Taxing risk and the optimal regulation of financial institutions

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.