05/10/2010 05:21 pm ET | Updated May 25, 2011

Fed's Kocherlakota: Financial Reform Bill Can't End Bailouts Or 'Too Big To Fail'

Despite declarations from President Obama, his top aides and Democratic leadership that the pending financial reform bill in the Senate will forever end taxpayer bailouts of large banks, a top Federal Reserve official argues the bill will do no such thing, calling bailouts "inevitable."

In a Monday speech, Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said that since bailouts are inevitable -- and that no legislation can completely end the future possibility of them -- policymakers should instead levy a tax on firms to build up a fund that would eventually fund those bailouts.

Referencing the Senate bill and the House legislation that passed in December, Kocherlakota said: "[B]oth bills significantly understate the extreme economic forces that lead to bailouts during financial crises. Indeed, the opening language of the Senate bill actually declares that it will end taxpayer bailouts. This objective is laudable.

"But it is not achievable -- and thinking that it is can lead to poor choices about the structure of financial regulation," he said in his prepared remarks.

"[N]o legislation can completely eliminate bailouts. Any new financial regulatory structure must keep this reality in mind."

Because "bailouts will inevitably happen," Kocherlakota instead calls for the creation of a tax -- one that would have the effect of limiting bailouts by changing financial firms' incentives.

In short, by taxing firms based on the risks they pose to the financial system -- particularly the risk that would ultimately be borne by taxpayers when they're bailed out -- firms will then choose "the socially optimal level of risk."

In other words, faced with decreased profits due to extra taxes, firms will dial back the risks they take.

"[K]nowing bailouts are inevitable, financial institutions fail to internalize all the risks that their investment decisions impose on society," Kocherlakota said. "Economists would say that bailouts thereby create a risk 'externality.'

"At least some big banks did make socially undesirable choices. But -- in large part -- they were led to make those choices by incentives within the tax and regulatory system. Parts of these incentives were shaped by the ultimately correct expectation that some bailouts would take place in the event of a financial crisis. These government guarantees -- no matter how implicit they might have been -- created an incentive for financial institutions to make socially undesirable choices. Taxation is a useful way to correct this incentive."

The reason why policymakers will always bail out financial firms, Kocherlakota argues, is that banks and other financial firms rely on short-term debt and deposits. These are exactly the kind of funds that are prone to "self-fulfilling crises of confidence that economists term 'runs.'"

Because "governments cannot risk such systemic collapse... policymakers inevitably resort to bailouts even when they have explicitly resolved, in the strongest possible terms, to let firms fail," he said.

"I do not believe that better resolution mechanisms will end bailouts," he said, an indirect reference to the Senate bill authored by Senate Banking Committee Chairman Christopher Dodd (D-Conn.). "Indeed, I'm led to make a prediction. No matter what mechanisms we legislate now to impose losses on creditors, Congress, or some agency acting on Congress' behalf, will block them when we next face a financial crisis."

So instead of financial firms taking appropriate risks, they take outsized ones because they know they'll always be bailed out. And their creditors, knowing they'll always be bailed out, won't charge the banks a premium on their debt because they know there isn't much risk.

"Now, imagine for a moment that we live in a world without bailouts, so that the government does not provide debt guarantees or deposit insurance. If a financial institution decided to increase the risk level of its investment portfolio, its debt holders and depositors would face a greater risk of loss. By way of compensation for that greater risk, they'd demand a higher yield. As a result, in the absence of government guarantees, financial institutions would find it more costly to obtain debt financing for highly risky investments than for less risky ones. This effect, on the margin, would curb a firm's appetite for risk. It would have an especially powerful effect on highly leveraged financial institutions, because high debt-to-asset levels mean higher risk of being unable to fulfill debt obligations.

"But now return to the real world, with deposit insurance and debt guarantees, and the inevitability of government bailouts. Even if they only kick in during financial crises, these guarantees change this natural market relationship between risk and cost. The depositors and debt holders are now partially insulated from increases in investment risk, and so do not demand a sufficiently high yield from riskier firms. Financial institutions take on too much risk, because they are no longer deterred from doing so by the high costs of debt finance. And this missing deterrence is especially relevant for firms that are highly leveraged, because they should be paying out especially high yields on their debts.

"In this way, the expectation of bailouts leads to too much capital being allocated toward overly risky ventures. These misallocations of capital don't create the collective mistakes in predictions that generate financial crises. But the misallocations do mean that society loses a lot from those mistakes -- a lot more than is efficient.

That's why a tax is necessary, Kocherlakota argues.

"The tax amount exactly equals the extra cost borne by the taxpayers because of bailouts, appropriately adjusted for risk and the time value of money. Knowing that it faces this tax schedule, the firm no longer has an incentive to undertake inefficiently risky investments. Its investment choices will be socially efficient. It is useful to tax a financial institution producing a risk externality, just as it is useful to tax a firm producing a pollution externality. The purpose of the tax in both instances is to ensure that the firm pays the full costs -- private and social -- of its production decisions," he said.

And there shouldn't be a cap on the total amount raised either, Kocherlakota said. The House bill calls for a special tax, but it caps it at $150 billion, which he said is "problematic."

The Senate bill recently jettisoned its plans for a tax after opposition from the Obama administration and Wall Street. It would have created a $50 billion fund funded by taxes on the banks.