Fighting the Return of the Mega Bonus: Europe Explores Ways to Keep Banks in Check

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When it comes to risky options and derivative deals, that's a real killer. Indeed, many investment bankers have made their livelihood for years trading in exactly these kinds of nebulous products.

Joachim Fels, the chief economist with Morgan Stanley in London, reportedly recently told his colleagues that the trend was going in the direction of smaller, highly specialized houses. He also said that the change was a desired one, even if large parts of the industry hadn't yet noticed. As he sees it, if boutique investment houses run into trouble, the state won't jump in to bail them out because, in the end, smaller houses don't present a systematic risk.

A heated political debate has also broken out in Germany over how to hold banks and bankers accountable. The fault line runs right through both sides of the new governing coalition. Chancellor Merkel and her conservative Christian Democratic Union (CDU) want to institute a tax on financial transactions, while the business-friendly Free Democratic Party (FDP), the junior partner in the coalition, is adamantly against it.

This CDU plan envisions a mini tax of between 0.01 percent and 0.10 percent on the volume of financial transactions, such as stock sales, currency transactions and the sale of derivatives. Since the annual volume of stock sales on the German exchange alone amount to several trillion euros, the government could easily rake in between €20 billion and €30 billion.

But the mini tax would also have some down sides: Since it would make every trade less profitable, it could lead to a drop in trading volume. And some experts fear that could lead to wider price fluctuations.

In any case, the so-called arbitrage business would be less lucrative. These are trading activities with which actors take advantage of slight inefficiences in the market, such as when stocks are priced differently on two markets, and thereby help stabilize the markets.

German Government Deeply Divided

When it comes to the political discussion in Germany, though, such objective arguments seem to go unheard. The camps are fundamentally divided: On the one side you have representatives of the CDU, led by Chancellor Angela Merkel, who are very open about their desire for taxes on all financial transactions. On the condition, of course, that it would be introduced globally, since any effort to go it alone could lead to the exodus of capital from Germany. On the other side is the business-friendly Free Democratic Party (FDP), the CDU's junior government coalition partner, which is against the nex tax. The conflict within the coalition was sparked by Development Minister Dirk Biebel (FDP), who already announced a change of course in his ministry at the end of November on the issue. "I am expressing my explicit opposition to a financial transaction tax," he said. The issue hadn't been addressed in the contract establishing the coalition government, he said, "so it will not happen during this legislative term."

During a chance meeting, Chancellor Merkel addressed the issue with her freshman cabinet member. She said she had taken note of his opinion but added that she would also adhere to international agreements. At the end of September, the G-20 states agreed to have the International Monetary Fund investigate the possibility of a transaction tax as well as alternatives.

Niebel's reply: The international agreement only applies to exploring the possibility, not the implementation, of the tax.

FDP party boss and Vice Chancellor Guido Westerwelle has also expressed skepticism. In an interview, he argued there's a danger the tax will impose a burden on people with savings and investors rather than the banks themselves.

Mandatory Crisis Insurance

In addition to the transaction tax, the IMF and German Finance Ministry are looking into another instrument with which the banking sector could be forced to compensate for the costs of the crisis -- those accrued in the past and the future -- by making them pay for an insurance policy.

Under this proposal, during good times, all financial institutions would be required to pay into a state banking insurance fund. Over time, the fund would build up reserves for crises. If individual institutions that are systemically important to the economy or the whole sector started to run into trouble, the funds could then be used to stabilize the industry. The fund would assume responsibility during times of crisis just as the federal government had to jump in to bailout a sinking industry during the current mess.

It is still unclear how large this buffer would need to be. If it were to cover all of Germany's banks -- including state savings banks and credit unions -- then it would require billions each year. A similar setup already exists in Sweden, which fell into an existential banking crisis during the beginning of the 1990s. The Swedish government bailed out the banking sector and banks are now required to pay a percentage of their balance sheet totals into the fund.

The experts in the German Finance Ministry are still working on another possibility. Under this model, instead of going into a capital buffer, the money from banks would go straight into the coffers for the national budget. This would help the German government to offset the tens of billions it has been forced to borrow with fees paid by the banks.

Should another crisis occur, experts in the government argue, the state would have to take responsibility for these costs anyway. In this way, the banks' insurance fee would be nothing more than a special tax whose income could help replenish the state's coffers.

'Encouraging Banks to Take Greater Risks'

But even if this plan, in one form or another, ever comes to fruition, it still has weaknesses. Rather than encourage banks to become more risk averse, it threatens to encourage them to take more risks. "With one of these sorts of solutions the institutions will feel even more secure because they can assume the state will come to their rescue," warned Clemens Fuest, a professor and director of the Center for Business Taxation at Oxford University, who is also a senior adviser to the German Finance Ministry. "I don't agree with these sorts of arrangements because they simply encourage banks to take greater risks."

For this reason, Fuest suggests instead that each bank be required to maintain a capital buffer within its own balance sheet for dealing with times of crisis. He argues this would automatically reduce a bank's likelihood to take great risks.

The banks have already decided that a pre-emptive strike is their best defense. A short time ago, Germany's leading financial institutions issued a voluntary committment to stop excessive bonuses. Leading investment bank Goldman Sachs has stated that bonuses for the company's 30 top executives will be given to them in the form of shares which cannot be sold for five years.

Is it hindsight or just a cold calculation? Banks can only do good business if they are accepted by society at large.

For 2011, Deutsche Bank CEO Ackermann is anticipating what would be the greatest profit of all time: €10 billion ($14.3 billion).

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• Part 1: Europe Explores Ways to Keep Banks in Check
• Part 2: A Death Knell for Investment Bankers?