Bank Busters

The Obama administration's schizophrenic affair with investment banks took another unfortunate turn this week. While Wall Street has been busy doling out compensation packages that rival the bonuses of the frothiest days of 2007, the White House has been busy trying to position itself as the avenger of Main Street. A hundred billion dollar bank tax is now on the agenda for debate (see recent post). But the proposal that has the greatest potential impact on finance as we know it is a prohibition on banks using customer deposits to finance trading operations.

While I support some sort of special tax, I do not support the proposed ban on risky investing by banks that accept customer deposits. It is clear that the government does not want banks to stop investing and trading altogether. Despite the tumult of the last two years, it is important to remember that the core business of finance is actually good for the world: moving capital from lenders to borrowers does wonders for real economic development. The difficult problem we face is how to regulate that process so as to foster economic growth, create fair outcomes, avoid systematic meltdowns, and keep taxpayer dollars out of Wall Street's hands.

Separating deposits from banks' trading operations would not improve the financial system. It might very well make it worse. Recall that in the Fall of 2008 firms with large reservoirs of customer deposits were best able to ride out the storm. Bear Stearns, Lehman Brothers, and A.I.G., on the other hand, did not have significant customer deposits. This is because F.D.I.C. insured deposits were a remarkably stable source of capital for banks. As the financial world unraveled, customers happily left their deposits in their accounts at J.P. Morgan Chase, Citi and Bank of America. Other sources of bank capital - the repurchase market, the commercial paper market, and the bond market - dried up. Without access to capital, banks were forced to sell assets at fire-sale prices to repay their obligations as they came due. The result was a market collapse and trillion dollar government interventions. One of the major lessons of Fall 2008 is that banks were buying risky assets with capital that could dry up very quickly. Customer deposits were a bright spot on banks' balance sheets; they were a source of stable capital throughout the crisis.

So why would the administration want to discourage banks from using a more stable source of capital? I don't know. Perhaps they believe that by taking away one source of capital they can reduce the amount of investing that investment banks do. This is probably correct. But surely we would want to restrict the sources of capital that are least stable first. And remember that we do indeed want banks to take some risk; investment is a good thing. Cutting off deposits from investment banking removes a stable source of capital. Such a policy could increase risk while decreasing investment and economic growth. Obama's team needs to go back to the drawing board.

Also check out this Bloomberg article about the proposal.

Obama's Bank Tax

President Obama this week unveiled a plan to raise about 100 billion dollars by taxing big banks. The overall thrust of the plan - replenishing government coffers with a slice of the profits made by institutions that were saved from destruction by government largesse - seems fair. And the U.S. Treasury could surely use the cash. So I support this effort to get taxpayers some of the money that is rightfully theirs.

However, this tax is far from ideal and raises some troubling questions about the future role of government in the financial sector. A system in which politicians run about deciding which industries they like and which they would like to tax is a bad one. Tax policy should be predictable so that investors can confidently invest without fear of retributive taxes. And taxes should not target certain industries; targeted taxes interfere with the free market and hinder economic growth. Another unfortunate consequence of a system in which Congress picks winners and losers in business is that such a system encourages lobbying and tends to corrupt the political process. Perhaps worst of all, this tax does little to remedy the hyper-leveraged risk taking that brought down the financial system in the first place. In fact, the tax has the unfortunate consequence of increasing leverage by reducing the firms' equity.

One desirable feature of the tax is that it hits bigger firms harder (the amount of tax owed is a percentage of certain types of assets and only kicks in if a firm has 50 billion in such assets). This may in some small way reduce the too big to fail problem, but the benefits of being big will still outweigh the costs of the tax. Other than that, the proposed levy does little to reform the financial system to make it more stable in the future.

A variety of superior alternatives exist. The first that comes to mind is an F.D.I.C. controlled investment bank bailout fund modeled after the current F.D.I.C. deposit insurance program. Firms would contribute to an annual fund that would be used for future problems and the amount contributed would be based both on a firm's size as well as an estimate of its risk. An important feature of an F.D.I.C fund would be the orderly wind-down of any firm that needed assistance. The F.D.I.C. has already successfully wound down hundreds of failed deposit banks and could extend this expertise to the investment bank behemoths. Funds would not be used to keep the firm alive or to bail out investors. Only customers would get bailed out and even they might be forced to take a haircut on their assets.

Another alternative would be a tax that accounts for leverage as well as size. Banks' excessive leverage was a much more significant factor in the financial meltdown than was size.

It is also worth quickly reviewing some T.A.R.P. history to point out how this tax is inconsistent with earlier theories used to justify the terms of the bailout. Many argued - including myself - that the terms of any bank bailouts should be much harsher for the banks' investors. Paulson - in conjunction with a Congress controlled by Democrats - doled out cash on generous terms. They argued that they were not trying to punish banks, but to encourage lending. Despite the fact that Warren Buffet was simultaneously extracting much better terms for his investment in Goldman Sachs, Paulson believed that he should not do so on behalf of the taxpayers who employed him. Had the government demanded much larger equity stakes and/or concessions from bondholders, taxpayers would have fared much better and banks would have learned a much sterner lesson about the dangers of excessive risk.

Obama is doing the right thing by trying to capture some of the profits that were made possible by taxpayers. But his tax proposal is a blunt tool that undermines political integrity and confuses investors. It also fails to discourage the types of behavior that caused the financial crisis in the first place. It would be easy to improve this bill.