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Pigouvian Banking 1 17 13 USING PIGOUVIAN TAXES TO CORRECT BANKING EXTERNALITIES: * A CAUTIONARY TALE Enzo Dia Ricercatore, Dipartimento di Economia, Metodi Quantitativi e Strategie di Impresa Università degli Studi di Milano-Bicocca Piazza Ateneo Nuovo 1, Milano 20126, Italy E-mail: [email protected] David VanHoose Professor of Economics and Herman Lay Professor of Private Enterprise Hankamer School of Business, Baylor University One Bear Place #98003, Waco, TX 76798 E-mail:[email protected] January 17, 2013 Abstract This paper examines a framework in which banks fail to incorporate into their individually optimal balance-sheet decisions combined effects on aggregate market lending that feed back via a strategic complementarity to influence the size of loan losses that they confront. It shows that in a setting with identical banks that fail to monitor their loans to mitigate such losses, a Pigouvian tax on lending can correct the resulting excessive-credit-expansion externality. In addition, however, the paper shows that in an expanded version of the model, in which banks can choose whether or not to incur a monitoring cost to eliminate the loan losses, the Pigouvian tax also has a perverse impact on the composition of lending. On the one hand, the impact of the tax on non-monitoring banks is smaller when their margins are thinner, while the tax falls more heavily on monitoring banks when their margins are greater. On the other hand, implementation of the tax compels monitoring banks to internalize the negative externality that falls on non-monitoring banks but not on them, which makes monitored loans less profitable. Consequently, although the tax reduces the supply of loans of both classes of banks, it tends to add to a growing market share for non-monitoring banks to a greater extent when their activity poses increased profit risks along their internal margins even as it tends to depress along the external margin the share of banks that voluntarily monitor loans to mitigate loan losses. Thus, the paper highlights unintended effects of applying Pigouvian taxation to banking markets that have not received careful attention in the literature to date. *Initial work on this paper by David VanHoose was completed during the term of a Baylor University research sabbatical, for which the author is grateful. Key Words: Pigouvian banking taxes, over-lending externality JEL Codes: G21, G28 USING PIGOUVIAN TAXES TO CORRECT BANKING EXTERNALITIES: A CAUTIONARY TALE 1. Introduction There has been a recent upsurge in interest in the idea of utilizing traditional public-sector-style tax instruments to address financial market externalities arising from divergences between social and private marginal costs—that is, marginal social damages—in financial markets. A number of economists have suggested trying to eliminate marginal damages via Pigouvian taxes set exactly equal to the values of those marginal damages. In theory, imposing such a tax on participants in financial markets might bring private marginal cost into alignment with social marginal cost and thereby induce sellers to reduce production, thereby alleviating negative externalities. A number of authors have proposed the potential for several types of financial-sector externalities. As Longworth (2011) notes, Brunnermeier et al. (2009) provide a particularly extensive list. Recently, however, De Nicolòet al. (2012) have developed three general categories: (1) externalities arising from strategic complementarities, such as a tendency for banks to engage in competitive interactions that generate decisions exposing the institutions to greater loss risks (what Brunnermeier et al. call “excessive credit expansion”); (2) externalities related to fire sales, or forced asset liquidations during times in which potential buyers of those assets also are experiencing difficulties; and (3) externalities related to interconnectedness of financial firms, most commonly called “systemic risk.” As noted by De Nicolò et al., most specific proposals for application of Pigouvian taxes are aimed at addressing externalities perceived to arise from 2 systemic interconnectedness. For instance, Acharya et al. (2011), Perotti and Saurez (2011), and Shin (2010) focus attention on directing Pigouvian taxes in an effort to mitigate negative externalities associated with systemic risks created by financial firms’ interconnected activities. Nevertheless, others, such as the International Monetary Fund Staff (2010), Keen (2011), Lockwood (2011), and Shackelford et al. (2010) have discussed and evaluated the merits of applying tax policies more broadly. Furthermore, Bianchi et al. (2011), Bianchi and Mendoza (2011), and Jeanne and Korinek (2010) have studied the possibility of preventing excessive credit expansion via imposition of Pigouvian taxes on debts issued by financial firms to private borrowers. The analysis conducted in this paper focuses on Pigouvian taxation of bank loans aimed at addressing a form of strategic-complementarity externality identified by Brunnermeier et al. (2009) and De Nicolò et al. (2012). The paper’s analysis is based on the competitive-heterogeneous-banks model developed by Kopecky and VanHoose (2006), which is extended to allow both for loan losses that banks confront to increase as the aggregate volume of lending increases and for the possibility of imposing taxation of bank lending. A negative externality arises if banks that fail to monitor loans in order to eliminate such loan losses regard their individual contributions to this aggregate effect on loan losses as negligible and consequently engage in excessive credit expansion. In principle, imposing an appropriate tax on lending by banks that expose themselves to such losses can bring their loan volumes back into line with the level consistent with recognition of this externality. Another feature of the model, however, is the capability of banks to incur monitoring costs—which vary across institutions—in order to mitigate loan losses. Nevertheless, this first-best, private-sector solution to the over-lending externality is pursued only by a fraction of banks that opt to monitor their loans. The remainder of the banking system does not monitor, however. Consequently, the non-monitoring portion of 3 the banking system experiences loan losses that are boosted by the strategic- complementarity externality. In this expanded framework with two classes of banks, the imposition of a Pigouvian tax continues to mitigate the negative over-lending externality that is created by all banks but falls only on the non-monitoring banks. For these banks, imposing the tax also has a smaller effect when their margins are narrower but a greater impact when their margins net of loan losses are larger. Monitoring banks confronting the tax are compelled to internalize the negative externality that adversely affects non-monitoring banks but which they incur costs to eliminate, which reduces their profitability from monitoring loans. Hence, although the tax addresses the negative externality by reducing aggregate loan supply, it also tends to adversely influence the composition of aggregate lending across both groups of banks. It does so by tending to add to a growing market share for non-monitoring banks to a greater extent when their activity poses increased profit risks on their internal margins even as it depresses along the external margin the share of banks that voluntarily monitor loans to eliminate loan losses. Thus, the paper highlights unintended effects of applying Pigouvian taxation to banking markets that have not received careful attention in the literature to date. Section 2 lays out a basic banking model in which identical banks engage in individually optimal behavior that generates an externality that lead to socially excessive credit expansion and shows how a Pigouvian tax can correct the externality. Section 3 expands the model to allow for a fraction of institutions in the banking system to opt to employ heterogeneous monitoring technologies mitigate loan losses. A solution for aggregate lending in this mixed banking system is developed and used to examine special cases in which either all banks leave their loans unmonitored or choose to incur differential costs to eliminate loan losses. Section 4 shows that implementation of the type of Pigovian tax scheme examined in Section 2 would, in the banking system made up of both non-monitoring and monitoring banks, have the intended effect of correcting 4 the over-lending externality while having the unintended immediate effect altering the composition of total lending in a way that tends to reduce aggregate loan quality. Section 5 concludes with a brief summary of the paper’s conclusions and a discussion of implications for further research on the application of Pigouvian taxes to banking. 2. The Banking Framework and a Pigouvian Tax without Monitoring This section discusses the basic banking framework examined in the paper, introduces a simply strategic-complementarity externality, and shows how a Pigouvian tax could mitigate this externality when banks fail to monitor their loans. Complications arising from loan monitoring by a portion of institutions in the banking system are considered in subsequent sections. The banking system is made up of numerous institutions that take interest rates on securities, loans, and deposits as given and that initially are assumed—for expository purposes in this section—to face identical cost conditions. An individual bank i that does not monitor loans to eliminate
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