Government May Put the Financial Industry at Risk

In the coming weeks we can expect the halls of Congress to echo with cries of outrage as banks announce their bonuses for 2009 performance. Abroad, Alistair Darling, the United Kingdom’s finance minister, already revealed a 50 percent “supertax” on all U.K. bank bonuses more than 25,000 pounds (about $40,000). France has announced that it will enact a similar tax.

The Obama administration plans to impose a fee on large finance firms to “recoup” public funds spent in the Troubled Asset Relief Program, regardless of whether the banks wanted to participate. Will Congress demand more as voters’ anger against banks remains high?

Two key economic concepts are under attack by the 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, despite significant competition from other financial centers such as Frankfurt and Singapore, for London to structure financial operations superior to others.

That leads to the second concept under attack — clustering. Since birds of a feather flock together, good performers were attracted to London. The comparative advantage of London’s banking sector attracted related and supporting industries as well. London therefore became a key market, attracting key players who were paid top rewards. Quite a perpetuum mobile if not disturbed!

However, disturbances did occur, as was evident in the past two years. Markets were not as successful. There were large losses because of 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 U.K. 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 London are angered by the “supertax.” Many bankers view the action as unfair and pandering to short-term populism. One key complaint focuses on the low threshold for the tax. In a business where individuals can generate millions of pounds worth of profits (and losses), a trigger amount of 25,000 pounds seems very low. Critics also fear that the “supertax” would damage the city’s attractiveness as a financial center. In a global environment, one can expect bankers and banks to look at alternatives such as Hong Kong, Singapore, Geneva or even Dublin.

Some governments might well see new opportunities to attract financial businesses. Perhaps Silvio Berlusconi, with visions of renewed Medici splendor, might position Milan as the bank-friendly city? Could German Chancellor Angela Merkel reposition Frankfurt as the new mecca for financiers?

The U.K. and French governments reject the criticisms 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 because of the government’s “bailout” 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 from high-performing financial executives. We should not punish excellence.

It is quite difficult to understand the financial community’s culture of very large annual bonuses. 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 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 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.

In the U.S., we have laboriously built comparative advantage for our 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 should 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 effects of their actions on global alternatives. Eliminating a comparative advantage and successful clusters without a productive replacement is a risky strategy.

Co-written with Charles J. Skuba. Prof. Skuba teaches international business and marketing at Georgetown University. .