Insurance plan could hold big banks to account

The meetings of the Group of 20 (G20) developed and emerging nations used to be somewhat dull gatherings, but this has changed as controversial ideas have been proposed that have far reaching implications for the financial system. The UK prime minister Gordon Brown certainly caused a stir at the recent meeting in Scotland of G20 finance ministers 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 in 1972. It was aimed at preventing speculators destabilising the foreign exchange system after the US abandoned the gold standard. Seven years after Tobin's death, it was revived by Lord Turner, the chairman of the Financial Services Authority of the UK, who said a levy on financial transactions would curb the power of the City of London financial centre.

Why the attraction now? And how will the proposed tax differ from other risk-based insurance premiums that the US seems to favour? In the end, their objectives are the same: to ensure that the financial sector, rather than the taxpayer, pays the cost of future crises. There are other pressure groups, however, supporting Mr Brown in the hope that the funds raised would be used for aid, specifically to help developing countries respond to climate change. This seems idealistic, but the G20 officials had more pressing issues on their mind. Those issues centred on their inability to address the simmering financial crises and government bailouts of 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." 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 the bill.

The big question remains: 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 and created a number of massive banks. If those banks get hit by a loss of confidence, they can bring down the whole system. Doing nothing is not an option. But given a generous government safety net, the risk of institutions repeating costly mistakes and going unpunished is inherent in the system. Economists call this moral hazard.

There seems to be a way out that is more acceptable than the Tobin tax for some: insurance. Most of us have taken out some sort of insurance and pay premiums to protect ourselves against unexpected risks. If we are extremely careful, the following year's premium might be reduced. If we are unlucky, we receive a payout. Unlike government bailouts, such protection is not free, as premiums had been paid. Some will argue that government bailouts of 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 provide insurance to the financial sector? Central banks can be the explicit insurers, as they are the implicit bailout providers. 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 with 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. This premium could be adjusted periodically based on an evaluation of the level of risk in a financial institution's holdings. If a bailout is required, the fund would act as a reserve, instead of relying on taxpayers for the entire amount. 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. Investment banks, for example, 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 the wider society, including those who lost their homes, the losers. In such an environment, a mechanism based on bailout insurance might be a useful regulatory signalling tool to reduce the likelihood of future government bailouts. Mr Brown is to thanked for initiating the debate.

Dr Mohamed A Ramady is a former banker and visiting associate professor, finance and economics at King Fahd University of Petroleum and Minerals, Dhahran.