Nestled in the massive budget reconciliation that lawmakers are hammering out this week is a provision that could cut off credit to weak banks.

The national depositor preference measure would put insured and uninsured depositors, along with the Federal Deposit Insurance Corp., ahead of all nondeposit creditors when a bank fails.

Banks with less-than-solid capital levels would find it harder to float debt, borrow federal funds from other banks, lease computers, or rent space.

Right now, insured depositor get paid back first. Then the FDIC and uninsured depositors share equally what's left with the other creditors.

"This will be an additional disadvantage to weak banks. Period No question about it," said Bob Harris, president of the Texas Bankers Association.

Ticket of Regulation

Congress has been piling regulations on troubled banks for years. The 1991 banking law spawned regulations that:

* Take away weak banks' ability to buy brokered deposits.

* Limit discount-window borrowings from the Federal Reserve.

* Require the weakest banks to pay the the most for deposit insurance.

* Impose increasingly severe sanctions against banks as their capital falls. Once capital falls to 2% of equity, regulators are required to seize banks.

Even banks experiencing temporary problems could be hurt by the new law, according to James Sexton, a partner with Bracewell & Patterson, a law firm in Austin, Tex.

|In Last Place'

"Say you're a fed funds supplier and you see that a bank lost a fair amount of money last quarter. You are going to be gone and that bank is going to be dealing with the Fed," Mr. Sexton said.

"The fed funds suppliers are going to know they are in last place if anything happens to that bank."

Karen Shaw, president of the Institute for Strategy Development, predicted that some banks could be shut out of the derivatives market because no one will want to be on the other side of the transaction. "By putting creditors of banks at a greater disadvantage than creditors of nonbanks, the government's stake in insured institutions will necessarily increase," she said.

"This is counterproductive to the long-term goal of both reducing the government's involvement in the banking system and making that system more competitive."

The measure could lead the ratings agencies to downgrade some institutions or lower the ratings of their nondeposit obligations such as letters of credit and bank notes.

|Actively Watching'

"It's something that we are actively watching," said Bob Swanton, a director in the financial institutions group at Standard & Poor's. "Until we see how they are really going to apply this, it's tough to say how we're going to come out."

Christopher Mahoney, a vice president at Moody's Investors Service Inc., said his company agency will put out a statement on the new provision this week.

"The question we have to ask ourselves is: Would it affect nondeposit obligations?" he said.

Depositor preference is becoming law mainly because it is seen as the lesser of two evils.

The Clinton administration wanted the FDIC to raise money by charging for its exams. The depositor preference provision was agreed to as a tradeoff.

Savings Seen for FDIC

The Congressional Budget Office estimates that the FDIC would save $750 million over five years as a result of the preference provision.

Paul Fritts, the FDIC's executive director of supervision and resolutions, said the agency supports the measure.

"One of two ways, it's going to save us money," Mr. Fritts said.

First, if a bank fails, the FDIC is going to recoup more money - because it gets paid before other creditors.

Second, Mr. Fritts predicted, nondeposit creditors are going to avoid the risk and convert their funds to deposits. The bank will then have to pay insurance premiums on more deposits.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.