Will a Bank Tax Harm Lending?

The Senate Finance Committee held a hearing today to ponder the Obama administration's plan to tax big banks. Testifying on its behalf was Treasury Secretary Timothy Geithner. He claims that the bank tax, which is expected to cost the industry around $90 billion over the next decade, won't significantly harm lending. How could that be?

This is one of those situations where you have to hope that the Treasury Secretary is smart enough that he doesn't really believe what he's saying, because it's just so obviously political rhetoric. In his prepared testimony he argues:

The fee is designed to limit the risk of any adverse impact on lending. The fee excludes over 99 percent of U.S. banks, which currently provide the majority of small loans to businesses and farms across the country. If covered firms try to pass on the costs of the fee to their borrowers, they will lose market share to other institutions. The Congressional Budget Office (CBO), in its review of our proposal highlighted these advantages by noting that the proposal "would improve the competitive position of small- and medium-size banks, probably leading to some increase in their share of the loan market."

First, protecting the "majority of small loans to business and farms" is certainly noble. But what about the big loans, and that minority of small loans to businesses and farms? They clearly go unmentioned because they will be deeply affected by the tax. And even though big loans and small ones from large banks aren't politically popular, the economy sure will miss them.

By how much might lending be reduced? As Steve Bartlett, President and CEO of the Financial Services Roundtable, says the tax could reduce lending by as much as $900 billion, assuming a 10% leverage rate. Even if it only turns out to be a fraction of that, the damage could be incredibly significant to the economic recovery, which is expected to be a slow one that will drag out over the next several years.

Next, will this really cause big banks to lose market share? Maybe a little, but there are two things to remember here: a) small banks don't have the balance sheet to make the big loans that will be most affected so won't gain any market share there, and b) the big banks are the ones experiencing a robust recovery and might actually have more money to lend.

That second point was demonstrated by bank earnings last quarter. The giant financial institutions with a Wall Street component had huge profits, while banks that focus solely on lending and deposits had far more modest results. Wells Fargo's relatively modest earnings made this clear. Small banks can't acquire market share in lending if they don't have more money to make additional loans.

Another unmentioned messy consequence besides fewer loans: the lending that does occur will have a higher price tag. If you reduce the supply of available funds, then the price will necessarily rise. If smaller banks face less competition from the big banks, then small businesses and consumers will be charged higher interest rates.

This measure is clearly being proposed to punish the large financial institutions, since any taxpayer loss that results from the bank bailout will come from AIG, the automakers, and the residential mortgage bailout. For those who just want to flog the big banks that might not much matter. But it's simply absurd to claim that a huge tax levied on them won't affect lending. The question, however, is whether now is the right time to inflict the intended pain, when the economy is trying to regain its footing and credit is already on the decline.