To Tax or Not to Tax January 19, 2010, Bob Eisenbeis, Chief Monetary Economist
President Obama has announced his intention to pursue legislation that would impost a 15-basis-point tax on uninsured liabilities of financial institutions greater than $50 billion in size. This proposal will strike a positive tone from a populist perspective and be politically popular. While in no way condoning the behavior of many of our major financial institutions or their leaders, the proposed tax is both ill-designed and irrelevant as a punitive measure or exercise in retribution. Furthermore, it will likely have unintended and far-reaching consequences, especially for smaller regional institutions that may be caught up in the tax.
It is clear that the tax advocates know little to nothing about either financial institutions or how financial markets work. It’s a sure bet that the potentially affected institutions already have a taskforce of people exploring ways to avoid the potential tax. Their lobbyists are being mobilized for a frontal attack in Washington on these issues.
As with all such proposals, the devil is in the details; but here are some considerations and issues before we get to the unintended consequences. The proposal reportedly would tax the net uninsured liabilities of the largest financial institutions, including allegedly the subsidiaries of foreign institutions in the US. But would the tax be on consolidated liabilities or on just the uninsured liabilities in US offices? If the tax is on only domestically booked liabilities, then it is a simple issue for both US-chartered and foreign institutions to shift their funding by booking liabilities off-shore. This is especially easy for foreign-chartered banks that could essentially conduct all their US business utilizing technology and back-office capabilities to book the bulk of their business offshore, in a pinch. Moreover, since they can simply use financial-engineering techniques to employ off-balance-sheet mechanisms to duplicate the traditional loan-funding-by-liabilities process, more and more tax avoidance will take the form of off-balance-sheet activity by both foreign and US institutions.
On the other hand, if the tax is on consolidated liabilities, then the US has no authority to tax the consolidated liabilities of foreign institutions operating within the US, which means that foreign institutions can avoid the tax while their large US competitors cannot. This would only further incent US institutions to shift to off-balance-sheet methods of supporting funding, especially since such activities seem to be treated more favorably from a US regulatory perspective at the moment. This competitive disparity seems in the former instance unfair and in the latter counter to current risk-control concerns and prudent supervision.
But the unintended consequences are even deeper than just described. Consider the following issues. Most of the largest US financial institutions earn a small fraction of their returns from the traditional lending/liability-funding business. The Bank of England, two years ago in their financial-stability report, stated that large, complex financial institutions earned only about 1/3 of their returns from traditional banking – the rest was from fees and trading.
This point is driven home even more strongly in looking at the release by JPMorgan Chase of its fourth-quarter 2009 earnings. Virtually all of their reported profits were made in their investment banking, asset-management, and corporate and private equity businesses. They had net losses of $700 million in their retail and consumer banking areas and a small net profit of $223 million in their commercial banking function after provisions for expected losses of approximately $8.4 billion in these three units. This means that in the traditional commercial banking part of the firm, JPMorgan had a net loss of nearly a half a billion that was subsidized in part by diversified earnings in the other portions of the company. This loss compares with consolidated net income for the company as a whole of $3.3 billion ($11.7 billion for the year as a whole). Interestingly, JPMorgan Chase's consolidated average total loans were approximately equal to its average total deposits ($667 billion), much of which were not likely to be federally insured, and this accounts for less than a third of its total liabilities. All of their nontraditional banking activities outperformed any of their commercial banking activities, by many orders of magnitude after allowing for expected banking loan losses. The bulk of the rest of the assets are in securities, Federal Funds sold, and trading account assets, which can be funded in many different ways, both on and off the balance sheet.
It is no wonder that the markets have already shrugged off the potential punitive aspects of the tax on large banks – it is simply irrelevant to their basic lines of business and hence not punitive in the slightest. Nor are the revenue estimates likely to be correct, because of the tax-avoidance measures that will be put in place.
On the other hand, who is likely to bear the brunt of the tax? The answer is those institutions smaller then the top five or six, who are mainly the regional institutions whose main business is the lending and deposit taking upon which their profitability depends. These are the institutions that primarily fund smaller and intermediate-size businesses. The tax-punishment proposals may make political sense. They may appear to the general public to make even more sense, given the dismal performance of the CEOs of four of the major financial institutions at last week's hearings by the Financial Crisis Inquiry Commission. Lloyd Blankfein of Goldman Sachs tried to position himself as the bartender who simply served whatever drinks the customers ordered, with no sense of responsibility for the consequences when they left the bar. John Mack of Morgan Stanley was a bit more contrite but still tried to blame others, including the regulators. Brian Moynihan was simply too new on the job at Bank of America. And Jamie Dimon of JPMorgan Chase at one point offered the lame excuse that the mistake that they made was simply assuming that real estate prices would always go up. If that's as sophisticated as the analysis was, then the British comedians Byrd and Fortune were dead-on in their wonderful skewering of investment bankers in their routine on the financial crisis (check it out on YouTube), and the whole industry is over-valued.
Whether or not retribution is justified, the proposal from the Administration makes little economic sense. Moreover, the spin that the tax is intended to recoup the losses banks caused to the TARP is misleading, because the primary sources of those losses to date have been Freddie and Fannie and the automobile companies that may be exempted from the tax.
If there is a desire to extract revenue-retribution from large institutions, it turns out that there is no easy way to do it. If one wants to punish management then the efforts should be directed towards taxing their bonuses and other compensation. But there are four problems with this. First, most of those responsible are no longer in their positions, so it will be the new management who will suffer, not those who caused the problems. Second, taxing bonuses won't prevent another crisis. Third, there are always ways around the tax, in terms of how payments can be structured. Finally, managers of foreign institutions that might be covered can escape entirely.
If the objective is to levy the tax according to how government support was provided, there is the issue in the case of those TARP recipients that were "forced" to take the government support even though they didn't want it. It is not clear how one can rationalize imposing a penalty on those who took the funds to support the government's rescue policies, even if those policies were misguided. Furthermore, there is no justification from the taxpayers' perspective of excluding the auto companies or Freddie and Fannie from responsibilities for losses, as well.
The current proposal primarily punishes shareholders, and to some extent the management of smaller regional institutions. How can one justify the desire to punish large institutions with a set of proposals whose main economic impact is on those institutions that Main Street America relies upon the most and upon whose activities the recovery depends?
Finally, it should be noted that government support to financial institutions extends far beyond just the TARP. The big, and nearly impossible to estimate, subsidies have come not from the TARP or other programs but have manifest themselves in the form of access to low-cost funds, either through borrowing at subsidized rates utilizing Federal Reserve special programs, from the subsidies inherent in the low-rate policies, from merger assistance, from FDIC deposit and debt guarantees, and from the implicit subsidy inherent in too-big-to fail. Meanwhile, it seems clear that the market has gotten the current tax policy correctly: it is a nonevent for the US's largest institutions.
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