Too-Big-To-Fail – Just-Right to Tax

A Bottom-Up Solution to the Too-Big-To-Fail Problem

 John Staddon

It is almost inconceivable that any Treasury secretary will be able to make the tough decisions necessary to finally address too-big-to-fail by chopping the banks down to size.  So writes Neil Barofsky, former Special Inspector General of TARP, the $700 billion bailout program implemented by President Obama’s Treasury Department [1. Bailout, Free Press, 2012].  Politically, practically, psychologically, there is no way that too-big-to fail banks will be broken up by any top-down decision.  Far from mitigating the pre-crisis status-quo of TBTF banks, the first hang-‘em-then-try’em Dodd-Frank bill [2. D-F was passed six months before the report of the committee asked to report on the causes of the crisis cemented it.  The big banks are even larger now].

The political and bureaucratic facts mean that nothing really effective will be done without a public outcry.   

The mega-banks are nodes in a huge web of obligations.  If they are not somehow dispersed, they will bring down the financial system again in a few years.  Unfortunately, the public, while disgusted with both banks and regulators, is also bored and confused by the issue.  This is no accident, of course.  Legislation and finance have been intentionally complexified to limit scrutiny.  Check out the 848 pages and, potentially, 30,000 pages of regulations (8000 or so done, the rest still to follow), of Dodd-Frank and the accounts of a large entity like Bank of America [3. “Even with 40 years’ experience in banking, I cannot fully understand the financial statements of Bank of America.” writes John Allison in The Financial Crisis and the Free Market Cure:  Why Pure Capitalism is the World Economy’s Only Hope. McGraw-Hill, 2013.] if you don’t believe me. 

There is an approach to the problem that is much simpler the than piecemeal tweaking of the junkpile of existing banking regulations – which is all that seems to have been proposed so far.  First, despite the insane competitiveness of individual players, the bottom-line evidence is that the financial industry is not truly competitive.  It is a cartel [4. http://www.moneynews.com/StreetTalk/Cohan-Big-Banks-Illegal/2012/01/20/id/424856] that allows excess profits and ‘rent seeking’[5. “The banking industry enjoys operating margins, returns on assets and returns on equity which most other sectors would die for. It’s actually an oligopoly.” UK financier Lord Myners, Telegraph – Sat, Jun 4, 2011].

The monopolistic structure of high finance is in fact obvious.  No banking expertise is required.  When Toyota was in trouble a few years ago because of supposed accelerator problems, Ford and GM were happy.  Toyota’s misfortune was good news for GM – because automobiles are a truly competitive market.  So did Goldman Sachs cheer when Lehman Brothers went belly-up?  Well, no, actually.  What they and all the other major Wall Street players did was run to Goldman Sachs alum Treasury Secretary Henry Paulson for aid.  Their cartel was in as much danger as was GM when GM division Pontiac began to lose money. 

In his autobiography Secretary Paulson reports an angst-ridden midnight scene where he put his trust in a Higher Power to help rescue his Wall Street friends.  The ‘Higher Power’ turned out to be the US taxpayer, of course, when Paulson engineered the TARP bailout. 

Monopolies and cartels are bad for the public.  Competition is the only real restraint on irresponsible behavior by large businesses. What is needed for Wall Street is some robust trust-busting, bespoke tailored for financial markets. 

Here is a suggestion.  There are three things that everyone seems to agree on. 

  • The US has a severe government-debt problem. 
  • Consequently some taxes will have to be increased, even though raising taxes in the middle of a slump may slow recovery. 
  • A major cause of the 2007-? crisis was that big banks took on too much risk. 

These three things suggest a relatively simple solution.  If something is thought to be injurious to the common good, like smoking or drinking, a standard policy move is to tax it.  Clearly taking on too much risk contributed to the present crisis.  In the present dilemma, two birds, government debt and (financial) vice, may therefore usefully be slain with one regulatory stone by imposing a tax on financial risk.  The national debt will be alleviated by a tax that should also have beneficial rather than damaging economic effects. 

