Thomas M. Hoenig, president of the Federal Reserve Bank of Kansas City, recently gave a very thoughtful talk on financial regulation at the World Economic Forum.

Mr. Hoenig said that the principal goal of financial regulation is to promote financial market stability. The concern is that a large failure, in an interdependent financial world, will cause other failures and lead to a financial panic.

The federal deposit insurance system was established to alleviate the possibility of panics. It has worked. The depositing public remained calm throughout the enormous banking and S&L problems in the 1980s and early 1990s.

The downside of providing a safety net for depositors is that it diminishes market discipline. Taxpayers, as we learned in the S&L crisis, may ultimately be put at risk.

The diminution of marketplace discipline has led to an increasingly intrusive system of regulation. Mr. Hoenig suggests that the costs associated with our current system of bank regulation are excessive. Moreover, he questions whether the system can do the job it is intended to do in the modern world of finance.

The financial markets have experienced substantial structural changes, spurred largely by a revolution in technology. Capital markets have grown in importance in credit intermediation. Complex new instruments have been developed to intermediate risks.

Much of the intermediation business has moved from banks to less- regulated firms that are outside the safety net. The financial markets have become global, making it difficult to gather information, much less to regulate the intermediation process.

The risk profiles of larger banks have been altered dramatically. They have substantially more exposure to market and operating risks, which, unlike credit-related losses, can cause problems with immediate negative consequences.

The private sector, notes Mr. Hoenig, has significantly more resources than the regulators to keep pace with the changes in financial markets. Moreover, traditional approaches to regulation, such as capital adequacy rules, simply don't work very well in the new environment.

Mr. Hoenig offers two suggestions for how bank regulation might be improved. First, some of the larger, more complex banks could be cut loose from the federal safety net of deposit insurance and the discount window. These banks would be regulated largely by the marketplace in the same manner as Merrill Lynch is today.

Second, Mr. Hoenig suggests strengthening the limits on interbank exposures to contain the potential ripple effects of a large bank failure. There are some obstacles to Mr. Hoenig's plan. Who will decide which banks to remove? On what basis will the decision be made? What activities will be allowed in "traditional" banks?

There is a relatively expedient way to alleviate these concerns. We could leave the regulation of bank holding companies and their nonbank affiliates to the marketplace. Changes of control of banks would still require regulatory approval, and transactions among banks and their affiliates would still be regulated.

If the regulation of large, complex banks is ineffective and inefficient, those banks would almost certainly transfer their "nontraditional" activities to nonbank affiliates in order to escape intrusive regulation. In short, we would allow the marketplace to determine whether the price of regulating nontraditional activities is worth the cost.

Mr. Isaac, a former chairman of the Federal Deposit Insurance Corp., is chairman and chief executive officer of Secura Group, a financial services consulting firm based in Washington.

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