Bank Reform Must Address Flaws of Deposit Insurance

Article excerpt

OVERHAUL of United States banking law, which has been stumbling through Congress this year, will pass its first major milestone later this month. The outcome will be critical to the economy. Huge losses have damaged hundreds of banks - including many of the largest. If the financial center suffers, the economic structure will be weakened.

The House Banking Committee has tentatively scheduled a series of crucial votes that will shape the nascent banking act of 1991.

While the full House of Representatives and later the Senate are certain to modify portions of the resulting bill, the Committee's decisions will likely set the boundaries of the debate.

Unfortunately, it is still a tossup whether members of Congress will address the underlying ills that triggered the crisis. They could decide simply to prop up the federal Bank Insurance Fund, which guarantees bank deposits. The BIF is now nearing insolvency.

Bankers are in business to make money, not lose it. Though some bankers are not competent, professional, and scrupulous, the overwhelming majority are. Why, then, did so many of them get in trouble all at once?

Obviously, many factors contributed to the crisis. Unstable monetary policy first flooded the economy with lendable funds and then cut off almost all new supply. The loss of profitable markets lured bankers into new and unfamiliar lines of business to compensate.

The real estate recession proved deeper and longer than most bankers expected. Lax regulation may have encouraged incautious lenders to jump into deep water.

Thomas Johnson, president of Manufacturers Hanover Corporation, says "one way out of the banking problem is a massive consolidation of banks. The cost efficiencies that can be realized are huge.... With fewer players, lower costs, and lower risks, (banks) will make more money."

He noted that in California only four banks dominate the market. Consumer deposit rates in that state are lower and loan rates higher than in New York, which has a dozen important competitors. The combined difference is almost two percentage points.

While Mr. Johnson's analysis was doubtless correct, the fatal flaw is elsewhere: in the system of federal deposit insurance, which protects depositors against almost all loss. At large banks, the idea of "too big to fail" evolved into a system of 100 percent deposit guarantees.

Robert Black, the erudite president of the Richmond Federal Reserve Bank, says that "risk may be systematically underpriced in the US economy because deposit insurance reduces the risk premium that depository institutions have to pay when they compete for deposits. …