A fixed income specialist, Dr Stephen Nash, who is a Director of FIIG Securities and previously managed a large pension fund for the United Nations, has published this proprietary policy piece as a guest post on my blog. Enjoy!
Risk-based taxation – a possible policy tool for banking regulation
10 November 2010
By Dr Stephen Nash
The US has recently introduced means of dealing with the too-big-to-fail (TBTF) institutions. An alternative to that approach exists – a risk-based taxation system. This piece quickly reviews the US approach and its problems. As an alternative to the US, we suggest a risk-based taxation system, where the government charges institutions for the potential TBTF risk they pose.
Upon the President’s signature, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Act) became law on 21 July 2010. As the most significant legislative change since the depression, the Act will impact all financial institutions – great and small. In many ways, the Act is like a new operating system for a computer and it will set the rules for the financial markets in the future. Specifically, the main feature of the Act is to eliminate the systemic support for banks. FIIG reviewed the Act in The Wire dated 28 July, under the heading, “Is the Dodd-Frank Act a Recipe for Another Crisis?”
As the US President has commented, there will be no more “bailouts” for US banks:
“Finally, because of this law, the American people will never again be asked to foot the bill for Wall Street’s mistakes. There will be no more tax-funded bailouts – period. If a large financial institution should ever fail, this reform gives us the ability to wind it down without endangering the broader economy. And there will be new rules to make clear that no firm is somehow protected because it is “too big to fail,” so we don’t have another AIG.” Source: Office of the Press Secretary, White House, Washington D.C, For Immediate Release July 21, 2010
While it is a praiseworthy approach, the problem is that credit rating agencies ascribed what they call a rating ‘uplift’ to bank ratings, as a result of government, or systemic support. As the Bank of England has recently commented, “Moody’s ratings suggest expectations of government support improve their bank ratings by up to five notches”. The following graph from the Bank of England, illustrates this point.
Source: Bank of England, Financial Stability Report, June 2010, Issue No. 27, Chart 3.21, p.43.
If systemic support has been removed, then a credit rating downgrade of US banks may well emerge, and this will increase the cost of funding. On 22 October, Fitch Ratings announced that several major US banks, are on rating watch negative. In part, this action reflects the uncertainty of how the Dodd-Frank Act will impact the degree of support offered by the US Government to larger banks. Moreover, adoption of similar approaches to the US in Australia may lead to similar credit rating downgrades in the short term.
Another problem with the US approach is that bondholders, who fund the ongoing operation of Banks, remain uncertain as to their financial responsibility and their recovery position, should the bank fall into liquidation – essentially an untested procedural framework.
An alternative approach
An alternative approach may be to provide TBTF support, where governments use the tax system to price for risk. In the event of the failure of a large firm, or bank, the government would incur large costs, which might be estimated in various ways. Small firms would cost less to support than large firms, and an actuarial calculation could be made to derive a premium for TBTF failure, charged by the government to firms, based on the estimated cost that the failure of such a firm would impose on the broader economy. Such a tax would adequately compensate the government for possible future costs, and also provide an incentive for smaller firms to grow, up to a point. Current regulatory frameworks and the costs that pertain thereto may mitigate the possibility of failure; they do not adequately compensate the government for the risk large firms pose.
The advantage of such an alternative approach to the solution recently explored by the US, to the problem of TBTF, is that it maintains the credit uplift for the banks and reduces the uncertainty for bondholders in the case of liquidation. At the same time, the tax would compensate the government for the periodic role it plays in a crisis situation.
While explicit guarantees to bond issues for banks were available, in return for a premium, this solution generalises that approach and pragmatically recognises the role of government in a crisis. In other words, TBTF firms need to realise the implicit guarantee on their operations provided by the government, and to start to pay for it. In many ways, current taxation implies that the failure of the local newsagent is the same as the failure of a TBTF firm – we know that is not the case and regulation of banks does not rule out collapse. Armed with such information, we need to make sensible policy that translates these realities into a system of taxation that prices for risk, one that possibly improves on the ambitious solution now attempted in the US.
Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.
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