Deadly Medicine for the Bank Fund

The Federal Deposit Insurance Corp. wants to borrow quite a few billions of dollars from the Federal Reserve and pay the money back from future deposit insurance receipts.

Comptroller General Charles Bowsher says this borrowing will lead to a taxpayer bailout of the Bank Insurance Fund. FDIC Chairman L. William Seidman wisely stays away from the taxpayer bailout issue. He knows that he does not know and cannot know whether it will be necessary.

Congress could, however, make sure that taxpayers will have to bail out the bank fund.

For example, it could, as proposed, enact laws that reduce the future amount of insured deposits and the future riskiness of bank assets.

Cutting into the Base

But by reducing the amount of insured deposits, Congress would reduce the base against which the FDIC can levy premiums.

And by reducing the riskiness of banks' portfolios, Congress would cause banks to shrink. It would also reduce the maximum level at which insurance premiums can be set without exceeding a market rate.

Ironically, these actions will ineluctably reduce the future premiums available to the FDIC.

Thus, it appears that the solutions many sensible people advocate to redress the apparent riskiness of federal deposit insurance will, in practice, force taxpayers to pick up the tab for past mistakes.

But, my economist friends would say, if you continue to permit banks to engage in risky lending with insured funds gathered on the basis of underpriced deposit insurance, you will be throwing the dice to try to recoup what the FDIC lost on the last throw.

That, they might say, is the same as the weak thrift institutions gambling for salvation in the mid-1980s. The strategy is bound to lose - and to increase the cost. Therefore, you should ignore the potential taxpayer cost; it is a cost already incurred.

That free market counsel of despair is hard to deal with. If you throw the dice, you are as likely to lose as to win.

But is it really gambling to continue to give depositors insurance and permit banks to make loans? Why did the FDIC fund do just fine from 1933 to 1976?

Until the government promoted lending to lesser-developed countries, until inflation drove interest rates crazy, until real estate lending went on a binge, the insurance fund was adequate.

Indeed, only a few short years ago, the FDIC regularly rebated a part of its premiums because the fund was big enough and losses were minimal.

40 Years of Luck?

I reject the idea that the fund was lucky for more than 40 years and then got its natural comeuppance. The fact appears to be, rather, that technology changed the world, requiring interest rates to be deregulated, and banks and bank regulation did not keep pace.

The questions are: Now that we know this happened, can banks and the regulatory system catch up? What is the cost of catching up? Is that cost less than the existing overhang that the taxpayers would have to pick up? And what course of action would foster a banking system that is better for the U.S. economy?

I don't have all the answers to those questions. But here is what I suspect: The great technological leap forward has occurred. Its effects are still working through the system and technological changes will continue. But regulators no longer have to be behind the curve. (Watch out for all the off-balance-sheet shenanigans.) They can catch up, and the cost need not be great.

The banking system will continue to shrink relative to the financial sector generally - even if Congress doesn't try to make it shrink - because fewer loans need to be made by banks.

This process of shrinkage needs to be managed better than we have managed the changes in banking over the last 15 years. But we can manage it better if we gradually introduce market value accounting, put bank balance sheets on line to the regulators, establish good early warning mechanisms, encourage banks to become more efficient, and permit banks to become financial supermarkets.

If the banking system fades away for reasons of economic redundancy, so be it.

But there is no need to kill it. Instead, we should broaden banks' authority to sell consumer financial products so that consumer banks can offer people real efficiency.

And we should let business banks function like investment banks provided that, like investment banks, they mark their assets to market every day and maintain a low ratio of illiquid loans to assets.

The author is counsel to the law firm of Rosenman & Colin, New York, and the author of "High Rollers: Inside the Savings and Loan Debacle," to be published in the fall.

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