A total-risk (total-exposure, in the jargon) tax should be steeply progressive: zero to negligible on ‘small’ risks, large on very large ones.  With this kind of progressive tax, it will not pay a firm to build up its daily exposure beyond a certain point.  So large financial firms will be forced to divide themselves into a number of smaller ones – small enough, given the proper choice of tax rates, that none is ‘too big to fail.’  A financial industry with small ‘failable’ firms should be truly competitive – which the current industry is not.  Its share of total national profits should decrease – which, historical data suggest[6. See The Malign Hand of the Markets, John Staddon (McGraw-Hill, 2012), Chapter 10.]. would be good for the economy as a whole –and it should also be more efficient, in the real sense of serving the resource-allocation needs of society in an inexpensive and stable fashion. 

How can this be done in a way that does not impede real market efficiency?  A common risk-management tool is something called value at risk (VaR).   It is defined this way:

For a given portfolio, probability and time horizon, VaR is defined as a threshold value such that the probability that the mark-to-market loss on the portfolio over the given time horizon exceeds this value…[7. http://en.wikipedia.org/wiki/Value_at_risk; see Testimony of Richard Bookstaber Submitted to the U. S. House of Representatives, Committee on Science and Technology Subcommittee on Investigations and Oversight For the Hearing: “The Risks of Financial Modeling: VaR and the Economic Meltdown” September 10, 2009 for a clear account.]

The value at risk for each obligation is its amount times the probability of loss at a given time.   The firm just adds up the VaR for each commitment to get the total VaR.  

Unfortunately, the probabilities are a problem, because they are based on math models that have proven wildly inaccurate.  The bank J. P. Morgan in May of 2012 had an average daily VaR of $69 million, but its actual loss on May 11, 2012, was estimated at $2.3 billion (or more: “JPMorgan Trading Loss May Reach $9 Billion” headlined the New York Times in June of 2012).  In short, the probability part of VaR is pretty useless.  The number I propose is simply total obligation if everything fails – no probabilities, just assume that the bank loses everything.  It’s equivalent to a technical measure called capital at risk[8. Capital at risk — a more consistent and intuitive measure of risk.  David J. Cowen and David Abuaf. Cass-Capco Journal of Financial Transformation, Series on Risk, no. 28, March 2010,  p. 22-26.]. 

VaR (or CaR) is typically computed once a day, after the close of trading.  Why not impose a steeply graduated tax, applied daily, to the total capital at risk?  On a CaR  of $1M or less the daily tax might be negligible, say $100, less than a tenth of one percent.  But on a billion (one thousand million) it might be $9M, just under one percent, a disproportionate increase. This or a similar formula6 would set up for the financial industry what biologists call frequency-dependent selection, whereby rare forms (in this case small firms) have a fitness advantage over common forms (large firms).  In other words it would reverse the situation we have now where the opposite is true: large banks have several advantages over small, such as the ability to borrow money more cheaply and government-guaranteed stability.   

This is just an example.  The actual numbers would require some research into details of profit margins to be expected from transactions of different sizes and so forth.  The aim is just to discourage very large exposures by making them unprofitable even if they usually pay off.    

The money obtained from the CaR tax could be subtracted from corporate tax, making tax offshoring that much less attractive to firms[9. See for example http://www.carolinajournal.com/cjprint/display_cjprint.html?id=136, p. 23, and http://www.ft.com/intl/cms/s/0/da0840fc-33f5-11e2-8270-00144feabdc0.html#axzz2D37kzlt8].  In other words, the process could easily be made generally beneficial as well as revenue-neutral.

The CaR tax could be applied relatively quickly since little research is needed – no need to look over the thousands of pages of Dodd-Frank, for example.  The rate could be ‘tuned’ just like the Federal Funds Rate.  Perhaps Mr. Bernanke could advise? 

Picture credit: Financial District by Bobby Mikul