Bank Reform Must Address Flaws of Deposit Insurance

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. Loan rates may therefore not reflect adequately the risk associated with particular loans."

"Too many economic resources," Mr. Black says, "are being drawn to relatively high-risk ventures and away from lower-yielding but economically more defensible projects. The apparent excess supply of office buildings and condominiums in many parts of the country currently suggests that there may have been a significant misallocation of capital in the United States over the last decade. Deposit insurance may have contributed to this misallocation."

Meaningful bank reform must include deposit insurance. As it stands, federal deposit insurance resembles fire insurance that pays off in cases of arson by the insured. The debacle in the savings and loan industry illustrates what can happen if financial institutions are allowed to lend freely while depositors are fully insured.

Warren Oskey, chairman of the First National Bank of Glenwood City, Wis., is outraged to see banks and thrifts lumped together in the banking crisis. "All along," Mr. Oskey said in a recent letter, "banks have operated under different statutes and have been regulated by different governmental agencies. Our regulators have generally kept in close contact, whereas [thrift] regulators were long absent from examining many of their institutions."

Friendly regulators did indeed play a key role in allowing the savings and loan problem to snowball out of control. Happily, federal authorities have largely avoided repeating this mistake in dealing with commercial banks. Nonetheless, the underlying economic principles are identical.

Despite all kinds of restrictions on loans and securities, the present system of federal deposit insurance encourages bankers not only to lend money to marginal borrowers, but then to charge too little interest on such loans.

Let's hope that members of Congress have the wisdom and the courage to deal with the causes, rather than just the symptoms, of the banking crisis. If Congress does not go to the root of today's bank troubles, these will simply be a prelude to a more damaging future debacle.