Hard-working New Zealanders will suffer the consequences of bank windfall taxes: higher interest rates, monetary policies frustrated, and a weaker financial system, argues associate professor Martien Lubberink
Opinion: This week, after Westpac announced its $1.165 billion profit, political parties left and right took aim at our banks and their returns.
The Green Party repeated calls for a windfall tax to rein in excess profits of large corporates. Prime Minister Jacinda Ardern weighed in on the discussion, agreeing there was something wrong with bank profits.
It must be said our banks' profits are substantial. For the year ending June 2022, combined profits for the largest four banks in New Zealand were $6 billion, about $1,200 per New Zealander. These figures understandably prompt the question: are bank profits too high to not be taxed?
Size matters in banking
Our financial system, and that of many other countries, favours large banks. They benefit from economies of scale: the larger the bank, the lower the cost of overheads and systems per customer.
Bank regulations, often based on global standards from the Basel Committee, also favour big banks. Under Basel rules, large banks have more freedom to calculate their own capital requirements.
Large banks are also systemically important, which, in practice, means they cannot fail.
More importantly, even in the absence of regulation, larger banks benefit from their size. They have more opportunities to diversify risks and they can invest in thriving areas and diversify away from more risky areas.
Because of these advantages, large banks are more profitable. The return on equity of the BIG-4 New Zealand banks is about 13 percent, whereas the return on equity of the small banks is about half that.
Some of us may think that small is beautiful. However, there is ample historical evidence showing banking systems that restrict bank size fail.
The problem with small banks is that they tend to operate locally. This is a problem for two reasons. To begin with, a local bank cannot easily diversify its risks. If the local economy collapses, then so will the bank. The second problem is the temptation of a small, locally operated bank to bankroll local politicians who then make decisions in favour of banks.
A case in point is Spain during the global financial crisis. The country harboured many small banks, cajas, which made bad loans. Many of these cajas were run by local politicians and business owners. In one case, a caja was run by Catholic priests.
The managers of the cajas were not capable of handling their jobs, especially once foreign money flooded Spanish banks after the Euro was introduced. During the GFC, the Spanish real estate market collapsed and with it the cajas.
Now, I hear you say, what happened in Spain will not happen to us. Perhaps. However, the recent purchase of Kiwibank by the government does not bode well. Kiwibank's operational independence may have been promised by this government, but it is unclear whether the next government will also make good on the promise.
The bank tax you will pay
Prime Minister Ardern and Green MP Julie Anne Genter referred to other countries introducing a windfall profit tax. Spain, again, is an example. The country's government wants to use the proceeds to compensate taxpayers who are suffering the consequences of the cost of living crisis and of the war in Ukraine.
Whether Spain has set a good example remains to be seen. But the case for a windfall bank tax is weak for several reasons.
First, with an economy that continues to perform well, the tax take is already high. Finance Minister Grant Robertson therefore downplayed the need for an extra tax.
Another reason to tread carefully on taxing banks is that the government relies on them to support the economy in difficult times.
The recent Covid years are an obvious example. Important policy initiatives, such as the Funding for Lending Programme and the Large Scale Asset Purchase Programme, relied on the banks’ cooperation. So it isn't obvious why our government should turn its back on the banks when profits are high and ask for assistance when times are difficult.
More important, however, is the empirical evidence on bank taxes: do they work in practice? I am sorry to disappoint the good intentions of those in favour. Recent studies have shown that such taxes do not work as intended.
A study by the Bundesbank, which examined levies imposed on German banks from 2011 to 2014, showed the tax take of the German bank levy was lower than expected as banks managed to avoid the levy. A bigger worry is that banks affected by the levy reduced lending.
Another study on German bank levies showed banks increased their lending interest rates by about 0.14 percentage points, which is substantial. Interestingly, the study also showed non-levy paying lenders increased their rates. These banks piggybacked on the bank levy, at the expense of borrowers.
In a 2010 study, the International Monetary Fund (IMF) also acknowledged banks will pass on levies to customers:
"... financial institutions will likely be able to pass on some part of the levy to customers (by adjusting prices and quantities of different business lines and margins) or employees. In practice, their ability to do so will depend on the elasticities of demand and supply and their degree of market power in any business segment."
Given New Zealand banks have a lot of market power, they are in a strong position to pass on any tax to borrowers.
The studies showed a bank tax increases the cost of doing business for banks and banks respond to that by avoiding the tax, lending less, and charging higher fees. For New Zealanders, this means that homeowners, small businesses, and other borrowers will suffer the consequences of the bank tax. How fair is that?
Financial risks
Last, there is the response of the European Central Bank, which last week issued a non-binding opinion on Spain’s bank profit windfall tax. The Central Bank warned the Spanish tax could affect profits, which would negatively affect banks’ capital ratios. This would render them less resilient, with consequences for monetary policy and financial stability.
The problem, according to the Central Bank, is that the collection of the bank tax may happen next year when the economy could be in a recession. That presents a problem for the banks, since they then have to deal with higher tax costs and higher credit losses at the same time.
Additionally, the European Central Bank warns about the effects of lower profitability on bank capital. Less capital means less lending to the productive economy in times of economic uncertainty. In my recent research, I also found less capital increases bank risk.
The Central Bank's opinion is relevant for New Zealand because banks are building their capital buffers to meet increased capital requirements imposed by the Reserve Bank of New Zealand . A bank tax may therefore also frustrate the Reserve Bank's efforts to improve the resilience of our financial system.
In the current context of a strong economy, there is the temptation to tax bank profits. However, if formidable institutions such as the Bundesbank, the European Central Bank, and the International Monetary Fund are skeptical about a bank windfall tax, our government should think long and hard.
There is a non-trivial risk that hard-working New Zealanders will suffer the consequences: higher rates, monetary policies frustrated, and a weaker financial system. Be careful what you wish for.
