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Taxing risk and the optimal regulation of financial institutions


  • Narayana R. Kocherlakota


Knowing that bailouts are inevitable because governments will rescue firms whose collapse may cause systemic failure, financial institutions fail to internalize risks their investments impose on society, thereby creating a “risk externality.” This paper proposes that just as taxes are imposed to deal with pollution externalities, taxes can also address risk externalities. ; The size of the optimal tax depends on risk-related attributes and may be difficult for supervisors to calculate and implement. A market-based method can estimate its appropriate magnitude. For a particular financial institution, the government should sell “rescue bonds” paying a variable coupon linked to the size of the bailouts or other government assistance received by the institution or its owners. Coupon prices will reflect the market’s judgment of an institution’s risk profile and can therefore be used to set the tax. ; A well-designed tax system can entirely eliminate the risk externality generated by inevitable government bailouts.

Suggested Citation

  • Narayana R. Kocherlakota, 2010. "Taxing risk and the optimal regulation of financial institutions," Economic Policy Paper 10-3, Federal Reserve Bank of Minneapolis.
  • Handle: RePEc:fip:fedmep:10-3

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    References listed on IDEAS

    1. Yongheng Deng & John M. Quigley & Robert Van Order, 2000. "Mortgage Terminations, Heterogeneity and the Exercise of Mortgage Options," Econometrica, Econometric Society, vol. 68(2), pages 275-308, March.
    2. Gerardi, Kristopher & Herkenhoff, Kyle F. & Ohanian, Lee E. & Willen, Paul S., 2013. "Can't Pay or Won't Pay? Unemployment, Negative Equity, and Strategic Default," FRB Atlanta Working Paper 2013-04, Federal Reserve Bank of Atlanta, revised 01 Jun 2017.
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    Cited by:

    1. Ueda, Kenichi & Weder di Mauro, B., 2013. "Quantifying structural subsidy values for systemically important financial institutions," Journal of Banking & Finance, Elsevier, vol. 37(10), pages 3830-3842.
    2. Benjamin Eden, 2012. "Does a low interest rate support private bubbles?," Vanderbilt University Department of Economics Working Papers 12-00010, Vanderbilt University Department of Economics.
    3. Golec, Pascal & Perotti, Enrico, 2017. "Safe assets: a review," Working Paper Series 2035, European Central Bank.

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    Financial crises ; Taxation ; Risk ; Regulation;

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