Simply because the housing market has appreciated in the past, that is no reason to believe that it will continue to do so indefinitely (for example, if the property market truly never falls, investors could make a risk-free profit by simply buying property and holding it indefinitely).

For example, while many economists (including Reserve Bank governor, Glenn Stevens) warn that variable mortgage rates will return to “normal” levels (of about 8%), what of the possibility that interest rates will continue rising above so-called normal levels? Or the possibility of unemployment increasing, leading to reduced income levels and a substantial weakening in housing demand? Or what about the other alternative, that the cash rate set by the RBA becomes irrelevant as the cost of wholesale funds globally continues to increase?

By placing such a large proportion of capital into the housing sector, Australian banks have been able to boost earnings (greater lending leads to increased short-term profitability). The problem is, the massive lending to the housing sector led to a rapid, albeit hidden, increase to the risks attaching to owning their capital. Meanwhile, the executives who are taking increased risks with shareholders funds are reaping the rewards — NAB’s top 14 executives collected $46 million in 2009, an increase of almost 15% on the prior year. CBA chiefs did even better, $55 million in 2009, almost 60% higher than the previous year.

It appears therefore that extreme capitalism is alive and wel l… and backed by government guarantees.

Adam Schwab is the author of Pigs at the Trough: Lessons from Australia’s Decade of Corporate Greed, in bookshops.