Taxation and Regulation of Banks to Manage Systemic Risk

Abstract

As a form of negative externality, a natural economic response to systemic risk is to look to taxation to correct it. However, we argue in this paper that the problem of systemic risk is not a standard externality problem. First, a 'polluter pays' approach is inapplicable because the polluter is insolvent in a systemic crisis and so cannot pay. Second, we show an equivalence between taxation and regulation under a set of strict assumptions: the same economic outcome arises if banks maintain higher capital ratios or prepay into a central fund that is used to bail them out in the case of a crisis. Third, we show that any levy that is not solely in the form of pure capital is a double-edged sword. The imposition of a levy increases the per-loan funding requirement of banks and potentially the total amount of debt in the system. The levy may thereby perversely exacerbate potential systemic crises unless paid in capital, in which case it returns full circle to capital regulation.

Keywords: Taxation, Regulation, Banks, Systemic Risk, Capital Adequacy

JEL Classification: G21, G28