Taxing Bank Risk

I’m a proponent of higher taxes on large financial institutions, most recently along the lines of the Financial Activities Tax proposed by the staff of the IMF. Even better than taxing bank size, however, would be taxing bank risk. Via Annie Lowrey, it seems Federal Reserve Bank of Minneapolis President Narayana Kocherlakota proposed just this at a speech to the Economic Club of Minnesota:

The firm is told that the government will estimate the expected, discounted value of bailouts that the financial institution (or any of its stakeholders) will receive in the future. I say “expected” because the amount of the bailout is uncertain (and indeed is likely to be zero much of the time). I say “discounted” because the bailout may be received next year or in 30 years, and we need to discount accordingly. Clearly, this estimate will depend on many firm choices and attributes, including its leverage ratio, the maturity structure of its liabilities, the risk characteristics of its investment portfolio, and its incentive compensation schemes. For example, the expected bailout will be higher for firms with highly risky investments than for firms with less risky portfolios.

Then with that calculation done, the government levies a pigouvian tax on the bailout externality: “the government then charges the firm a tax that is exactly equal to the expected discounted value of the firm’s bailouts.”

My first thought is that this is a nice idea, but wildly infeasible. We might as well ask the IRS to base a tax on the number of angels who can dance on the head of a pin. Kocherlakota sort of has an answer to this objection—gambling:

Suppose that, for every relevant financial institution, the government issues a “rescue bond.” The rescue bond pays a variable coupon equal to 1/1000 of the transfers made from the taxpayer to the institution or its stakeholders. (I pick 1/1000 out of the air; any fixed fraction will do.) Much of the time, this coupon will be zero, because bailouts aren’t necessary and so the firm will not receive transfers. However, just like the institution’s stakeholders, the owners of the rescue bond will occasionally receive a large payment. In a well-functioning market, the price of this bond is exactly equal to the 1/1000 of the expected discounted value of the transfers to the firm and its stakeholders. Thus, the government should charge the financial firm a tax equal to 1000 times the price of the bond.

That’s clever, but it also seems kind of nuts. Financial markets are very volatile. That would especially be true of a relatively small, relatively illiquid market like the market for Wells Fargo rescue bonds. And this market would be subject to terrifying positive-feedback loops in which an increase in the rescue bond leads to higher taxes, which leads to both lower profits (and thus higher risk of insolvency) and also lower stock prices and thus even higher rescue bond prices. The whole thing seems like it would be enormous prone to panics and runs. And, indeed, Kocherlakota concedes that ” it would be inappropriate to rely only on market measures to compute the appropriate taxes.”

But once you put discretion back into it, I think this whole plan unravels. You’d be asking regulators to do much to much, everything would become politicized, and moral hazard problems would get more severe. I think it makes much more sense to just accept that there are limits to what’s possibly, and crudely tax bank size while using blunt regulatory instruments to limit leverage.