Friday, January 15, 2010

Bank tax : cost recovery fee or deterrent tax?

So finally, the Obama administration has bitten the bullet and announced a Financial Crisis Responsibility Fee (FCRF) "that would require the largest and most highly levered Wall Street firms to pay back tax payers for the extraordinary assistance provided so that the TARP program does not add to the deficit".

The fee is to be levied on the debts of only those financial firms (banks, thrifts and insurance companies) with more than $50 billion in consolidated assets and having the most leverage, and is expected to be a deterrent against excessive leverage. The proposed fee would be 15 bps of covered liabilities per year, and the liabilities would be determined by the formula

Covered Liabilities = Assets - Tier 1 capital - FDIC-assessed deposits (and/or insurance policy reserves, as appropriate)

The fee would amount to about $1.5 million for every $1 billion in bank assets subject to the fee. It would apply to about 50 companies and would impose the greatest burden on firms that rely less on customer deposits.

The fee, to go into effect on June 30, 2010, is expected to remain in place for 10 years, so as to fully re-pay the TARP expenditures incurred by the Government. If the costs have not been recouped after 10 years, the fee would remain in place until they are paid back in full. In its estimations for imposing the Fee, the Obama administration has scaled down its projected cost of TARP from $341 billion in August, 2009 to $117 billion. Over sixty percent of revenues will most likely be paid by the 10 largest financial institutions. The fee would be imposed on both US financial institutions and US subsidiaries of foreign institutions.

In many respects, the FCRF is a political balancing act between strong calls for taxing windfall bonuses for executives announced by many of the largest financial institutions who benefited from the TARP bailout at the peak of the crisis, and the more broader advocacy of a tax on cross-border speculative transactions. Further, by avoiding the use of the word "tax" and using the more benign "fee", the administration hopes to take the sting out of the big government war mongers who get genetically attracted into mounting campaigns against such any form of taxation.

However, by indicating its intent to levy the fee only till the TARP costs are recovered, it risks becoming a case of post-facto cost-recovery on a specific past event, and may do little to exercise any deterrent effects. Achieving deterrence against running up leverage and loading on excessive risks would require permanently institutionalizing such levies on specifically systemic risk creating TBTF institutions.

The reactions to the FCRF is available here and here. Mark Thoma advocates recouping the bailout money and increase the safety of the system at the same time through a tax on assets (to get at the too big to fail problem) and a tax on leverage (to reduce the damage the big banks can cause if they do fail).

Mark Thoma also feels that the proposed fee will fuel moral hazard concerns in so far as banks will now be encouraged to take risks in the belief that they will not only be bailed out but will not have to ebar the full costs of their actions. Instead of paying an ex-ante insurance claim, they are now left to pay a far lower ex-post fee.

Update 1
Douglas Diamond and Anil Kashyap propose taxing banks based on the difference between their assets at the end of August 2008 and their current level of capital, on the grounds that the "support these firms received was based on the size of assets before the financial panic began, not the size of those assets today". This tax would be equivalent to insurance premiums that should have been charged ahead of time on institutions who took the bailout money which ended up effectively insuring its bondholders and other creditors.

Update 2
Sweden has imposed a permanent 'stability fee' or direct tax on banks so that they pay for their own bailouts. Unlike the American TARP cost recovery fee, the Swedes hope to ensure that when another banking crisis occurs, as it surely will, the tools are in place to manage and pay for it. The levies are allocated to a stability fund, managed by the National Debt Office and the government plans to keep the tax until it hits a total of 2.5% of GDP in 15 years, the amount estimated to be required to cover for a full-blown banking crisis.

The fee will be due annually, starting at 0.018 percent of each institution’s liabilities, excluding equity capital and some junior debt securities, based on audited balance sheets. The bank levy will rise to 0.036 percent of liabilities in 2011, when the government is planning to introduce a weighted charge as well. Companies with riskier balance sheets would pay more.

Update 3
Thomas Cooley has three suggestions - modify the bankruptcy code and create mechanisms to allow for the orderly failure of these institutions; impose a tax on them that is proportional to the risk to the system that they create; and treat that tax as an insurance premium to cover the cost of future problems, just as the FDIC charges banks for deposit insurance.

He feels that this tax should have two parts - "a portion to cover the risk a firm creates for itself and its investors by taking on excessive leverage, and a portion to cover the risk that leverage creates for the system as a whole".

Mark Thoma weighs in here.

Update 4 (26/5/2010)

David Leonhardt argues that in view of the inevitability of a bailouts, a bank tax is the only way to ensure that tax payers do not get saddled with the costs of the bailout.

Matthew Richardson and Viral Acharya argue that while firm-specific risks can be diversified away, "systemic risk" (joint failure of financial institutions or freezing of capital markets) cannot be and will remain with the firm and as recent events have shown such risk can have catastrophic consequences for the broader economy at large. Further, the management, shareholders, and creditors do not bear the full systemic costs of a failure, while the real economy feels the burden and society pays the price, whether in the form of bailouts, lost productivity or unemployment. While profits remain privatized in good times, downside risks are socialized. They therefore argue that the only way out of is to force these firms to internalize the systemic costs they impose on the rest of the economy by a bank tax. They propose a tax on "each financial institution an amount equal to the expected systemic costs of a crisis multiplied by that institution's percentage contribution to financial sector losses".

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