Why Harper is taking his bank-tax fight to Europe's doorstep

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When Prime Minister Stephen Harper meets in London today with newly minted British Prime Minister David Cameron, there will be sparse time for pleasantries. Mr. Harper has a pressing item to deal with, one that has come to suddenly dominate his government's foreign-policy agenda of late: stopping the push for a global tax on banks.

With little more than three weeks to go until the G20 summit in Toronto, where a bank tax will be on the agenda, the Harper government knows time is short to marshal opposition to what it believes is a dangerous plan.

The bank tax, an idea first raised last year in response to the debate over how to pay for bailouts of financial institutions that collapse during economic crises, is an idea that has seen Canada break from the pack of G20 nations. Though the idea has significant support in the European Union, Ottawa is trying to convince those in the G20 that a bank tax could do more damage than intended. Members of Mr. Harper's cabinet have fanned out across the globe to argue that such a tax could lead to bigger problems.

If there is ground to be made for Canada, Mr. Harper will find out this week. Following his meeting with the British PM, he will deliver a similar message to French President Nicolas Sarkozy. Jim Flaherty will meet with G20 finance ministers in South Korea on weekend, where similar conversations will take place.

From those talks, a new vernacular has been created. In short, the bank-tax debate turns on three key issues that could dominate the agenda in Toronto.

1. Orderly failure

When the concept of a bank tax was first raised in G20 circles, the world was reeling from a financial crisis that saw billions of taxpayer dollars poured into propping up financial institutions, most notably in the United States, to keep the contagion from spreading.

Amid pressure from EU countries in the G20, the International Monetary Fund was instructed last year to come up with a suggested plan for a bank tax. Its report described a scenario where financial institutions are taxed to cover the cost of the recent bailouts, and to create a contingency fund against future economic disasters.

That contingency fund would provide for what the European Commission calls "orderly failure." Rather than a hard crash, banks would have money on hand for a soft landing. But in this case, the banks themselves pick up the tab through the tax on their operations.

But the details are a problem: What exactly would be taxed? Proposals have suggested everything from taxing bank profits to executive compensation and individual transactions, and there is no clear consensus. Canada is concerned that the cost of any sort of tax would flow to the consumer.

Of greater concern, though, is who would administer these funds. Would there be a global organization to handle and disperse the emergency dollars when needed - a sort of financial United Nations? Or do countries preside over their own tax funds?

Already there is a divide over that issue: some governments want bank tax money to go into general revenues, not to be held in a contingency account. "France and the U.K. think this tax should go into the budget, not into a fund," French Finance Minister Christine Lagarde told reporters in Paris. If this sounds like a sticky issue, it is. Keeping track of where the money goes could be a problem. Should a tax be adopted by the G20, the debate over who holds the keys to the vault is only just beginning.

2. Moral hazard

The global bank tax is often considered an insurance policy against bank bailouts, since banks' mismanagement of risky investments - particularly those tied to U.S. housing and mortgages - is what sparked the crisis of 2008.

But Canada worries a bank tax will have a reverse effect - making the global financial system weaker by encouraging the banks to take more risks than before. Under the so-called moral-hazard argument, the banks would inherently know there is a pool of money to tap if their investments go awry.

"It penalizes strong performers, it increases moral hazard in the system, and it focuses on remediation of future banking failures rather than the regulatory prevention of future financial problems," said Kevin Lynch, vice-chair of BMO Financial Group and a former clerk of the Privy Council.

Mexican president Felipe Calderon lent his support to Canada's argument last week in Toronto putting it another way: "If the global economy builds a fund in order to bail out banks - you can be sure that there will be bailouts in the future," he said.

3. Embedded contingent capital

Knowing he needs a counter proposal, Mr. Harper is taking a complex idea with him to London and Paris: embedded contingent capital.

It's not the most eye-catching terminology ("bank tax" made for better headlines in the British election). But this is the Canadian solution. Under the plan, banks would sell debt that could be quickly converted to shares in the event of a crisis, giving the banks emergency capital to bail themselves out. The move would cost the banks, since it would dramatically dilute their share pool, hurting shareholders. But if done right, it could prevent messy insolvencies. This notion has gained traction inside Ottawa, since it puts the cost of a bailout at the feet of the financial institutions without explicitly taxing them.

But here, too, the details are yet to be worked out.

"The embedded capital idea, it's really at an infant stage in its development," said Steve Foerster, professor of finance at the Richard Ivey School of Business at the University of Western Ontario. "It's the notion of issuing debt which - in a time of crisis somehow to be determined by a regulator - would then morph into equity. Which would somehow provide a cushion for a bank that was in trouble."