31/3/2013: Bank Leverage, Systemic Crises and Debt v Equity Funding: Tax Asymmetry

As the readers of this blog would know, I have been advocating more symmetric tax treatment of equity and debt, both in terms of public and private bonds and lending taxation. Here's a recent IMF paper on the topic that provides evidence that asymmetric taxation of debt and equity, with preferential treatment of debt over equity, generated internal instability in the system, making it more prone to crises.

Mooij, Ruud A., Keen, Michael and Orihara, Masanori paper "Taxation, Bank Leverage, and Financial Crises" (February 2013). IMF Working Paper No. 13/48 argues that "that most corporate tax systems favor debt over equity finance is now widely recognized as, potentially, amplifying risks to financial stability. This paper makes a first attempt to explore, empirically, the link between this tax bias and the probability of financial crisis."

The study "…finds that greater tax bias is associated with significantly higher aggregate bank leverage, and that this in turn is associated with a significantly greater chance of crisis. The implication is that tax bias makes crises much more likely, and, conversely, that the welfare gains from policies to alleviate it can be substantial far greater than previous studies, which have ignored financial stability considerations, suggest."

The paper "aims to provide a first attempt to establish and quantify an empirical link between the tax incentives that encourage financial institutions (more precisely, banks, the group for which we have data) to finance themselves by debt rather than equity and the likelihood of financial crises erupting; and then to try to quantify the welfare gains that policies to address this bias might consequently yield."

The paper combines two elements in a causal chain:

"The first is that between the statutory corporate tax rate and banks’ leverage. This has received substantial attention in relation to non-financial firms, but very little in relation to the financial sector. Keen and De Mooij (2011), however, show that for banks too a higher corporate tax rate, amplifying the tax advantage of debt over equity finance, should in principle lead to higher levels of leverage; the presence of capital regulations does not affect the usual tax bias applying, so long as it is privately optimal for banks to hold some buffer over regulatory requirements (as they generally do).

[In other words, capital requirements regulations are not sufficient to address the problem created by skewed incentives. The authors state that "Regulation, of course, has historically had the dominant role in addressing such problems of excess leverage in the financial sector, and the higher and tighter capital requirements of Basel III should to some degree reduce the welfare costs of debt bias."]

Empirically too, Keen and de Mooij (2012) find that, for a large cross-country panel of banks, tax effects on leverage are significant—and, on average, about as large as for non-financial institutions. These effects are very much smaller, they also find, for the largest banks, which generally account for the vast bulk of all bank assets. …Importantly, the finding that tax distortions to leverage are small for the larger banks, which are massively larger than the rest, does not mean that the welfare impact of tax distortions is in aggregate negligible: even small changes in the leverage of very large banks could have a large impact on the likelihood of their distress or failure, and hence on the likelihood of financial crisis."

The second link in the causal chain is the link "between the aggregate leverage of the financial sector and the probability of financial crisis. We estimate such a relationship for OECD countries, …capturing data on the recent financial crisis… The results suggest sizeable and highly nonlinear effects of aggregate bank leverage on the probability of financial crisis."

"… we consider three tax reforms that would reduce the tax incentive to debt finance:

• a cut in the corporate tax rate; 
• adoption of an Allowance for Corporate Equity form of corporate tax (which would in principle eliminate debt bias); and 
• a ‘bank levy’ of broadly the kind that a dozen or so countries have introduced since the crisis."

"The implications of these reforms for aggregate leverage are readily estimated using the results above.

1. We suppose, as before, that a 1 percentage point reduction in the CIT rate reduces banks’ aggregate leverage by somewhere between 0.04 and 0.15. 
2. This means, for instance, that the bank levy of 10 bp would reduce financial leverage by between 0.1 and 0.4 percentage points, for example from 93 percent to 92.9 or 92.6. 
3. Eliminating debt bias altogether with an ACE would reduce leverage by 2.2 percentage points under what we shall take to be the central estimate of 0.08: say, from 93 to 90.8; with the upper bound estimate of 0.15, leverage would fall by 4.2 percentage points."

The above clearly suggests that ACE approach, basically removing disincentive to equity funding compared to other policy alternatives. It also shows that in impact terms, lower corporate tax rates are not sufficient to eliminate or reduce the adverse effects of the asymmetric treatment of debt against equity.

28/8/2012: Debt- v Equity-led Funding and Systemic Crises

Apparently, there's been some serious movements in today's banks CDS, signaling some pressure building up in the system and potentially a disconnect between equity markets and bond markets. This wouldn't be the first time the two are mis-firing in an almost random fashion. In the longer-term, however, such episodes are very troubling for a good reason - long term imbalances build up in the two sources of capital funding is hard to unwind. It turns out, however, the difficulty of unwinding these is non-symmetric.

Last week's NBER Working Paper number 18329 (link here), titled "Debt- and Equity-led Capital Flow Episodes" by Kristin J. Forbes and Francis E. Warnock looked at "the episodes of extreme capital flow movements—surges, stops, flight, and retrenchment... [leading to] the question of":

• Which types of capital flows are driving the episodes and 
• If debt- ( bonds and banking flows) and equity-led (portfolio equity and FDI) episodes differ in material ways. 

"After identifying debt- and equity-led episodes, we find that most episodes of extreme capital flow movements around the world are debt-led and the factors associated with debt-led episodes are similar to the factors behind episodes identified with aggregate capital flow data. In contrast, equity-led episodes are less frequent, more idiosyncratic, and differ in nature from other episodes."

The study uses data on 50 emerging and developed countries starting with 1980 (at the earliest) and running through 2009.

The study found that "the vast majority of extreme capital flow episodes across our sample—80% 

of inflow episodes (surges and stops) and 70% of outflow episodes (flight and retrenchments)—are 
fueled by debt, not equity, flows."

After that, the paper develops analysis of "the factors that are associated with debt- and equity-led episodes of extreme capital flows. We follow the Forbes and Warnock (2012) analysis here by describing capital flow episodes as being driven by specific global factors, contagion, 

and/or domestic factors." 

The study found that: "to a first approximation equity-led episodes appear to be idiosyncratic, bearing 
little systematic relation to our explanatory variables. Notably, even the risk measures that were 
highlighted in Forbes and Warnock (2012) as being significantly related to extreme movements in 
aggregate capital flows have little or no significant relationship with equity-led episodes. In contrast, 
risk measures are important in explaining debt-led episodes; when risk aversion is high, debt-led surges 
are less likely and debt-led stops are more likely. Contagion, especially regional, is also important for 
debt-led episodes. Country-level variables are largely insignificant, except for domestic growth shocks; 
debt-led stops are more likely in countries experiencing a negative growth shock and debt-led surges are more likely in countries with a positive growth shock."

Perhaps in a warning to the policymakers currently embarking on financial repression path for dealing with the ongoing crises, "capital controls have little or no significance in  both equity-led and debt-led episodes, as also found in Forbes and Warnock (2012)."

Of course, we have to keep in mind that the current crisis is really a debt-led capital markets crisis, both at the corporate and sovereigns levels. And it is symmetric both for the US and Europe, where the main difference is not as much in equity vs debt financing, but in intermediated vs direct debt issuance.