AS OFFICIAL interest rates creep up this year, what's to stop the big banks from inflicting even bigger rises on their home-loan customers?

Banks like to say these unpopular decisions hinge only on funding costs, which are set on global markets and are out of Australia's control. But this misses a vital part of the story: the strength of competition from their smaller rivals.

Aggressive small banks and non-bank lenders are a key influence on how far the big banks dare push up their loan rates. Unfortunately, non-bank lending is now a fraction of its former self.

After keeping the big banks on their toes for much of the past decade, many non-bank lenders have been gobbled up. A few, such as Resimac, remain, but the big four lenders have a stranglehold on the market. Last year, at the peak of their dominance, they wrote a record 93 per cent of new home loans.

But there have recently been signs of life among the remaining non-bank lenders. Official figures this week showed that the big banks' share of new loans had dipped to 91 per cent. Securitisation markets - where non-bank lenders obtain their funds - are also starting to recover.

How much non-banks can challenge the big four depends on recovery in the clumsily named residential mortgage-backed securities (RMBS) market. RMBS are bundles of home loans that are sliced into pieces and sold to investors. This is known as securitisation.

Nicholas Gruen, of Lateral Economics, says securitisation and non-bank lending are key to a competitive mortgage market in Australia. In their heyday, non-bank lenders could raise funds through securitisation at a cost slightly above that which banks charged when lending to each other. They would then lend the money to home buyers at slightly higher rates.

But subprime loans spoiled the party. Investors recoiled, non-banks' cost of raising funds blew out, and the market ceased in its tracks.

The big lenders pounced: Westpac bought RAMS, Commonwealth Bank grabbed Wizard and a third of Aussie Home Loans, and NAB bought Challenger. Smaller regional banks survived, but were weakened by their dependence on securitisation.

All this turmoil has taken a hefty toll on competition. Banks have upped their mortgage rates safe in the knowledge their customers have few alternatives.

But as the economy lifts, many hope a revival in RMBS could inject more rivalry into home-loan markets.

Late last year a Reserve Bank deputy governor, Guy Debelle, said the cost of securitised deals was falling; any such improvement would allow the non-banks and small lenders to compete more aggressively.

Others paint a darker picture. Christopher Joye, chief of the real estate funds manager Rismark, says few new players will appear in non-bank lending. ''The securitisation market's open for business, but that's open for banks, primarily, because banks are the last men standing,'' he says.

Surely the Government could help restore the balance? Not so far. Support dished out to banks and non-banks has been highly unequal. Regulators have lent traditional banks their crucial AAA credit rating to raise wholesale funds and protect deposits, ensuring a rush to the safety of the big banks. The securitisation industry and the non-bank lenders, on the other hand, were put on life support through a program in which the Government will buy up to $16 billion of RMBS assets.

There are good reasons for only supporting the banks, but critics say these policies support banks' profits while helping cripple their competition. Non-bank lenders will survive, but they won't be the competitive force they once were.