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Large US Banks Still Don't Get It



On January 14 President Obama announced that he would ask Congress to impose a "financial crisis responsibility fee" on the 50 largest financial institutions. The fee (hereafter referred to as the tax) would be applicable to all financial institutions with more than $50 billion in consolidated assets. If it becomes law, approximately 35 US banks and 15 US subsidiaries of foreign banks are expected to have to pay the tax. The tax rate would be 0.15 percent of the firm's covered liabilities, where covered liabilities are defined as global assets minus the sum of Tier 1 capital (i.e., capital of a higher quality) and FDIC-assessed deposits (or insured policy reserves for insurance companies). Banks could satisfy their tax liability over a 10-year period. It has been estimated that the tax would generate about $90 billion in revenue for the Treasury—roughly the same amount as the estimated remaining taxpayer loss in the Troubled Asset Relief Program (TARP).

Not surprisingly, large US banks are screaming bloody murder about the "unfairness" of such a tax and about the likely damage it will do to the US economy—and this just when these same institutions are announcing not only extremely large profits but also record or near-record bonus payments to their employees. According to the Wall Street Journal,1 major US banks and security firms are expected to pay out 18 percent more in total compensation in 2009 than in 2008 and slightly more than in 2007, although the estimated share of compensation in revenue for 2009 will be lower than in either of the two preceding years.

From their statements, it is clear that large US banks still have a highly distorted and self-serving view—of their role in the origins of this crisis, about how much their survival and subsequent return to profitability were dependent on the government's crisis management policies, about their fair share of the burden of adjustment to the crisis, and about the kinds of reforms necessary to prevent a recurrence of the crisis. They also are already mischaracterizing the rationale and likely impact of the tax.

The financial responsibility tax makes sense on a number of counts.

The tax will fall more heavily on large banks than on smaller ones because the latter will fall below the $50 billion asset cutoff. This is appropriate because it was the large commercial and investment banks that were at the center of this crisis. In a similar vein, the tax will also fall more heavily on financial institutions that rely heavily on wholesale funding sources relative to those that lean more on insured deposits. Again, this carries the right incentives because it was the group of financial institutions that counted most on wholesale funding and that did not have access to a relatively large and stable deposit base that was shown to be most vulnerable in this crisis—and not just in the United States. Exempting insured deposits (and insured policy reserves) from the tax base is also appropriate (to avoid double taxation) because banks (and insurance companies) are already assessed an insurance fee (by the FDIC) on this element of their liabilities. Note too that covered liabilities are reduced for financial institutions with relatively high Tier 1 capital—and not necessarily for those with high total capital (Tier 1 plus Tier 2). This focus on the quality of capital is again justified by the experience of the crisis when investors, in assessing creditworthiness, paid more attention to some types of capital (e.g., tangible common equity) than to less differentiated capital aggregates. Other things being equal, taxes on output also tend to generate smaller employment losses than taxes on wages, because the former generate only one kind of substitution (away from the products whose price is increased by the tax) whereas the latter generate two substitution effects (away from labor toward capital and away from the products with now higher prices). And by stretching payment of the tax over a 10-year period, there is little likelihood that the tax will do undue harm to the banks.

Most important, the tax sends an important message to the largest financial institutions: if you mismanage risk on such a scale that you put not only the solvency of your own firm in question but also threaten the financial stability of the entire US economy, then you and the relevant parts of the financial industry will be held accountable and responsible for your fair share of the costs of such a rescue. Contrary to what the banks have been arguing, that fair share goes well beyond repaying the TARP with interest. After all, the collateral damage from this crisis—to which the large banks and securities firms contributed more than anyone else—encompasses, inter alia: the most serious US downturn since the Great Depression; a 10 percent unemployment rate; and much lower tax revenues, along with massive increases in both the US budget deficit and ratio of US public debt to GDP. To suggest that the "fair" share of the large banks in this wider collateral damage is in the neighborhood of $100 billion (or even less because of TARP disbursements to the auto companies) is simply ludicrous. If the financial responsibility tax were the last crisis-related assessment placed upon the banks (rather than the first installment on what they truly owe taxpayers), they would have gotten off dirt cheap. Indeed, if one looks down the road and wants to adhere to the principle that large, systemically important financial institutions (SIFIs) should be responsible for cleaning up their own mess, then regulatory reform packages should include tougher capital, liquidity, and leverage requirements for SIFIs, a stipulation that SIFIs need to shrink if they cannot offer plans that show how they can be wound down without causing adverse systemic effects on the economy, and either an ex-ante or ex-post assessment to cover the costs of future failures.

