Bush's Banking Reform Proposals Are Too Timid

THE most critical post-Gulf-war item on the domestic agenda of the Bush administration should be the need to rejuvenate the United States financial system. Like Humpty Dumpty, banks and thrifts have fallen off the wall. Time will tell whether Washington can put them back together again. The public will soon discover that fixing the banks will be as crucial as finding lasting peace in the Middle East.

Make no mistake, the US financial system is in crisis. Banks and savings and loan associations are failing at rates not seen since the Depression. The federal Bank Insurance Fund, which backs bank deposits, may well follow the Federal Savings and Loan Insurance Corporation into insolvency.

Private financial institutions have been losing money since mid-1989. On average during the 1980s, the finance sector earned a paltry 0.8 percent per year on investment. These substandard rates of return combined with a misbegotten system of federal deposit insurance to encourage bankers to "gamble for resurrection." If such bets paid off, bankers would be heroes; if they did not, taxpayers would pick up the tab.

Last month, the Treasury Department proposed a three-pronged attack on the financial crisis:

1. A broad reshuffle of federal financial regulatory agencies designed to create a structure that would force bureaucrats to focus on the causes of the crisis.

2. Overhaul of the federal deposit insurance system to remove perverse incentives for bankers to gamble with depositors' money.

3. A substantial broadening of the permissible ownership and activities of banks to open the door for fresh infusions of capital and create new opportunities for profit.

The Treasury's proposal was long overdue. Sadly, it represented timid steps that will not deal adequately with the crisis.

Even the Treasury's cautious program may be too much for Congress to swallow. Republicans and Democrats are busy trying to duck responsibility for the S&L debacle. Banks, S&Ls, insurers, investment firms, and regulators are battling to hold traditional turf.

On the key question of when to close a failing bank, the Treasury would replace mandatory rules with discretion. As the "Keating Five" showed, that may open the door to political manipulation.

While Capitol Hill is still far from a consensus on financial reform, lines of opposition are forming. For example, the other day Charles Bowsher, head of the General Accounting Office, rejected most of the key Treasury provisions.

Mr. Bowsher urged Congress to move slowly in changing the system of federal deposit insurance. He argued that depositors are already worried about the banks. A significant shift in the deposit insurance rules, he said, might result in "major bank runs," which in turn could trigger further crises in a banking system that even now is "on fairly thin ice."

Instead, Bowsher said Congress should focus narrowly on pumping fresh cash into the Bank Insurance Fund and, second, on tightening an extensive list of regulatory provisions.

In effect, Bowsher would punish banks for their misdeeds by blocking expansion into potentially lucrative areas.

Unfortunately, micromanaging the finance sector will not make the red ink disappear. Limits on interstate banking increase banking risk and cut profits by limiting the opportunity to diversify.

Any meaningful reform clearly must include deposit insurance. Experience with the thrift industry demonstrates what can happen when financial institutions are allowed to choose assets without restriction while depositors are fully insured.

Federal deposit insurance can no longer resemble fire insurance that pays off in cases of arson by the insured.

Regulation, plainly, is no substitute for profit. Lending institutions must have the opportunity to earn a fair return. If they cannot, then the crisis will simply drag on. The time to act is now.