Taxing Bailed-Out Financial Institutions

The administration's proposed bank tax can be considered an insurance payment that is paid after disaster strikes rather than the more usual case of collecting premiums ex-ante (as I talked about here). But what's the best way to structure this after the fact insurance premium? Diamond and Kashyup say that the answer is to base the tax on the difference between bank assets at the end of August 2008, and their level of capital today:

Return Our Investment, by Douglas Diamond and Anil Kashyup, Commentary, NY Times: 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... So rather than debate the constitutionality..., 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. ...

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...

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. ... 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. ...

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.

If we are going to provide such insurance -- and there is an implicit guarantee that the insurance will be available whenever a shock to the banking system has the potential to create systemic trouble -- then (as I argue here), one part of the regulatory response to the crisis must be to limit the amount of risk that these firms can take on.