(Bloomberg) -- UK banks face a new levy to rescue failed small lenders under proposals to enhance the bail-out regime set out by the Treasury.

The government has opened a consultation on plans to strengthen its resolution powers through the Financial Services Compensation Scheme, the industry-funded insurance program that protects the first £85,000 ($108,290) of customer deposits.

The Treasury said the FSCS would be used to provide recapitalisation funds that would protect taxpayers and ensure an orderly wind-down of a failing bank. It would be “funded by a levy on the banking sector.” 

Under current laws, the government can demand banks pay up to £1.5 billion a year into the FSCS. The new proposal would “expand both the FSCS’s statutory functions and its levy-raising powers, to allow it to provide funding and levy for this new purpose,” the Treasury said in a statement.

The Treasury added that the arrangements “would be achieved in a way that does not impose additional upfront financial costs for banks.”

The BOE has been reviewing its resolution tools since the failure of Silicon Valley Bank UK last year. SVB UK was bought by HSBC over a dramatic weekend of emergency meetings last March in what was deemed a successful rescue. 

However, its failure revealed shortcomings in the existing regime. Had SVB UK been placed into insolvency as the BOE originally planned, its customers would have lost access to all except £85,000 of their cash to pay customers until insolvency was complete — a process that can take months. 

Many of the bank’s business clients were start-ups that generated little revenue and relied on cash deposits to meet business costs such as salaries. The issue made bank insolvency an unworkable resolution option because it risked unnecessarily pushing many start-ups into administration. 

The only alternative, other than being bought by a rival, was to recapitalise the lender with taxpayer money — leaving the state exposed. The resolution regime is supposed to protect the UK taxpayer against future bank bail-outs like the billions spent rescuing Royal Bank of Scotland Plc and Lloyds Banking Group Plc in 2008.

The Treasury proposals will reduce the state’s exposure to losses by requiring the banking industry to foot the bill to recapitalise a small bank. The failing lender would then be able to access the Bank of England’s liquidity facilities, which would provide the cash to allow business clients to continue operating.

The arrangements will not apply for big lenders, which are already subject to tougher regulations.

“The new mechanism would allow the Bank of England to use funds provided by the banking sector to cover costs associated with a resolution, including those associated with recapitalizing and operating the failed bank,” the Treasury said.

“The government believes that a targeted enhancement would best ensure the UK continues to have a world-leading regime, whilst giving the Bank of England more flexibility to manage small bank failures effectively.”

“The government’s preferred approach would involve the FSCS providing the funds through an ex-post levy on the banking sector, in the same way that it currently funds a pay-out or transfer of covered deposits after a firm is placed into insolvency.”

The FSCS can current levy the banking sector £1.5 billion a year. If a rescue recapitalization requires more, the Treasury would top it up with taxpayer money and “subsequently recoup any funds provided through levies on the banking sector after the event, subject to the levy cap,” it said.

The BOE said it “welcomes the consultation paper and supports measures to continue to enhance the UK bank resolution regime.”

--With assistance from Tom Rees.

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