The credit crunch of 2007 and the collapse of the financial system led to the worst crisis since the Great Depression. How did the bank-funding system get so fragile? As I argue in a new CEPR Policy Insight, an important part of the answer lies in the bankruptcy privileges granted in 2005 to overnight secured credit and derivatives by the US authorities. These privileges – which essentially allowed such leaders to ‘front run’ all other lenders in case of problems – made such lending safe for the lenders, and thus cheap for the borrowers. The result was fantastic growth in this market to the detriment of stability.
The build-up in liquidity risk
Liquidity risk grew explosively in the last decade, as disintermediation and globalisation led to a vast increase in uninsured wholesale funding. This growth reflects the excess liquidity created by the Fed since 2001, the massive global imbalances invested in safe dollar assets (Caballero and Khrishnamurti, 2010), and the steady deposit flight from banks to money mutual funds.
Containing liquidity risk
A tool to regain control over this trend is liquidity-risk charges, as I proposed with a co-author last year in the Financial Times (Perotti and Suarez, 2009). These levies would decrease with maturity, discouraging the negative externality associated with cheap, unstable funding without suffocating or segmenting financial intermediation. They would eliminate the tax bias against insured deposits. Their goals would be to increase stable funding, discourage useless gambles and charge for potential fiscal costs. Critically, they could be adjusted over the cycle as macro prudential tools to break reckless credit bubbles without raising interest rates for everyone.
The principle has been adopted in the UK and German bank tax proposals, with reduced or zero tax rates for funding with maturity longer than one year. One year maturity is too long to target liquidity risk, but the choice reflects a number of implementation issues.
First, authorities never collected such data, and bank resistance to disclose is fierce, as it gets to the heart of their recent business model. Second, a tax which does not include the shadow banking system is suboptimal (Haldane, 2010). Third, financial innovations may seek to camouflage actual maturity. Fourth, while balance sheet taxes are harder to avoid than transaction taxes, banks may threaten to move headquarters abroad. On the other hand, this is only partially credible if it implies a switch to financial systems less able to bail out liquidity needs.
Targeting the losses from liquidity runs: Tax the bankruptcy exceptions
We propose here to target the very short-term risk by taxing the so-called bankruptcy privileges. The bankruptcy privileges reflect a recent but poorly understood financial change, which fed the final and most damaging stage of the securitisation wave.
It is certainly legitimate for some investors to insist on an extraordinary level of protection. Yet if in systemic events this construction shifts risk to other parties and ultimately to the financial system, it is appropriate that they pay for the privileges. Taxing the bankruptcy exceptions by a significant amount, say 10 basis point, has a number of advantages. First, of course, it is only fair if it helps revealing debt priority information to third parties. Second, it would discourage the excessive build up of such liquidity risk. Third, it would curb carry trade incentives in both the banking and shadow banking sector. Fourth, it resolves any potential ambiguity in defining the tax base and avoiding arbitrage, since only claims with a specific legal construction enjoy the bankruptcy privileges. Fifth, it cannot be avoided by relocating transactions, unlike a Tobin tax.
Repealing the bankruptcy exceptions is probably an impossible task, notwithstanding compelling arguments. Suspending the privileges for unlisted transactions seems a bare minimum. But surely, if some investors claim such privileges which potentially create such negative systemic externalities, they should not just be subject to full disclosure, but pay for the privilege.
Perotti, Enrico (2010), “Systemic liquidity risk and bankruptcy exceptions", CEPR Policy Insight No. 52.
Perotti, Enrico, and Javier Suarez (2009b), “Liquidity Risk Charges as a Macro Prudential Tool”, CEPR Policy Insight 40, November