And a McKinsey Expert, Breaking Ranks, Agrees

The "core banking" proposal, championed by Rep. Charles Schumer, D-N.Y., proceeds from the premise that banks fail as a consequence of bidding up interest rates paid on insured deposits and then using these funds to make risky loans.

Core banking proponents also argue that banks get into trouble by making larger rather than smaller loans.

Hence the Schumer bill would restrict interest on all deposits -- not just insured ones -- to 105% of comparable Treasury bill rates and would reduce the lending limit to one borrower from 15% to 3% of a bank's capital.

The Schumer bill would have three direct consequences:

* It would reduce banks' ability to attract insured deposits.

* It would severely limit their ability to gather uninsured deposits.

* And it would force banks to abandon large corporate and real estate loans.

Consequently, it would jeopardize the nation's credit creation process, exposing the economy to the risk of a major credit crunch.

The core banking bill won't create safe banks. Hundreds of the commercial banks that failed in Texas, Oklahoma, and in the New England region due to credit losses had asset characteristics similar to a "core" bank.

Nor could a core bank be safe from disintermediation risk.

Over the past five years, depending on how the proposed deposit rate limits are defined, healthy banks on average have had to pay more than the proposed rate limit as often as 40% of the time for six-month deposits, 70% of the time for one-year deposits, and even more frequently for the uninsured funds that are proposed to be included.

Adverse Effect on Credit

In several respects, core banking would almost certainly raise the cost and restrict the availability of loans to corporations and real estate. Proponents of core banking have estimated that it would force at least $650 billion of these loans to leave the banking system and migrate to new, uninsured entities.

But since a shift of this magnitude would require funding equivalent to over a third of the U.S. money market, the continued availability of credit could not be assured.

A particular concern should be raised about the impact on commercial paper, virtually all of which is supported by backup lines of bank credit.

Commercial paper would presumably have less acceptance if backed by entities that fund themselves largely in the same market.

To the extent funding could be obtained, depositors would require higher rates than they require from banks, which have more diversified assets and lower liquidity risk.

High Cost of Loans

Since the higher funding cost would be reflected in higher lending rates for borrowers, the consequences presumably would include prolonging the current real estate depression in many areas.

And by restricting U.S. banks' ability to meet the large credit needs of global companies, core banking would essentially cripple these banks in their roles as participants in the international financial arena.

As for the assertion that commercial banks bid up rates for insured deposits and then use the funds to make risky loans, banks' reliance on insured funds actually decreased from 56% of loans to 52.5% of loans over the past decade. In fact, banks with a high reliance on insured deposits tend to have fewer credit problems than banks that rely less on these deposits.

A case in point is the Bank of New England. In the years before discovery of serious loan problems, its uninsured deposits increased at only one-fifth the rate of its loan portfolio -- and it had been bidding below the regional market for interest rates.

This same pattern of decreasing reliance on insured deposits can be observed at other so-called troubled banks.

No Point to Lending Limit

As for reducing a bank's lending limit to one borrower from 15% to 3% of total capital, the fact is troubled loan portfolios usually are caused by hundreds of bad loans each below 3% of capital.

Core banking would present risks to the country's credit creation process and would not accomplish the objective of a safer banking system.

Mr. Roger Kline is a director of New York-based McKinsey & Co., a management consulting firm, and heads its banking and securities practice.

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