Federal Deposit Insurance Corp. Chairman Ricki Helfer recently criticized a proposal developed for the Bank Administration Institute by McKinsey & Co. to privatize deposit insurance.

While the chairman made a good argument for government rather than private-sector operation of the existing deposit insurance system, I believe the wrong question is being debated.

Chairman Helfer noted the "moral hazard" presented by deposit insurance. When a depositor is protected against loss, he or she has little reason to care about the bank's riskiness.

The government attempts to mitigate this hazard by supervising banks, setting capital standards, adopting risk-based premiums, and limiting the banks' activities. Ms. Helfer believes the same deposit insurance system operated by the private sector would entail the same hazard. Moreover, a private system would impose similar rules and supervision on banks to limit its losses.

Would we rather, she asks, that the federal government supervise and regulate banks or a private organization established by the banks? In my view this isn't the right question. The critical issue isn't who should operate the deposit insurance system but what the system should do.

When a federal depositor protection plan was proposed in the early 1930s, it was opposed by both President Roosevelt and the American Bankers Association. They believed the system would subsidize marginal banks and be excessively expensive.

The ABA argued for a private-sector solution to the banking crisis. It believed the government should authorize interstate branch banking to enable stronger banks to acquire weaker ones and diversify.

The proponents of a government solution prevailed. A limited depositor protection plan, covering only $2,500 per depositor, was enacted.

The deposit insurance scheme was accompanied by a host of laws limiting competition in banking. Deposit interest rates were set by the government, entry into the business was limited, and expansion by banks was tightly controlled.

A lot has changed since then. The deposit insurance limit has been increased to $100,000. Worse yet, the FDIC developed the technique of merging failed banks into other banks, protecting all depositors against any loss.

While the scope of deposit insurance was mushrooming, the laws controlling competition were being circumvented and eventually dismantled. So now we have the worst of all worlds: a significantly deregulated financial system accompanied by a pervasive deposit insurance system.

The risks in such a system are enormous. Witness the $150 billion taxpayers lost in the S&L crisis and the tens of billions of dollars banks lost in their recent crisis.

The government has tried to lessen the risks by heaping massive amounts of additional supervisory burdens on the banks. This is destined to fail.

First, it's far too costly and is driving consumers out of the banking system into less regulated financial institutions. Second, the modern financial world is far too complex and fast-paced for any regulator to understand completely and control.

What's needed is more private-sector discipline. This will come about once the scope of depositor protection is curtailed sharply, including abandonment of the "too big to fail" doctrine. Millions of organizations and sophisticated individuals must be given the incentive to understand, monitor, and control the risks in the financial system.

Once we decide what the deposit insurance system will do, we will be able to decide who should operate it. Depending on the reforms, it might be privatized - at least to the extent of repealing the "full faith and credit" pledge the federal government made in the 1980s and replacing the FDIC's $30 billion Treasury line with a line of credit from the banking industry.

I close with a couple of questions of my own. If we don't significantly reform the deposit insurance system now, when the banking industry is strong, when will we? How much more damage will we inflict on banks, their customers, and taxpayers before we act?

Mr. Isaac, former chairman of the Federal Deposit Insurance Corp., is chairman and CEO of Secura Group, Washington.

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