Keith Anderson: Banks should have to pay a premium for the privilege of being "too big to fail"

Dr. Keith Anderson is a Lecturer in Finance at the York Management School at the University of York and a private investor.

When my Russian parents-in-law come to visit, I’m financially responsible for them. If they end up with a large hospital bill and they didn’t buy enough medical insurance, I pay for it. But that’s fair enough, because I explicitly agreed to that risk when I invited them. One of the most egregious features of the banking crisis is how we have found out after the event that we have all for years been implicitly on the hook, ensuring that no UK-based bank or building society ever goes bust. As the recent case of the Dunfermline Building Society shows, these bills are still coming out of the woodwork, and we are all still liable for untold billions more.

George Osborne is considering breaking up the nationalised banks, and preventing others from becoming too big. The trouble is, at the moment all the incentives work the other way. The larger a bank grows, not only do the executives get ever more perks and bonuses, but they also know that they are more likely to be bailed out should everything go disastrously wrong. So as Northern Rock showed most vividly, they grow larger and larger, faster and faster, taking whatever risks the regulator will allow them to take.

I have a suggestion that should ensure the same result, but will not involve the regulator trying to force the banks to do something when every other incentive is telling them to do the opposite. It also fits in with the Conservative philosophy of allowing the market to regulate itself wherever possible.

My suggestion is quite simple: turn this implicit State guarantee into explicit insurance. It should also be public, since we all have to help pay. Each year, a committee of the FSA announces a list of those banks and building societies that are officially too big to fail. The banks included then pay a handsome premium for the privilege, whether they like it or not. The levy would be based on the amount the taxpayer would have to stump up should everything turn to dust, as it has so often recently.

Total assets seems an obvious measure of size, since banks do not have turnover as normal companies do. The percentage of total assets charged as a premium each year should be enough to hurt, but not to wipe out profits. It should make the management think seriously about how they could split up their operations to avoid paying it (and not coincidentally, no longer be a massive contingent liability on the taxpayer).

For example, last year Barclays reported profits after tax of just over £5 billion on total assets of £2,000 billion (for comparison, this is more than three times what Chancellor Darling spends each year). So 0.1% of net assets, or £2 billion, would be a good starting point. The percentage could even be raised at times of increased risk, as long as the formula for it was publicly available well beforehand.

Two possible problems: firstly, very clever people will be paid large amounts of money to present the accounts so as to minimise the apparent size of the group. Northern Rock and Granite spring to mind, although Granite’s purpose wasn’t to mislead. Human ingenuity being what it is, the only permanent way to counter this is for the FSA committee to hire its own accountants (inevitably much more poorly paid, but hopefully almost as clever) to come to a fair view of the overall size of the group, regardless of any clever accounting wheezes.

Banks may also decide to relocate to outside the UK. There is little that could be done to counter this, but taxpayers would at least have the security of knowing that their money would no longer be at risk should the bank get into trouble. Depositors and other creditors would also be left in no doubt that should the bank get into trouble, it would no longer be the British Government’s problem.

Which brings me to my last point: it should become a criminal offence to use taxpayers’ money to bail out any firm that is not covered by the “too big to fail” guarantee. There should be no more cases like the Dunfermline Building Society, taken over by the Nationwide with a reported payment from the taxpayer of £1.6 billion. This is £26 for every man, woman and child in the country, for a company of which very few outside Dunfermline had ever heard. The size of the deal, compared to the size of the Dunfermline, is breathtaking: it would have cost a third as much to give each of the 530 staff £1 milion on which to retire.

Such a tiny building society could not possibly have posed a systemic risk to the banking system. Losing their jobs would be a horrible experience for those affected, but out in the real world small companies that have disastrously misjudged their market go bust all the time, and no-one steps in with billions of pounds of taxpayers’ money to save them.

Of course this is all too late to affect the majority of our banking industry that is now majority State-owned. But shutting the stable door after the horse has bolted is still better than leaving it open for next time too.