The Obama administration recently proposed the "Financial Crisis Responsibility Fee", a tax on big banks, which will raise about $100 billion over the next 10 years to pay back the US taxypayer for the cost of TARP and other government bailout programs.  The tax is on uninsured bank assets of 0.15%, and only applies to banks with assets over $50 billion.  Sounds like a great idea, right?

In fact it's a terrible idea, but not for the reasons you might expect.  The Law of Unintended Consequences will come into play, again as it inevitably does.  And the taxpayer will have to foot the bill for multi-billion dollar losses caused by it.

The standard reasons to oppose the tax are that it will be passed on to consumers, it's unfair to healthy banks, and anyway banks (except Citigroup) repaid their TARP funds.  The tax could hurt lending and therefore jobs and the economy.  The tax also doesn't get to the root of the problem, which is the continued government support of the housing market.  These are all good reasons, and certainly should make politicians think twice before passing the tax.

But the biggest problem with the tax is the unintended consequence that no one is talking about.  The tax is on uninsured assets only.  It doesn't apply to FDIC insured assets.  This gives banks tremendous incentive to get the assets insured, and that means that ultimately the government, and the taxpayer, will be responsible for even more of the junk that banks acquire.

The tax rate is 0.15%, as compared to the FDIC insurance assessment, which is as low as 0.07%.  Although this might not seem like much, it is the kind of spread that can make or break a bank.  It can significantly eat into profits.  In fact, in the 90's, there were two bank insurance funds, the Bank Insurance Fund (BIF) and the Savings and Loan Insurance Fund (SAIF).  These two deposit insurance schemes were both backed by the government, but the SAIF was higher by a small amount (perhaps as low as 0.03%).  As a result, many banks merged in order to qualify for the lower rate.  Ultimately the two programs were merged.

With a spread as great as 0.08%, big banks will be under tremendous pressure to insure all their assets.

Primarily this will be done by attracting FDIC insured deposits away from other banks.  FDIC insured ssets have risen from $2.5 trillion to $4 trillion in the last 10 years, and will increase even more.  These deposits can be invested in risky assets such as residential and commericial mortgages, thereby increasing the risk for the taxpayer if the housing market falls further (and it probably will).

But potentially more damaging in the long run will be the reclassification of assets that are eligible for FDIC insurance.  Money market funds, for example, are not FDIC insured.  They invest in commercial paper, which is used to supply the cash flow for the daily operations of businesses.  They offer a higher return than FDIC insured accounts, and are considered too risky for FDIC insurance.  But under pressure from banks trying to avoid the tax, regulators and legislators could reclassify this investment.  Certainly this would not happen in today's environment, but in 5 years it becomes much more likely as the memory of the financial crisis fades and new administrations are elected, appointing new regulators.  If you think it's impossible that money market funds could ever be insured, think again: they were insured for a year after September 2008 by the Treasury to stabilize the banking system.  This temporary measure could become permanent.

There are many other ways a bank could change the insurance rules, and they are masters of the game.  'Regulatory capture' is behind many of the past financial crises, and is impossible to avoid because it requires eternal vigilance.  Ten years after a crisis the public and politicians have already moved on, and the banks are free to game the system through political manipulation.  On top of that, the government has shown great willingness to insure all aspects of the banking system, as can be seen in the Bailout Scorecard.

The Financial Crisis Responsibility Tax really should be levied on the government entities like Fannie & Freddie, the FHA, and the FHLB, which are at the heart of the financial crisis.  They artificially inflated the housing market, which created the financial crisis once the bubble burst (combined they guarantee 3/4 of the housing market).  Even worse, they left the taxpayer on the hook for the resulting decline.  The ultimate cost could easily be in the trillions.

It may take 10 years to realize the unintended consequences of this seemingly justified policy.  But as with all attempts to tinker with the free market, it cannot work and will ultimately fail - just in time to aggravate the next financial crisis and create more pain for the US taxpayer.