Government subsidies, if they are to be effective, need to be targeted. In the case of the banks, taxpayer funds that were intended to rebuild the banking system’s capital base, to enable them to lend more and to absorb future lending losses, are instead simply being paid out in bonuses.
Caught up in the blame game of trying to shift responsibility for the banking crisis, government ministers are returning to their old tricks. Today’s generation of politicians seem to think that taxation is the answer to all our woes. Many of those who pass our tax laws have never worked in the private sector – let alone run a private business – and are oblivious to the economic damage that high taxes can inflict upon industry. Since income taxes were first introduced by William Pitt the Younger in 1798 as an easy means of funding government expenditure, successive British governments have become accustomed to responding to new problems simply by introducing new taxes. Westminster’s answer to global warming? Green taxes. A bloated, inefficient public sector? Yet more taxes. Excessive banker bonuses? Excessive banker taxes.
Whilst governments are right to attempt to contain excessive banker remuneration – especially when it is directly or indirectly funded by the public purse – higher tax rates rarely achieve their intended purpose. Rather, they tend to have a negative connotation. They discourage enterprise and investment. They encourage a highly mobile industry to relocate overseas. All these things work ultimately to reduce the overall level of tax revenues flowing into the Treasury’s coffers.
Instead of playing a tune that appeases voters, politicians are more likely to achieve lasting results if they start talking the language of business. If the banking industry expects taxpayers to be their insurer of the last resort, then the government should extract a premium for that service. That insurance premium should be sufficiently large on a collective basis to cover the cost of the last bail out as well as paying for the next one.
Banks should be left free to decide whether or not they need these government-backed insurance contracts. But those banks that choose not to insure their balance sheets would naturally be deemed high risk by the markets – by shareholders, creditors, customers – and by regulators. They would see borrowing costs rise relative to their peers. Bank shareholders and bond holders would all be put on notice that, in the event that their bank runs into capital or liquidity problems that warrant government intervention, their investments might be wiped out. Under these circumstances, the likelihood is that all bank executives would see the commercial imperative of insuring their operations against default.
As is normal practice in the insurance industry, the government – as sole insurer – would perform a rolling risk assessment of the industry, segmenting the banking industry into high risk, medium risk and low risk players, each carrying an appropriate premium. Some parts of the banking system may carry such high risks as to be uninsurable. If so, those parts of a bank would have to be segregated and would be ineligible for taxpayer funding. Indeed, as a country, we may well be better off if the riskiest parts of the banking sector left the country. They would then become a problem for another set of taxpayers.
The insurance premium would naturally reduce the pot available for bonuses. Unlike taxation, an insurance scheme provides a strong market-based rationale for capping bonuses. To tackle the bonus culture, further measures are required. We need to return to the basic principles of any good employee incentive scheme. Bonuses should be tied to the performance of the individual and the company. If the company performs disastrously, employees must share the pain. Banking profits should be calculated on a more prudent basis, with greater general provisions for future losses, so as to smoothen profits out over time – after all, many banking executives announced record profits in 2006, only to hit their shareholders with record losses a couple of years later. Bonuses should only be paid out of profits, not losses. Short term bonuses should be replaced with long term bonuses. Tie an employee’s bonus to his pension scheme and I guarantee you he will think twice about taking big bets.
If such rules were made clear now, bank executives would be forced to put their house in order, to manage costs better, rather than casually assuming that they will be bailed out with impunity. Investors would have greater clarity over which banks would be saved and which would be allowed to fail. Aggrieved shareholders or bond holders would have no case for claiming compensation.
Some argue that the Basel III rules already provide an implicit form of insurance against bank failure. The Basel III Committee in Switzerland agreed last year to raise the minimum core Tier 1 capital ratio from 2% to 7% by 2019. The problem with the Basel III rules is that they are essentially internal controls which can be easily manipulated to give regulators the perception that they are being followed. Whilst Basel III provides banks with an internal buffer against future losses, it would help to have an external buffer before the tax payer is called upon to rescue the sector.
Remember that a lack of capital and a lack of liquidity were the two primary causes of this crisis. Had banks put aside enough capital and enough cash to cover their losses, we may not be in this mess today. But banks are never likely to maintain adequate capital over the long term because their industry suffers from ‘moral hazard’ – that is, bankers know that if their own capital reserves are inadequate to absorb future losses, they can always rely on the taxpayer to bail them out. If banks are forced to pay a premium for the taxpayer guarantee their industry demands, the problem of moral hazard partly falls away. In the long run, that is the only way to prevent the banking industry from bringing us all down.
