Republican leader, Senator Mitch McConnell, opposes the current version of the financial reform bill.  He claims that the bill generates “moral hazard” by creating a fund that bails out banks if they fail:

Mr. McConnell has framed the Republican opposition as an attempt to prevent future bailouts, and has specifically criticized a $50 billion fund, to be created with a tax on banks, that would help cover the costs of dealing with failing firms in the future. Mr. McConnell said the mere existence of the fund is an invitation to banks to take on risk that could lead them to fail. The White House does not support the fund, which is being pushed by Congressional Democrats.

Democrats have countered that the fund is intended pay for dismantling such firms and putting them out of business – and that setting up in advance would help ensure that the financial industry, rather than taxpayers, would cover the expense of future failures.

Note that the White House does not support the fund either and recently advised the Congressional Democrats to ditch the provision from the bill.  As far as I can tell, the White House view is that the fund is too small and its existence would complicate efforts to raise extra money should it be needed.   If McConnell is right, a bigger fund would exasperate the moral hazard problem so the White House’s preferences would make things even worse.

Also, the Democrats’ faith that firms would be dismantled if they fail may turn out to be mistaken.  The same executives who get their firm in trouble by taking risky bets are in the best position to disentangle them if they go bad.  That’s what happened with A.I.G.

All that leaves just one feature of the current bill to discuss: the fund is to be created by taxing financial firms in good times to help them out in bad times.  Depending on how the tax is designed, it can mitigate risk-taking.  The tax would have to affect the marginal incentive to make a risky bet and cannot be a lump-sum tax.  A successful tax would basically work by decreasing the upside to a trade to compensate for the fact that the firm is insured on the downside by the fund.  This brings up the whole question of what the optimal incentive scheme might be.  I was puzzling about this but then I realized I was trying to reinvent the wheel.  Much attention has already been paid to these issues in the finance literature and our very own Jeff Ely linked to a blog where Eric Maskin gave his five recommendations for great papers to read for guidance about the financial crisis.

To summarize some of the main points:  Banks must take equity in the bets they take to reduce moral hazard and this may have to be regulated (Holmstron and Tirole).  Depositors and small shareholders do not have good incentives to monitor so the government may have to set capital requirements to substitute for them (Dewatripont and Tirole).  Tight monetary policy can be used reduce the profitability of lending, much like a tax.  There are lots of other points but they are less relevant for the topic of this post.  I have not read a couple of these papers myself (eg Kiyptaki-Moore) but I intend to!

There are lots of other ideas floating out there (Volker rule, breaking up banks, reinstating Glass-Steagal).  Which is truly the best is hard to say.  But the basic principle is clear: If banks are going to be bailed out as a bank failure would cause systemic risk, they do have the incentive to take on riskier bets (let’s call this the “McConnell effect”).  Then, there has to be a countervailing effort to reduce the upside of risky bets (let’s call this the Olympia Snowe/Susan Collins/Scott Brown effect as we know who’s in the driving seat).

This brings me to my final point: While such a policy is designed for the long run, it will create pain in the short run.  Banks are pretty reluctant to lend right now (I assume?).  They do not need a tax to dis-incentivize them.  They may need the reverse.  How does financial reform deal with this?  Do we delay the implementation of the restrictive legislations?  This would create the incentive to invest and lend now rather than delay if profits from future lending are going to be taxed.  Probably there is some old finance paper that already discussed this too!  But I do not know it.