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G-20 Bank Tax: Poor Fiscal Policy and Even Worse Prudential Policy

12 June 2010
A. Michael Andrews
Ottawa-based consultant on financial sector policy and regulation, and former staff member of the International Monetary Fund.

The Canadian-led victory in the international bank tax debate may prove pyrrhic. Having abandoned the attempt to coordinate through the G-20, many countries are likely to introduce new levies on banks unilaterally or coordinated in another international forum such as the European Union. If based on current proposals these new taxes will detract from rather than enhance financial stability. Perhaps more importantly, the need for a credible alternative to bailing out systemically important institutions has been submerged by the G-20 bank tax debate.
Large deficits in the United States and much of Europe make new levies on banks an almost irresistible option to increase government revenues. And this particular option comes with political cover from the usual criticisms of tax increases.  New levies on banks are presented as necessary to deal with the costs of the last crisis and, at least until now as part of the international initiative to prepare for the next crisis. The near-universal popularity of bank-bashing places a cloud of suspicion over critics of the new bank levies.   
The problem is that current proposals such as the International Monetary Fund’s (IMF) Financial Stability Contribution and the Financial Activities Tax are bad fiscal policy and even worse prudential policy. Taxes on banks, like taxes on any corporation, ignore the precept that there is only one taxpayer—the individual customer of the bank. Banks are easy targets, but the taxes will be paid by customers in the form of higher fees and interest rates.
The features of the proposed Financial Activities Tax which seem positive at first glance are the most dangerous from a financial stability perspective. This tax would be levied on the sum of the profits and the remuneration of financial institutions. From a government fiscal perspective, the beauty of including remuneration in the base is that tax revenues will be fairly constant regardless of the profitability of the institution.
From a financial stability perspective, a Financial Activities Tax which is only partially linked to profitability risks exacerbating the problems of a troubled institution.  Inflexible levies compound losses and erosion of capital at the very time when the bank should be conserving capital. The proposal that the Financial Stability Contribution be based on liabilities is similarly flawed by this risk of pro-cyclicality.
Pursuit of counter-cyclical policies that would dampen rather than amplify the effect of future financial shocks was endorsed by the G-20 in November 2008. It follows logically that taxes on capital, which perversely encourage institutions to reduce their capital buffer against unexpected losses, and taxes based on size or transactions or fixed costs, which are not sensitive to the institution’s ability to pay, should be avoided. If more government revenues are required from financial institutions, the best solution is higher income taxes. Banks would pay more when profits were higher, and lower taxes when profits decline would provide an automatic stabilizer.
Possibly the most worrisome aspect of the ongoing debate is that the G-20’s 2008 undertaking to pursue improved ways to deal with systemic and cross-border failures,  and the more recent IMF proposal that the Financial Stability Contribution should be “linked to a credible and effective resolution mechanism,” have been largely ignored. As Bank of Canada Governor Mark Carney recently observed, practical obstacles to many theoretically attractive measures have meant there has been little uptake on Canada’s proposal for Embedded Contingent Capital as an alternative to a bail-out fund, or other alternatives such as breaking up large banks or the earlier U.S. proposal for “living wills” to facilitate intervention in systemically important institutions. It may be time to revisit a much simpler concept.
Compulsory bank recapitalization was proposed eight years ago by the Reserve Bank of New Zealand (RBNZ) as a potentially credible alternative to bailing out a systemically important institution. Conceptually elegant—a troubled bank would be seized by the supervisory authority, shareholder rights extinguished, and the bank then re-opened with deposit and other liabilities “haircut” by a sufficient margin to recapitalize the bank—the approach avoids the moral hazard problems arising in the recent crisis from shareholders benefitting at taxpayer expense. Deposits up to the deposit insurance limit would not be affected, but deposits in excess of the limit and other creditors’ claims would be reduced by the percentage required to recapitalize the bank.  
The RBNZ confirmed that it would be technically possible to pre-position information technology capabilities in the systemically important banks so that in case of a crisis the compulsory recapitalization could be completed over a weekend. The RBNZ identified a range of operational issues that would have to be addressed to develop a viable contingency plan. Addressing these issues on an international basis would provide a viable alternative to tax-payer funded bailouts of systemically important institutions.

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