Andrea Leadsom: Why Vince Cable's vengeful tax on bank profits would benefit nobody - and what we should be doing about the banks

Andrea Leadsom is the Conservative prospective parliamentary candidate for South Northamptonshire and former head of Barclays' Investment Banks team.

Vince Cable thinks that banks should be forced to cough up 10% of their profits to the Inland Revenue to help plug the hole in public finances. He is right in part - the taxpayer deserves compensation for saving the banks. 

But contrast the fate of the banks with that of the employees of Woolworths.  Woolies' staff paid the full cost of business failure with their jobs at the beginning of the year. No taxpayer bailout for them.

Yes, the taxpayer deserves compensation, but not in the form of a vengeful windfall tax seen by the banks as punishing success and potentially driving them offshore. That will benefit nobody, particularly as the British economy until two years ago received billions in tax revenues from the sector, and we hope it will do so again the future.

What banks should be paying is a one off compensation payment to the taxpayer in recognition that it is only our munificence that has ensured their survival, and allowed banks like Barclays to return to £4.5 billion of profit this year.   A 10% tax is just about right as a one-off compensatory payment to the taxpayer.
And banks should be paying an insurance premium in future to the Government in return for the implicit taxpayer guarantee.  These premia can be adjusted to reflect the risk at different economic periods. 

Such fees would encourage banks to rearrange their businesses so that they would only pay a fee for those parts of the group that would necessarily be bailed out in the event of another banking crisis.  And it is this rearrangement within banks that is critical in the battle to avoid another devastating crisis in future.
Banking groups must be split up.  Over the last decade, mergers and takeovers have led to vast financial institutions – often to the benefit of board member incentives, rather than showing any benefit to the customer.  The poor perception of customer service in the banking sector is testament to the failure of the supposed economies of scale.

Government should establish a ‘Monopolies and Mergers’ style body to consider the size and scope of financial institutions.  In much the same way as companies like BAA were forced to sell off airports when it was considered they wielded too much monopoly power over the aviation industry, so banking conglomerates should be forced to slim down and sell off parts of the business if they become ‘too big to fail’.

But there’s another side to the debate on ‘what to do about the banks’.  There’s no doubt it suits the Government to have the entire banking industry carry the can for the credit crisis – it conveniently conceals the real story of the incompetent thinking that allowed banks to get into this mess.

The real culprit is Labour’s tri-partite regulatory system.   If you want control in a regulatory system, then accountability is key.  When Barings went bust in the 1990’s it was absolutely clear both to Eddie George (then Governor of the Bank of England) and to the financial markets that the regulatory buck stopped with him.  As Head of Barclays Investment Banks team, I worked closely with the Governor and the Chairman of Barclays over that critical weekend to ensure that there was no run on Barings, nor on the interbank system.

Yet once Labour split the responsibility for regulation between the Bank of England as lender of last resort and their new Financial Services Authority (FSA), who took on the role of regulator to individual financial institutions, the accountability was lost.  The result was that we had a run on Northern Rock last year while the Bank, the FSA and the Chancellor all looked to each other to do something about it.

It’s an obvious point that financial institutions exist to make money for their shareholders.  In pursuing that goal they often follow good corporate practices, supporting staff and the local community.  They also, until recently, generated enormous revenues for the Treasury in the form of taxes.

But if we want them to pursue a goal other than purely profit, the only way to make this happen is by regulation.  And inevitably, the regulation has to be workable and not just wishful thinking. We need to learn from what actually happened to cause the credit crisis.  The key cause was massive leverage on bank proprietary trading books into illiquid and complex assets.  The home and credit card loans underpinning these assets were not as creditworthy as they were made out to be by their creators, who were in collusion with credit rating agencies.  The paper profits on these books were so huge that the risk departments in financial institutions either went along with it or their warnings were ignored.

It is precisely this activity that good regulation can stop.   Hedge funds, for all the criticism they received for short selling bank stocks, had on the whole far lower leverage than the banks.  Ironically the ‘safe’ image of banks gave them the ability to gear up their balance sheets to levels that hedge fund managers could only dream of.

One key way to limit the activities of banking groups is to prevent them from trading proprietary capital within the same legal entity as the lending bank.  In other words, if they want to have a business that looks and smells like a highly geared hedge fund, then they should create a separate entity that will not be subject to tax payer bailout if it fails.

Another way to limit risk taking in banking groups is to refocus the incentives for individual employees.   Having been closely involved with writing incentive plans for fund managers over the last 12 years, both in a hedge fund and in a retail funds management company I found it’s astonishing how closely you can link performance and activity with reward....

If banking groups want to ensure they reward staff in line with business performance then neither cash nor equities alone will do.  There needs to be a cash element in a bonus otherwise the incentive link is lost between one year’s performance and the same year’s reward.  However, a large proportion (40-60%) could be deferred with links to the individual and business performance.

Deferrals in equities are problematic because this only encourages higher risk taking in pursuit of equity gains.  A better deferral might be into preference shares.  That way if the business performs, the coupon gets paid.  If the business bombs, the employee ends up with equity.

Overall though, giving responsibility for the financial system and the individual solvency of financial institutions back to the Bank of England has got to be a key policy going forward.   Arguably, if the Bank had been closely monitoring individual financial institutions over the last few years, the Monetary Policy Committee might have shown more concern about the effect on bank balance sheets of booming house prices and rising consumer debt. 

If only global interest rates through 2007/8 had been set higher, the bubble might have never got so out of hand and the credit crisis might never have happened.  Accountability, in financial markets, is power.