President Obama recently proposed a tax on some of major banks’ liabilities to pay for TARP-related (bank bailout) losses, and to reduce risk taking by big banks. While the proposed tax might accomplish the former goal, analysts have opined that it is unlikely to decrease financial risk-taking. Regulation might decrease risk-taking, but it doesn’t resolve the issue of paying for past losses, nor does it establish a reserve for any future risks. Is there a better way to reduce risk taking while simultaneously paying for losses past, present, and future?

Why not consider a financial leverage tax on all corporations? The US has historically encouraged debt, which helped fuel the recent credit crisis. A tax on leverage would help penalize excess risk taking by taxing the very fuel that feeds the fire. While it’s perfectly acceptable for any company to gamble with their own equity, systemic risks are created when institutions bet in the trillions by borrowing dozens of times their own capital. That’s precisely what Lehman Brothers and other investment banks did during the boom years, with leverage ratios well over 40 times their own capital. A tax on financial leverage that increases taxation as a function of leverage would allow companies to take on risk while penalizing the Lehmans that took excessive risk with borrowed money.

How would a financial leverage tax work? The tax rate would be based on the debt-equity leverage of the company, so that the tax rate would rise with leverage. The tax might not apply to the first billion dollars in liabilities, so that it would affect only larger corporations. Assume the base tax rate is 0.03% of liabilities. A large non-financial company with $10B in debt and a debt-equity ratio of 1 would have to pay $3 million in taxes [1]. A bank with $10B in liabilities and $1B in equity would have to pay ten times that amount as a result of its 10x leverage, resulting in a tax bill of $30 million. If the bank lends out 10 Billion with a 3% interest margin, it would earn $300 million in net interest. For this bank, the leverage tax would effectively be 10% of net interest income [2].  On the other extreme, under this tax regime a company like Lehman would have had to pay 1.2% of its gross liabilities, which were in the neighborhood of $700 Billion. This would amount to $8B per year, double Lehman’s 4B net income in 2007 [3]!

The financial leverage tax would make it impossible for banks, corporations, and hedge funds to create the kind of credit bubble they created in the mid 2000s. Funds raised by such a tax could be used to pay off the TARP bailout, and also to fund the SEC and other enforcement agencies. The benefit of this approach is that it could be applied across the economy in a uniform way. Current proposals don’t apply to hedge funds and other highly leveraged non-bank institutions, leaving pockets of risk to grow. Excess financial leverage has fueled almost every major financial collapse in history, and a tax on leverage would directly address this issue.

[1] 0.03% of $10 Billion is 10 Billion * 0.0003, or $3,000,000. In the case of the bank with 10x leverage, this figure goes up by a factor of 10, to $30 million

[2] The St. Louis Fed tracks net interest margins of US banks, and they have been above 3% over the last 30 years, making this a very conservative estimate. A leverage tax of $30 Million would be 10% of the bank’s net interest of $300 Million.

[3] At 40x leverage, the leverage tax in the example given would be 1.2% of gross liabilities. With net interest margins around 3.5%, a 1.2% tax would consume about 1/3 of a bank’s interest. Since a bank’s operating expenses and loan losses often consume more than 50% of net interest, this tax rate would likely cause a bank with this kind of leverage to be unprofitable – which is precisely the point.