The federal government has given itself until the end of the year to respond to the many recommendations contained within last year’s Financial System Inquiry report, but in one area it has already decided to act against the Chair David Murray’s advice.

From January 1, 2016 the government will levy a bank deposit tax. In all likelihood this will be 0.05% of deposits up to $250,000. The scheme would be limited to the big four (ANZ, NAB, CBA and Westpac). The thinking is that the big four are big enough to absorb the tax, without passing it onto depositors. The small banks, credit unions and friendly societies would be exempt.

Under the proposal, if a bank fails and needs a bail-out, the money generated by the tax (one estimate puts it at A$500 million annually) would foot the bill. Whether that’s correct is debatable. A modest A$10 billion bailout would require the scheme to run for twenty years.

Murray says this “ex ante”, or upfront arrangement, is the incorrect approach. He argues the levy should be “ex post” - in other words, the scheme should seek to collect the funds after a bank becomes insolvent, from all of the banks that remain. This, he argues, would only be necessary in the event that the government was not able to recoup its costs through the liquidation of the failed bank’s assets. Pretty unfair to those banks that were well run, and, in effect, a free pass to the ones that fail.

Murray is very wrong indeed. The government will struggle to recoup its costs from an insolvent bank, because…it’s insolvent. In addition, bank rescue is usually aimed at re-capitalising the bank, which precludes liquidating its assets. But more important even than that, is that the conventional wisdom has come down firmly on the side of the “ex ante” argument, and Murray should have been aware of that.

A flight to smaller banks?

There are a raft of other issues this proposal throws up. First, it should be the big four plus one: Macquarie should not be exempt. Secondly, what happens to deposits in excess of $250,000? Will they attract a higher tax? In which case most depositors will simply split their deposits. Or will they attract a lower tax? In which case we will, in effect, be levying a poverty tax - that is to say, poorer, smaller depositors will be taxed more. Hardly fair.

Then there are the arguments put forward by the Australian Bankers’ Association (ABA) which highlight the disadvantage this scheme will have on larger banks: the scheme will encourage a flight of depositors to smaller banks.

There are two sides to this argument however. The first is it will level the playing field between the big and small banks. Small banks currently have to pay more for deposit funding because they are perceived as presenting a higher risk. The other side of the coin is that small banks currently have to pay more for deposit funding because they are - well - higher risk, and so should pay more.

In our rush to punish the big four we should be circumspect about distorting the market by distorting the cost of deposit funding. ABA Chairman Steve Munchenberg’s assertion that taxing the big four is unfair, because it is only the small banks that would need rescuing, is arguably nonsense. Where else would we get the concept “too big to fail”? Not from the dangers posed by the collapse of small banks. Furthermore, the empirical evidence that emerged from the GFC was that it was big banks that toppled more than small ones.

The real problem with the tax

There is a fundamental shortcoming with this proposal for a flat rate tax, and one which has not been discussed: protection of depositor’s funds is akin to an insurance contract. The insurance is against the risk of the bank collapsing. In return for which an insurance premium is charged. But the premium does not fluctuate. It is a flat rate (0.05%). A flat rate premium for a variable risk distorts the price of risk. The risk in question is a crucial one: insolvency. This represents a distortion of the risk which is the raison d'être for having the safeguard of depositor protection in the first place. Hardly optimal to have said raison d'être muddy the waters and encourage a critical point of failure.

In all probability, a risk-sensitive premium, able to fluctuate up and down as the risk of the bank not remaining solvent rises and falls, would be preferable. The IMF has recommended this for Europe, and there are several European countries where such schemes have been operating for some time.

There are differences in the risk-sensitive premium arrangements employed across those countries, and some have been more successful than others. One of them was Greece. So these types of arrangements need further study. But if operating optimally, a risk-sensitive deposit tax would almost certainly create a more effective deterrence against excessive risk taking by banks, than would the current proposal for a flat rate fee of 0.05%. For a government that is avowedly free-market, this should not be a tough sell.