Hot money tax

US bank levy: The Obama administration's planned liability levy looks increasingly like a Wall Street tax. The apparent decision to exempt insured deposits from the new tax will hit pure investment banks like Goldman Sachs and Morgan Stanley disproportionately hard, while commercial banks such as Wells Fargo won't suffer too badly. JPMorgan, Bank of America and Citigroup, which combine investment banks and commercial banks, will have a partial reprieve.

The big three certainly won't each face a $20 billion hit, as seemed possible when it was thought that all liabilities including deposits would be taxed.

Focusing the tax in this way is politically astute, given the unpopularity of everything connected to Wall Street. But it also makes economic sense to tax wholesale hot money rather than deposits, which tend to be a more stable source of funding. Ideally, medium and long-term borrowings should also be carved out of the tax, as they are also relatively stable.

An excess reliance on short-term wholesale money to fund long-term assets led to disaster in the 2008 credit crunch. Lehman Brothers, Bear Stearns and Merrill Lynch were all in the game of borrowing short to invest in illiquid assets.

So was Northern Rock, the UK mortgage bank. And a similar reliance on hot money played a big role in past crises — in the Asian economies in 1997 and Long-term Capital Management in 1998.

Financial institutions are drawn to hot money like moths to the flame. When liquidity is gushing, it's cheaper for banks to borrow short-term on the wholesale markets than to attract retail deposits through branches or to lock in longer-term funding.

But when the liquidity drains away, the short-term crew is left high and dry. In the latest crisis even Morgan Stanley and Goldman were close to the brink. This wouldn't matter if reckless banks were allowed to fail. The problem is that they aren't. Given the almost inevitability of government bailouts, the moths are actually quite rational in flying close to the flame. A perfectly logical response then is to make the flame less alluring by making hot money more expensive.