Should We Place Windfall Tax on The Banking Sector?

(a) Explain why the Banking sector is not a contestable market (20)

A contestable market mean that there is freedom of entry and exit into the market. Therefore, there must be low sunk costs. Because there is freedom of entry and exit, there is always the threat of new firms entering.

It is difficult to enter the banking sector because:

1. Brand Loyalty to existing banks. People prefer big established banks; small new banks are more risky. A new firms would have to spend a lot on advertising.
2. Economies of scale. Banks usually have a national presence in each of the major towns. This includes organisational economies of scale, the benefits of having a branch in each town.
3. Risk Bearing economies. Trust is very important for a bank. The bigger it’s balance sheet and deposits the more people will trust the bank.

(b) Discuss whether high profits and the dominant market share in the banking sector suggests that there should be more government intervention – either through windfall taxes or regulation of prices. (30)

British banks are highly profitable. They made a combined profit of £42bn in 2007

- High profits are arguably because of monopoly power. Bank have the monopoly power to set high interest rates; there is a lack of competition in the banking sector and it is difficult to encourage new firms to enter. Therefore, there is a case to have a windfall tax on profits and / or for the government to regulate prices. e.g. maximum prices for overdraft penalties.

However,

• New firms have entered the banking sector. e.g. online internet banks like Egg. Therefore, there is more competition than people might think
• A tax on profits may reduce the amount banks are willing to lend to business and consumers. It may encourage banks to try and avoid tax payment e.g. offshore accounts. Also, Banks already pay alot in corporation tax. However, banks don’t lend out of profit; profit mainly goes to shareholders and does not benefit the economy.
• Higher taxes may create a disincentive to be efficient by banks.. Because efficiency savings just get taxed.

More reasons to Regulate Banks

Banks are able to set charges far higher than the marginal cost. (this is allocatively inefficient) For example, the cost of going overdrawn has received penalties of upto £60; this is a clear example of monopoly exploitation and therefore, governments are justified to set maximum prices.

• However, limiting penalty charges may encourage consumers to go into debt and overdrawn.

The high profits of the banks are unnecessary. They do not need to invest in risky investment projects like oil exploration companies. Therefore, a windfall tax will not harm the productivity and dynamic efficiency of the banking sector.

The banking sectors is an oligopoly rather than pure monopoly. There are 5 banks are more building societies which create a reasonably competitive market.

• British banks set for bumper profits
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