In defence of the bank levy
Sometimes governments do the right things, even if for the wrong reasons
When an Australian financial institution is Too Big Too Fail there is the implication that the federal government will step in to bail them out or facilitate a shotgun wedding (say, by indemnifying the acquiring bank) should they be at risk of collapse. This is the very definition of moral hazard for the government.
This is a benefit enjoyed by the TBTF institutions for which they have hitherto not had to pay. It is an example of market failure that creates an uneven playing field. For this reason I have privately argued for a liability-based Moral Hazard Levy for many years. The government’s recently announced levy is a step in the right direction, towards applying a price signal on what has previously been a free benefit.
The government’s recently announced levy is a step in the right direction, towards applying a price signal on what has previously been a free benefit.
The full detail of the levy is not yet known. We know only that a 0.06% levy will apply to as yet unspecified liabilities of the four major banks and Macquarie and that the levy is expected to raise c.$1.5 billion per year. This article suggests a robust and equitable mechanism for a Moral Hazard Levy.
Three key questions need to be answered. To what should the levy apply? To whom should the levy apply? What is the appropriate rate?
To what should the levy apply?
The government is right to base the levy on liabilities. These are, after all, what will have to be made good in the event of collapse. But which liabilities? Some portion of the assets on the balance sheet will be realised, surely? Then there is the buffer provided by the excess of assets over liabilities (AKA Shareholders Funds). In the best case the government might realise the net assets. In the worst case, the assets might vaporise and the government would have to cover total liabilities. To keep it simple and objective, I suggest the levy should apply to the halfway point between those two extremes. The formula is:
Levy Base = (Total Liabilities – Shareholders Funds) / 2
To whom should the levy apply?
The government has explicitly identified Macquarie plus the big four banks. But what about insurance companies? I suggest the levy should be phased in from a lower threshold of “clearly not TBTF” to a higher threshold of definitely TBTF.
Guidance for the lower threshold might be provided by Australia’s largest financial institution collapse, HIH Insurance Group. HIH was not bailed out. According to the last annual report prior to the collapse it had $7.1 billion total liabilities and net assets of $0.9 billion. So its levy base would have been $3.1 billion – but that was sixteen years ago. I suggest the levy should begin phasing in from a base of $5 billion.
Guidance for the upper threshold might be provided by Macquarie, the smallest of the five to be nominated by the government to pay the levy. According to its latest annual report it has $165.6 billion total liabilities and net assets of $17.3 billion. So its levy base would be $74.2 billion. I suggest the levy should apply fully from a base of $50 billion, coincidentally 10 times the lower threshold.
The table below shows Australia’s largest financial institutions, ranked by total liabilities.
This approach would see five more financial institution paying at least a portion of the levy: Bank of Queensland, IAG, QBE, Bendigo Bank, Suncorp and AMP. Of these only AMP would be subject to the full levy.
What is the appropriate rate?
The bank has set the levy at 0.06%. In an opinion piece in the AFR, Christopher Joye argued that increased credit rating of the banks due to the government’s implicit guarantee is worth 0.17% in reduced funding costs.
At the other end of the spectrum are the fees that the banks themselves charge their customers for providing guarantees. For a small business the fee is around 1.50%, when cash or property is provided as security. Large corporates might get the fee down to 0.50%.
Under my suggested approach, to generate $1.5 billion in pre-tax levies requires a rate of 0.09% of the levy base – as shown in the following table.
At that rate the big four are paying between $300 million and $360 million each. Or between 2.7% and 4.3% of pre-tax profits. The hardest hit under this regime is AMP, who would pay 8.0% of underlying profit – reflecting its relatively poor profitability. Return on equity would be down by around 0.4% for all the big four and by 0.5% for AMP. This would hardly seem to merit the shrill responses that have been heard from some quarters – especially as those same complainants often express their desire for level playing fields.
What if the rate was set at 0.17%? The government take would rise to $2.9 billion and the big four return on equity would be down by around 0.8% – still hardly fatal.
One more thing
I have yet to see any commentary to date on the impact of the levy on inequality – but this seems to be a good example of a “Robin Hood” tax. It is likely to contribute to a reduction inequality rather than exacerbate it. But that’s a topic for another article.