Q&A: Bank levy explained

UK chancellor George Osborne in the Canary Wharf financial district of London The chancellor wants banks to pay their "fair share"

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The government says it will increase the levy on banks from 0.078% to 0.088% from 1 January.

So what is the levy? What's really at stake? And why raise the rate now?

What is the bank levy?

It is an annual tax on the value of all of the debts of the UK banks (including money deposited with the banks), except that:

  • ordinary deposits covered by the UK's deposit insurance scheme are exempt
  • borrowing backed by UK government debts is exempt
  • the first £20bn of any bank's taxable debts is exempt
  • the banks only pay half the tax rate on their long-term debts

Originally, the Treasury had planned to charge a lower rate of 0.05% during 2011, but in February it changed its mind, and switched to the standard rate of 0.075% from May.

The standard rate was originally set at 0.075%, but it was raised slightly in March to 0.078%, and is now being raised again, to 0.088%, from January.

What's it for?

The government thinks it will discourage banks from relying on risky forms of borrowing, which were blamed for making the 2008 crisis much more dangerous.

The tax will also raise a lot of money for the government.

So will this help deal with the budget deficit?

The Treasury hopes the tax will bring in £2.6bn every year.

That's equivalent to 2.1% of the Office for Budget Responsibility's forecast for the budget deficit this year.

It's no small amount for the banks either. It's equivalent to about 19% of the reported profits before tax of the big five UK banks over the 12 months to September this year - although the tax burden will be borne by more than just these five.

What's risky about the type of borrowing that the government wants to discourage?

Traditionally, most of the money that banks lend out comes from the deposits they receive from ordinary people and companies.

But during the past decade, banks found new and more complex ways to borrow trillions of pounds from international markets.

Unlike ordinary deposits, there is no natural limit on the availability of this money, as it can come from anywhere in the globe, and the same money can be recycled between the banks again and again.

A lot of the debts created were very short-term - meaning the banks needed to go back to the markets to reborrow every few days.

When the financial crisis hit, investors began to worry that banks might not be able to repay their debts.

This caused a kind of bank run, with investors refusing to lend.

Unable to refinance all of their short-term debts, even profitable banks were threatened with failure.

Why are retail deposits exempt from the levy?

Run on the American Union Bank in New York in 1931 Before the financial crisis, bank runs were considered a thing of the past

Bank runs are popularly associated with long queues of ordinary depositors wanting to empty their bank accounts - just as happened to Northern Rock.

But since the 1930s, governments have insured most of the money deposited by their citizens in order to discourage these depositor bank runs. Indeed, the government responded to the Northern Rock crisis by promising to guarantee all of its deposits.

In the UK, the first £85,000 of an individual's money is insured (it used to be £35,000 before the financial crisis).

This means that most depositors do not need to worry about the safety of their money during a financial crisis, and the banks don't need to worry about all those deposits being withdrawn.

So why not just insure all the banks' borrowings?

The bank levy was actually first proposed to all countries by the International Monetary Fund (IMF) as a type of insurance scheme.

The IMF said the money raised should be channelled into a special fund that could be used to pay for the cost of cleaning up future banking crises.

However, the UK government took the view that these borrowings are inherently risky, and wanted to discourage them altogether by taxing them.

If the debts were insured, lenders would see them as less risky, making them a cheaper and easier way for banks to borrow.

The government's fear is that the banks would then just continue taking on more and more debt, until they became impossibly large to rescue - as proved the case in the Republic of Ireland or Iceland.

Indeed, the total debts of the UK's banks had already reached a staggering 4.5 times the size of the entire UK economy before the crisis.

Some might also point out another reason why the government chose not to go for an insurance scheme.

By making it a tax instead, the revenue raised can be channelled straight to the Treasury, helping to pay for the government's own spending.

Why is the first £20bn of debts exempt from the tax?

The government wants to encourage banks to shrink.

The thinking is that the collapse of a big bank could threaten the stability of the entire financial system, whereas the failure of a small bank should not.

The £20bn figure is about the size of the Coventry Building Society. So it means banks will only pay the tax to the extent they are bigger than that.

Why is the tax rate lower on long-term debts?

Longer-term debts are inherently less risky.

Financial crises - at least the most intense part of them - tend to be over in a matter of a few weeks or months.

If a bank does not have to repay its debts for more than a year, then it can probably ride out the crisis.

Will the levy really discourage banks?

The tax will increase the cost of "risky" short-term borrowing for banks by just under one-tenth of a percentage point.

This may seem small, but it will eat into the banks' precious margins - the difference between the interest they pay on their deposits and what they earn on their lending - which is their main source of income.

However, the banks may pass some of the tax cost on to their savers (via a lower deposit rate) or their borrowers (via a higher lending rate).

But to get the 0.088% in context, the Bank of England slashed short-term borrowing costs by 5.2 percentage points in response to the financial crisis.

Graph showing 6 month sterling interbank borrowing rate since mid-2008

Why did the government want to phase the levy in?

The original plan was to charge 0.05% for 2011, before going up to the full 0.075% rate next year (increased to 0.078% in March).

The government didn't want to raise the banks' borrowing costs at a time when their financial stability was still in question.

They also did not want to sap the banks' profits too quickly.

The banks might need to use all the profits they could get to rebuild their capital - their buffer against future losses - in order to meet tough new international standards being set by the Basel committee of banking regulators.

So why did the government change its mind?

In February, the Treasury said it wanted to charge the full £2.6bn this year after all.

It pointed to the Bank of England's latest Financial Stability Report, which painted a much rosier picture of the UK's banks.

Moreover, the new Basel rules on bank capital won't take full effect until 2019, giving banks a full eight years to meet the higher standards.

It probably also helped that the banks have been reporting much better profits than many would have expected a year ago.

And markets seemed less and less concerned about the risk of lending to banks - at least until the eurozone debt crisis flared up since the summer of 2011.

Why is the government raising the rate again?

The chancellor raised the rate to 0.088% in his Autumn Statement.

According to the Treasury, the tax was not on course to raise the £2.6bn originally planned for this year.

The Treasury said that it had simply overestimated how much borrowing is done by foreign banks in the UK - and is therefore subject to the tax.

It could also be that banks have been reducing their borrowing. Foreign banks may be moving their borrowing offshore to avoid the tax.

And all banks may be cutting back their borrowing and lending requirements in response to the recession, the eurozone financial crisis, and stricter regulatory requirements.

Which banks will have to pay most?

The Treasury does not say how much of its £2.6bn target it expects to be paid by each bank.

British banks face a bigger burden than foreign banks that do business in the UK, because the British banks must pay the levy on all their borrowing worldwide, and not just on their borrowing in the UK.

That has led to suggestions that some banks - perhaps Standard Chartered, HSBC and Barclays - may relocate their headquarters to another country in order to reduce their tax bill.

Moreover, the probability is that the tax will hit Royal Bank of Scotland and Lloyds Banking Group hardest.

It may seem perverse to tax most heavily the two banks in which the government has the biggest stake.

But one of the reasons the government ended up owning these banks is precisely because they (in the case of Lloyds, because of its merger with the Halifax) had become too dependent on riskier forms of financing, and had to be rescued during the crisis.

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