Accounting 101 and the New Bank Tax

Christine Hurt and Erik Gerding have several good posts at Conglomerate on how the White House tomorrow will formally propose a tax on banks to recover losses government incurred providing capital infusions under the so-called Troubled Asset Relief Program (TARP).

It appears the tax would be computed based on a bank’s total liabilities other than its insured deposits, although some reports say the tax could be based on profits. Aside from recouping costs, the liability approach suggests creating an incentive for banks to avoid incurring liabilities deemed riskier than insured deposits, though without appearing to distinguish among risk types.

Aside from the inevitably contentious debate about the merits, fairness or efficiency of such a proposal, a particularly strange feature is how, according to a Wall Street Journal report, liabilities other than insured deposits would be calculated. The report says that liabilities would be calculated as “the difference between a firm’s assets and its combined equity and insured deposits.” Isn’t this a convoluted way of speaking?

Anyone vaguely familiar with business or accounting knows that owners’ equity equals total assets minus total liabilities. For five hundred years, bookkeepers have used this relationship to define the fundamental equation of accounting. Contemporary corporate law students describe equity as the residual claim on firm assets, reflecting that same subtraction of liabilities from assets.

Isn’t it confusing and backwards then to propose to measure liabilities as the difference between assets and equity (setting aside insured deposits)? Assets and liabilities are the normative categories forming the substantive content of accounting’s fundamental equation. Equity is only the difference between them.

So if you want to impose a tax on liabilities, there is no need to think of them as the difference between assets and equity. Apart from looking forward to hearing the President tomorrow defend the proposal’s merits and spell out its details, I’d like to know whether this reported feature appears and, if so, why it makes any sense.

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4 Responses

  1. That is an odd definition.

    I’m not familiar with the contours of the proposal, but I wonder, do they mean equity in the colloquial sense of aggregate stock value?

  2. Lawrence Cunningham says:

    Kaimi–Thanks and interesting possibility, so creating incentives to boost stock market capitalization, though perhaps fraught with peril!

  3. Kaimi says:

    I haven’t followed the details; it just seems like that would be one politically popular approach. There were frequent media discussions of the ways in which high leverage contributed to the financial crisis. I saw the definition you mention in the post, and I wondered if this was a political statement: “We will tax the Bear Stearns’s of the world if they make $400 billion bets with money they don’t have.”

    It doesn’t really make much policy sense (if we’re worried about risk and leverage, why impose a tax rather than a higher reserve requirement?), but it puts money in the coffers, and it also castigates the bad actors at Bear Stearns (boo! hiss!), both of which would be likely to be play very well with voters.

  4. Ken Rhodes says:

    I suspect the formulation means “equity” in the traditional accounting sense. Yes, that would simply invert the normal computation sequence, but think how much easier it would be to do that calculation, instead of having to examine the books to determine which “liabilities” should count.

    Also, if there is a tendency for the “bad actors” to inflate their reported assets, thus justifying more loans and/or speculative “investments,” this formulation would be a strong incentive for more honest accounting.