1

Can taxes tame the banks? Capital structure responses to bank levies

Michael DevereuxOxford University Centre for Business Taxation

Niels JohannesenUniversity of Copenhagen – Department of Economics

John Vella Oxford University Centre for Business Taxation

2

UK Bank Levy: rationale

“… the Government will introduce a levy based on banks’ balance sheets from 1 January 2011, intended to encourage banks to move to less risky funding profiles. The Government believes that banks should make a fair contribution in respect of the potential risks they pose to the UK financial system and wider economy…”

Budget, HM Treasury, June 2010

3

Neutrality of tax

“… the Government should consult on whether to introduce a limited form of the allowance for corporate equity for the regulated banking sector, alongside an uplift in the bank levy…” 

Parliamentary Commission on Banking Standards, Budget, June 2013

4

Use of tax as regulation

Several elements of regulation designed to improve loss absorbency

Tightening of Basel regulations:

Increase in ratio of equity capital to risk‐weighted assets

Introduction of leverage ratio 

Bank levy intended to contribute to same regulatory goal

IMF Proposal, June 2010: Financial Services Contribution (FSC):

A levy on bank liabilities less Tier 1 equity capitalTo reduce excessive risk‐taking and raise revenue

5

Objective of research

How did bank levies affect:

Funding risk – the leverage ratio?

Portfolio risk – risk inherent in the choice of asset portfolio?

Total risk – taking into account both funding and portfolio risk?

How did effects vary between different banks?

6

European Bank Levies

13 EU MS introduced bank levies in the period 2009‐12

10 on “risky liabilities”: 

Austria (2011), Belgium (2012), Cyprus (2011), Germany (2011), Netherlands (2012), Portugal (2011), Romania (2011), Slovakia (2012), Sweden (2009), UK (2011)

3 on other bases: 

France (2011), Hungary (2010), Slovenia (2011)

7

Interaction with regulation

Theory: tax or regulation interchangable as policy tool

In practice, tax and regulation both adopted: how do they interact?

Intuition: if bank levies induce banks to raise equity capital there is scope for increasing portfolio risk

Also applies to leverage ratio

8

9

Empirical approach: dataBank informa on → Bankscope

balance sheets, income statements, regulatory capitalroughly 5,000 banks in the EU

Levy informa on → hand‐collected from various sourceslevy rateslevy basesimplementation dates

Other macroeconomic variables used as controlsSample period: 2008‐2011

10

Empirical StrategyExploit four sources of variation:

some EU countries adopted levies, some did notcountries adopting levies did so at different timescountries adopting levies apply different rates and baseswithin countries adopting levies banks face different marginal rates

Test whether banks hit by bank levies systematically changed their behaviour relative to other banks

11

Empirical Model3 outcome variables

equity/assetsrisk weighted assets/assetsequity/risk‐weighted assets

2 levy variableszero‐one dummy for bank levy in placeapproximate marginal levy rate

Control variablesbank size, profitabilityGDP growth, inflation, corporate tax ratebank and time fixed effects

12

Basic Results: all banks

When bank levy is present:

Equity/assets 1.5 percentage points higher Risk weighted assets/assets 2 percentage points higher Equity/risk‐weighted assets 0.8 percentage points higher

All estimates subject to uncertainty, but statistically significant

13

Robustness of resultsResults are robust to inclusion of:

region × time dummies → control for region specific shocksbank size × time dummies → control for bank size specific shocksequity / assets × time dummies → control for equity ratio specific shocks

Results are robust to controls for regulatory changes:larger risk-weights on trading assets (Capital Requirement Directive III, 2010)temporary capital buffers for large banks (EU Banking Package, 2011)

Increase in equity / assets comes from an increase in equity and not a decrease in assets

14

Results: high capital v low capital banksWhen bank levy is present:

HIGH CAPITAL BANKSEquity/assets 1.7 percentage points higher Risk weighted assets/assets: no effectEquity/risk‐weighted assets 1.4 percentage points higher

LOW CAPITAL BANKSEquity/assets 1.2 percentage points higher Risk weighted assets/assets 2.9 percentage points higher Equity/risk‐weighted assets: no effect

15

Conclusions 

Direct effect: increase in equity-asset ratioslarger for "safe" banks than for "risky" banks

Risk shifting: increase in measured risk of assetsonly for "risky" banks

Total risk: drop in equity / risk-weighted assetsonly for "safe" banks

If risk-weights reflect risk, then bank levies only reduced risk of initially safe banks

16

Possible lessons for a leverage ratio

“My view is that a minimum leverage ratio is a vital component of the overall capital framework”

Governor, Bank of England, November 2013

“A simple leverage ratio framework is critical” Basel Committee, January 2014

Leverage ratio addresses financial risk, like the bank levy, and could have similar effects