IMF plan: the wrong kind of reform
Thursday, 22nd April 2010
IT is a quote that sums up the new cross-party consensus on London’s financial services industry. Reacting to proposals from the International Monetary Fund, which would hit all financial firms – including hedge funds and insurance companies, not just banks – with two very large new taxes, Alistair Darling had this to say: “The recognition that banks should make a contribution to the society in which they operate is right.” Really? All those firms and people don’t currently contribute anything? Tens of billions of pounds in tax and hundreds of thousands of jobs apparently mean little to a political establishment which believes the City can be replaced by green industries or a reborn manufacturing base. And why are firms such as Aviva, Prudential, Axa, Lloyds of London or Henderson Global Investors going to be hit, even though nobody has linked them with the crisis?
The City needs substantial reforms to make it more robust (a point which I have been making ad nauseam). The pre-2007 system was always a disaster waiting to happen, as many far-sighted economists had long warned. But there are good reforms – and then there are punitive ones which hit innocent bystanders rather than tackling the real causes of the crisis.
The IMF is completely wrong about some things – its FAT tax (explained in detail in the article below) will increase the costs to consumers without delivering commensurate improvements to stability. Even if adopted globally, it will cost London large numbers of jobs as the industry shrinks, hit share prices (and hence pension funds), depress house prices and cripple GDP growth.
But the IMF’s second tax is not completely wrong-headed (though its actual proposal is much too large and badly conceived, and is already being made even worse by politicians). A radically reformed variant – a fee, not a tax – would work. We need a fund akin to America’s Federal Deposit Insurance Corporation (FDIC) – but not for the purposes of funding future bail-outs. Rather, like with the FDIC, a pot of cash is needed as part of a radically new system that allows special bankruptcy courts to dissolve and wind down failed institutions without endangering the rest of the economy.
Under such a scheme taxpayers and depositors would be protected; shareholders, bondholders and top staff would be wiped out; a troubled investment bank would be temporarily financed by the fund while its positions were wound down and assets sold. Think of the way engineers are able to demolish a tall building with a controlled explosion while protecting surrounding structures.
There is a vital distinction between asking banks to pay a fee to finance this wind-down fund – and telling them the cash will be used for future bailouts, which would fuel more moral hazard. A related, crucial reform would be to set-up automatic procedures for the private sector to recapitalise troubled banks; this would allow bail-ins, as opposed to bail-outs. Banks could issue contingent convertible securities (CoCos); these debt instruments would convert to equity if capital ratios fell below an agreed level. Ordinary debt could also be turned into equity if a bank were to run out of capital. These ideas would transform banking, make it more market-based, introduce incentives to control risk and protect taxpayers. It is a tragedy the IMF and politicians are so obsessed with taxing everything that moves that they are incapable of a grown-up debate.