Let's Talk About Tax: Fixing Bank Incentives to Sabotage Stability
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.
The Shadow Banking System and its Legal Origins
The global financial crisis cannot be understood without closely analyzing the development and the failure of the shadow banking system. Shadow banking, in turn, cannot be understood without examining how law shaped it. This article provides a definition of the shadow banking system and describes the critical role law and legal change played in shaping it. The shadow banking system describes a web of financial instruments (asset-backed securities, credit derivatives, money market mutual funds, repurchase agreements) that connected commercial and household borrowers to investors in capital markets. This system differs, however, from traditional bond markets and is marked by six features: - institutions serving a critical intermediation role;- the pooling of financial assets and risks;- “structuring,” or the unbundling and re-bundling of cash streams and risks from financial assets;- maturity transformation;- the creation of assets with theoretically low risk and high liquidity that have many of the features of “money”; and- opacity.This system provided many of the core economic functions of banking, including supplying credit while offering investors theoretically liquid and stable investments (similar to bank deposit accounts). Yet the system escaped bank regulation. This system ultimately experienced the same types of liquidity and solvency crises as banks, causing massive economic damage. The article explores how regulatory arbitrage, deregulation (broadly construed), and legal subsidies midwifed the birth of the shadow banking system and fostered its growth.
The Use of Qualitative Information in Macro-Economic Policy Analysis
The majority of macro-economic policy models takes for granted that conflicts among objectives can be assessed by means of a tradeoff analysis. Such tradeoffs imply that sacrifices and benefits of various impacts of decisions can be measured on a cardinal scale, so that a conventional macro-economic utility or welfare analysis can be applied.