Who Pays for the Big Bank Tax and How It Affects the Economy and Jobs
Carlos M. Pelaez
The administration announced on January 14, 2010, the creation of the Financial Crisis Responsibility Fee or the Tax on Big Banks (http://www.whitehouse.gov/the-press-office/president-obama-proposes-financial-crisis-responsibility-fee-recoup-every-last-penn ). The tax is fifteen basis points of covered liabilities per year or: (0.0015) x covered liabilities. These covered liabilities are defined as assets less Tier 1 capital less FDIC-assessed deposits (and/or insurance policy reserves, as appropriate). Tier 1 capital as defined in the Basel Capital Accord, also applied to Basel II, is being reformulated in the current consultative document of the Basel Committee on Banking Supervision (BCBS) (http://www.bis.org/publ/bcbs164.pdf?noframes=1, 4) as consisting mainly of retained earnings and common shares. The remaining portion of Tier 1 capital must consist of subordinated instruments with dividends or coupons that are non-cumulative without maturity date or incentive of redemption (for soft law and the Basel accords see Pelaez and Pelaez, International Financial Architecture, 239-300, Globalization and the State Vol. II, 114-48, Government Intervention in Globalization, 145-50, Financial Regulation after the Global Recession, 54-6, Regulation of Banks and Finance, 69-70). The BCBS is calibrating the overall minimum capital ratio and the composition of Tier 1 capital as part of the impact assessment process. Retained earnings and common shares will remain as the major portion of Tier 1 capital. The assessment of the Federal Deposit Insurance Corporation (FDIC) is a fee paid by insured depository institutions on their insured deposits (http://www.fdic.gov/regulations/laws/rules/2000-5000.html#fdic2000part327.3 See Pelaez and Pelaez, Regulation of Banks and Finance, 71-8, Financial Regulation after the Global Recession, 56-8). Consider the administration’s example of a bank with $1 trillion assets, $100 billion in Tier 1 capital and $500 billion in assessed deposits. The yearly tax would be: 0.0015 x ($1000 billion - $100 billion - $500 billion) = 0.0015 x $400 billion = $600 million. This tax will be assessed only on banks with more than $50 billion in assets and the administration expects that 60 percent of the tax will be collected from the largest ten banks. The objective of the tax is collecting over time the expected net cost of the Troubled Asset Relief Program (TARP) of $117 billion. The expected revenue from the tax in the first ten years would be $90 billion so that in about 12 years the government would recover the loss from TARP. The rationale of the tax is that the largest banks that received (and repaid with interest and repurchase of warrants) capital injection from TARP benefited directly or because of improved financial markets and should pay for the losses of other TARP recipients such as car manufacturers, Fannie Mae, Freddie Mac and AIG.
The objective of this post is to provide analysis of the purely economic issues of the Big Bank Tax: microeconomics of financial markets, capital regulation, efficiency in resource allocation in the economy, financial stability, growth and employment, budget deficit and the incidence or who pays for the tax. These issues are discussed in turn.
First, microeconomics of financial markets. This Big Bank Tax is at the wrong time for the wrong reasons. The administration claims that “many of the largest financial firms contributed to the financial crisis through the risks they took and all the largest firms benefitted enormously from the extraordinary actions taken to stabilize the financial system.” The fact is that the credit/dollar crisis and global recession originated in four combined policies that stimulated excessive construction and high real estate prices, highly-leveraged risky financial exposures, unsound credit and low liquidity (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4): (1) the interruption of auctions of the 30-year Treasury in 2001-2005 that caused purchases of mortgage-backed securities (MBS) equivalent to a reduction in mortgage rates; (2) the reduction of the fed funds rate by the Fed to 1 percent and its maintenance at that level between June 2003 and June 2004 with the implicit intention in the “forward guidance” of maintaining low rates indefinitely if required in avoiding “destructive deflation”; (3) the housing subsidy of $221 billion per year; and (4) the purchase or guarantee of $1.6 trillion of nonprime mortgage-backed securities by Fannie Mae and Freddie Mac. The combined stimuli mispriced risk, causing excessive risk and leverage as the public attempted to obtain higher returns on savings. John Cochrane and Luigi Zingales provide evidence that the failure of Lehman Bros. was followed by an increase of 18 basis points in the LIBOR-OIS spread, a proxy for the risk of interbank short-term lending, but increased by 60 basis points after the testimony of TARP in Congress two weeks after Lehman’s failure (http://faculty.chicagobooth.edu/luigi.zingales/research/papers/lehman_and_the_financial_crisis.pdf ) The alarmist marketing of TARP as “provide funds or bankrupt banks” in Congress and the media created uncertainty in banks about the quality of their own assets and of those of possible counterparties, squeezing funds out of the sale and repurchase agreements that finance securitization of most credit. The ongoing tax and regulation effort is inopportune when the stocks of the four major investment and commercial banks of the US peaked at the end of October 2009 and have trended down to this writing. The earnings report of a major bank on Friday January 15 contained weakness in loan quality compensated by earnings in investment banking and trading. The crisis revealed how the stock price of banks can collapse to near zero, such as it occurred with Fannie, Freddie and Lehman, preventing the raising of new Tier 1 capital and dooming the institution to failure. The true lessons of TARP unveiled by Cochrane and Zingales should not be ignored. Sound large banks did not need TARP. Market confidence appears to have recovered primarily on its own not because of TARP or monetary policy.
