Monday, March 2, 2009

How the Tail Wags the Dog - An analysis of “too big to fail “ in the case of the Swiss bank UBS

First the facts, collected from the reputable Swiss newspaper Neue Zurcher Zeitung:
The Swiss bank UBS operates in the USA as a bank advising clients on wealth management, which is essentially advice on reducing taxation. In this function, the bank has admittedly violated US laws. The bank is threatened by an indictment with a probable consequence of the loss of the US banking license. It is given the alternative to cooperate with IRS and produce data about the clients involved in the illegal operations.

From the US perspective, this is a regular, legal procedure to enforce US taxation laws. The interesting case presents itself in Switzerland: UBS is considered “system relevant” by the swiss government, meaning it is too big to fail. Because the government judges the danger for UBS real and immediate, the government advises UBS to cooperate with the IRS, even though this is likely violating Swiss law (the famous 'banking secret') and certainly Swiss legal procedures of due process.

A company considered “system relevant” is not only protected from going bankrupt but also exempt of other laws of the land! The moral hazard of 'private gains, public losses', which we see in the discussion of the US or German banking or car management salaries, is multiplied when companies from small countries are involved. They may unpunished violate the law – the ultimate moral hazard!

A banker suggested in the (liberal) newspaper Neue Zuercher Zeitung to held upper management (CEO and the board of directors) jointly and privately liable for losses, effectively reducing the moral hazard by making their positions similar to a private owner of a company, which feels losses personally. I think this is addressing part of the problem, not the core:

The core of the problem is size (specifically relative size): UBS is for Switzerland too big to fail. Our social and political system is based on a division between state and private; state operations are controlled by (democratic) politics, private operations are controlled by law. If a company becomes so large that it is “system relevant”, it is above the law (usually only thought of the bankruptcy law, but as the above case shows, other laws, e.g. the rules protecting the privacy of its clients). Admitting that a company is 'too big to fail' means that it must be controlled politically, i.e. nationalized. How to avoid nationalization of all the big players?

Identifying size as the problem, a simple taxation scheme punishing size would reduce the advantage of bigger companies, make mergers and acquisitions unattractive and lead to breaking up the current large companies into units which individually can be allowed to fail, thus reducing the moral hazard. Size of companies today is not the result of natural growth, the economic counterpart of a Darwin like evolution, where the fittest survives, but they are the result of mergers and acquisitions (e.g. UBS is the result of the acquisition of SBC through UBS, necessary 1998 for UBS to maintain its balance sheets). The current institutions and technology award a premium to large companies, creating the moral hazard discussed above.

A very progressive tax on size could be simply based on employees (and perhaps include net turnover) to identify the element which makes a company 'too big to fail'. As a simple idea, a company would pay for each employee an amount corresponding to the total numbers of employees it has; the tax liability would be the square number of employees. Small companies would pay near to nothing, but a company like UBS with 79'000 employees would be taxed $6.4 billion cutting substantially in its net income of US$ 16.2 billion. Such a tax is not taxing the economic production but is a compensation for the risk that is created by a large cooperation and may be due at every location for the size of the company controlled from there not avoiding double taxation and effectively increasing the tax by a factor of 2.

Some Postscripts:

Ironically, UBS was the company that did not extend a credit line to Swissair and caused its immediate grounding in the morning of October 2, 2001

Fortunately neither Madoff nor Stanford's pyramid schemes were too big to fail. Imagine a merger between UBS and Madoff and the Swiss government legalizes and pays for the Ponzzi scheme!

The tail (UBS as a small player in the USA) wags the dog (Switzerland). This asymmetry makes it difficult for the swiss government to negotiate with the USA and creates a lot of David and Goliath rhetoric in Swiss newspapers.

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