TAX NEWS - JUNE 2010

Alberta Tax: Oil spills, bank taxes, and the "Fat Tail"

CALGARY, AB, May 5, 2010 -- The recent disaster in the Gulf of Mexico dramatically highlights a point about crises and how unforeseen events can have devastating consequences. The lesson extends to the financial world and to the G20 leaders meeting in South Korea and Toronto this month.

Up until this week, finance ministers from the US and Europe were pushing for an international tax on banks. The tax (or "levy" as they like to call it) would be collected, held in a special fund, and used to bailout troubled financial institutions in the future. Ironically, forms of the bank tax plan have been backed by the International Monetary Fund, a group that supposedly imposes strict behavioral guidelines and fiscal discipline for the financially troubled governments.

Think about the oil spill. The bank tax idea is the equivalent of world governments saying: "Let's tax oil companies so the next time there are millions of barrels of oil gushing uncontrollably from the ocean floor because of human error, greed and incompetence, there will be a bit of slush fund around to help clean it up."


There shouldn't be a next time

Why not just impose stricter rules on drilling so that there is no "next time"?

That's the position that Canada, supported by a few other countries like Australia and Mexico, is taking in opposing the bank tax. Not only does Canada see the tax as an unfair penalty on its own banks and financial institutions – which operated under stricter regulations and never got into much trouble in 2008 – the tax also avoids the bigger issue, which is the need for financial reform.

Fortunately, it now appears that the G20 countries previously supporting the bank tax are now cooling to the idea. Canadian Prime Minister Stephen Harper and his finance minister, Jim Flaherty, can take some of the credit for helping to thwart it.

But the parallels between the banking crisis and the giant plume of oil spewing out beneath the waves of the Gulf of Mexico are eerie.

It was because of new innovation and technology that oil companies are now able to go miles beneath the water's surface, drill into the rock of the ocean floor, move pipe horizontally, and pinpoint within a matter of metres the oil and gas deposits that seismic technology can locate. It's a true miracle of human innovation and creativity!

In the same way, it was innovation in the banking sector that gave rise to complex hedge funds, derivative trading, securitization of debt, and a host of other incomprehensible financial "products." A lot of money was being made. In the US, both the Clinton and Bush administrations gushed over these banking innovations, and did everything they could to unleash creativity and innovation by cutting regulation and red tape.

With both the oil spill and the investment banking collapse, we know in hindsight that events can turn spectacularly bad. It is not the fault of the innovation or creativity, however. Rather, it is the miscalculation of the risk associated with the "fat tail" – the term that refers to the occurrence of extremely unlikely events, which can wreak havoc on the entire system.

With the Gulf oil spill, the chance of the pipe bursting exactly where it did was extremely improbable. For that to happen, engineers would have said before-hand, the entire drilling platform sitting on the surface of the water would have to collapse, and that was not seen as possible. The event that the engineers did not consider was the explosion that rocked the platform, causing it to tip and sink, which in turn ruptured the pipe on the ocean floor.


Improbable events do happen

It's the same story with the "innovative" financial products such as the mortgage-backed securities which were being bundled and sold as safe investments. "What could possibly go wrong?" the financial wizards asked back in 2007. The only way the products could fail is if a massive number of home owners defaulted on their mortgages at the same time. It seemed extremely improbable.

Yet improbable events do happen, and if the system is not prepared to handle them, the consequences are unimaginable.

The challenge for G20 leaders – both those dealing with financial reform and those tackling offshore drilling regulation – is not to put aside more money to deal with crisis when it strikes next. The challenge is to put into place proper regulatory limits that take into account the possibilities of rare events, and to do everything possible to mitigate the damage when they occur. Creativity and innovation are not the culprits here, but they do need to be contained.

The "fat tail" rare events will strike again!