Is America Ready for Britain's Banker Bonus Tax?

The British government has just announced a one-time 50% tax on banker bonuses. This affects all banks in the U.K., including subsidiaries of foreign banks. Only bonuses larger than 25,000 pounds (about $41,000) are subject to the special tax. This and other British government limitations on bonuses send a pretty clear signal that the Labour government of Prime Minister Gordon Brown will keep a heavy regulatory hand on banking while recovering through taxes some of the $1 trillion or so in assistance the British government provided to banks.

In the U.S., Bank of America announced that it will repay all of the $45 billion in financial aid it received from the TARP program. Among other things, this will free up B of A from the executive compensation limitations imposed by TARP and from paying the U.S. Treasury dividends on B of A preferred stock it owns through TARP. Much of B of A's ability to make this repayment is because of the extensive federal support given to banks, courtesy of the taxpayers. The Fed has funded the banks at a cost of virtually zero, and banks in many instances used that ultra cheap money to invest in U.S. Treasury securities or mortgage-backed securities effectively guaranteed by taxpayers. In other words, B of A is in part repaying TARP money with funds that it directly or indirectly received from taxpayers. The Treasury Department will probably put this down on its TARP scorecard as repayment in full, but how that could be when taxpayers provided some of the money that they received in "repayment"?

It would hardly be unprecedented for taxpayers to receive the short end of the stick. But they may also be receiving the short end of Britain's stick. The British tax on banker bonuses is a not very well-disguised way of inviting banks in London to reduce their riskier activities or move them out of the U.K. Risky activities generate enormous profits, and consequently gratifying bonuses. Since profits are the source of outsized compensation, bankers would move the risky stuff somewhere else and earn their mega bonuses there, before reducing their gaggle of golden egg laying geese.

The U.S. may be a logical place to shift the risky stuff. Financial regulatory reform is gradually slipping down the administration's list of priorities. Virtually all the changes that have been or are being made are the result of administrative and regulatory measures taken by the existing body of agencies (i.e., the Fed, FDIC, Treasury Dept., SEC, CFTC, etc.). Reform of the derivatives markets is taking place to a large degree through industry measures to improve the settlement and clearance process (with stern encouragement from regulators). The bigger issues of monitoring systemic risk and greater transparency in the derivatives markets are stalled in rush hour traffic, as health care reform and federal budgetary matters take front row seats, with a Congressional debate over the wisdom of President Obama's Afghanistan policy close behind. Riskier financial activity could quietly slip across the Atlantic and settle in, with little immediate oversight by the federal government. The American taxpayer might soon again be on the hook for another AIG-type monster bailout, and not even know it until too late.

The problem rests with the too-big-to fail-doctrine, where large financial institutions have the incentive is to conduct risky activities--somewhere--instead of be prudent. The individuals involved in high-octane financial activities rarely lose even if the crazy stuff they do is so systemically bad the federal deficit has to be almost doubled to salvage the economy. Bankers are incentivized to shift risky activity to new venues if they get the boot. Prudence doesn't finance yachts. And if the government--and taxpayers--will absorb the cost of bankers' failures, then all the better (from the bankers' standpoint).

Governments in continental Europe, Canada, and Asia won't welcome derivatives traders gone wild. America is the one remaining major economic power with the infrastructure to support fancy finance. Britain could, in effect, be exporting some of its most difficult financial regulatory problems. And the American taxpayer may be left holding the bag.