A Banker’s Tax: Accepting the Inevitability of Bailouts and Enhancing Government Response

[Karan Kamath is a 2020 B.A. LL.B. (Hons.) graduate from Symbiosis Law School, Pune]

Since the 2008 financial crisis, regulators around the world have made regulations more stringent to prevent, inter alia,bank collapses and resultant bailouts. Governments maintain that bailouts are not something they wish to repeat. However, bailouts have been resorted to rather commonly. A 2016 economics working paper of the University of Glasgow has argued that governments should abandon denialism with respect to bailouts, embrace them instead, and form frameworks to make bankers pay for bailouts instead of the taxpayer. This post introduces a “Banker’s Tax” proposal, its characteristics, and its feasibility in India.

It must be mentioned at the outset that the proposal is not a tax in the ordinary sense of the term, and is modelled as tax merely for simplicity. The author herein uses the term for conformity with the aforementioned working paper.

Bailouts and their inevitability

Banks provide considerable services to the economy, essentially keeping the machine alive and well oiled. When a bank is about to fail, governments are invariably compelled to take up debt and infuse liquidity, or “bail out” the bank. Bailouts are more common than is popularly believed. In the years 1970 to 2011, 147 banking crises occurred around the world that required some credit response from governments.

After the 2008 financial crisis, banking regulators have increased regulation and pursued other reforms. However, none of these reforms are aimed at preventing a failure, but at reducing the cost of the bailout to the taxpayer. In the author’s view, this is implied acceptance of the inevitability of bailouts. However, regulators refuse to directly accept the same lest the moral hazard of an assured safety net aggravates risk taking amongst bankers.

In the aforementioned working paper, economics professors Charles Nolan, Plutarchos Sakellaris, and John D. Tsoukalas (“Nolan et al”) argue that governments should admit that bailouts are inevitable; but should combine this acknowledgement with imposition of the Banker’s Tax, or penalties on bankers’ remuneration after a bailout. This answers the moral hazard problem directly and at its helm.

Incumbent mechanism for addressing bailouts and shifting burden on the treasury

Currently, most regulators have adopted structural changes such as ring fencing (disconnecting a bank’s regular activities from its investment arm) and identifying systemically important financial institutions for greater oversight.

Another method, used especially in the United Kingdom, is to establish a separate resolution regime for financial institutions wherein “bail-in” or internalising losses is the norm and the burden is shifted away from taxpayers. Bail-ins force cancellation of debt owed by the financial institution to its creditors and depositors. The Reserve Bank of India proposed a similar regime in a January 2014 report, wherein a separate financial resolution authority would be established. The objectives of this authority would be, inter alia, to

[A]void use of taxpayers’ money and not create an expectation that public support will be made available, thus ensuring market discipline;

and to

[E]nsure imposition of losses to shareholders and unsecured creditors in a manner that respects hierarchy of claims.

Subsequently, the Financial Resolution and Deposit Insurance Bill, 2017 (“Bill”) was introduced in the Lok Sabha, to provide for a special regime and to establish a Resolution Corporation to anticipate, monitor, correct, and resolve failure of financial institutions. The measures for resolution provided in the Bill included bail-ins; creating a bridge service provider for holding assets and liabilities; transferring assets and liabilities; merger, amalgamation, or acquisition; and/or winding up.

Additionally, the Bill allowed clawback of performance incentive received by a chairperson, director, chief executive officer, or any other officer. This would occur if the Resolution Corporation held, after hearing the officer concerned, that her acts or omissions were either reckless or negligent, and materially contributed to the financial institution’s failure. The author shall argue that this draft provision is a crude form of Banker’s Tax, and any future Banker’s Tax could be modelled on it.

