April 27, 2010 A Bank Tax as Insurance for Us All By DAVID LEONHARDT Washington The financial regulation bill before the Senate has the potential to

April 27, 2010
A Bank Tax as Insurance for Us All By DAVID LEONHARDT

Washington

The financial regulation bill before the Senate has the potential to do a lot of good. But it also has at least one major flaw: it would not do enough to prevent taxpayers from paying the bill for a future crisis.

What would? A tax on banks. The International Monetary Fund has started pushing for a bank tax, and a tax has also become part of the debate in Britain’s election campaign. In this country, however, the subject has taken a back seat to issues like derivatives regulation and the Goldman Sachs case. Those other issues are important, but they are not as central to minimizing the damage from the next crisis.

To understand why, let’s take a glimpse into the future. Imagine the year is 2020, and a major financial firm is collapsing.

The financial regulation bill that President Obama signed back in 2010 was meant to deal with just such a problem. It gave regulators something called “resolution authority.” They could seize a dying firm, wipe out its shareholders, fire its top executives and keep it operating until its surviving parts could be sold off in an orderly fashion. Now, in 2020, the regulators are preparing to use that authority for the first time.

But as they dig into the details, they realize they are facing a raft of problems. One of the biggest is that the firm has 70 percent of its assets abroad (roughly the share of Citicorp’s business that was overseas in 2009). Washington can’t simply seize assets held in London, Shanghai or Moscow.

So ultimately, the regulators are left with the same choice that arose in 2008: bankruptcy or bailout. Regulators can let the firm fall apart suddenly and risk the kind of collateral damage that the bankruptcy of Lehman Brothers caused. Or they can spend billions of taxpayer dollars propping up the firm, as was the case with A.I.G. It’s a miserable choice.

You also can be pretty sure which of the two options tomorrow’s policy makers will choose: bailout. History — in the form of the Great Depression and, more recently, Lehman — argues against the idea of liquidate, liquidate, liquidate, as Herbert Hoover’s Treasury secretary, Andrew Mellon, advocated. The downside, of course, is that taxpayers end up paying for Wall Street’s sins.

Obama administration officials insist that the reregulation plan will prevent this outcome. They note that both the Senate and House bills will give regulators more authority to monitor financial firms. Banks will also be required to hold more cash in reserve, which will give them a bigger cushion when some investments do go bad. The rules for resolution authority, meanwhile, will be written with international cooperation in mind.

And maybe time will prove the administration correct. But a good number of economists and banking experts are worried. They think the odds of a future bankruptcy-or-bailout dilemma will remain uncomfortably high even if reregulation passes.

For starters, there are the cross-border problems; in the midst of a crisis, governments may have trouble cooperating. Then there is the fact that the regulators have never before tried to shut down anything as complex as a multibillion-dollar financial firm. “It’s really hard — really hard,” says Robert Steel, who worked on the financial crisis in the Bush Treasury Department and later was chief executive of Wachovia. “Anyone who says they know exactly what we should do is overconfident.”

Another former top government official adds, bluntly, “Don’t kid yourself into thinking that if J. P. Morgan were on the rocks, it would disappear.”

Above all, no one knows what the next crisis will look like. So no one can be sure exactly how to prevent it. In all likelihood, Wall Street will eventually figure out ways around technocratic rules — and technocrats — and create trouble that today’s proposals don’t anticipate.

The beauty of a bank tax is that it acknowledges as much. Financial firms play a vital role in a market economy. But they also have a long record of causing crises, be it the South Sea bubble of 1720, the Panic of 1873, the Great Depression or our own Great Recession. A bank tax is akin to an insurance policy that taxpayers would require Wall Street to hold. The premiums on that policy would keep Wall Street from making big profits in good times while foisting its losses on society in bad.

The current Senate bill includes a kind of bank tax, but it has all kinds of problems. It would initially collect only $50 billion from firms and then set the money aside to pay the costs of future bailouts. Other crises have cost far more than $50 billion.

For this reason, the Obama administration prefers a postcrisis tax. The White House has proposed a so-called TARP tax, to raise at least $90 billion over the next decade and cover the costs of the 2008 bailout fund (the Troubled Asset Relief Program). But this idea has its own flaws. It does not leave any money for future busts. It assumes Washington will always be able to recoup those costs later, which doesn’t sound like a great bet.

The I.M.F. prefers a permanent tax, for the good reason that the risk of crises is permanent. “The challenge is to ensure that financial institutions bear the direct financial costs that any future failures or crises will impose — and maybe somewhat more, given all the other costs that bank failure can impose on the economy,” Carlo Cottarelli, the head of the I.M.F.’s fiscal affairs unit, wrote last weekend. The tax wouldn’t go into a dedicated bailout fund. Its purpose instead would be to discourage too much risk-taking and, over the long term, help offset any bailout costs.

Because the tax would be calculated based on a firm’s holdings, a small local bank or a larger bank with billions of dollars in safe consumer deposits might pay nothing. A leveraged investment bank would surely be taxed.

The TARP tax, in its technical design, would be similar. And Timothy Geithner, the Treasury secretary, told me recently that he was open to the idea of the tax’s becoming permanent. “There is a very good argument you should put a fee on finance, like a tax on pollution,” he said.

Yet the administration — nervous about upsetting the fragile support in Congress for financial reregulation — has been afraid of making the tax part of the broader bill. That strikes me as a mistake, given the tax’s importance. Obviously, though, if Congress passes a bank tax in a separate bill later this year, it will work out the same in the end.

There is some reason for optimism, too. Max Baucus, the chairman of the Senate Finance Committee, told Politico this week, “I don’t think there’s much doubt that there will be a bank tax.” Why? The tax is not just about punishing banks.

The federal government, remember, is facing a huge deficit. To pay it off, Washington will need to make spending cuts and raise taxes. Can you think of a better candidate for taxation than an industry that made huge profits during the boom and then helped cause the bust that has sent the deficit soaring?