If we didn't have a deposit insurance system today, would we want to develop one? What would we want the system to do? To the extent the current system is at odds with the system we would design for the future, how might we get from here to there without undue turmoil? These questions are on the minds of a lot of bankers.
The direct costs of deposit insurance are significant. The cost of supervising and regulating banks is much higher than it would be if taxpayers weren't perceived to be at risk. Deposit insurance premiums, while minimal today, have been substantial over the years, reaching nearly $6 billion annually in the early 1990s.
An even greater cost is the price sound banks pay when marginal competitors are in the marketplace. During the 1980s hundreds of weak thrifts and banks were able to grow because they had insurance on their deposits. They bid up deposit rates to fund high-risk, underpriced loans, undermining the market for all competitors.
Then there is the political price the industry pays for deposit insurance. Whenever banks seek broader competitive freedoms or a reduction in their regulatory burdens, they're reminded by politicians of their deposit insurance "subsidy." The initiative to tax banks to recapitalize the savings and loan insurance fund is a striking example of the political cost of the deposit insurance system.
The costs of the deposit insurance system, as steep as they are, would be tolerable if bankers could identify offsetting benefits. Unfortunately, it's becoming clear the public no longer places much value on deposit insurance.
Bank customers, particularly younger ones, have been voting with their wallets. In less than 20 years mutual funds and money market funds have grown from virtually nil to exceed the total deposits in U.S. banks.
Originally conceived as a program to protect the savings of small depositors, the deposit insurance system has evolved into a program to stabilize the banking system. It has in reality had the opposite effect.
The insurance limit was increased, in a series of steps, from $2,500 to $100,000. Worse yet, the government began arranging mergers for failing thrifts and banks, thereby protecting all creditors against loss.
As private sector exposure to loss decreased, risk taking in insured institutions increased. The $150 billion loss taxpayers suffered in the thrift industry wouldn't have been remotely possible if private sector discipline had been allowed to operate.
As the scope of the deposit insurance system expanded and the losses escalated, the government tightened regulation. The result is that insured depository institutions are being regulated into obscurity. Twenty years ago the banking industry held 45% of the financial sector assets in the United States. That figure stands at 22% today.
Huge financial conglomerates operating without deposit insurance and with little regulation are becoming ever more dominant. Neither the banking system nor the public is protected when banks are rendered ineffective in the marketplace.
Deposit insurance reform proposals advanced by various academics in recent years have gotten nowhere. A major difficulty has been that the proposals have been far too complex and untenable politically.
What's needed is a reform effort led by bankers. They know better than anyone how changes in the system will affect banks and their customers. Moreover, they bear the burden of paying the costs of whatever system is in place.
The timing is right for reform. The banking system is strongly capitalized, earnings are excellent, and problem banks are almost nonexistent.
There's a growing awareness among bankers that the benefits of the current system of deposit insurance are shrinking almost daily and the costs are excessive. The system should be changed before it does any more damage to banks and the public.
Mr. Isaac, former chairman of the Federal Deposit Insurance Corp., is chairman and chief executive of Secura Group, a financial institutions consulting firm based in Washington, D.C.
