Big banks should be broken up, not taxed

Prospect Magazine

Big banks should be broken up, not taxed

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A Tobin tax would only work by destroying financial activity. The government must instead break up large banks and regulate them better

Read our other exclusive online responses to Adair Turner from Tim Congdon, Oliver Kamm and Robert Kuttner

FSA chief Adair Turner’s willingness to consider taxes on financial transactions, or a Tobin tax, to rein in the financial services industry has provoked a furore.

Much of the debate has, naturally, surrounded pay and bonuses. But to focus on compensation is to miss the bigger picture about how to control credit booms and finance in the first place. Turner is well aware of this. When he referred to possible Tobin taxes, he did so before saying “if increased capital requirements” are insufficient. Moreover, his comments came in the context of a longer debate about the excessive growth and size of the financial sector in general. Put another way, regulatory reform is essential for a more stable and orderly financial system in which discipline is restored. And in finance, size really does matter—but I would argue that the size of financial entities is more important for stability, profits and compensation than the size of the financial sector in principle.

If a Tobin-type tax were introduced, where would the authorities apply it? On foreign exchange trades, credit derivative exposure, leveraged lending, or particular types of asset-backed products? It beggars belief to imagine that this would subdue the financial industry. Resources would simply be switched to non-taxed products and services, taxed activities that were profitable would be moved to other locations, and clients would probably end up paying the tax in some form. Ultimately, a tax would have no effect on the compensation structures and levels of financial companies unless it were sufficiently penal to distort and destroy bona fide financial activity. Nor would it act to suppress the ability of banks to take excessive short-term risks and profits, especially now that we have created banks that are too big to fail.

This lies at the heart of the issue. Banks need to earn their way back to financial health, albeit currently with the aid of unprecedented financial policy intervention by public authorities. But the management of the financial crisis has ended up with a financial system dominated by a few banking behemoths, the most successful or strongly supported of which are scooping up profitable business from weaker rivals. This concentration within the sector is occurring alongside the revival of practices that have raised eyebrows, for example, leveraged lending and more aggressive compensation programmes, including the use of bonus guarantees.

It is now imperative for the government to undertake two vital tasks. First, following most of what Turner had to say in the Prospect interview, regulatory reform has to be implemented sensibly but quickly. This includes the application of higher capital requirements, linked to the stage of the economic cycle, and risk and liquidity on banks’ balance sheets. Higher capital is a direct charge against aggregate bank profits, and a wholly prudent way of mitigating systemic risk.

Second, governments generally should summon the political courage to break up the largest banks, directly or otherwise, with the express purpose of introducing more competition. That way, super-normal profits will be reduced, compensation structures will have to be changed, and larger rewards will accrue only to the really successful over the longer term.

One can understand the thinking behind a Tobin tax to affect compensation and profits, but it wouldn’t work in an open economy—and it is no substitute at all for the more pressing and effective challenges of re-regulation and more competition. Coincidentally, this is the way things used to work once upon a time before the boom.

More debate on the Turner interview will be featured in the October issue of Prospect, published 24th September

  1. September 6, 2009


    There are several flaws with this argument. Firstly, the purpose of a Tobin tax is not to directly “subdue the financial industry”. A Tobin tax would reign in short term speculative investment without directly affecting long term investment. Secondly, whereas re-regulation is necessary, the alternative of simply creating more competition is little more than a sticking plaster on a bigger wound. Creating more competition would simply lead to greater distrbution of profits within the banking system until the stronger banks regained control further down the line. Essentially we would find ourselves at square one again in a matter of years. A combination of tight public regulation and active deterrents against purely speculative investment (i.e. a Tobin tax) is what the economy needs to prevent a recurrence of this financial collapse.
    Either that or we start reading up on Marxism.

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George Magnus

George Magnus
George Magnus is Senior Economic Adviser to UBS, and author of "Uprising: Will Emerging Markets Shape or Shake the World Economy?" (John Wiley) 

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