Richard L. Thomas, chairman of First Chicago Corp., last month addressed a conference sponsored by the Federal Reserve Bank of Chicago about the effects of the Federal Deposit Insurance Corporation Improvement Act of 1991 on banks. His remarks are excerpted here.

The practical effect of FDICIA is to limit the latitude of the regulators and to micromanage the banks. We should not forget that there are costs associated with such increased regulation. They may be marginal with each new regulation or each new supervisory action, but their effect is cumulative and real over time.

The cost of FDICIA add to other legal and regulatory costs mandated by the Financial Institutions Reform, Recovery, and Enforcement Act, the Community Reinvestment Act, and other ligislation.

In sum, rising regulatory and supervisory costs have impeded the ability of banks to make credit available to their customers on a cost-effective basis.

[New] and less regulated competitors have exploited holes or inconsistencies in the regulatory system and have captured an increasing share of traditional bank markets.

A new deposit-taking system has grown up, provided by less regulated, and therefore lower-cost, competitors, and I am not sure that the consequences of this development have been truly appreciated by the Congress or the depositors themselves.

Within the context of the market developments that flow from holes in regulations, allows me a short digression.

Credit the Yield Curve

The recent improvement in banking industry earnings has frequently been cited -- at times in panel discussion of FDICIA -- as evidence against the argument that the antiquated U.S. regulatory system has been progressively squeezing commercial bank revenues.

That argument is wrong.... The rebound in profits is actually very closely tied to unusual conditions in financial markets: most notably, the steep yield curve and wide spreads between the cost of funds and bank interest rates.

Those market conditions are temporary and, therefore, will only temporarily mask the systemic erosion of bank profitability that stems, from the the inherent weakness in the regulatory system that I described earlier.

Look at the Big Picture

Let me now turn to solutions to the broad public policy problem of commercial banking.... I propose that we all step back and look at the problem as a whole, including the legitimate concerns of all the participants in the regulatory debate [the banks, Congress, the regulators, and the White House].. A broader approach to the problem can be the basis for a new compact among the contesting parties..

My proposed compact would rest on three principles:

First, satisfactory performance of the U.S. economy requires an efficient commercial banking industry. An inefficient industry heavily penalizes the most dynamic sectors of the economy: small and midsize business.

Avoiding Another Bailout

Second, taxpayers should never again be required to bail out a deposit insurance system. Three regulatory principles would serve to provide them protection:

(1) Deposit insurance should be further limited, especially in eliminating or restricting to extreme cases the "too big to fail" concept. This would reintroduce depositor discipline into the system.

(2) Bank leverage should be limited... and early intervention (and least-cost, flexible resolution mandated when capital ratios fall below a critical point..

(3) The deposit insurance fund should be wholly financed by the industry on a fee schedule linked to the credit quality of individual banks.

Abolishing |Too Big to Fail'

Significantly, the most important provisions of FDICIA would be part of the new compact: Those that do away with the concept of "too big to fail," and those that gear to capital strength the rewards and punishment inherent in the regulation.

Equally significantly, additional regulation -- including the provisions of FDICIA that focus on micromanagement of banks -- would be recognize as unnecessary to protect taxpayers. An example is the provision to have another layer of auditors audit the auditors who audit the auditors..

Doing away with unnecessary micromanagement of banking leads to the third and final principle of the new compact, which is that commercial banks must be given a new regulatory framework in order to perform their role in the economy and the deposit insurance system

The sine qua non of the new compact -- and an effective solution to banking problems in general -- is a comprehensive overhaul of Depression-era regulatory framework.

An example of actions to rationalize the existing regulatory burden is the payment of interest on required reserves. Failure to pay interest on sterile reserve balances reduced bank earnings by $1.6 billion in 1991.

In effect, it was a special tax of 8% on bank profits that year. The interest on these industry-owned funds could in fact be use to further bolster the Bank Insurance Fund.

Now, before closing, since the title of the conference is: "- FDICIA: An Appraisal," I probably should provide a brief appraisal. Here it is: FDICIA is badly flawed legislation.

The most important problem of FDICIA from a public policy perspective is not the usual list of bankers' complaints -- the mandates and prohibitions that raise industry costs, limit managerial flexibility, and penalize bank customers, which further erode the industry's capacity to compete in a rapidly changing market environment.

Don't get me wrong. The effort to micromanage banks via the regulatory and supervisory process that is implicit in FDICIA has generated and will continue to generate significant problems that ought to be corrected.

No Attempt to Modernize

From a public policy perspective, however, the most important problem is that the legislative effort to protect the taxpayer from failures in deposit insurance funds was not part of a comprehensive effort to modernize the antiquated system of bank regulation.

There is no problem with the desire to protect taxpayers from deposit insurance fund failures. That goal is important and is part of my proposed compact.

Rather, the problem is that the corrective actions embodied in FDICIA are excessive and self-defeating and, most important, were not enacted as part of a comprehensive reform of bank regulation that would permit banks to adjust to their changing market environment.

It is not too late. I recommend that the President, in consultation with congressional leaders, establish a blue ribbon commission to formulate a regulatory framework for banking that would result in a healthy and modern banking system.

Of course, Congress would have to be prepared to act on such a commission's recommendations, but such a commission could be the vehicle needed to get "all of us" to the table, that is, to put into reality the concept I have formulated today for a new compact on banking regulation, a compact that would recognized the communality of our legitimate interests, and allow us to work together to produce the broad reforms necessary to engender an efficient, healthy banking industry.

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