Where will the next financial crisis come from? Perhaps it will be a sovereign debt crisis, led by countries on the brink of default, such as Greece. Maybe an implosion of the Chinese economy, which is increasingly the sole engine of world trade. Or it could well come from central banks withdrawing the stimulus they have been pumping into the system, so provoking a fresh round of bank collapses. However, the answer is probably none of the above. The seeds of the next crisis are being sown in the political and regulatory response to the current one.
This month, President Obama has put forward a tough new tax on the banking system. The Financial Crisis Responsibility Levy is craftily constructed, imposing a 0.15% levy on the total liabilities of the 50 largest financial institutions in America. It’s estimated that the tax will raise around $9bn a year and, over ten years, recoup the bulk of the money the government had to spend bailing-out Wall Street during the crisis.
In Britain, the government has imposed its one-off tax on bankers’ bonuses, designed to confiscate the bulk of the money London’s bankers might have earned during 2009. Other taxes are being discussed. Lord Myners, the City minister, has said that Britain may well impose a levy on its financial system similar to the American one. Angela Merkel, the German chancellor, praised the tax, but said she preferred an “international levy” on financial transactions. Other countries may well follow Britain and America’s leads.
It’s impossible not to sympathise with the thinking behind the new taxes. The banks have been bailed out with huge taxpayer support and appear intent on going back to their old ways. At the very least the taxes may assuage public anger and build up funds to deal with the next crisis. And there are ways the taxes will help. The US levy will discourage what might be called the ‘Fred Goodwin syndrome’ – massively increasing the size of your balance sheet by ramping up leverage and offering more and more credit to everyone who walks through the door. The more liabilities you take on, the more tax you pay. On top of that, it will favour small banks, who will be exempt, over bigger ones. In so far as it encourages smaller, less risky banks, that will be a good thing. In Britain, everyone acknowledges that the bonus culture played a role in creating the crash, so it makes sense to impose taxes on what bankers get paid: it won’t fix the problem by itself, but if it brings some sanity back to bankers’ wages, it will help.
The trouble is, there are big risks as well. Both taxes may well drive more and more business offshore and off balance-sheet. Obama’s levy, for example, sets up a very clear incentive to use off balance-sheet vehicles. If you can roll-up your liabilities into a new company, and park it somewhere else, so that they don’t appear on the balance sheet, you can avoid the tax. Give most bankers a big incentive to indulge in fancy financial engineering and they’ll jump at the chance. So liabilities that used to be on the bank’s balance sheet, where everyone could at least see them, will disappear behind a brass plaque somewhere in the Cayman Islands.
The same goes for the bonus tax. There is already plenty of evidence that banks are reviewing whether they should base themselves in London. JP Morgan has already hinted that it may rethink its decision to build a new European headquarters in Canary Wharf because of the tax. Individuals will go to work in hedge funds based in Zug or Malta instead of working for a London-based investment bank. The result: trading and investment will move away from Britain, where it could be regulated, to offshore centres, where it will be largely invisible.
That is hardly an improvement. In the wake of the credit crunch, it was clear that one of the main problems was the way banks had hidden their loans. It wasn’t that the losses on sub-prime mortgages were that terrible. Indeed, by historical standards, they were relatively containable. It was that they were rolled up into products of such complexity that nobody could figure out who owed what to whom, or how much money might have been lost. As a result, the circuits of the financial system blew out, creating a crash far worse than the losses themselves really justified.
The risk now is of repeating precisely that mistake. Roll forward a few years. Imagine there are some nasty losses to deal with. Greece, for example, has defaulted on its debts. It is a bad but manageable crisis, with banks facing heavy but far from crippling losses. Except for one thing. The liabilities have all been hidden offshore. No one knows which bank is taking the hit, or for how much. Meanwhile, half the losses have been traded away to hedge funds. But who they’ve sold them on to, and whether they can survive, no one really knows, because they haven’t the foggiest who owes what or where.
A small problem ramps up quickly into a real crisis. And all because of the taxes introduced to cope with the fall-out from the last crisis. The measures may well be well-intentioned – but they are just sowing the seeds of another crisis.