The Obama Financial Tax Is A Start, Not The End

The flurry of interest this week around ways to tax Big Banks is important, because officials in the US are – for the first time – recognizing that reckless risk-taking in our banking system is dangerous and undesirable.
But the possibility of a tax on bonuses or on “excess profits” that are large relative to the financial system should not distract us from the more fundamental issues.
Mr. Bernanke and Mr. Geithner need to admit that the Federal Reserve and New York Fed played a key role in creating this problem through misguided policies.  They were part of the regulatory failure, not independent of it.  When you keep interest rates very low and let balance sheets explode under your watch, we’ve seen how things fall apart.
As long as Bernanke and Geithner do not concede this point, they send a clear message to banks throughout the US and around the world that they can load up on risk again, and hope to profit – personally and professionally – from Mr. Bernanke’s next great credit cycle. 
Yes, a new tax on these profits will raise money.  But it will not prevent a major collapse in the future.  There is no use discussing tough regulation when the previous regulators are still in charge, and they refuse to admit they were part of a system which egregiously failed. Mr. Bernanke’s speech at the American Economic Association 10 days ago was a big step backwards for those – such as Tom Hoenig, head of the Kansas City Fed – who want to send a message that there is a new regime in place to stop future crises.
One view of regulation is that you can adjust the rules and make it better – with each crisis we learn more, so eventually we can make it perfect.  This appears to be the current White House position – there is even mention of the US becoming “more like Canada”, in the (mythical) sense that we’ll just have four large banks and a quite life.
Another view is that the current complicated rules obfuscate and make it easier for the financial sector (sometimes with collusion of regulators) to game and hide risk.  Successive failures of regulators at large cost over the last three decades make it clear that fine tuning the system is not likely to work; every time you hear the “Basel Committee [of bank standard setters] is meeting today to discuss the details”, you should wince.
The ingredients for regulatory reform need to be simple and harsh.

1. Capital requirements at banks need to be tripled from the current levels so that core capital is 15-25% of assets.
2. Simple rules need to be in place to restrict leverage – the amount that banks, firms, and individuals can borrow (including in the form of mortgages).
3. Complex derivatives where risk is hard to measure need to have very high capital requirements behind them. It is not the regulators’ job to work out the complex implications of derivatives, and we can’t rely on banks or ratings agencies to do the job, so just keep it simple (and less profitable than today).
4. And, as the ultimate fail-safe, we need a hard size cap on major banks.  All financial institutions have to be small enough so they can fail without causing major damage to the economy.

By all means, implement a sensible tax system that creates a punitive disincentive to size in the banking system – if you can figure out how to make this work.  Most likely, the big banks will game this, like they have gamed everything else over the past 30 years.
But don’t think taxes are the answer.  We need to go back to simple, transparent regulation, and much smaller banks.
By Peter Boone and Simon Johnson
An edited version of this post appeared this morning on the NYT’s Economix; it is used here with permission.  If you would like to reproduce the entire text, please contact the New York Times for permission.