Wednesday, January 22, 2014

Taxing banks does not tame them

During the last financial crisis, it was quite obvious that at least some banks were taking excessive risks. What do economists usually advocate when it comes to discouraging particular behaviors? Taxes. And that is popular as the foolishness of banks has imposed costs on the taxpayers. Thus, some countries such as Germany, the UK and the Netherlands have imposed taxes on banks. Did that work?

Not really, tell us Michael Devereux, Niels Johannesen and John Vella. They look back at the experience in various European countries and conclude that while this taxation on borrowed funds indeed reduced borrowed funds, and therefore loans, it turns out that it also increased the riskiness of the funding. These are two bads. First, loans actually encourage the economy. Second the risk has increased is of course counter-productive. Even worse, it is the safest banks that reduced most borrowing the the unsafest ones that took on additional risk. How could this happen? As there were fewer borrowed funds, and hence relatively more own assets, regulations allowed banks to modify their risk-weighted portfolio. In other words, regulation that was invariant to the introduction of the taxes made things worse.

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