The Punishment of Banks: To Whose Benefit?

Michael R. Czinkota and Charles J. Skuba

Large banks are under siege by governments. There are widespread cries of outrage as banks announce their bonuses for 2009 performance.

In the UK, Alistair Darling, the finance minister, already revealed a 50 percent “supertax” on all UK bank bonuses above £25,000 (US$ 40,000). France has announced that it will enact a similar tax. President Obama has announced the imposition of a fee on large finance firms to “recoup” public funds spent in the Troubled Asset Relief Program, irrespective of whether the banks wanted to participate or not.

There is talk of breaking up large banks in order to avoid ever again the problem of institutions which are too large to fail. Two key economic concepts are under attack by government. First is the principle of comparative advantage. Ironically, in light of British government action, the term was popularized almost 200 years ago by Briton David Ricardo. There seems to be a great willingness to extinguish the value of this advantage overnight. It took decades, in spite of significant competition from other financial centres such as Frankfurt and Singapore, for London to develop financial operations superior to others.

That leads to the second concept under attack – clustering. Since birds of a feather flock together, good performers have been attracted to a few locations of financial excellence. The existence of a comparative advantage of the financial sector attracted related and supporting industries as well. London and New York therefore became key markets, attracting key players who were paid top rewards. Quite a perpetuum mobile if not disturbed!

However, disturbances did occur as was evident in the last two years. Markets were not as successful as one would like them to be. There were large losses due to opaqueness in corporate activities and high risk exposure. Are we now seeking to find ways to reform finance in order to offer more transparency and better risk management?

Apparently not. The UK Government seems to believe that curtailing the work of markets will improve conditions. Even conservative-led governments in France and Germany are leveraging public opinion to increasingly tax the banks. When public anger is high, it can easily be used to support political action. Taxation is an easy recourse, but is it the right course?

Finance employees in are angered by any “supertax.” Many view the action as unfair and pandering to short-term populism. In a business where individuals can generate millions of pounds worth of profits (and losses), a trigger amount of £25,000 seems very low. Critics also fear that special taxes and fees would damage the attractiveness any current financial centre.

In a global environment, one can expect bankers and banks to look at alternatives such as Hong Kong, Singapore or Geneva. Some governments might well see new opportunities to attract financial businesses and shift comparative advantage. Perhaps Silvio Berlusconi, with visions of renewed Medici splendour, might offer Milan as the bank friendly city? Could Chancellor Merkel of Germany reposition Frankfurt as the new Mecca for financiers? Is this the time to see Shanghai emerge as the global super banking centre?

So far, governments reject any criticisms of their special assessments as humbug. They justify the “one-off” tax with the argument that banks were able to realize profits, and subsequently pay large bonuses, in large part due to the government’s “bail-out” of the banking system. While there is merit to this argument, we advise a more prudent approach supportive of a renewed and thriving financial system and limited in its imposition of pain on high performing financial executives. We should not punish excellence.

There have been corporate compensation structures that rewarded top executives at levels beyond their contributions to the firm. Reform is needed. While a forceful counterpunch against an industry and its employees may lead to short term popular contentment, one should bear in mind that in the long run, there is little support for high levels of taxation. As we pursue needed reforms, let’s not put a desire for retribution over good business sense.

Government actions can have significant indirect effects. We are reminded of the Empress Dowager Tz’u-hsi. In 1896, in order to finance the renovation of the summer palace, she impounded funds that had been designated for Chinese shipping and its navy. As a result, China’s participation in world trade virtually ground to a halt. In the subsequent decades, China operated almost in total isolation, without any transfer of knowledge from the outside, without major inflow of goods, and without the innovation and productivity increases that result from international exposure.

A few locations have laboriously built comparative advantage for their financial sector. Prosperous financial firms provide treasure and opportunity to the fortunate societies in which they cluster. Given today’s mobility of both industries and employees, banks that are convinced of their righteousness can fight back and move core units to business-friendly locations.

Businesses, in general, need to remember that they are but one integral component of society. The level and structure of their profits and executive compensation should reflect a firm’s long term best interests within an overall societal context. MBA programs without an emphasis on such context and proportionality, must revise such shortcomings in their teaching.

Legislators and government in turn need to recognize the direct and indirect effects of their actions on global conditions. While reforms are good and necessary, the breaking up of a comparative advantage and successful clusters without a productive replacement is a risky strategy.

Michael Czinkota researches international marketing issues at Georgetown University and the University of Birmingham in the United Kingdom (czinkotm@georgetown.edu). Charles Skuba teaches international business and marketing at Georgetown University (cjs29@georgetown.edu).

Filed under: Opinion

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