Community Banks Hit Core Plan

The banking industry thought it had avoided Armageddon in the spring when, after a flurry of activity in support of "core banking," the idea appeared to be dying.

The House Banking Committee voted down the proposal, albeit by only 28 to 23, and the Senate Banking Committee included a relatively innocuous core banking study in its version of banking reform.

But the idea did not die.

Recently, there was new momentum to attach core banking to the House version of banking reform. We have to snuff it out.

Under a narrow, highly restricted system, the reasoning goes, banks would almost never fail, permitting Congress to offer voters complete safety for their savings but almost never forcing the government to make good on its promise to bail out depositors of a failed bank.

Consultant's Proposal

Core banking's most recent incarnation is a proposal by a partner of McKinsey & Co. that was put forward on Capitol Hill by Rep. Charles Schumer, D-N.Y. Their idea is to return banking to its roots by capping interest rates at 105% of the prevailing rate on similar Treasury debt and putting severe new limits on loans to one borrower.

In the past, a few paragraphs of explanation from regulators and economists have served to deep-six core banking. Not this time. It has become, instead, the proposal that will not die.

The fact of the matter is, the core banking proposal could prove disastrous for communities and local economies across the country. It could cause a dramatic decrease in the amount of money available for lending to small business, thus striking at the heart of American economic growth.

There are these areas of concern.

* The proposed cap on interest rates could cause many depositors to withdraw funds from banks and seek higher returns on investments they perceive as similarly safe.

Faced with low interest rates in accounts that are insured versus higher rates offered in other sectors of the financial services industry, consumers are likely to put their money directly into money market funds, mutual funds, and the like, especially those sold by nationwide financial giants that enjoy consumer confidence.

We saw this happen in the late 1970s, when banks' interest rates were last capped. It would be almost certain to happen again.

* This disintermediation would mean a long-term decrease in the amount of money available for lending to small and medium-size business. The proponents of the proposal expect reduction in deposits of $600 million to $800 million.

Who Would Fill the Gap?

True, part of the Schumer proposal involves the emergence of broader, uninsured institutions to fill the business lending gap. That idea has some appeal for industries having a tough time getting loans from today's banks.

But where would these institutions come from? It seems unlikely that consumers would invest their money in local uninsured banks or finance companies they are likely to see as risky. And it is not clear exactly what incentives the financial community would have.

* Core banking would likely result in the perpetuation of the industry's "too big to fail" problem. In a situation in which much of the nation's wealth was tied up in uninsured institutions, the government could well find itself in the position of needing to step in and rescue a large, uninsured financial giant whose failure could affect hundreds of thousands of consumers and businesses.

The Meaning of Banking

The core banking proposal rests on a basic misperception of what banking is all about. Banks are not just about insured deposits. They are about community economies. Proposals that undermine the community banking system strike at the heart of local businesses.

The banking community is confronted this fall with legislation on Capitol Hill that needs drastic change before it is even remotely acceptable. The prospect that still another damaging provision will be attached is disheartening, even unnerving.

Core banking is not merely another bad idea. It has the potential to destroy the industry.

Mr. Mark J. Riedy is president of the National Council of Community Bankers.

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