Eighteen months since the crisis, despite all the debate and public pressure, remarkably little financial reform has materialised. International bank regulators are busy with the Basel III process, to replace a still-born Basel II. This gestation will surely take an inordinate amount of time in prolonged negotiations with the financial industry, which is in no hurry. Yet the present political momentum for action is palpable, just as the growing sense of alarm at the renewed risk appetite by intermediaries awash with short-term liquidity.
The IMF report to the G20 states that macro prudential taxation and regulation are essential complementary tools. It highlighted the need for fiscal tools to recover the costs of the crisis, as well as to contain future risk creation. This approach distils a consensus view on the negative externality caused by risk shifting, and the need for a prudential approach broader than bank regulation.
The IMF report is very timely, as the first decisive reform steps are likely to come from fiscal authorities rather than cautious regulators with a narrow mandate. The first reason is that political pressure for bank taxation cannot be eluded by the Basel III process, which takes place behind closed doors and is clearly focus on a traditional set of policy tools. If anything incisive is to happen soon, it will have to come from pressure from governments desperate for revenues, and sustained by furious taxpayers.
The second reason why a fiscal initiative must lead is that any serious reform needs to encompass the shadow banking sector. This has shown a versatile ability to morph, managing to feed on the insured banking system while escaping the administrative reach of regulators. Unlike banking rules, fiscal laws can be extended on any form of resident financial intermediation. Moreover, assigning a tax on risky strategies ensures better measurement and enforcement, since fiscal evasion is a crime. Capital ratio and leverage limits based on accounting rules still allow for excessive discretion, as the Repo 105 case illustrates.
A systemic risk tax
Critically, the IMF report addresses the notion of a systemic risk tax which may be adjusted to preventively counter any build up in systemic risk, and refers to concrete proposals such as Acharya and Richarson (2009) and Perotti Suarez (2009). It focuses on a tax on uninsured liabilities (excluding retail deposits, which already pay a fee), similar to the Obama large bank tax proposal but with a broad coverage.
Next to size and interconnectedness, it cites unstable short-term funding as a critical risk factor. Liquidity risk creation was the most tragic omission in Basel II. Short-term wholesale funding fuelled rapid credit growth, yet rapidly escaped before taking any losses, producing a negative externality on other investors. Only public intervention stopped the domino effect of fire sales forced by rapid funding withdrawals, ultimately shifting the losses on bad investments to taxpayers (Brunnermeier 2009; Gorton 2009).
The academic consensus is that a fiscal initiative is particularly appropriate to discourage such risky funding strategies. Economists know that externalities are not internalised by private parties and need to be contained by taxation or tight quantity constrains. Strict prohibitions on risky strategies, as in the Volcker rule prohibiting deposit taking banks to trade on their own account, would recreate a segmented financial market, reduce the volume of credit, and shift risk to less regulated intermediaries, without discouraging investors who have become used to ex-post bailouts. In contrast, taxing unstable funding would decrease the spread to be earned by carry trade strategies.
This critical innovation would finally create a financial stability tool separate from the discount rate, whose use is too often delayed to avoid hurting the real economy. Unlike capital requirements which have large adjustment costs, systemic risk taxes can be raised in a timely fashion to contain risk accumulation.
In the absence of a forceful G20 fiscal decision later this year, we can expect only delayed regulatory action, with critical details exposed to a most formidable lobby. The regulatory debate will ultimately produce higher capital requirements, an essential complementary reform which targets asset risk along the lines of Basel II. Yet these ratios do not address the short-term funding risk which caused such devastating propagation in 2007-2008. The current Basel proposals for liquidity risk are old fashion reserve requirements, which have several limits when used by themselves. First, as all quota restrictions, they are distortionary. Second, they create trigger points. But most critically, they are easily eluded by new shadow banking intermediaries not subject to reserve monitoring. Even when they are not notionally covered by liquidity support by the Central Bank, recent experience shows that a liquidity panic forces a system wide liquidity bailout. Only a general taxation tool can address the issue of coverage.
A final advantage of taxing intermediary liabilities is that they cannot be easily arbitraged. It cannot be easily escaped by recording transactions elsewhere, unlike a Tobin tax. Intermediaries in tax havens do not appeal to investors, as they operate under weak legal rules, and the states have limited fiscal credibility to bail out overstretched lenders (not least since the investors would be largely foreign !). Of course some governments may decide not to tax its own banks, but in that case it will be their Treasury to suffer if local banks took advantage of unstable funding to sustain excess credit growth. In other words, countries which would not levy bank liquidity charges would bear most consequences of insolvency, and put its policymakers on the spot.
In conclusion, decisive progress on controlling future risk depends critically on the determination of the G20 to take a lead on systemic risk taxation. This would not just help fiscal balances, but also restore confidence in the ability and determination of policymakers to act preventively in the future.
Acharya, Viral, Lasse Pedersen, Thomas Philippon, and Matthew Richardson (2009), “Regulating Systemic Risk”, in Viral Acharya and Matthew Richardson (eds.), Restoring Financial Stability: How to Repair a Failed System, Wiley, March.
Brunnermeier, Markus (2009), “Deciphering the Liquidity and Credit Crunch 2007-08”, Journal of Economic Perspectives, 23(1),77-100.
Gorton, Gary (2009), “Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007”, paper prepared for the Federal Reserve Bank of Atlanta’s 2009 Financial Markets Conference, May.
Perotti, Enrico, and Javier Suarez (2009a), “Liquidity Insurance for Systemic Crises”, CEPR Policy Insight 31, February.
Perotti, Enrico, and Javier Suarez (2009b), “Liquidity Risk Charges as a Macro prudential Tool”, CEPR Policy Insight 40, November
Perotti, Enrico (2010), “Tax banks to discourage systemic-risk creation, not to fund bailouts”, VoxEU.org, 19 February.