Nor is the claim of the large banks credible that large bonus payments are deserved because they "earned" them by way of their superior skill and market savvy. Most of the firms to be taxed were at death's door at the height of the crisis and might not have survived without the government's intervention. Moreover, the scale, breadth, and depth of those crisis management efforts are what primarily generated the sharp bounce-backs in bank revenues and bank profits. In questioning Goldman-Sachs Chairman Blankfein last week at the opening hearing of the Financial Crisis Inquiry Commission, Chairman Angelides hit the nail right on the head:

"…It seems to me that you (Goldman-Sachs) survived with extraordinary government assistance. There was $10 billion in TARP funds, $13.9 billion as a counter party via the AIG bailout. By your own form 10-K, you said that you issued $28 billion in debt guaranteed by the FDIC, which you could not have done on the market but for that. You were given access to the Fed window and the ability to borrow at next to nothing. You became a bank holding company over the weekend. You had access to TALF. You benefited from a ban on short selling… And you got relief, some relief from mark-to-market rules…."

One ought also to take with a very large grain of salt recent comments from the large banks that the tax will lead to a significant drop in bank lending, that the tax will not penalize banks because it will simply be shifted to shareholders and bank customers, that any effort to tax bank bonuses will result in a disastrous wholesale exodus from the taxed institutions, and that the tax is unnecessary because banks are already championing financial regulatory reform.

If hundreds of billions of dollars of capital injections to banks under the TARP were not able to produce an increase in bank lending because the real constraint on lending was weak loan demand (due to a depressed economy) and reluctance by banks to make new loans to questionable borrowers, it is hard to see how a much smaller tax bite (spread over 10 years)—enacted against the backdrop of a recovering economy and improving creditworthiness—is going to single-handedly tank bank lending.

Yes, it is possible for banks—after the tax—to continue to pay the bonuses they intended to pay before the tax by passing on the tax to their shareholders and/or their customers. But neither of those options would be costless for the banks. Their shareholders have already been significantly diluted by their capital-raising efforts and bank dividends are a tiny fraction of their precrisis level. The more the banks squeeze their shareholders so that they can fatten farther their pay envelopes, the greater the risk that shareholders balk and ultimately turn voluntary "say for pay" measures into compulsory ones. Similarly, banks can increase their fees to customers but because small financial institutions are exempt from the tax and because some large banks may pass on less of the tax than others, those that do pass on more risk a loss of business to their competitors—especially if the perception grows that (some) large banks are in business only for themselves.

Another favorite refrain from the large banks—dating back to before the crisis—is that they have no choice but to pay such huge bonuses; after all, if they were not so generous, their best employees would depart for competitors that exercised no such restraint, with the result that human capital in the banking industry would be much lower. The claim that employees at large banks care a great deal about how much they are paid cannot be denied—particularly in light of recent events. It is the other parts of this self-serving argument that merit challenge. If banks lost some of their best employees to hedge funds and private equity groups, risk taking might not change so much; in fact, it might increase. But there is the uncomfortable fact for banks that when hedge funds and private equity funds were failing in this crisis, the government did not have to save them (at least directly). It is also relevant that some other large countries with sizeable financial sectors (the United Kingdom and France) are enacting taxes on bank bonuses of their own; and the Obama administration has indicated that it will try to convince other G-20 countries to enact taxes similar to their financial responsibility scheme. Is the tax going to convince large banks that now is the time to move operations in mass to small islands in the Caribbean? I doubt it. And what—God forbid—if some of the brightest employees were to leave the financial industry and take up new careers in other fields—from medicine to engineering to teaching—and if the size of the financial industry were to shrink some? Sorry, but it just doesn't seem like the apocalypse.

Last but not least there is the charge that we don't need to reach the hearts and minds of the large banks through such a tax because these banks have already gotten the message of the crisis and have now embraced financial regulatory reform. If so, why are those same banks currently spending millions of dollars in lobbying efforts to block everything from the creation of an independent consumer financial protection agency, to the needed migration of OTC derivatives to clearinghouses and exchanges, to agreement on much higher capital standards for banks?

In the end, I couldn't agree more with a recent comment from Jamie Dimon, the CEO of JP Morgan, who, opining on the financial responsibility fee, declared: one has to be "a little fair."  


1. "Banks Set for Record Pay," Wall Street Journal, Friday, January 15, 2010.

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