Caught up in the blame game of trying to shift responsibility for the banking crisis, government ministers are returning to their old tricks. Today’s generation of politicians seem to think that taxation is the answer to all our woes. Many of those who pass our tax laws have never worked in the private sector – let alone run a private business – and are oblivious to the economic damage that high taxes can inflict upon industry. Since income taxes were first introduced by William Pitt the Younger in 1798 as an easy means of funding government expenditure, successive British governments have become accustomed to responding to new problems simply by introducing new taxes. Westminster’s answer to global warming? Green taxes. A bloated, inefficient public sector? Yet more taxes. Excessive banker bonuses? Excessive banker taxes.
Whilst governments are right to attempt to contain excessive banker remuneration – especially when it is directly or indirectly funded by the public purse – higher tax rates rarely achieve their intended purpose. Rather, they tend to have a negative connotation. They discourage enterprise and investment. They encourage a highly mobile industry to relocate overseas. All these things work ultimately to reduce the overall level of tax revenues flowing into the Treasury’s coffers.
Instead of playing a tune that appeases voters, politicians are more likely to achieve lasting results if they start talking the language of business. If the banking industry expects taxpayers to be their insurer of the last resort, then the government should extract a premium for that service. That insurance premium should be sufficiently large on a collective basis to cover the cost of the last bail out as well as paying for the next one.
Banks should be left free to decide whether or not they need these government-backed insurance contracts. But those banks that choose not to insure their balance sheets would naturally be deemed high risk by the markets – by shareholders, creditors, customers – and by regulators. They would see borrowing costs rise relative to their peers. Bank shareholders and bond holders would all be put on notice that, in the event that their bank runs into capital or liquidity problems that warrant government intervention, their investments might be wiped out. Under these circumstances, the likelihood is that all bank executives would see the commercial imperative of insuring their operations against default.
As is normal practice in the insurance industry, the government – as sole insurer – would perform a rolling risk assessment of the industry, segmenting the banking industry into high risk, medium risk and low risk players, each carrying an appropriate premium. Some parts of the banking system may carry such high risks as to be uninsurable. If so, those parts of a bank would have to be segregated and would be ineligible for taxpayer funding. Indeed, as a country, we may well be better off if the riskiest parts of the banking sector left the country. They would then become a problem for another set of taxpayers.
The insurance premium would naturally reduce the pot available for bonuses. Unlike taxation, an insurance scheme provides a strong market-based rationale for capping bonuses. To tackle the bonus culture, further measures are required. We need to return to the basic principles of any good employee incentive scheme. Bonuses should be tied to the performance of the individual and the company. If the company performs disastrously, employees must share the pain. Banking profits should be calculated on a more prudent basis, with greater general provisions for future losses, so as to smoothen profits out over time – after all, many banking executives announced record profits in 2006, only to hit their shareholders with record losses a couple of years later. Bonuses should only be paid out of profits, not losses. Short term bonuses should be replaced with long term bonuses. Tie an employee’s bonus to his pension scheme and I guarantee you he will think twice about taking big bets.
If such rules were made clear now, bank executives would be forced to put their house in order, to manage costs better, rather than casually assuming that they will be bailed out with impunity. Investors would have greater clarity over which banks would be saved and which would be allowed to fail. Aggrieved shareholders or bond holders would have no case for claiming compensation.
Some argue that the Basel III rules already provide an implicit form of insurance against bank failure. The Basel III Committee in Switzerland agreed last year to raise the minimum core Tier 1 capital ratio from 2% to 7% by 2019. The problem with the Basel III rules is that they are essentially internal controls which can be easily manipulated to give regulators the perception that they are being followed. Whilst Basel III provides banks with an internal buffer against future losses, it would help to have an external buffer before the tax payer is called upon to rescue the sector.
Remember that a lack of capital and a lack of liquidity were the two primary causes of this crisis. Had banks put aside enough capital and enough cash to cover their losses, we may not be in this mess today. But banks are never likely to maintain adequate capital over the long term because their industry suffers from ‘moral hazard’ – that is, bankers know that if their own capital reserves are inadequate to absorb future losses, they can always rely on the taxpayer to bail them out. If banks are forced to pay a premium for the taxpayer guarantee their industry demands, the problem of moral hazard partly falls away. In the long run, that is the only way to prevent the banking industry from bringing us all down.
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