Return Our Investment

(c) 2010 F. Bruce Abel

This is worth considering!


Op-Ed Contributors
Return Our Investment

By DOUGLAS W. DIAMOND and ANIL K KASHYAP
Published: January 19, 2010
Chicago
Skip to next paragraph
Related
Op-Ed Contributor: Taxing Wall Street Down to Size (January 20, 2010)
Times Topics: Financial Regulatory Reform
WALL STREET is considering legal action to prevent President Obama from imposing a new tax on bailed-out financial institutions. Because the law that created the Troubled Asset Relief Program compels the government to recoup the bailout money, it’s unlikely that banks will succeed in avoiding recompense. So rather than debate the constitutionality of the proposed tax, it is far more productive to design the best possible repayment plan.
The consequences of getting this right are huge: with a new tax, the administration aims to raise $90 billion over the next 10 years, which would do much to offset TARP’s estimated $117 billion losses. We therefore suggest taxing banks based on the difference between their assets at the end of August 2008 and their current level of capital. After all, the support these firms received was based on the size of assets before the financial panic began, not the size of those assets today.
With the bailout money, the government wound up insuring the bondholders and other creditors of the financial institutions. The tax we propose would allow the government to effectively collect insurance premiums now that should have been charged ahead of time. (Thus it exempts insurance companies and others that were not bailed out.)
Commercial banks might complain that they already pay a fee to the Federal Deposit Insurance Corporation, making the new fee a double tax. That is partly correct, but the deposit insurance they paid for was underpriced. As a compromise, however, we suggest that the current year’s deposit insurance payments be deducted from the new tax payments.
Because our version of the tax would require each firm to pay a tax proportionate to the size of its bailout, it would fall hardest on the former investment banks whose very survival was in doubt before the government stepped in. These firms are now making eye-popping profits and are on a path to pay record bonuses, but more importantly they had the most borrowed money that wound up being unexpectedly insured. This is why they ought to pay more.
Even TARP recipients that have repaid the bailout funds benefited from the stability the government provided, so they too would have to pay some portion of the tax. But our formula would lower the tax for organizations that have raised capital after August 2008 and would lower it further if they raise more. Regulators around the world have announced a preference for having banks raise more capital, and our tax has the advantage of reinforcing this goal.
By focusing on each institution’s assets before the fall of Lehman Brothers almost brought down the system, our plan would make it impossible for banks to shrink their way out of the tax. Since the crisis, banks have been reluctant to take on more risk and lend; some have responded to losses by selling assets and not renewing loans, which has only exacerbated the economic downturn. Our approach would remove the incentive for such behavior because it ties the tax to the size of the firms when the government guarantees were so valuable.
Likewise, by focusing on the historical size of a bank, our plan would allow little room to engage in sham accounting transactions to sidestep the tax. As we saw in the time leading up to the crisis, banks created many legally separate companies — the infamous “special purpose vehicles” — to buy certain assets without having to put up the bank’s capital to support them. If the banks had bought the assets directly they would have been required to hold more capital.
By August 2008, these tricks had been exposed; financial institutions can’t retroactively cover such vehicles back up, or make themselves seem smaller than we know they were. Nor should they be able to avoid the tax by inventing any new tricks to change the appearance of their current size.
It is generally a bad idea to enact after-the-fact penalties. But giving away free insurance, as the government did during the bailout, is also bad. Our tax would merely ask financial institutions to finally pay for the insurance policy that kept them afloat.
Douglas W. Diamond is a professor of finance and Anil K Kashyap is a professor of economics and finance at the University of Chicago Booth School of Business.