Deposit Insurance Shouldn't Be a Free Ride

Congress must broaden its horizons beyond conventional thinking in reorganizing the Bank Insurance Fund. Recapitalization must be implemented in such a way that financial institutions have a vested interest in the fiscal strength of the program.

A brief analogy underscores the proposition. I belong to a small recreational club, a not-for-profit association that operates a swimming pool and some tennis courts. When I joined, I agreed not only to pay an annual fee but also to place a large "capitalization" deposit with the association.

My interest in maintenance of the club's property is clear. If upkeep of the facility is accomplished by simply using the annual fees, when I resign from the club my deposit will be returned.

By the same token, if the members do not maintain the facility the deposit may well be utilized for that purpose and will not be available to me when my membership ends. The result: All families have a stake in caring for the club's property.

A Place for |Civic Pride'

The same sort of civic pride I have in my club should be the guiding principle in recapitalizing the insurance fund. Institutions that are associated with, and have their accounts insured by, the Bank Insurance Fund should be stimulated to conduct their affairs in such a way as to minimize erosion of the fund's strength.

U.S. financial institutions have been brought to their current state of affairs by a lack of the oft-cited characteristic "moral hazard."

Financial organizations, thrifts, and banks have been insulated from exposure to significant losses that might be occasioned by having a segment of their assets placed at risk. Market discipline has been an insufficient force.

The cure for this flaw, though obvious and available, appears to be unpalatable to the forces able to precipitate change.

To bring about behavior modification and instill discipline in boards of directors and senior managers, some institutional capital must be placed in an environment where there is the possibility of loss. |Unsafe and unsound conduct of an organization should result in the forfeiture of an institution's stake in the fund.

Banks Must Pay Own Way

The American public cannot be expected to capitalize the insurance fund or open a public liquidity facility, such as the Federal Reserve System, to compensate for unprofessional conduct. Financial institutions must ante up the capital for their own protection.

The suggestion should not come as a surprise to prefessionals in the industry. Risk or "self-interest" has been a key ingredient as a hedge against default for any number of institutional and regulatory programs. Indeed, elements of this nature have become more prominent commercial practices in recent years to instill a sense of duty.

The are abundant examples of mechanisms designed by both institutions and regulators to bring about a desired level of adherence to standards of conduct. On the institutional side, lenders may require a substantial investment of personal funds in a project, personal guarantees, or colateral before agreeing to extend credit. In all lending, whether consumer, mortgage, or commercial, the stake diminishes credit risk and enhances the soundness of the venture.

The Role of Risk

Regulators also have begun to understand to extraordinary value of risk as a means of motivation.

In the regard capital levels, as the basic gauge for the extent to which an institution can involve itself in lending programs, are being based on risk. Assets, as building blocks of capital, are weighted according to safety and soundness. Similarly, serious discussion is being accorded to creating a system of risk-based insurance premiums. In both cases, the message is clear: Positive conduct is rewarded; untoward action is punished.

This brings us to the heart of the matter concerning recapitalization of the bank insurance fund. The effectiveness of any new system must require insured institutions to be placed "in harm's way." These organizations must have "a piece of the action."

Some prominent individuals have briefly pondered creating such a system. Thus, the idea of rebuilding the fund based on the purchase of preferred stock has surfaced. Others have suggested emulating a successful model that relies on vested interests in the National Credit Union Share Insurance Fund.

Self-Capitalization

Some trade representatives have spoken broadly in term of self-capitalization. It is imperative that government officials review the facts and consider the potential benefits of a risk-based approach.

Nonetheless, there are pundits who challenge the viability of such an approach. A close assessment of any objections that surface should dispel the naysayers. Still others will be antagonistic to a risk-based approach in order to remain "PC" - politically correct.

Ultimately, the extreme state of the U.S. financial system and its requirements will force a change. Rational, unbiased deliberation must be given to the merits of a proven solution to the problem - a proposal that embraces a risk element. Only this will ensure a stronger system.

More Responsibility

Let's face the realities of rebuilding a strong Bank Insurance Fund. The safety and soundness of financial institutions is directly related to the activities of the organizations' officials. These individuals need to take more responsibility for the outcome of their activities.

One way to accomplish this result is by ensuring that an institution has a vested interest in the health of the fund. This can be accomplished by contribution of a returnable deposit that is exposed to forfeiture if the practices of the entity are not prudent.

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