Deposit insurance reform remains controversial. One need look no further than the Sept. 2 issue of American Banker ("Pare 'Too Big to Fail' Policy, Minneapolis Fed Chief Suggests") to find examples of the emotion the topic evokes.
The article reported on a draft paper on deposit insurance reform by Gary Stern, president of the Federal Reserve Bank of Minneapolis. Mr. Stern is one of several bright and thoughtful leaders in the Federal Reserve banks. He believes the marketplace should be involved to a greater extent in regulating financial institutions.
Mr. Stern's paper reportedly proposes to eliminate the de facto government guarantee of all liabilities in large banks. He would prohibit the Federal Deposit Insurance Corp. from invoking its "too big to fail" doctrine.
I haven't seen Mr. Stern's paper, but I'm sure it's intelligent, provocative, and worthy of serious debate. Regrettably, it provoked instantaneous, thoughtless rejection from various sources interviewed by the reporter.
The leader of a bank trade group was quoted as saying, "This is an irresponsible recommendation. This is a tactic to undermine the core deposit base of community banks (because depositors would flee to large banks, which are perceived to be safer)."
My experience with Gary Stern is that he wouldn't consider making an "irresponsible" public policy recommendation. Moreover, the notion that eliminating the "too big to fail" doctrine would somehow cause depositors to feel more warm and fuzzy about the safety of their funds in large banks is silly.
A banker was quoted as saying:
"They are changing a system that has basically worked since the Great Depression. If it's not broke, don't fix it. Not even the regulators have had a very good record of predicting which banks are going to fail and which ones won't. The unsophisticated depositor is not capable of making that decision."
The only reason the deposit insurance system isn't broke today is that banks, thrifts, and taxpayers coughed up more than $200 billion during the past 10 years to keep it from collapsing. The losses were senselessly large because deposit insurance allowed problems to be ignored until the system was drowning in a sea of red ink.
It's true that the regulators can't predict failures with precision. That's why Mr. Stern and others are trying to enlist the support of sophisticated creditors in monitoring banks. I know of no serious proposal to impose losses on small depositors.
The American Banker article also referred to a proposal by the Bankers Roundtable in May to abolish the "too big to fail" doctrine and implement "other drastic deposit insurance reforms".
The Bankers Roundtable's membership consists of roughly the 125 largest banks in the country-not a group noted for its radicalism. I was an adviser to the Roundtable's deposit insurance reform task force and am intimately familiar with its proposals, none of which is "drastic."
Federal deposit insurance was opposed in the 1930s by none other than President Roosevelt. He said he believed the system would be unduly expensive to taxpayers and would undermine strong banks by forcing them to subsidize their weaker competitors.
A compromise was reached to implement a limited protection plan-$2,500 per depositor. The potential "moral hazard" stemming from deposit insurance was recognized. Therefore the plan was accompanied by restraints on entry into the business and expansion, controls on deposit interest rates, and limitations on permissible activities.
Some 60 years later we have expanded the deposit insurance system almost beyond recognition. Moreover, we are in the process of eliminating virtually all restraints on competitive behavior. Eliminating these restrictions is essential, but the moral hazard will grow exponentially if we don't also address the deposit insurance system.
The reform proposals offered by the Federal Reserve Bank of Minneapolis and the Bankers Roundtable deserve serious consideration. It would be both drastic and irresponsible to dismiss them.
