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The G20 and a bank tax

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The G20 and a bank tax

Richard Thaler, a professor at the Booth School of Business at the University of Chicago, wrote in the New York Times on June 11: “For the financial crisis, it has become clear that many chief executives and corporate directors were not aware of the risks taken by their trading desks and partners. And it is clear that regulators like the Securities and Exchange Commission, an agency staffed primarily with lawyers, are not well positioned to monitor the arcane trading strategies that helped produce the crisis.”

Thaler was addressing so-called Black Swan, or one-in-a-million (billion?) events and what can be done to deal with their consequences. He concluded his article: “Neither the private nor the public sector seems up to handling these kinds of problems. And we can’t simply wait for the next disaster, because, as people might say if they had to use G-rated language, stuff happens.”

As I noted in my blog last week regarding BP, we are dealing with an insurance problem. The problem is exacerbated by an inability to accurately measure the probability of Black Swan events and their subsequent costs. The measurement problems make it extremely difficult to price the insurance. Moreover, in certain cases, for example the financial meltdown in 2008, the magnitude of the costs might be too large for private insurance markets to absorb.

In the case of BP, the company chose to self-insure, and it should be able to cover the total costs. In the case of the financial crisis of 2008, it appears that the risk measurement problems were much more pronounced than in the BP case. More importantly, the subsequent costs were many times larger and beyond the capabilities of the private insurance markets.

Thus, since governments were left to deal with the aftermath of the financial market meltdown, a meltdown caused by an inability to determine failure risks, market instability and a rapid erosion in trust, one of the issues that remains is who should pay?

Thaler has suggested that banks could pay before a crisis materializes or after one has happened, but banks should pay. With the uncertainties involved, Thaler believes that it would be very difficult to determine the amount each bank should pay beforehand. And there is a corollary problem of what to do with the “premiums” collected. Taxing banks after the fact might not work either since a number of banks could fail imposing larger burdens on the survivors, and the resulting larger costs might drive some of the surviving banks out of business as well, creating a vicious downward spiral.

However, a bank tax should not be ruled out like the G20 is recommending. Even if the magnitude of the tax cannot be determined with any degree of precision prior to another crisis, or the magnitude of the tax ex post might be too great for all banks, imposing such a tax should limit the scale of banks and banking activity. This by itself might reduce future damages. If the bank tax is linked to capital ratios, asset risks, past performance, and other indicators of risk, it might compel bank CEOs and their boards of directors to take their responsibilities more seriously and become more actively involved in risk management.

Unlike the views expressed by Canada and some other countries, views based on poor economics, a bank tax is likely to produce positive outcomes, even if the value of the tax might be too low.

There also are lessons here for the environment and climate change. Carbon taxes can play a role similar to that of a bank tax.

The opinions expressed in this blog are personal and do not reflect the views of either Global Brief or the Glendon School of Public and International Affairs.


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