The current
approach to solving the banking crisis is to put more government money
into banks. The problem with this approach is that it creates fear of
government meddling in the operational and financial decisions of the
banking sector. Banks can only survive if they are run by managers and
boards who sincerely believe their goal is to maximise shareholder
value. This requires managers who are willing to maximise shareholder value and are capable of doing so.

problem with government control is that these conditions are not likely
to be met. Take the recent cap on compensation imposed by US President
Obama on assisted banks. Neither a maximum nor a minimum wage is likely
to promote the long-term competitiveness of these banks. Politicians
and bureaucrats fundamentally care about stakeholders, not
shareholders, so that government control represents bad corporate

The result is that, although government injections of new capital increase the book value of equity, the market
value of equity may actually decrease as a result of collapsing stock
prices after the announcement of government 'help'. The result is that
bank stocks end up in a death spiral, fuelled by the ultimate threat to
shareholder value: nationalisation

alternative, putting more private capital into banks may also be badly
received by capital markets as it may be interpreted as a bad 'signal'
that the bank is in trouble. Unless existing shareholders buy all the
newly-issued equity, such a negative signal means that banks that are
(wrongly) perceived to be bad are forced to sell undervalued equity to
new investors, which dilutes the interest of current
stockholders. Moreover, equity holders are reluctant to put new money
into a company when they perceive that the main beneficiaries of this
capital increase are the debt holders. This debt-overhang problem
prevents the obvious deleveraging that is necessary to put the banks
back on sound financial footing.

how to get out of this dilemma? Perhaps the world should get some
inspiration from the Belgian tax reform of 1982, which represents the
most successful experiment in government-engineered deleveraging in

In 1982, the Belgian government
introduced a law allowing companies to deduct the cost of equity
(estimated at 13 per cent) of newly-issued equity from its corporate
taxable income for the next 10 years. The rate of 13 per cent was based
on the prevailing rate of interest on corporate debt in 1982. So a
company that issued one million euros in equity could deduct 130,000
euros a year from their taxable income, the same amount as if it had
issued one million euros worth of debt.

At the same time, Belgian investors were
allowed to deduct up to 1,000 euros of investments in Belgian stocks
from their taxable income. As a result more companies issued equity in
1982 than during the previous 13 years and the Belgian stock markets
rose by 50 per cent as seen in the graph below which shows the movement
of the Belgian stock market index relative to the Morgan Stanley World
Market market index from January 1981 to January 1984. Note that in
1981, the Belgian market behaved like others around the world, but then
experienced a 50 per cent jump in the spring of 1982 when the law was


Let’s think about a similar global tax reform today.

First, end the tax subsidy to debt
financing by making the cost of equity tax deductible in the same way
as the cost of debt. Specifically, every company should be allowed to
take a charge against the book value of equity, at a rate tied to the
corporate borrowing rate. A similar law has existed in Belgium since
2006. This will take away the tax advantage of borrowing money. This
means that more banks and their clients will be interested in equity
issues, which will encourage deleveraging without negative tax
consequences. This tax law change should be permanent.

Second, give a tax deduction or a tax credit to anyone who buys newly-issued
bank shares in 2009. This will increase the demand for bank shares: in
some ways, banks have now obtained a licence to sell tax credits to
investors. Note this part of the tax law would be applied only to
equity issued in 2009 to encourage immediate action.

a tax measure will have three major advantages over the current
approach of putting more taxpayer money into banks. First, the
government will not become a shareholder in the bank, preserving the
benefits of private ownership. Second, by tying equity issues to tax
credits, the negative signal will be avoided. Banks that issue equity
will be considered as banks that sell tax credits, not banks that are
in trouble. When firms issued equity in Belgium in 1982, stock prices
increased significantly, in contrast to the typical decline observed
after announcements of capital increases. Third, the critique that
taxpayers are bailing out banks would be avoided.  Of course, the
government will help finance the bailout by giving tax reductions, but
the cost of these reductions is going to be smaller than the costs of
the guarantees and subsidies that governments are handing out right now.

such a change in tax laws reduce banks’ incentives to borrow and have
more reasonable leverage ratios? We would hope so, although we are
still concerned about one major issue: in spite of the Nobel
prize-winning contributions of Merton Miller and Franco Modigliani, who
have shown that without tax benefits, there is no reason to prefer debt
over equity, there seems to be a widespread belief in banks that debt
is cheaper than equity, regardless of the tax treatment. This is, I
believe, a result of the obsession with earnings per share and return
on equity as corporate objectives. It is true that borrowing increases
earnings per share and expected return on equity, but it makes earnings
more risky so that the present value of earnings is independent of
capital structure. So, the boards of financial firms have to make sure
that executive bonuses are not tied to earnings per share or return on
equity targets, but to performance measures that take risk into account.