Worthless banks

Are UK banks worth anything at all? I’m prompted to ask by Mervyn King’s recent speech, in which he says “of the many ways of organizing banking, the worst is the one we have today.”
One remedy he discusses is a levy on banks’ profits. He likens this to a Pigou tax, which is intended to internalize the externalities generated by banking - the main externality being the risk of a crisis.
Yes, Osborne has introduced something like this, but only in watered-down form. King says:

It is not difficult to see that a crisis that reduces output by between 5% and 10% for a number of years, and occurs once every fifty years, amounts to an annual cost several multiples of the revenue that will be generated by the UK bank levy

Let’s do the sums.
Let’s assume that a financial crisis reduces GDP by an average of 5% per year for five years. This is a loss of around £360bn in today’s money. If in the average year there is a one-in-fifty chance of such a crisis, it follows that the bank levy should be 0.2 x 360 = £7.2bn per year. This is three times as big as that planned by Osborne.
But what is the net present value of this?
Clearly, this levy should grow in line with GDP over time, because the larger is GDP, the larger is the absolute cost of a 5% fall in it. So let’s assume a 5% pa growth rate in the levy.
We must then apply a discount rate to this. Let’s call it 8%, which is a reasonableish estimate for the likely annual return on equities.
Applying Gordon’s growth model therefore gives us a present value for the levy of 7.2/(0.08 - 0.05) = £240bn. Granted, one-third of this - the likely size of Osborne's proposed levy - should already be priced into bank shares (but is it?). But this leaves £160bn not priced in.
But the market capitalization of the big five banks in the FTSE 100 is now only £266bn.
If other words, a proper Pigovian tax on banks could easily wipe out over half of their equity value.
You can quibble with these numbers in all sorts of ways. One reason why King is not enthusiastic about the levy is that it is so hard to truly estimate what it should be.  (Another issue he doesn't mention is that the incidence of the levy might not fall upon banks at all). But the fact remains. A large part of the private value of the banking sector arises solely from the fact that the costs of its activities - the risk of a crisis - are externalized. In an efficient market economy - one where private costs equal social costs - banks might not have much, if any, equity value at all.
Perhaps nationalization isn’t a wholly bad idea.

Comments

[Last hun]

In my opinion nationalisation remains a bad idea because incompetent politicians will be unable to resist the appetite for state sponsored / abetted lending booms. Either to favoured national champions or to homeowners which inevitably will result in a sub optimal allocation of resources.

[The Silent Sceptic]

I can see the theoretical value in charging this levy. What would worry me though, is what happens to it during the good years. My guess is that the government of the day will convince itself it has "abolished boom and bust" and spend the lot on trying to buy votes, meaning that when the crash comes, the cupboard is still bare and we have a painful recession exactly as we have just done.

If we therefore assume the worst of whatever government the question then is whether it is better for the government to gather the tax during the intervening period or whether to distribute the implicitly greater profits to shareholders etc.? It's not clear to me which of these you would choose, hopefully a more economically literate person might have a view.

[Luis Enrique]

another great quote from that speech:

"And it is hard to see why institutions whose failure cannot be contemplated should be in the private sector in the first place."

Mervyn you commie.

[Carl]

Perhaps the words of US NY Mayoral candidate Jimmy McMillan resonate with you, Chris?

“If they [bankers] say they [banks] are “too big to fail”, and hate the free market when it applies to them, then make them a government organisation”

[...]

“Cut the average top banker salary from $20m a year to $45,000 a year. Bankers do not deserve big money. The free market has spoken: their businesses collapsed.”

[http://www.guardian.co.uk/commentisfree/cifamerica/2010/oct/27/jimmy-mcmillan-the-rent-is-too-damn-high]

[fistofonan]

@Last Hun: if not nationalised - how about mutualised?

[Ralph Musgrave]

The weakness in a Pigou tax is that it’s a blunt instrument: it cuts down on EVERY bank activity, good and bad. But I accept that it may be the least bad option.

A better option is to prohibit or curtail clearly undesirable bank activities. I would include in this list fractional reserve and maturity transformation (i.e. borrowing short and lending long).

There is a lecture tomorrow (Thursday 28th) at the LSE by an opponent of fractional reserve. Anyone is allowed in, but it’s first come first served.

See: http://www2.lse.ac.uk/publicEvents/events/2010/20101028t1830vSZT.aspx

[Hal]

Nationalisation of a large bank is a terrible idea because the potenential liabilities in a crisis are enormous. It would be like owning an unexploded bomb. At least in the private sector the government always has the option of refusing a bail-out. Very important.

[Luis Enrique]

a Pigou tax needn't be so blunt, there are various proposals knocking around that try to tax systemic risk but wouldn't tax banks that play safe and hence don't emit an externality

[Luis Enrique]

does it matter that a pigouvian tax "might not fall on the banks"? - the point of making a manufacturer pay for its pollution is to achieve the socially optimal quantity of pollution - it doesn't matter if the tax means higher prices for consumers, lower wages or lower profits.

To restate an element of a comment I requested deleted yesterday - at the moment the banks are like a polluting manufacturer whose private valuation is entirely offset by the costs its polluting imposes on society.

If we were to impose pigouvian tax (I'm hazy on this) wouldn't 2 things happen: 1. behaviour would change the reduce the quantity of pollution and 2. society would be compensated for whatever quantity of pollution that remains via taxation. Is that right?

[David Andrew]

You say: "Perhaps nationalization isn’t a wholly bad idea."

Mr King says, in his speech: "And it is hard to see why institutions whose failure cannot be contemplated should be in the private sector in the first place."