If we are going to allow some financial institutions to enjoy a government promise to back them up in emergencies — a call option on aid — then some sort of tax has to be levied on someone to pay for this bailout policy. The best way to handle this would be to raise capital standards for these “too big to fail institutions” and/or require compensation policies that help align the costs and benefits of risk-taking. This way, the tax would be paid by the institutions/individuals that are creating the risk of a future bailout.
Of course, the government should draw a bright line to signify which institutions are potential recipients of aid. Also, these institutions should have the chance to opt out — by becoming “not too big to fail,” for example, by reducing leverage or clarifying who owns what in case of bankruptcy.
One problem with the Obama administration’s proposal is that it is retrospective in nature, aligning the size of the tax with past costs rather than potential future costs. Another problem is that it appears the levy will be placed on firms without sufficient discrimination based on different kinds of risk.
– Robert Stein is a senior economist at First Trust Advisors.