Core Banking: The Wrong Rx
A doctor treats a patient who on occasion suffers seizures.
The doctor prescribes the drug Nomoseiz, only to discover that it makes the patient violent. Rather than reducing the dosage of Nomoseiz, or trying a different elixir, the doctor commits the patient to a padded cell - to prevent him from hurting himself or others.
Sound preposterous? You bet. But that's precisely the course of treatment urged by proponents of the "core bank" concept narrowly rejected by the House Banking Committee.
The core-bank proponents correctly note that the current problems in the banking industry are due, in large part, to the overly broad coverage of the deposit insurance system. This has enabled marginal banks and thrifts to attract a disproportionate share of the nation's deposits and dump them into bad loans.
Facing Solitary Confinement
Rather than reducing the dosage of the drug - deposit insurance - these doctors would attempt to keep the industry from hurting itself and others by placing it in the equivalent of a padded cell: reinstituting deposit interest rate controls and dictating the terms and conditions of loans the industry could make.
Though the core-banking concept has been around for months, it received scant attention until a few weeks ago when one of the more able and powerful members of the House Banking Committee - Rep. Charles Schumer, D-N.Y. - indicated that the idea appealed to him. Not wanting to offend Mr. Schumer, whose support will be important for any reform bill, other members of the Committee began to profess interest in the idea.
I was one of those caught off guard by this development. It never occurred to me that an idea so radical, the implications of which had been given so little thought, would be taken seriously on the Hill.
The idea has an appealingly simple ring to it. We made a huge mistake in deregulating deposit interest rates in the early 1980s without reforming the deposit insurance system.
The |Core' of the Problem
It would be impractical, so the argument goes, to address the deposit insurance issue at this stage, so let's reregulate depository institutions: Ergo, the "core" bank.
If banks should wish to pay market rates of interest for their funding or to engage in activities, including traditional commercial lending, that we deem to be high risk, they would be required to establish "wholesale" bank affiliates. These affiliates would have access to the payments system through membership in the Federal Reserve but would not be eligible for deposit insurance.
We eliminated deposit interest rate controls in the early 1980s because they were distorting the markets. Depositors were being asked to forego a market rate of return on their funds. To the extent that they were willing to do so, they subsidized borrowers; to the extent that they were unwilling to do so, they disintermediated the banking system.
Moreover, by restricting price competition for deposits, the rate controls led to excessive staffing, overinvestment in bricks and mortar, and underpricing of services.
While the transition to a deregulated rate environment has been painful for many banks, most have adjusted by lowering overhead and repricing their loans and services. As a result, they have become more viable competitors in the financial marketplace.
Now, the core-bank proponents would undo all of the progress that's been made. They would once again regulate depository institutions to the level of the lowest common denominator.
The core-bank proponents argue that, this time around, the interest rate controls would have a less pernicious effect because they would float with Treasury rates. That doesn't wash: If the spread between the Treasury rate and the bank rate were narrow enough to have any binding effect, it would necessarily have the same adverse consequences as the old fixed-rate controls.
Indeed, even the author of the core-bank proposal estimates that it would cause banks to lose 25% of their business. That's a sobering prospect for a nation already suffering through a credit crunch.
Picking Winners and Losers
The winners would probably include a handful of large banks that would be able to escape deposit insurance assessments by transferring much of their business to their wholesale bank affiliates.
Wall Street firms and various other nonbanking companies would probably be winners as they would gain access to the payments system through their wholesale bank affiliates. And they would be aided in their drive to swipe the banking industry's best commercial customers.
Clearly, savers and most banks would be losers. Ultimately, the biggest loser would probably be the taxpayer.
Moreover, although - or perhaps because - wholesale banks would be outside the deposit insurance system, there's little doubt the government would be called upon for a bailout if a large wholesale bank were to find itself on the brink.
The treatment for the banking industry's current trauma is clear: Reduce the level of deposit insurance by applying a 10% or so "haircut" to interest-bearing deposit balances above the $100,000 insurance limit - anytime a bank of any size requires federal financial assistance. Enact the legislation with a delayed effective date, to give banks and their customers an opportunity to adjust.
The haircut plan is not a new idea. It was recommended by the Federal Deposit Insurance Corp. in 1983 and was unanimously endorsed by the Bush Task Group in 1984. It would represent a modest step in the right direction.
What we don't need at this perilous time in the history of banking is to rush headlong into a radical restructuring of the industry without understanding the consequences. Let's hope the House Banking Committee's rejection of the core-bank concept will put this ill-conceived idea to rest once and for all.
Mr. Isaac, a former chairman of the Federal Deposit Insurance Corp., is managing director and chief executive of the Secura Group, a Washington-based financial services consulting firm.
