Wednesday, January 20, 2010

Obama's banking levy

President Obama has proposed a levy on large banks in order to recoup costs incurred by tax payers in the financial crisis. There are two separate questions. One, is the levy merited or is it just? Two, will it serve the larger purpose of ensuring financial stability?

To answer the first, here is the levy in brief: 15 bp on covered liabilities; insured deposits are subtracted because banks are already charged by the Federal Deposit Insurance Corporation. It will yield about $90 bn over ten years. US banks- the top 50 or so to whom it will apply- can bear it, all right, since it is estimated to amount to 2-7% of pre-provision profit of US banks.

According to one estimate, American tax payers have lost $47 bn on the capital they had infused into banks, so the levy is fair. I don't know what the basis for this estimate is. Capital infused into banks has been mostly returned.Are we talking of interest on this amount? Besides, the government can hope to make a profit on bad assets hived off and sold in future. I am not sure that the levy can be justified as recovery of loss.

It makes more sense to justify it on other grounds:
  • penalty on windfall profit- similar to the one-time windfall tax imposed in the UK.
  • Intended to penalise large banks
  • Intended to penalise dependence on wholesale funds as deposit liabilities are not covered by the levy
  • Help bridge huge fiscal costs incurrred in crisis
  • Assuage popular anger against bankers
As for the second question, two academics argue in FT that we cannot hope to abolish or diminish banking crises with levies of this kind:
First, we must sharply raise capital requirements at leveraged institutions, so shareholders rather than regulators play the leading role in making sure their money is used sensibly. This means tripling capital requirements so banks hold at least 20-25 per cent of assets in core capital.

Second, we need to end the political need to bail out every institution that fails. This can be helped by putting strict limits on the size of institutions, and forcing our largest banks, including the likes of Goldman Sachs and Barclays, to become much smaller.

As readers of this blog would know, I agree with the above. The nature of banks and banking needs fundamental change. But the present crisis does not seem to have done enough damage to focus minds in the political class or fend off all-powerful banking lobbies. Alas, we need a bigger disaster, it seems, before this happens.

6 comments:

Anonymous said...

Fundamentally should we call the likes of Goldman Sachs and Morgan Stanleys of the world as banks? My Indian psyche doesn't simply allow me to think this way. I would like to call these entities as brokers and not Banks just because they call the activity they carry out as "Investment Banking" or "Merchant Banking"..

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K.R.Srivarahan said...

Obama calls his proposal to ban proprietary trading by large banks as the "Volcker Rule". Given your steadfast and logical crusade for limiting the size of "too big to fail" banks, his proposal to prune the size (and scope) of such banks must be called the "Ram Mohan Rule".

T T Ram Mohan said...

Srivarahan,

Thanks for the flattering suggestion!
I must caution that limiting the scope of banks is an indirect way of limiting the size. It is not obvious to me that this is preferable to more direct limits on size itself. It is also not clear to me that restrictions on scope are desirable- the academic literature on Glass Steagall casts doubts on the rationale for it.

-TTR