The Bill was referred to a Joint Parliamentary Committee but was subsequently withdrawn after stakeholders raised apprehensions regarding, inter alia,usage of bail-ins. Although bail-in processes have not been tested with a major bank yet, there are already several doubts about their feasibility. Bail-ins are good alternatives to other forms of resolution and insolvency in case of small financial institutions. However, it is considered that bail-ins are successful only where there is “rapid restoration of market confidence, accurate evaluation of losses, and successful restructuring of the bailed in bank’s operations to give it a sound business model to avoid successive rounds of bail-in rescues.

Managing these prerequisites at the time of a bank failure is an arduous task. The methods invented since the 2008 financial crisis are not adequate to negate the possibility of a future bailout. However, they do attempt to halve aftereffects and manage occurrences. The Banker’s Tax enhances these efforts; and additionally, seeks to resolve the moral hazard of bailouts.

The Banker’s Tax

Modelled as a pro rata tax for simplicity, the Banker’s Tax is essentially a penalty for forcing a bailout. The Banker’s Tax ex ante identifies the bank’s key individuals who will have to foot the bill. Thereafter, the precise nature of the penalties could be financial fines imposed by courts (which deviate from its claimed tax nature), deductions to remuneration and pension rights, etc. Lawmakers have to provide for the forms of the Banker’s Tax and a structure for identification of those responsible, while regulators need to calculate the precise imposition of the Banker’s Tax, based on the conditions and forms of the correlated bailout.

The Banker’s Tax, as proposed by Nolan et al, improves on bail-ins and other similar arrangements in several ways. Firstly, it admits the efficacy and necessity of bailouts in rescuing banks. Secondly, it directly counters the moral hazard of government rescue by penalising the persons responsible. It compels key personnel of systemically important institutions to have skin in the game, by ensuring that the errant ones have to suffer consequences of their actions. It seeks to prevent “rational herding” by acting as an effective response to the catastrophic market failure that it causes. Thirdly, unlike bail-ins, it does not solely focus on the bank’s creditors agreeing to a haircut. Lastly, the Banker’s Tax is the correct form of penalisation that ought to be associated with finance. It does not seek imprisonment for financial wrongdoings, which has been sought to be abolished lately. It seeks to console the want of retribution with that of recompensing the treasury for its aid.

The Banker’s Tax in India

It is the author’s view that the provision for clawback of performance incentive paid to officials in the Bill is already a form of Banker’s Tax contemplated in India. Several factors on which the Banker’s Tax is dependent are already resolved in the Bill.

Firstly, the phrase “chairperson, director, chief executive officer (by whatever name called) and any other officer” is adequate coverage for identification of personnel.

Secondly, the Bill provided for a standard for invoking the provision against a person, viz. negligence or recklessness combined with material contribution to failure. The Banker’s Tax would perhaps require additional correlation with the quantum of the bailout and proportionality vis-à-vis the officer’s role.

Lastly, the arrangement in the Bill was to allow the Resolution Corporation to assess which part of the officer’s remuneration was performance incentive, and seek repayment of the same. A Banker’s Tax is expansive and  will require extension of coverage to salary paid and payable, pension rights, golden parachute arrangements, and stock options. The Bill further provided a notice and hearing requirement, without the possibility of appeal. Considering the stringency of the Banker’s Tax, enabling appeal would be adequate.

Conclusion

India has not seen any major bank bailout, but past performance is not an indicator for future outcomes. The recent banking crisis, exacerbated by the coronavirus pandemic, will eventually end in major bailouts or other mechanisms that will strain the treasury. Some cooperative banks and financial institutions already have a bleaker picture. Bailouts are inevitable in India just as everywhere else. In such a situation, it is necessary that the government contemplates a banker’s tax system and implements it before any major bailout occurs.

Identification of systemically important institutions, ring fencing, bail-ins, are considerably effective ways of addressing bank failures and bailouts. The Banker’s Tax would be a suitable addition to the effectiveness of these methods. Moreover, its anchoring on the moral hazard associated with bailouts, by justifiably penalising the individuals responsible, makes the Banker’s Tax proposal worthy of serious consideration.

Karan Kamath

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