The Bankwatch

Tracking the consumer evolution of financial services

Euro proposal to create a ‘failed bank’ fund is a bad idea

I believe George Osborne has got it right with a refusal to accept the Euro bank fund levy (tax).  If we consider the notion of a ‘failing bank fund’ the idea arose because of the 2007 banking crisis.  One result of that crisis was that bank liquidity dried up following banks’ refusal to lend to each other.  The only solution adopted by all the western nations was to provide the necessary liquidity by purchase of bank assets for cash.  The cash was ‘printed money’ created by the central banks’.

Osborne rules out fund for failing banks | ft.com

The chancellor believes that setting up dedicated funds to protect against bank failures would create “moral hazard” and that banks paying a levy might think of the tax as an insurance fee, buying them cover in an emergency.

The amounts involved were horrendous.  In the US alone the Fed added over 1 trillion dollars to their balance sheet almost overnight in this exercise.  The Bank of England added $124 billion in reserves between Aug 2008 and today.  That proportion is roughly equivalent for the two countries based on relative GDP.

The lesson of that crisis is this.  For an individual bank to fail is less common and usually related to fraud (Barings) or bad investment decisions (LTCM).  The bank failures we see now are directly related to the causes of the banking crisis and is systemic in nature.  The lemming strategies of banks’ has meant they all participated and failed on the lending mania and asset bubble which burst in 2007.  There were differences between banks to some degree, but when the crisis occurred it affected every single bank and they were all able to survive only by the grace of government assistance. 

Banks’ operate in a quasi social contract between government (Central Banks) and citizens.  No bank or company for that matter can survive crises when equity represents less than 10% of liabilities. They do survive because people require a smoothly operating and liquid financial system.  Unless we all go back to keeping gold bars under the bed that is the system we have all accepted.

To suggest that a levy to manage failed banks can be set up is ridiculous and the Euro bureaucrats need to go back to the drawing board.  To use UK as an example you would need to tax each bank (say 5 of them) something like £20 billion each and wipe out any equity in so doing thus creating the very problem which the levy was designed to preclude.  If the government wants to tax banks to compensate for the bother and cost of propping up the banking system then that is a political call, but the notion of a fund is ridiculous.

The idea of moral hazard is that circumstances are set such that no risk is perceived, but in reality the risk is very real.  The euro fund would create real moral hazard and allow banks to create ever more crises.

Written by Colin Henderson

May 26, 2010 at 12:35

Posted in Uncategorized

3 Responses

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  1. Surely there’s no economic difference between a bail out fund and forcing banks to hold more capital on their own balance sheets? The distribution of losses might be different but the systemic outcome would be the same…

    Thomas Barker

    May 26, 2010 at 17:13

  2. There is no economic difference from a systemic view. But the moral hazard issue only exists with the former (bail out fund).

    Colin Henderson

    May 27, 2010 at 23:15

  3. […] Euro proposal to create a ‘failed bank’ fund is a bad idea […]


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