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Finance & Banking | Global Arab Network
Bailout insurance would help to spare the taxpayer
Global Arab Network - Dr Mohamed Ramady
Meetings of the Group of 20 (G20) developed and emerging economies used to be somewhat dull gatherings, but not any more. Lately, there have been controversial ideas proposed that have far-reaching implications on how to manage the changed financial landscape. Gordon Brown, the UK prime minister, certainly caused a stir at the recent G20 finance ministers meeting in Scotland when he suggested a tax on financial transactions, sometimes called a Tobin tax after the Nobel Prize-winning economist James Tobin.

The Tobin tax – a charge of between 0.1 per cent and 0.25 per cent on foreign exchange deals – was first proposed by the Mr Tobin in 1972. It was aimed at preventing speculators destabilising the foreign exchange system after the US abandoned the “gold standard”, where currencies had been pegged to the metal since the end of the Second World War. Seven years after his death, it was revived this year by Lord Turner, the chairman of the Financial Services Authority in the UK, who said a levy on financial transactions would curb the power of the City.

Why the attraction now, and how will the proposed tax differ from other risk-based insurance premiums that the US seems to favour, given the lukewarm reaction by Timothy Geithner, the US Treasury secretary, to Mr Brown’s suggestion? In the end, their objectives are the same: to ensure the financial sector, rather than the taxpayer, pays the cost of future crises. There are other pressure groups, however, who have supported Mr Brown in the hope that the funds raised are to be used for aid, specifically to help developing countries respond to climate change – to curb their own greenhouse emissions.

This seems idealistic, but the G20 participants had more pressing issues on their minds and this centred on their frustrating inability to address the simmering financial crises and government bailouts of failed financial institutions. And what did Mr Brown actually say to cause this shock? His words are clear enough: “There must be a better economic and social contract between financial institutions and the public, based on trust and a just distribution of risks and rewards.”

Translated in plain English, Mr Brown was saying that global banking cannot go back to business as usual, backed by global government guarantees that they will be rescued in the event of a crisis, and leaving taxpayers to pick up the bill.

The big question is posed: is the economic and moral relationship between Big Finance and taxpayers symmetrical and fair? The answer is obvious. The size of the financial system has exploded, populated by superbanks that, if they get hit by a loss of confidence, can bring the whole system down. Not doing anything is not an option. Given a generous government safety net, the risk of repeating costly mistakes and going unpunished is always inherent in the system. Economists call this moral hazard. There seems to be a way out that may be more acceptable than the Tobin tax for some, and the insurance industry provides a potential answer.

Most of us have taken out one form of insurance and pay premiums to protect against unforeseen risks. If we are extremely careful, the following year’s premium might be reduced or held the same. If we are unlucky, we receive a payout, but unlike government bailouts, this insurance payout is not free because we pay for it. Some will argue that government bailouts of distressed financial institutions are in a different league from personal insurance cover, as the potential damage to the overall economy and consumer confidence is substantially higher than the potential cost of government bailouts.

Who would charge this insurance to the financial sector? Central banks can be the explicit insurers, as they are the implicit bailout insurers. Instead of becoming last-resort lenders, central banks might also become the insurers of first resort and force financial institutions to think twice before engaging in risky financial activities. This is what is appealing to some of those who are dissenting against Mr Brown’s Tobin tax alternative, as they argue that a Tobin transaction tax cannot work unless all financial centres fall in line.

If some huge banks are “too big to fail”, why not make the implicit government insurance explicit and charge them a premium? Central banks would then require member banks to purchase insurance, at a price the central bank would set, and adjust this premium periodically based on an evaluation of the level of risk in a financial institution’s holdings. In case of bailout payments, the fund would act as a reserve, instead of a 100 per cent taxpayer bailout. The raising of bailout insurance premiums would have negative consequences on a financial institution, and make it think twice before engaging in risky activities.

Some will argue that the financial system performs best when it is less regulated and innovative. Investment banks have prided themselves on their ability to manage risks and returns. The global regulatory framework was premised on that ability, but it has failed badly. Financial institutions did manage risks, but in a way that left them seemingly the winners, and wider society, including those repossessed of their homes, the losers. In such an environment, a signalling mechanism based on bailout insurance premiums might be a useful regulatory signalling tool to reduce the likelihood of future government bailouts. Mr Brown is to be thanked for initiating the debate.

Global Arab Network

Dr Mohamed A Ramady is a previous banker and currently visiting associate professor, finance and economics at King Fahd University of Petroleum and Minerals, Dhahran, Saudi Arabia. This article appeared in The National.

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