–Taxes Would Force Financial Insitutions to Internalize Risk
–Legislation Can’t End Bailouts;House Tax Cap Ends Desirable Incentives

By Heather Scott

WASHINGTON (MNI) – Regardless of the final shape of the financial
regulatory reform bills debated in Congress, no legislation can
eliminate bailouts and the best way to limit their size is to impose
taxes on financial institutions to force them to internalize risk, the
head of the Minneapolis Federal Reserve Bank said Monday.

Minneapolis Fed President Narayana Kocherlakota said “the
expectation of bailouts leads to too much capital being allocated toward
overly risky ventures,” the costs of which will be paid by the taxpayer
in the event of a crisis as the government tries to prevent a bank run
that will hit even those institutions that did not take undue risk.

But, he said, “although bailouts are inevitable, their magnitude
can be limited by taxes on financial institutions.”

Even if the bailouts only kick in during financial crises, these
guarantees insulate depositors and debtholders from increases in
investment risk, and so they “do not demand a sufficiently high yield
from riskier firms,” he said, noting that he was speaking only for
himself, and not for the Fed. He was speaking to the Economic Club of
Minnesota in Minneapolis.

As a result, “Financial institutions take on too much risk, because
they are no longer deterred from doing so by the high costs of debt
finance. And this missing deterrence is especially relevant for firms
that are highly leveraged, because they should be paying out especially
high yields on their debts.”

Kocherlakota said that “risk externality can be eliminated with a
well-designed tax system.”

Citing the example of a manufacturing firm taxed on the amount of
pollution it creates, but not told how to achieve that level, he said,
“a financial institution should be taxed for the amount of risk it
produces that is borne by taxpayers. The firm will then choose the
socially optimal level of risk.”

As a result “my proposed risk tax, like the pollution tax, corrects
the risk externality without creating any new inefficiencies,”
Kocherlakota said.

Knowing the amount of the tax will be complex, since bank
supervisors will have to calculate and expected value of a potential
bailout and then discount it, he said.

He suggested creating a “rescue bond” for each financial firm,
which has the advantage that the government would not have to decide in
advance how systemically important each firm is, “the market itself could
reveal how systemically important each institution is through the price
of its rescue bonds.”

He noted that the House bill has a new risk-based assessment on
large banks and hedge funds which “should have desirable incentive
effects on the targeted firms.”

However, he said that since the tax will end once it has raised
$150 billion “so too will its desirable incentive effects,” which he
called “problematic.”

And he cautioned that despite good intentions of legislators to
design better regulation, and better resolution procedures to allow
financial firms to fail, “I do not believe that better resolution
mechanisms will end bailouts.”

He said that “no matter how well-written or how well-intentioned
the legislation may be, no law can completely eliminate the kinds of
collective investor and regulator mistakes that lead to financial
crises. … And once these crises happen, there are strong economic
forces that lead policymakers — for the best of reasons — to bail out
financial firms.

“In other words, no legislation can completely eliminate bailouts.
Any new financial regulatory structure must keep this reality in mind.”

** Market News International Washington Bureau: 202-371-2121 **

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