–G20 Proposals On Capital Requirements ‘Too Weak’

By Brai Odion-Esene

WASHINGTON (MNI) – Minneapolis Federal Reserve Bank President
Narayana Kocherlakota Wednesday said that even though financial crises,
and the resulting bailouts, are inevitable, their likelihood and the
magnitude can be limited by taxes on financial institutions.

Capital and liquidity requirements are “intrinsically
backwards-looking,” Kocherlakota argued in remarks prepared for the
annual meeting of the Society for Economic Dynamics in Montreal, and
described the G-20’s capital requirement proposal as “too weak.”

“We need forward-looking instruments for what is intrinsically a
forward-looking problem,” he said, “And that’s a key reason why taxes,
based on market information, will work better.”

He warned that no law can completely eliminate the kinds of
collective investor and regulator mistakes that lead to financial
crises; mistakes that have taken place periodically for centuries and
will certainly do so again.

“Taxes are a good response because they create incentives for firms
to internalize the costs that would otherwise be external,” Kocherlakota
said. Otherwise, knowing bailouts are inevitable, financial institutions
fail to internalize all the risks that their investment decisions impose
on society.

He said bailouts are inevitable because financial institutions’
liabilities often take the form of short-term debt and deposits. These
short-term financing instruments are prone to self-fulfilling crises of
confidence or “runs.”

“And during a crisis, the panic in the air means that any
institution — even one with solid fundamentals — may be subjected to a
run if its investors lose confidence in its solvency,” he added. “Thus,
policymakers inevitably resort to bailouts even when they have
explicitly resolved, in the strongest possible terms, to let firms
fail.”

And although sweeping financial regulatory reform legislation about
to be passed in the U.S. seeks to end future bailouts, Kocherlakota
predicted that no matter what mechanisms are legislated now to impose
losses on creditors, Congress, or an agency acting on Congress’ behalf,
will block those mechanisms when faced with the next financial
crisis in order to prevent a system-side collapse.

So how should financial institutions be taxed? Each bank should be
taxed for the amount of risk it creates that could be borne by
taxpayers, Kocherlakota said. “Once the firm faces the correct tax, it
will choose to produce that risk with a cost-minimizing mix of capital,
liquidity, incentive compensation and other factors.”

As for how the tax would be calculated, Kocherlakota said the
government will estimate the expected, discounted value of bailouts that
the financial institution — or any of its stakeholders — will receive
in the future. The discount rate should be “possibly substantially
less” than the rate of return on Treasuries.

“Having done this calculation, the government then charges the firm
a tax that is exactly equal to the expected discounted value of the
firm’s bailouts,” he said.

“The tax amount exactly equals the extra cost borne by the
taxpayers because of bailouts, appropriately adjusted for risk and the
time value of money.”

Kocherlakota acknowledged that calculating the risk tax will not
only be complex in many ways, but could also be controversial. Financial
institutions that follow highly risky strategies get especially high
profits when those strategies are working, he noted, so supervisors
would be required to levy high risk taxes on exactly those institutions
that appear to be extremely successful.

He argued against imposing capital and liquidity requirements in
order to reduce the level of debt held by banks, saying having to repay
debt “imposes much sharper constraints on managers.”

“Debt-especially short-term debt-helps align the incentives of
managerial insiders and investing outsiders,” he said, “Tougher capital
standards will undercut this alignment, and inhibit economic growth.”

In addition, “Banks with more liquid asset holdings are certainly
better protected against the possibility of runs, but they’re also
performing less of the maturity transformation that improves capital
allocation and economic efficiency.”

The tax system he proposes should be viewed as ideal, Kocherlakota
said, for if a bank knows it faces this tax schedule, it no longer has
an incentive to undertake inefficiently risky investments.

“It is useful to tax a financial institution producing a risk
externality, just as it is useful to tax a firm generating a pollution
externality,” he concluded. “The purpose of the tax in both instances is
to ensure that the targeted firm pays the full costs-private and
social-of its production decisions.”

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

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