Impose a Fee on Large Financial Institutions

During the financial crisis that occurred between 2007 and 2009, concern about the impact of the failure of large financial institutions on the financial markets and on the broader economy prompted federal action. The government provided substantial assistance to major financial institutions through the Troubled Asset Relief Program, the Federal Reserve System, and the Federal Deposit Insurance Corporation (FDIC). That action effectively protected many uninsured creditors of large financial institutions from losses but at great potential cost to taxpayers. It also reinforced investors' perceptions that large financial firms are "too big to fail"--that is, so important to the financial system that their creditors are likely be protected by the federal government in case of large losses.

Banks and other large financial institutions benefit from a federal financial safety net, but they do not bear the full cost of that protection. The vast majority of the funds that financial institutions lend is obtained from creditors, which for commercial banks include insured and uninsured depositors, and purchasers of bank commercial paper (short-term debt obligations) and other bank debt (such as bonds). Deposits (saving and checking accounts and certificates of deposit) are one of the most important sources of funding for small and medium-sized banks and are insured against losses (generally up to $250,000 per account) by the FDIC. Banks pay a premium for FDIC insurance and also are obligated to make up for losses that exceed the reserves of the FDIC. Large financial institutions, including big banks, are much more likely than smaller banks to obtain financing from sources other than insured deposits. They also are more likely to be perceived as too big to fail. Those implicit federal guarantees, which large financial institutions do not pay for under current law, give them a cost advantage over smaller banks in the form of lower borrowing costs.

This option would assess an annual fee on banks, thrifts, brokers, security dealers, and U.S. holding companies that control such entities. The fee would apply only to firms with consolidated assets of more than $50 billion. (Consolidated assets include all assets controlled by the financial institution's parent company and all of its subsidiaries.) The option would impose a fee at an annual rate of 0.15 percent on the firm's total liabilities as reported in their financial statements, excluding deposits insured by the FDIC (for banks) and certain reserves required by insurance policies (for insurance companies). If implemented, such a policy change would generate $31 billion in revenue from 2012 through 2016 and $71 billion from 2012 through 2021. (Such fees would reduce the tax base of income and payroll taxes, leading to reductions in income and payroll tax revenues. The estimates shown here reflect those reductions.)

At 0.15 percent, the fee would probably not be so high as to cause financial institutions to significantly change their financial structure or activities. The fee could affect to some extent institutions' tendency to take various risks, but the net direction of that effect is uncertain. On the one hand, the fee could reduce the profitability of larger institutions, which might create an incentive for them to take greater risks in pursuit of higher returns to offset their higher costs. On the other hand, the fee would provide an incentive for larger financial institutions to reduce their dependence on liabilities subject to the fee. To the extent that institutions increased their reliance on equity and did not change their investment strategies, the risk of future losses would be reduced. The amount of the fee could vary with the amount of risk an institution undertakes, but it might be difficult to measure those risk factors precisely.

The fee also might affect the market concentration of the financial industry. Banks would have an incentive to keep assets below the $50 billion threshold, which could reduce the number of large institutions. The fee also would improve the relative competitive position of small and medium-sized banks.

The main advantage of this option is that it would help compensate taxpayers for the cost of providing large institutions with a financial safety net. It would also create a more level playing field for large and small financial institutions, by charging the largest institutions for the greater government protection they receive. By applying the fee to noninsured liabilities, the option would allocate costs from government rescue actions more evenly across the sources of funding.

The option would also have several disadvantages. The fee might be borne by unintended groups: Large financial institutions could pass much of the cost to their customers, employees, and investors, but the precise incidence among those groups is uncertain. In addition, unless the fee was risked-based, stronger financial institutions that pay lower interest rates on their debt would face a proportionally greater increase in funding costs than would weaker financial institutions. Furthermore, more- stringent regulations such as those in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and those in the international Basel III agreement could better protect taxpayers from the risks of large-bank failures than would be the case under previous rules. If so, those regulations would reduce the need to charge large banks a fee to offset the potential costs of being "too big to fail."