Calculating a bank tax

Among the proposals under consideration for financial market regulation reforms in the aftermath of the sub-prime crisis, have been those relating to placing limits on the size of TBTF institutions and raising resources to finance future bailouts. While the former has not made much headway, the later has received considerable attention in many countries in the form of bank taxes.

Like on many other initiatives during the recent crisis, Britain has been first off the block with the new coalition government's decision in its austerity budget to impose a levy on banks to raise £2 billion per year. The levy will start at 0.04% of banks’ riskier liabilities — excluding Tier 1 capital and insured deposits — in 2011, rising to 0.07 percent in 2012, and will be imposed on banks with liabilities of more than £20 billion. Following the British decision, France, Germany, and the EU too have thrown in their weight behind a bank tax with the "aim to ensure that banks make a fair contribution to reflect the risks they pose to the financial system and wider economy, and to encourage banks to adjust their balance sheets to reduce this risk".

In the US, President Barack Obama's proposed tax of 0.15% of net bank liabilities to raise up to $117 billion over 10 years, has met with stiff opposition and is not likely to sail through. However, one of the biggest challenges with these bank tax proposals has revolved around arriving at a widely acceptable approach/formula to decide on the optimal tax rates.

Calculating the appropriate tax for a financial institution with debt guarantees requires measuring the quantity of taxpayer risk and then pricing that risk. The latter can be accomplished through options markets designed specifically to price risk accurately. However, calculation of the former by regulators comes up against severe information asymmetry problems and other market failure risks.

In this context, Narayana Kocherlakota, President of the Minneapolis Fed proposes a new market-based method for determining the quantity of tax to be paid by financial institutions so as to internalize their risk externalities. He proposes that governments should provide debt guarantees to all firms in the financial sector and the resultant risk externality (created by this guarantee) be controlled by appropriate regulation should control. He writes,

"For a particular financial institution, the government should sell 'rescue bonds' paying a variable coupon linked to the size of the bailouts or other government assistance received by the institution or its owners. Coupon prices will reflect the market’s judgment of an institution’s risk profile and can therefore be used to set the tax.

... (say) the rescue bond pays a variable coupon equal to 1/1,000 of the transfers actually made from the taxpayer to the financial institution or its stakeholders. Much of the time, this coupon will be zero. However, just like the financial institution’s stakeholders, the owners of the rescue bond will occasionally receive a large payment. In theory, or in a perfectly functioning market, the price of this bond is exactly equal to the 1/1,000 of the expected discounted value of the transfers to the financial institution’s stakeholders. Thus, the government should charge the financial institution a tax equal to 1,000 times the price of the bond...

In principle, the government need not figure out in advance which institutions are systemically important and which are not. Instead, the market would provide this information through the pricing of rescue bonds... A well-designed tax system can entirely eliminate the risk externality generated by inevitable government bailouts."