20/07/2011: EU's Banks Levy is a dangerous idea that will impede reforms in the sector

The latest calls for introduction of the banks levy within the EU (see here) as:

• the means for financing some of the banks rescue measures and
• the means for reducing the probability of the future crises
  

represents nothing more than a cynical and/or largely economically illiterate attempts by the EU lawmakers to dress up new revenue raising measures as ‘reforms’.

The core problems with this proposals are:

1. With current market structure & declining competition in Euro area banking sector, this levy represents another hidden tax on European households & companies. The current environment in banking sectors in many EU countries lends itself to the incumbent banks being able to pass the levy on to their customers without incurring any, whatsoever, direct moderation either on their own leverage levels or stabilization of their funding streams.
2. xWith declined competition in the sector, the new levy will act to further reduce Returns on Equity for any new entrant into the market, thus effectively acting as a barrier to entry and the means for protecting European zombie banks from competition from non-legacy banking institutions.
3. A levy will do absolutely nothing to resolve the problem if Europe’s zombie banks unable to exist as functional banking institutions, but sapping vital deposits and savings out of investment stream, thus starving the European economies of capital. European banks require some €250-500 billion worth of funds to cut their dependence on public funding and ECB/CB emergency assistance for funding and capital. Raising €10 billion annually through the proposed banks levy is simply too little to address the above gap.
4. In many cases, this levy will in effect result in a transfer of taxpayers’ own or guaranteed funds from the banks balance sheets (where these funds are now being deposited to support capital and funding activities of the zombie banks) to the EU collecting body.
   

A recent (June 2011) IMF Working Paper /11/146, titled “Recent Developments in European Bank Competition” by Yu Sun clearly finds that introduction of the common currency and the current financial crises have led to repeated reductions in overall degree of competition within the European banking sector, compared before and after EMU (1995–2000), post-EMU (2001–07) and post-crisis (2008-09)."

"Columns (3) and (4) in the table below report the H-statistic (higher H-stat reflects higher degree of competition in the banking sector) and standard error before EMU for each country or region, columns (5) and (6) after EMU. Column (9) displays the changes in the H-statistics from pre to post EMU period."

Thus, “the overall competition level in euro area dropped slightly after EMU, from 0.699 to 0.518 while competition levels across member countries converged [the standard deviation of H-statistics of euro member countries drops from 0.17 before EMU to 0.12 after EMU]."

“The finding that large and financially integrated countries or regions tend to exhibit less competitive behavior than smaller sectors is in line with others studies, including Bikker and Spierdijk (2008), who also find some deterioration in competitive behavior over time for Europe’s banks. They argue that banks in large and integrated financial markets are pushed by rising capital market competition and tend to shift from traditional intermediation to more sophisticated and complex products associated with less price competition."

“While the small decline in the level of bank competition for the euro area is statistically significant, it is somewhat smaller than the estimates reported by Bikker et al. (2008) using an un-scaled revenue function. For Austria and Germany, a slight increase in the competition level of their banking systems is estimated; however, the increase is not statistically significant. The H-statistics in Finland, France, Greece, Italy and Netherlands dropped after EMU. At the same time, Spain, the U.K. and the U.S. experienced some small but statistically significant improvement in the competition level of their banking systems."

Before and after the recent financial crisis: “The recent financial crisis and possibly corresponding policies seem to have left a strong mark on bank competition in many countries, as indicated by the competition indicators before and after the crisis for the sample…. Columns (7) and (8) of Table 3 show the H-statistics after the financial crisis. In the U.S., Italy, Germany, Spain and the euro area, bank competition seems to have declined following the financial crisis; however the declines in Germany, Italy and euro area are trivial.”

Bank competition among large (top 50) and small banks (bottom 50): “For some countries, like U.S. and U.K., small banks compete more intensively, while larger banks in Austria, France, Italy, Portugal and Spain are more competitive before EMU. In other countries, the competition indicators of larger banks are not statistically different from those of smaller banks before EMU”. Competition within small and large banks: “The euro area, France, Greece, Italy and Netherlands have experienced a significant drop in competition in both small and large banks, while both banks in the U.S. and U.K. showed a noticeable increase."

So overall, “the euro area experienced a significant but small decline in bank competition after EMU and the financial crisis. Some studies with similar findings have attributed the decline in competition to the process of consolidation, and the movement of bank activities from traditional financial business to off-balance sheet activities [both anti-competitive processes have accelerated under regulatory blessings of many Governments since the crisis]. More importantly, competition levels in euro countries seem to have converged after EMU, not just at the average national market level, but also between different bank types and ownership [so that less competitive markets became more competitive with euro creation, while more competitive ones became less so]. Finally, following the financial crisis, competition fell in many countries, and especially in some countries where large credit and housing booms took place."

In this environment, in my view, introducing a banking levy will simply reinforce the existent market structure and further prevent markets-led corrective adjustments in the sector. At the same time, the levy will exert new costs and pressures on banks clients.