New Lib Dem proposals – tax prudent banks to shore up risky ones

I welcome Vince Cable’s repudiation of the Tobin tax but, instead, he has proposed a tax on bank profits to help provide a sort of insurance premium to pay for the losses banks impose on the taxpayer when they go bust. It would be better to have other reforms to ensure that a “no bail out” pledge can be made credible, but let’s assume that we are starting from here, what is wrong with Vince Cable’s proposal?
 
1. Insurance this is not. The tax is not in any way related to the risk that a particular bank poses. It therefore increases moral hazard in the system by institutionalising bail outs (the sector as a whole is paying for bail outs so it will get bail outs) whilst profitable banks will be charged more regardless of whether they are more risky.
 

2. Given that better lending decisions lead to higher profits it taxes those banks that make the most prudent decisions. Of course, other things can lead to higher profits too (such as good luck with risky assets) but a well-managed bank will be more profitable in the long term and therefore will be penalised more than a badly managed bank.
 

3. The levy will be on profits before tax but not on profits before interest. The tax is therefore yet another tax on equity. This is extraordinary because it is partly the tax treatment of equity relative to that of debt that causes financial companies to create complex instruments to increase gearing in the first place. But Vince Cable now proposes what is, in effect, a subsidy for gearing.
 

The problems that Cable identifies with the corporation tax system which lead (he believes – I don’t entirely agree) to banks paying too little tax could be fixed from first principles. The imposition of this proposed levy is, I am afraid, entirely misguided.
 

Are there alternatives – ignoring a move to a completely deregulated banking system with no bail outs? Yes, there are. One could have voluntary risk-based deposit insurance where the banks that had casinos attached would pay more. If they did not want to buy deposit insurance they could find other mechanisms to signal security but there would be no bail out for anybody if a bank went bust without deposit insurance. Paul Tucker’s suggestion of contingent loan capital that turned into equity capital when a bank is close to insolvency is also very sensible. Banks used to have a lot of that – it was called “preference share capital”, but then our tax system penalised it so heavily it became more or less extinct. This should be a warning to Vince Cable about the unforeseen consequences of misguided tax changes.

A suggestion I have seen (I forget by whom) is for banks to have equity shares that are only partly-paid. The idea (a bit like Paul Tucker’s suggestion above of contingent loan capital) is that a regulator who believes that a bank’s position has become ‘too risky’ would be able to require shareholders to pay up more cash on their (partly-paid) equity shares. It is hoped that this would induce shareholders to take a keener interest in monitoring the risks a bank’s management was running.

This is also very similar to double liability for shareholders – which is something that banks used to have voluntarily in the days before regulation in order to communicate their soundness to the market.

Vince Cable seems to have acquired something of a reputation as a guru recently, on rather flimsy evidence. This latest proposal doesn’t enhance his reputation. Just seems like another rabble-rousing anti-bank idea which ignores government’s own responsibility for much of the current mess.

A suggestion I have seen (I forget by whom) is for banks to have equity shares that are only partly-paid. The idea (a bit like Paul Tucker’s suggestion above of contingent loan capital) is that a regulator who believes that a bank’s position has become ‘too risky’ would be able to require shareholders to pay up more cash on their (partly-paid) equity shares. It is hoped that this would induce shareholders to take a keener interest in monitoring the risks a bank’s management was running.

This is also very similar to double liability for shareholders – which is something that banks used to have voluntarily in the days before regulation in order to communicate their soundness to the market.

Vince Cable seems to have acquired something of a reputation as a guru recently, on rather flimsy evidence. This latest proposal doesn’t enhance his reputation. Just seems like another rabble-rousing anti-bank idea which ignores government’s own responsibility for much of the current mess.

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