Bank liability levy may not be foolish

January 13, 2010

A levy on bank liabilities would get the industry squealing – especially if it approached $120 billion. But the Obama administration isn’t crazy to float the idea. A well-crafted tax could help recoup bailout costs while also giving banks an incentive to behave more sensibly. It doesn’t have to apply just to the United States, either.

Populism aside, the main rationale for a levy is that the size of a bank’s liabilities is a goodish proxy for the risk it poses to the financial system – as well as the benefit it received from the cheap money central banks doled out to offset the credit crunch. It’s reasonable that banks should pay for help from their lenders of last resort.

There is one big proviso. Deposits should be taken out of the liability bucket. In the United States and elsewhere banks already pay deposit insurance fees – so including them would amount to double taxation. Any new liability tax should focus just on wholesale finance, a riskier “easy come, easy go” form of funding. With such a charge in place, banks would have an incentive to build up their deposits – something that regulators across the world are urging them to do anyway.

There is also one big question. Should such a tariff be an ongoing part of the fiscal framework or a one-off? The argument for permanence derives from the fact that it’s best viewed as an insurance premium paid in return for a continuing safety net.

But there is a case for a special one-off levy in addition to an ongoing tax, to take account of the extraordinary assistance banks have received over the past two years. Walter Bagehot, the 19th Century British economist, said that in a crisis, central banks should lend freely but at penal rates. During the recent crisis, the authorities thought banks were too fragile to pay through the nose for help. Now that the industry is again making bumper profits, there is an opportunity to call in that favor.

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