The Proposed “Financial Crisis Responsibility Fee”

President Obama this morning announced a new “Financial Crisis Responsibility Fee” to recoup the taxpayers’ expected losses from the Troubled Asset Relief Program (TARP). Approximately 50 banks and similar firms with $50 billion or more in assets would be charged a total of roughly $9 billion a year for at least 10 years. The fee would run for longer if required to fully recover the TARP costs.

The proposal broadly makes sense from both a political and a policy perspective. The politics are obvious - right now the public is extremely angry at bankers and would support measures up to shooting and then burning them. There is a strong imperative for politicians and regulators to show that they are on the public’s side and not the banks. This is particularly important as banks are about to announce near-record bonus payments, which the public will find galling.

However, this proposal is not all about political theater. There are valid policy reasons as well for a moderate tax, spread out over a number of years. First, the Emergency Economic Stabilization Act, which authorized the TARP, requires the Administration to eventually propose specific means to recoup any taxpayer losses from the financial industry. The surprisingly swift recovery by the banks makes it reasonable to accelerate the recoupment effort. Second, there is a need to show taxpayers that the TARP not only helped them by averting a potential mini-Depression that could have resulted from a further financial meltdown, but will have done so at no net cost to them. This cost issue is an important policy goal in its own right and also increases the probability that Congress and the public might support any remaining actions that need to be taken to deal with the tail end of this financial crisis.

Taxation virtually always has downsides and they exist here as well. First, the financial system is still somewhat fragile and a few of the largest banks share in that fragility. Although the proposed level is quite moderate in the aggregate, it will add to the problems at Citigroup, for example. Second, it is always hard to make targeted taxes fair. In this case, only the largest institutions would bear the cost. This is not completely fair, because many other financial institutions, both banks and non-banks, also benefited greatly from the various ways the government supported the financial markets. Further, it appears that the full costs of the TARP would be borne by these 50 firms, predominantly banks, even though some of the TARP aid was for the auto industry, AIG, and the government’s mortgage foreclosure mitigation efforts. In fact, the TARP investments in the banks themselves, which totaled under $250 billion, appear likely to be a break-even proposition. That is, the taxpayers will probably receive enough back in principal and interest payments, plus profits on free stock options, to make up for those banks which will default on their repayments. The losses will come from the other uses of the TARP funds.

The banks have a right to point out the unfairness that they perceive, and to push back on the amount they bear and how it is distributed, but I would urge them to avoid becoming ungenerous when they do so. The taxpayers may not have lost much directly on the bank rescues, but they took on tremendous risks in multiple ways to support the financial system and these actions had great value for the banks.

Finally, corporations are essentially pass-through entities. Any time you tax them, it eventually flows through as higher costs for customers, lower returns to shareholders, or reduced payments to employees and suppliers. Future returns to shareholders matter more now than usual, since we want the banks to be able to raise considerable further capital going forward as we work to safeguard the system against future problems. This pass-through cost is another argument for keeping the taxation moderate. Luckily, the banking system has over $13 trillion in assets and earns $200 billion or more in pre-tax income each year in normal times, which means there is room to collect the target of approximately $9 billion a year without dramatically affecting the system in the long term. As another point of comparison, compensation for the banking system as a whole runs about $150 billion a year, as reported by the FDIC. This does not include the very substantial levels of compensation paid at the bank holding company level or by investment banking or other affiliates.

Many observers will focus on the potential effects on lending, given the credit crunch that borrowers are experiencing. Fortunately, the effect of this fee is not likely to be large. Most lending is supported by bank deposits, which will generally not be assessed the fee. Also, smaller banks will not be subject to the fee and therefore will be able to continue lending at the original rates, if they choose to do so. This source of competition will decrease the ability of the large banks to raise loan pricing. In addition, some of the cost of the fee is likely to be passed on to employees and to existing shareholders. Finally, even if the full 0.15% fee were to be passed along, the level is not huge in comparison to the average interest rate of around 5% on total bank lending in the system.

There is likely to be a great deal of fighting over the details of the fee structure. The current proposal is for a fee of roughly 0.15% on the total size of the banks, minus the amount of capital and most deposits on the balance sheets. This means that the cost will hit the investment banking side of these firms considerably worse than the commercial banking side, which relies primarily on deposit funding. That skewing makes a fair amount of sense for two reasons. First, investment banking activities caused more of the problems in the crisis than did commercial banking activities. Second, most lending is supported by deposit funding, which means this approach should have less effect on loan availability or pricing than would many other potential fee structures.

However, there is bound to be a great deal of pushback from those firms that are most affected by this approach and there may well be a series of technical problems that are revealed after further study. One should not be surprised if the details of which financial firms would be included and how the fee would be divided between them changes as the proposal winds its way through Congress.

As a final observation, it will be interesting to see how this proposal changes the dynamics of the lobbying effort on the financial regulatory reform bill, which is expected to be acted upon by Congress in the first half of this year. The potential for the fee proposal to become even more onerous, as some are already suggesting, may cause the banking industry to blunt the fervor of its opposition to the reform proposals in order to avoid inciting reform advocates to hit back at the banks. If nothing else, it will consume lobbying resources that might otherwise be targeted against reform legislation.