A Failure Tax - A Commentary by Professor Jonathan GS Koppell
"A Failure Tax"
By Jonathan GS Koppell
Published in the New York Times on September 17, 2008
Read the article in its original context on the New York Times website.
As venerable American financial institutions topple like dominoes, the concept of "too big to fail" is being sorely tested. Bear Stearns gets help. Lehman Brothers does not. The Federal Reserve and the Treasury Department are acting like insurance claims adjusters, selectively providing assistance when a company’s failure seems too much for the financial markets to withstand.
Why not make investment banks and other companies pay premiums for this catastrophic risk insurance? The government already provides flood, bank and crop insurance. Unlike participants in those programs, however, the companies that qualify for "too big to fail" insurance do not pay for the privilege.
Designing this too-big-to-fail insurance would be tricky but feasible. The potential economic impact of financial companies’ failure and the risk in their portfolios would have to be evaluated to determine which companies would be required to obtain this protection, and to calibrate premiums.
The goal should be to limit the contagion of failure rather than to prevent failure itself. Thus the payouts, which could still take the form of loan guarantees to parties willing to cover the failing institutions’ obligations, should not go to shareholders, who would lose all or most of their equity, but to counterparties — the banks, hedge funds and pension funds that are jeopardized by default. Still, these parties must share in the losses to reinforce the need for due diligence in securities transactions.
Critics might denounce institutional risk insurance as a tax. But so what? Forcing companies to pay for undesirable side effects is routine. The risk of a financial meltdown introduced by companies intertwined through Byzantine financial transactions imposes a burden on the government as real as pollution. The premiums could cover the costs of better regulation, a trade most stockholders would happily make today.
What’s truly radical is that government officials are empowered to determine when corporate failure is not tolerable. The question now is who should pay for the intervention.
Jonathan G S Koppell is the director of the Millstein Center for Corporate Governance and Performance at the Yale School of Management.