Pigou Tax of Systemically Important Financial Intermediaries (SIFIs) In Financial Networks: An Empirical Application of Systemic Risk Monitoring and Governance

Macro-prudential policy is concerned with mitigating system wide risks arising from negative externalities from monetary and financial activities. The need to design a Pigou tax to control systemic risk from financial intermediaries (FIs) has come to the forefront after extensive tax payer bail outs in the aftermath of the 2007 financial crisis. Holistic visualization of the financial system using network models of bilateral obligations of FIs is increasingly being seen as essential to monitor and manage systemic risk. The eigen-pair approach first proposed in Markose (2012) prices the cost of failure of a FI in an interconnected system of financial obligations. The financial network is identified as being unstable when its maximum eigenvalue is greater than a common threshold of Tier 1 capital. The corresponding eigenvector centrality, EVC, gives the rank order of the FIs contributing to the instability. This method uses a ‘bail in’ escrow fund paid for by FIs proportionate to their individual eigenvector centrality to mitigate tax payer bail outs. These metrics can be monitored over time and system wide threats when FIs accumulate excessive liabilities relative to capital can be detected using this method. We argue that it is a mistake to focus on a preconceived list of systemically important FIs (SIFIs) and use ad hoc surcharges to stabilize the financial system. Governance issues surrounding ‘bail ins’ are discussed.