Let's Talk About Tax: Fixing Bank Incentives to Sabotage Stability

68 Pages Posted: 19 Dec 2012 Last revised: 5 Dec 2013

See all articles by Hilary J. Allen

Hilary J. Allen

American University Washington College of Law

Date Written: February 20, 2013


Regulatory capital requirements are in place to improve bank (and systemic) stability, by forcing banks to fund themselves with more loss-absorbent equity. But banks have strong incentives to prefer debt funding to equity funding, and thus to arbitrage regulatory capital requirements. In particular, banks have (often successfully) petitioned regulators to allow them to satisfy regulatory capital requirements with hybrid debt-equity instruments that can be treated as debt for tax purposes. Unfortunately, the Financial Crisis showed that the first generation of these hybrid instruments, including trust preferred securities, did not live up to their promise of promoting bank stability. The next generation of hybrids, the contingent convertible bonds or “cocos”, have the potential to be downright harmful to stability.

We therefore need to address bank incentives to create hybrid instruments, and otherwise arbitrage regulatory capital requirements. While regulatory capital requirements are almost always discussed in isolation from tax policy, this Article recognizes that banks’ reluctance to fund themselves with larger cushions of common equity is, in large part, a tax problem. Financial regulators, rather than accepting such tax preferences as a given, should engage with their tax colleagues and revisit the wisdom of tax policies that incentivize reliance on debt funding, and the instability such reliance creates. To that end, this Article takes the first step in fusing together regulatory capital scholarship with the tax literature on reducing debt bias, and proposes that common equity held by banks as regulatory capital should be made tax deductible. The hope is that this will inspire experts in the fields of economics, tax and financial regulation (particularly within the Basel Committee on Banking Supervision) to collaborate in refining this Article’s proposal, so that the efficacy of regulatory capital requirements (and financial stability) can be maximized.

Suggested Citation

Allen, Hilary J., Let's Talk About Tax: Fixing Bank Incentives to Sabotage Stability (February 20, 2013). 18 Fordham Journal of Corporate and Financial Law 821 (2013); Loyola University New Orleans College of Law Research Paper No. 2013-17. Available at SSRN: https://ssrn.com/abstract=2190999 or http://dx.doi.org/10.2139/ssrn.2190999

Hilary J. Allen (Contact Author)

American University Washington College of Law ( email )

4300 Nebraska Ave NW, Washington, DC
4300 Nebraska Ave NW, Washington, DC
Washington, DC 20016
United States

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