Second, capital regulation and replenishment. The consultative document of the BCBS provides for buffer stocks in the expansion phase of the cycle in order to manage capital requirements over the entire cycle, maximum ratios of debt to assets and sufficient liquidity to bridge banks through crises over at least 30-day periods. BCBS intends to conclude the new capital regulations by the end of this year but may suggest delay in implementation until after 2012 depending on recovery of banks. The same prudence should be exercised in financial tax and regulation legislation. Who would invest in common shares of banks, the key ingredient of Tier 1 capital, when banks are subject to taxes and regulation reducing remuneration of their equity capital?
Third, economic efficiency. Distortions such as taxes and quantitative controls prevent financial institutions from transferring excess savings to productive investments that increase efficiency and promote economic growth. The contemporary banking theory of Douglas Diamond, Philip Dybvig and Raghuram Rajan emphasizes the function of liquidity transformation and monitoring by which banks convert illiquid project with cash flows in the distant future into immediately available cash such as demand deposits (Pelaez and Pelaez, Regulation of Banks and Finance, 37-44, 51-60, Financial Regulation after the Global Recession, 22-6, 30-42, Globalization and the State Vol. II, 73-81, Government Intervention in Globalization, 128-31). The approach of functional structural finance (FSF) of Robert Merton and Zvi Bodie warns against frustrating financial innovation because of the adverse impact on the efficiency of the economy and growth (Pelaez and Pelaez, Regulation of Banks and Finance, 234-6, Financial Regulation after the Global Recession, 34-7). Prudence instead of rush to taxation and regulation would be advisable to permit the adequate provision of banking and financial functions required for optimum allocation of resources that can move the economy to full employment.
Fourth, financial stability and crisis prevention. The rationale of the Big Bank Tax is preventing leverage excesses that allegedly caused the credit/dollar crisis and global recession. A tax on debt increases interest rates. Thus, the tax is inopportune because it will add to the formidable pressure on interest rates originating in increasing fed funds rates and the entire structure of short-term rates from the current 0-0.25 percent target, unwinding the combined MBS portfolio of $2.5 trillion held by the Fed, Fannie and Freddie equivalent to about a fifth of total mortgages outstanding in the US, financing high projected fiscal deficits and refinancing rapidly growing debt. The tax contributes to financial instability by high increases and volatility of interest rates, affecting other financial variables and possibly the real economy.
Fifth, growth and employment. A key lesson of history is that the growth rate in this expansion phase must be similar to that in the 1980s. The economy expanded during five consecutive quarters at annual real rates ranging from 7.1 percent in the second quarter of 1984 (QII84) to 9.3 percent in the second quarter of 1983 (QII83), which were more than twice that of trend around 3.5 percent. Those high rates of growth are required in the next quarters to create again the jobs lost during the contraction. There is a critical difference in the current environment. Interest rates declined sharply in the 1980s from a high of 19.10 percent for the fed funds rate in June 1981 to 8.95 percent in December 1982, remaining between 8.95 and 11.06 percent after the expansion phase. The opposite trend will occur during the current expansion phase because the feds funds rate is fixed by the Fed at 0-0.25 percent and must and will increase sharply in the months and years ahead. Imprudence in financial taxation and regulation can frustrate rapid growth during the expansion phase of the economy, preventing recovery of full employment as it happened during the second half of the 1930s.
Sixth, fiscal budget. Dollars of revenue and expenditure are fungible, that is, identical dollars enter the government as revenue and exit as expenditure. It cannot be claimed that the dollars entering via the Big Bank Tax are the ones paying the deficit created by TARP. The Big Bank Tax revenue simply mixes with all other government revenue. What is required is restraint on the deficit and debt to avoid a more devastating future debt crisis such as that threatening the excessively indebted countries in Europe known as PIGS (Portugal, Ireland but sometimes Italy, Greece and Spain). The Big Bank Tax may remain forever.
Seventh, tax incidence. Consumers of bank credit will pay for the tax that will increase interest rates and reduce the total usage of credit. The analysis is similar to that of the social welfare loss of an excise tax by Harold Hotelling (cited in Pelaez and Pelaez, Globalization and the State Vol. I, 119-25, Government Intervention in Globalization, 87, Financial Regulation after the Global Recession, 22, Regulation of Banks and Finance, 27-32). Monopolistic conditions in banking markets suggest that demand is likely inelastic such that the total payment of interest by consumers will increase as a result of the tax with a part being appropriated by the government. Securitization is financed with debt such that of all consumer debt—credit cards, mortgages, auto loans, students loans and so on—will cost more to the borrowers. The Big Bank Tax will redistribute income from consumers of bank credit to the government instead of from big banks to the government. Institutional investors representing million of consumers own three quarters of the common equity of three of the largest four banks and 62.8 percent in the other bank subject to the tax and insiders about 0.6 percent with the exception of 9.7 percent in one bank. Banks are owned by millions of savers and retirees not by their managers.
The taxation and regulation syndrome could export the financial industry and its jobs to other jurisdictions. This is the time for prudence and protracted informed debate instead of rushing into harmful taxation and regulation. The emphasis should be on maintaining the volume of intermediation ensuring rapid growth of the economy and return to full employment. If taxation, regulation and government spending—ranking in similar longevity with the oldest professions—were a panacea, there would not be economic problems or need for this post. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)