Credit-rating agency Moody's Investors Service is projecting that the proposed tax from the Obama administration on bailed out financial institutions threatens the nascent credit recovery among banks, potentially risking a return to the restrictive lending conditions seen last year. Moody's said the interbank lending rate in 2009 reached highs ranging from more than 20 bps to around 17bps from February to June (illustrated above). The overnight funding rate, which is  tied to the ability of large banks to maintain liquidity, showed significant recovery, easing down to below 5 bps by October 2009. The bailout tax on the largest US banks may raise the cost of overnight funding, Moody's warns, possibly restricting smaller banks' ability to do business. The largest US banks are key providers of overnight funding, but if the cost spikes again, smaller institutions may not be able to afford borrowing at the overnight rate. Additionally, Moody's said the bailout tax will impose billions of dollars in fees annually at the top five banks, potentially draining capital and liquidity and stifling the ability to write new business. The bailout tax to recoup Troubled Asset Relief Program (TARP) funds would also weaken credit at the largest US banks, according to Peter Nerby, a senior vice president at Moody's. Obama in mid-January proposed a “Financial Crisis Responsibility Fee” to tax large financial institutions that received government funds through TARP. The fee would be assessed at about 15 bps of covered liabilities per year for at least 10 years, until all taxpayer dollars are repaid. The administration's initiatives to curb banks' size and trading activities and recoup TARP funds, along with a recent storm of securitization regulation, could cripple the lending strength and capital ability of banks to to business. Moody's estimates the yearly bailout tax could range from $621m to $2.06bn, depending on the size of the financial institution: In the Moody's report last week, Nerby said "the proposal will raise funding costs in general, as well as the cost of maintaining liquidity pools. Reducing profitability and raising the price of ready liquidity weakens the creditworthiness of affected banks." He added: "Our biggest concern is the disincentive created by the fee to maintain adequate liquidity risk insurance, since pools of unencumbered liquid securities will become more expensive to maintain." However, the proposals are meant to help recoup bailout funds, and key designer of the regulation indicates the benefits should outweigh costs. Paul Volcker, chairman of the president's Economic Recovery Advisory Board and former Federal Reserve Board chair, defended one of Obama's major proposals Tuesday before the Senate Committee on Banking, Housing and Urban Affairs. The proposed "Volcker Rule" would prohibit banks from owning, investing in or sponsoring hedge funds, private equity funds or proprietary trading operations for their own profit and other reasons unrelated to serving customers. Volcker said the proposal would restrict commercial banking firms from some proprietary and speculative activities, reducing risk in the overall system. As for hedge funds, private equity funds and other private financial institutions, "they are, and should be, free to trade, to innovate, to invest – and to fail," Volcker added. "Managements, stockholders or partners would be at risk, able to profit handsomely or to fail entirely, as appropriate in a competitive free enterprise system." But the proposed restrictions would place US banks at a competitive disadvantage versus non-banks and foreign banks in terms of attracting capital and employees, according to David Fanger, a senior vice president at Moody's. "Additionally," Fanger said, "the proposals could lead banks, in their search to replace lost profits, to expand into other activities that ultimately prove even riskier." Write to Diana Golobay.