How to Safely Bury |Too Big to Fail'

Richard Bove's article on June 18, "|Too Big to Fail' Is Too Important to Throw Away," comes to one of the most remarkable conclusions that ever appeared in the American Banker. "Our government must change course," he wrote.

"It must stimulate risk-taking within the banking system and assure depositors that money in the system will be protected."

He went on to say: "This is not a costly policy. It promotes economic growth, which in turn stimulates tax payments, which in turn cut Treasury debt."

|Blind to Moral Hazard'

Apparently, Mr. Bove has never visited Dallas, Houston, Denver, or Miami to view all the see-through buildings this policy has created. He seems blind to the moral hazard that causes financial institutions to undertake riskier and riskier activities - those more appropriate for venture capitalists and entrepreneurs.

The argument that no great nation would ever allow a major bank to fail usually does not get into much detail. It centers mainly on the cost of failure to domestic and worldwide commerce: It is inconceivable that a major bank could become unable to transfer the funds wired into and out of it, or to clear the tremendous volume of checks, including payroll checks.

The "too big to fail" doctrine came into existence in part because of the collapse of Continental Illinois bank. Another factor was the mid-1970s collapse of Herstadt Bank in Cologne, Germany, which apparently was not too big to fail.

Brevity the Soul of Transfers

Years after the collapse, the Federal Reserve concerned itself with daylight overdrafts and other arcane transfer matters. In this era, when money can be transferred in microseconds instead of a laborious fortnight, the sanctity of the system is important to everyone.

Everyone reading about Continental Illinois must have noticed accounts of how many smaller banks it would have brought down. Most of these stories never tell you on what day the theoretical failure would have taken place.

As Continental got deeper and deeper into trouble, more and more banks stopped selling it fed funds and avoided transferring dollars. How much damage Continental might have caused relates specifically to a theoretical date of a closure that never happened.

Is There Really Any Money?

If Continental had been allowed to fail as banks failed in earlier eras, with a takeover by receivers, thousands of payrolls would have been missed. Small, outlying banks would have been deeply troubled and, of course, collapsed if the Federal Reserve behaved in 1984 as it had in the early 1930s.

The problem of a large-bank failure is a hundred times more important today than it would have been 60 years ago because of the velocity of money.

Considering the way tens of billions of dollars fly around the world electronically, is there really any money, or are we dealing with a worldwide electronic "kite"? This concern explains the Federal Reserve's concern with daylight overdrafts.

Protect the Demand Deposits

A very simple solution to the "too big to fail" problem has generally been ignored by academics and regulators: Bifurcate the clearing mechanism from the savings and investment aspects of banking. When a bank gets in trouble, all its demand deposits, wire transfers, one-day fed funds, swaps, and certain other derivative products would be guaranteed without limit.

If the bank failed, the clearing mechanism could keep going. The bank could be liquidated in an orderly fashion, with the full knowledge that demand deposits, fed funds, and wire transfers are all guaranteed. The banking system would clear in days.

Investors - who are often greedy and put gigantic sums at interest in weak banks - would have to wait for a liquidator to determine how much they got above their fully insured $100,000.

A Guarantee for Fed Funds

The solution would be to guarantee, without limit, the system and the nonearning liabilities. The only interest-earning liability fully guaranteed would be one-day fed funds, the lubricant for the interbank relationship.

No interest-bearing instruments other than fed funds would be guaranteed 100%. This solution would have several desirable effects:

* Prevent disruption of the clearing mechanism and keep the system working more smoothly than it does currently.

* Allow for orderly liquidation of a large bank.

* Reduce the excess capacity that now troubles banking.

* Curtail the greed of both sophisticated and unsophisticated investors, who flock to the weakest large bank because it is secure.

Cleansing the System

It is difficult to estimate how much of the system is involved in demand deposits - due to the complications of double counting, float, and related practices. But there is little reason to believe it would be greater than 9% to 12% of total deposits.

In other words, if a money-center bank failed, we could see roughly 10% of its deposits being fully insured to 100%. This would have the tremendous benefit of clearing the system and, via liquidation, getting rid of excess capacity.

There would still be some moral hazard for sound banks selling overnight funds to weak banks. This could easily be handled by adding discipline, by degrees, to the fed-funds mechanism.

As an example, the interest earned on one-day fed funds could be lost by sellers, initially. At a second stage, a 1% or 2% penalty on principal could be added.

Market-Based Solution

This probably should be left to the discretion of regulators. It would be unseemly if banks did not have a high standard of discipline in culling their ranks.

Several years ago, the CEO of a bank in Oklahoma wrote a poignant letter to the American Banker, complaining, in essence, that the system didn't "clear": The first busted bank in a troubled area was recapitalized to compete with its weaker peers and do incredible damage.

It is time to let the economics of the market work and concern ourselves only with the clearing mechanism.

Academics are reaching out with what they call "new" ideas for narrow banks, while everyone else - and his brother - is taking away our markets. Witness the fact that auto companies, troubled as they are, are fighting to get into credit cards.

Any system that encourages banks to keep 80% of deposits in liquid assets, because of the fear of runs, is as perverse as Mr. Bove's proposal.

Narrow View of Problem

The narrow-bank idea has been around a long time. The most famous economist of his era, Irving Fisher, published a book in 1935 called "100% Money," which would have forced banks with checking accounts to keep 100% of their funds in cash.

Mr. Fisher's idea was that the use of cash would prevent both inflation and deflation, prevent depressions, and wipe out much of the national debt. It did everything but cure cancer.

Mr. Fisher, along with many before and after him, was concerned with the problem of banks creating money. This does not seem to be an issue in modern banking debates. Clearly, narrow banks are not a solution when we have to keep the money machine going to finance the monstrous federal deficits.

The problem today is that banks are over regulated. They have excess capacity. More unregulated financial intermediaries are moving against them, with increasing arrogance.

Nothing would help us more than to allow a few of the badly managed large banks to fail - without breaking the "system."

Mr. Fitzgerald is chairman of Suburban Bancorp, Palatine, Ill.

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