And Four Reforms that We Need, but Won't Get

Banking's inadequate profitability is caused by three structural problems in the industry: overcapacity, commodity-deposit products, and mandated subsidies to noncustomers.

Simply put, there are too many banks, thrifts, and credit unions that are opening branches and bidding against one another for deposits.

As they do, they compete with undifferentiated products because the deposits of all federally insured banks are covered 100% up to $100,000, regardless of the strength of the bank.

Overcapacity and commodity products mean narrow margins, yet by law or custom banks must do many things for free, including cashing payroll, welfare, and Social Security checks for noncustomers. In some branches, 40% of transactions are for noncustomers.

Promoting Risk-Taking

To compensate for these structural problems, banks have engaged in ever riskier activities. The results have been credit losses, industry losses, and a depletion of federal-deposit insurance funds.

To reverse this downward industry spiral, the goal of bank regulatory reform should be to encourage banks to operate more conservatively and to reward them for doing so.

Four measures would accomplish that goal.

First, eliminate all barriers to industry consolidation.

The barriers include geographical restrictions, deposit-insurance entry and exit penalties, recapture of bad-debt reserve deductions in the purchase of thrifts, and narrow definitions of market in antitrust calculations.

The geographical restrictions include the McFadden Act, the Douglas Amendment to the Bank Holdings Company Act, and regional banking compacts. They should be repealed, thus allowing national banks to branch nationwide, bank holding companies to buy banks in any state, and banks to acquire other banks nationwide.

Addressing Overcapacity

In recent years, the various regulatory agencies have been liberal interpreting guidelines regarding the antitrust implications of a bank's market share.

They should be even more liberal, defining market as any state in which an institution has a deposit-gathering office and including as competitors all federally insured banks, thrifts, and credit unions plus a percapita share of retail money-market mutual funds nationwide. The goal is to eliminate industry overcapacity.

Second, insure 90% of deposits, leaving 10% of everyone's balance exposed.

A system of 100% coverage allows yield-chasing depositors and risk-taking banks to contract for above-market deposit rates at no risk to them but at substantial cost to the deposit-insurance fund and the taxpayer.

Given these disadvantages, a system of less-than-100% coverage is preferable. Most depositors will accept such as system as long as their exposure is minimal and certain and their money is accessible.

Capital Requirements

Third, eliminate the leverage ratio from bank capital requirements.

The conservatively run bank also should be rewarded with lower capital requirements. The risk-based capital guidelines of the Basle agreements do just that. For example, a bank with all home mortgages could have half the capital and twice the leverage of a bank with all commercial loans.

Fourth, allow banks to charge noncustomers for their services.

Historically, many banks have performed many services for free, including cashing payroll, welfare, and social security checks and distributing food stamps and bus tokens. Under Regulation Q, borrowers and depositors subsidized these free services.

Now, however, with the elimination of most Regulation Q deposit-rate restrictions, borrowers and depositors no longer subsidized noncustomers. Yet as many banks have to charge noncustomers for formerly free services, they have faced legal, regulatory, and political restraints.

Congress must ask depositors and noncustomers to pay for a stronger banking system, something Congress will be reluctant to do. Yet a failure to do so will mean that banking's structural problems will persist and Congress ultimately will have to ask taxpayers to replenish the deposit insurance fund.

Mr. McConaghy is a general-management consultant specializing in retail-oriented banks and thrifts. He is based in Pawtucket, R.I.

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