The concept of directing behavior through the use of reward and punishment is as old as the proverbial "carrot and stick."

This notion; however, has not been fully developed in the field of bank regulation. While it is true that punishing bad performers always has been a standard bank regulatory practice, until recently there was little gradation in the treatment of banks that perform differently, and there really were no incentives for good performers.

This historic approach to bank regulation was fundamentally altered when Congress enacted the Federal Deposit Insurance Corp. Improvement Act of 1991, or FDICIA, which added several new tools to the bank regulatory arsenal to deter bad performance.

Most familiar is the "prompt corrective" action, which empowered the federal bank regulators to impose increasingly severe constraints on banks as capital decreased.

The harshness of the provisions allowed the seeds of incentive- based regulation to take root. That is, by installing such severe regulatory measures, Congress reduced the risks within the banking industry, strengthened its performance, and emboldened the regulators to experiment with the new concept of incentive-based regulation.

For example, the Federal Reserve Board is considering changes to Regulation Y that would streamline bank and nonbank application procedures for bank holding companies that are "well-managed and well-capitalized." Similarly, the Office of the Comptroller of the Currency has proposed streamlined application procedures for well-managed national banks. Both of these proposals are strongly supported by the banking industry and likely to be adopted before yearend.

Attention recently has been focused on the incentive-based approach to bank regulation by the Bank Administration Institute. A BAI study titled, "Building Better Banks: The Case For Performance-Based Regulation," advocates reduced oversight and regulatory burdens for well-managed and well-capitalized banks. In place of detailed regulation, regulators would make greater use of on-line risk reporting, market disclosures and feedback, and banks' own internal control mechanisms.

Institution of performance-based regulation would materially benefit all affected:

* For good performing banks, implementation of the plan would reduce superfluous and outmoded bank regulations

* For less-than-good performing banks, the plan provides an incentive for managers to improve their standards

* For bank shareholders, other investors, and depositors, the proposal would enhance the value of their investment or return

* For regulators, the plan would promote stronger banking organizations by managers who have tangible incentives to manage prudently.

The concept of incentive-based regulation undoubtedly will be perfected as it is more thoroughly studied. For example, a uniform and widely accepted definition of terms of such as "well-managed" and "well- capitalized" must be agreed upon. Similarly, the parameters of "good performance" must be established. Further, consideration should be given to applying the concept of differential treatment to all regulatory regimes, and even to the supervisory process. For example, certain examinations now performed on highly rated institutions could be eliminated, scheduled less frequently, or replaced with more disclosure, written reports, or even self-certification.

Not only should the banking industry and its regulators be working to develop this new approach to regulation, but so should the Congress. Parts of the regulatory burden relief section of the thrift insurance fund rescue, enacted Sept. 30, would streamline the process of acquiring bank and nonbank firms for well-capitalized and well-managed banks and eliminate the requirement for approval of investments in bank premises for well capitalized and well managed banks.

After the November elections, Congress will begin its homework in preparation for the 105th Congress. Given the leadership role that Congress should take, as well as the potential benefits of "incentive-based" regulation, it would be prudent for Congress to undertake a serious review of this new approach to bank regulation. The country as a whole would benefit from it.

Mr. Whiting is general counsel and senior director for regulatory affairs at the Bankers Roundtable in Washington.

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