Will the Administration's Proposed Bank Tax Create a Moral Hazard Problem?

Last Updated Jan 15, 2010 6:22 PM EST

Yesterday, the Obama administration proposed a Financial Crisis Responsibility Fee to recoup the cost of the bailout. Many people have claimed the tax will do two things, modify bank behavior and generate revenue the government can use to reimburse taxpayers for the cost of bailing out the financial system. However, as I noted here, the behavioral modification story is difficult to embrace because the size of the tax banks will pay compared to, say, the bonuses the give out each year is relatively small. It won't be very painful for banks to pay this tax.

But there is another way in which the tax could affect bank behavior. This has to do with the fact that the "tax" is more properly termed an insurance payment that is being paid after the event rather than the more usual case of being paid before the disaster happens (it could also be considered a loan to the industry if the banks repaid the costs of the bailout in full, but they are only being charged for some of the direct costs, and indirect costs such as the stimulus package to help the wrecked economy the banks caused are not part of the repayment).

This arrangement signals to banks that if there is another crisis in the future, and the government ends up bailing them out again, they will not be able to avoid paying some of the costs. That is better than not charging them at all, but it sets up an implicit insurance arrangement between the government and banks. Banks now know they can take excessive risks and, if things don't work out -- if too big to fail banks gets in trouble -- the government will be there to provide them the money they need to get through the bad times, and they won't be required to pay the full social costs of the damage they cause. (The government will also subsidize the cost of their raw materials, i.e. the cost of money for loans and investments, as it reduces interest rates to near zero in response to the crisis).

Thus, the implicit insurance the government is providing sets up a moral hazard problem in the industry (i.e. taking extra risks because insurance covers the downside). I don't think the government can credibly say that it won't insure the banks because the costs of letting them fail and wrecking the economy would fall on taxpayers and be even larger than the net costs of bailing the banks and the economy out. So the problem must be addressed through other means.

One of those is to reduce the size of banks (when I say size, I am including the interconnectedness of banks as part of the definition). When I asked Ben Bernanke why banks had to be too big to fail, I wasn't convinced by his answer. I've yet to hear a convincing argument as to why we can't break large banks up into smaller pieces. However, while breaking banks up might help, it is unlikely to fully solve the economic problem -- the right type of systemic shock could still take down two smaller banks derived from one larger one as easily as the larger bank itself. But it does at least reduce the political power of the large banks, an important consideration, and there are cases where smaller banks would, in fact, be safer.

If banks are going to remain large despite calls from some of us to break them up, then regulators need monitor and regulate the risks they can take, and they need to do a much better job at this than they did before the present crisis. In addition, regulators need a means of forcing too big to fail banks into receivership in a way that won't increase the risks to the system. When the present crisis hit, regulators didn't have either the plans or the authority to break up large banks, and if banks are going to remain large, it is essential that we fix that problem.

But even if bank size is reduced through a tax or through regulatory decree, that won't be enough enough on its own to make the system safe. We would also need to buttress the size reduction with other measures to shore up the vulnerabilities in the system. Again, part of this is to regulate and monitor the risks these firms can take. Another is a tax on leverage (or, the other side of the same coin, increased capital requirements). A tax on leverage won't necessarily prevent large shocks from hitting the financial sector, but it will reduce their impact through an attenuation of the amount of leveraging down that is needed once the shock hits.

The proposed financial crisis responsibility fee is a good first step, but much more is needed to try to prevent the next crisis, and to reduce the impact if a crisis hits despite our best efforts to prevent it.

Update: See also:
TARP oversight report: 'Implicit guarantee' of future bailouts hampering reform, The Hill: Unwinding the Treasury Department's $700-billion rescue program will be difficult, so long as there is an "implicit guarantee" that the federal government will continue to save failing banks, according to a new report.
The 2008 Troubled Asset Relief Program (TARP) has ultimately prompted banks to adjust "to the notion... [they] will be safe, no matter what," explained Elizabeth Warren, chairwoman of the Congressional Oversight Panel that has been tracking those dollars.
"The whole market has adjusted to the notion that the big banks will be safe no matter what, and they can start planning their business approaches accordingly," Warren told CNBC on Thursday. "And thats dangerous." ...

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