2 Reasons Why a Bailout Tax Won't Level the Playing Field

By Daniel Indiviglio

Yesterday, I wrote about a problem I see looming for a non-bank resolution authority: the creation of a fund used to resolve big financial firms may give them a competitive advantage over smaller ones. The sort of obvious rejoinder to that criticism is that banks will have to pay into the fund, thereby incurring a cost that could serve to remove that competitive advantage. The New York Times notes that such bailout taxes are gaining support. I don't think they'll help matters much.

I don't want to split hairs here. Whether you call it a "tax" or an "assessment" really doesn't matter. If you're forcing firms to pay a certain amount of money into a fund used to pay for the costs that would hit the U.S. economy if those firms fail, then the end result is the same. So even though the financial reform proposals out there don't create any sort of punitive tax, they do require that big firms are assessed to pay into a resolution fund, proactively. Same thing.

The problem, however, is that this tax won't level the playing field: these firms will still have a distinct advantage for two reasons.

First, the cost associated with failure might be more than the amount of money any given firm has been individually assessed. But the entire fund (or even more) can be used to pay the cost of a single firm's failure. So whatever parties were doing businesses with that firm and receive money from that fund to cover the costs of resolution could potentially reap more benefit than any given firm paid for. That means the cost incurred by a firm could be less than the benefit derived. On an industry basis, the total cost may be equal to or greater than the benefit, but from the competitive standpoint of individual firms, any given systemically regulated firm will have an advantage in luring customers because of this special benefit.

Second, even if these systemically regulated firms incur greater costs due to these assessments, smaller firms will suffer disproportionately due to their competitive disadvantage. It's unclear how great that competitive disadvantage will be. But under certain creditor or customer relationships, there may be an excessively large advantage obtained by doing business with a firm that has access to the resolution fund through its failure. For example, if swap counterparties will receive 100 cents (or even 60 cents) on the dollar if a systemically regulated firm goes bankrupt, then why would anyone ever want to be on the other side of a swap with a firm that isn't systemically regulated? If you do business with the large firm, your obligation is essentially guaranteed by the U.S. government. That's a huge barrier to competition.

Again, I'm a little unclear on what "costs" will be covered by the fund generated by bailout taxes. But you almost have to assume that certain types of creditors or customers would be covered. As I mentioned in my prior post -- otherwise, what would be the point? Essentially, the financial landscape would be analogous to one where only some banks paid for depository insurance and other banks just didn't have it. Who, in their right mind, would ever do business with a bank that didn't have that insurance when others did? Even though the associated premiums cost banks something, the benefit derived would be far greater than that cost.

This article available online at:

http://www.theatlantic.com/business/archive/2010/03/2-reasons-why-a-bailout-tax-wont-level-the-playing-field/37849/