Containing Systemic Risk by Taxing Banks Properly

At the root of recurring bank crises are deeply-implanted incentives for banks and their executives to take systemically excessive risk. Since the 2008–2009 financial crisis, regulators have sought to strengthen the financial system by requiring more capital (which can absorb losses from risk-taking) and less risk-taking, principally via command-and-control rules. Yet bankers’ baseline incentives for system-degrading risk-taking remain intact. 

A key but underappreciated reason for banks’ recurring excessive risk-taking is the structure of corporate taxation. Current tax rules penalize equity and boost debt, thereby undermining the capital adequacy efforts that have been central to the post-crisis reform agenda. This tax-based distortion incentivizes financial firms to undermine regulators’ capital adequacy rules, either transactionally or by lobbying for their repeal. The resulting debt-heavy structure not only renders banks fragile but also pushes them toward further excessively risky strategies.

This result is not inevitable. By repurposing tax tools used elsewhere, we show how the safety-undermining impact of the corporate tax can be reversed without affecting the overall level of tax revenue that the government raises from the financial sector. Several means to the desired end are possible, with the best trade-off between administrability and effectiveness being to lift the tax penalty on banks to the extent that they add to their loss-absorbing, safety-enhancing equity buffer above the regulatory minimum. This solution would minimize the tax impact and could have any revenue loss offset by modest tax changes affecting the riskiest forms of financial sector debt. Existing studies indicate that the magnitude of the resulting safety benefit should rival the size of the benefit from all the post-crisis capital regulation to date. Thus the main thesis we bring forward is not a small or technical claim.

Standard bank regulatory style is command-and-control, and while much can be and has been accomplished with the standard style, it has its limits. In today’s political environment, current safety rules’ continuance may not be viable, as repeal of recent regulatory advances, not their refinement, has become a serious possibility. Yet rolling back the post-crisis regulatory advances without addressing the underlying risk-taking incentives would be unwise. While our policy preference would be to supplement and not replace traditional and recent regulation with the tax reform, any major rollback makes reducing the risk-taking tax distortion more urgent than ever.