Bank Taxes and Loan Monitoring: A Cautionary Tale

This paper analyzes a model in which there is excessive bank lending and in which regulators attempt to correct the problem with a tax. A tax on lending can correct the over-lending problem by reducing the returns from lending. Imposition of the tax has a perverse effect on the composition of lending, however, because it falls more heavily on banks that incur expenses to reduce loan losses. Hence, along the external margin, the share of banks that voluntarily monitor loans decreases. In contrast, monetary policy tightening can produce the optimal level of lending without generating any distortion of monitoring incentives.