Saturday, January 16, 2010

The Bank Tax -- Boon and Bane

James Surowiecki of the New Yorker thinks stripping $117 billion from large banks is a good idea that will barely ripple the waters of the banks and their customers. Not likely.

However, imposing the Bank Tax is probably some of the best news ever for smaller banks. But don't look for deals at your local savings bank. The tax on the big banks will kill any incentives for the small banks to cut you a break.

The Two Worst Arguments Against the Bank Tax

Posted by James Surowiecki

The Obama Administration’s proposed bank tax doesn’t solve the too-big-to-fail problem. And it’s arguably too small, although I think one barrier to making it bigger was the issue I mentioned yesterday, which is that the balance sheets of at least some of the big banks are still a bit shaky, and taking substantial amounts of capital out of them this early in the recovery may have seemed injudicious. (I’m thinking here especially of Citigroup.) But for all that, it’s a good proposal that will raise a significant amount of money ($117 billion over ten years is not, even by today’s standards, trivial) and will provide a disincentive (a too-small disincentive, but still a disincentive) for banks to keep getting bigger.

This seems like such a reasonable proposal, in fact, that I’m a bit surprised that anyone to Obama’s right (that is, anyone who thinks the plan is too harsh, rather than too soft) is arguing against it. But they—with “they” meaning, above all, the banking industry—are. Two main arguments seem to have emerged. The first argument (which, oddly, some people on the left as well as the right are making), is that any tax would be passed along to consumers. Now, this is an argument that can be, and is, made against any corporate tax, and given the fact that Americans think that corporate taxes make sense generally, there’s no obvious reason why this tax should be an exception. More important, it’s unlikely to be true. To be sure, some of the tax will be passed along. But the Obama proposal exempts banks of less than $50 billion from the levy, which means that to the extent that the big banks raise prices in response to the tax, they’ll be making themselves less competitive in the marketplace. Now, it may be that in arguing that consumers will end up paying this tax, what bank lobbyists are really admitting is that smaller banks just aren’t real competitors to the big banks and serve as no competitive check on their prices. But I don’t think that’s an argument—“the big banks are so powerful that they can pass any cost increases along to consumers”—that bank lobbyists really want to be making.

Here's what will happen. The big banks will pass along the tax to borrowers in the form of interest rates that reflect their operating costs. The smaller banks -- those untouched by the bank tax -- will find themselves in the glorious position of having a government mandate granting them the right to earn more on a loan than the large banks paying the extra tax. The smaller banks will price their loans slightly beneath the levels of the big banks. Slightly below. Just enough to lure some customers away from the big banks. But as a result of their better tax status, the smaller banks will earn much bigger margins on their loans .

The Bank Tax will work like import tariffs on cars. When Congress hit Japanese car-makers with big tariffs, Americans were penalized. In response to the tariffs, GM was able to Raise its prices, increasing them to reflect the artificially higher price imposed on imports. Thus, when GM most needed to improve its operations, the government simply mandated higher margins instead. Where did that get the world's biggest carmaker?

The second argument is even more dubious, namely that the tax will crimp lending. Jon Hilsenrath offers up a sophisticated version of this argument, saying that since banks need to increase liabilities to fund new loans, any tax on liabilities will also reduce the number of loans. Now, in the first place, it isn’t true that banks have to increase liabilities to fund new loans: they can also fund them by raising capital. In other words, instead of borrowing money that they re-lend, banks could raise money by selling equity, and then lend that out. The truth is that the tax is too small to fundamentally shift the way banks fund themselves, but anything that encourages banks to rely more on equity and less on debt is a good thing.

More concretely, Hilsenrath’s argument implies that the banks are currently lending to their full capacity, so that if they want to do any more lending they’d need to expand their liabilities, which the tax will discourage. But this isn’t even close to being true: banks currently have more than a trillion dollars in reserves, which is effectively cash just sitting in the bank. If they wanted to lend—and if there was sufficient demand for lending—they have more than enough capacity to do so without taking another dime in liabilities. In other words, the impact of this tax on lending will be, to the nearest approximation, zero.

Surowieki believes banks can raise equity to expand lending. That's true. But the banks best able to sell equity to expand lending will be the banks untouched by the Bank Tax. The last of the mutual savings banks might go public to capture the opportunity the government is granting them. Then what?

Then we will see a resumption of bank mergers and takeovers. The small and medium-sized banks will combine to form bigger organizations, but they will form organizations that are not too big. They will limit their size to reflect the Bank Tax. Thus, as in too many other examples, the managers of this business will base some of their biggest decisions on tax policy.

A similar situation arose in the mid-1980s when the government imposed itself on the long-distance telephone market. Government intervention hit AT&T's long distance business with extra costs. The result was a government mandate allowing MCI to earn more money per call than AT&T. Suddenly MCI was almost printing money and it went on to great success during the early years of the revolution in the long-distance market, which followed the break-up of the Bell monopoly.

However, there is no monopoly in banking. Just like there was no monopoly in the auto industry. Thus, the Bank Tax is just a way to give some players an advantage they will milk it for all it's worth.

Will consumers enjoy any benefits from this Bank Tax. Not a Chance. It will result in the unintended consequence of higher borrowing costs for all. But that's the Obama administration for you.

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