Coinsurance Plan Puts First Things First

Mr. Stern, president of the Federal Reserve Bank of Minnesota, spoke about banking reform at a conference sponsored by the Rutgers University Graduate School of Management on June 27. The following is an edited excerpt of his remarks.

I do not see reform of the bank regulatory agencies as one of the truly critical public policy issues of the day.

Rather than try to prejudge or project an effective, politically acceptable regulatory structure, it seems far more sensible to address first the more substantive aspects of banking reform and then establish a regulatory structure appropriate to the new shape of the financial industry.

New Powers for Banks

The Treasury essentially proposes full nationwide banking and branching, a position with which I agree. It promises a wider range of institutional choices as well as terms and conditions on deposits, loans, and other services, and therefore is to be welcomed - indeed, promoted.

Viewed narrowly, so-called powers expansion - into equity underwriting and other securities activities now constrained, full-service insurance activities, and mutual funds - is constructive, although I strongly suspect there will be fewer new entrants and less activity by banks in these areas than expected.

As to [mixing] commerce and banking, I must admit to some lingering caution and unease. What principally concerns me is preservation of the independence and integrity of credit decisions.

Further, it seems to me that profitable banking organizations will attract capital and unprofitable ones will not, irrespective of rules governing banking and commerce.

How Reform Proposals Fall Short

I will not dwell on details of the various reform proposals except to say that in general there is an attempt to limit deposit insurance coverage, price it on the basis of risk factors, strengthen bank capital, and intervene promptly if and as capital deteriorates.

This is inadequate on two levels.

First, the proposed deposit insurance reforms do not address the fundamental flaw in the system - the moral hazard problem. Risk-taking in banking is underpriced; as a consequence, depositor institutions whose liabilities are insured take on more risk than they should, especially as insurance coverage is virtually without limit. As matters now stand, it is possible for even insolvent institutions to increase their insurance coverage and the size of their operations.

The other level on which many supervisory and regulatory reform proposals are inadequate is in their practical implementation. So far as I know, no one is seriously proposing a return to the capital levels prevailing before federal deposit insurance - although presumably those are roughly the levels required to contain moral hazard.

The Minneapolis Fed's Plan

We at the Federal Reserve Bank of Minneapolis have proposed a form of coinsurance to help straighten out incentives and increased market discipline.

Over the nominal $100,000 insurance limit (in a single insured account in the system per customer), depositors would explicitly be at risk for, say, 10% of their deposits. This would give [large] depositors ample incentive to pay attention to the caliber of the institutions with which they do business.

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