With interstate branching legislation approved, there are doubts that current regulations and insurance can handle the coming megabanks.

A debate is brewing as to the adequacy of current bank regulations and insurance, given the sprawling nationwide banking companies expected to emerge from interstate banking.

Following the recent passage of legislation allowing banks to cross state borders, some experts are beginning to wonder whether the benefits of consolidation, diversification, economies of scale, and reductions of overcapacity will be undercut by the unwieldy size of the new institutions.

Regulators have traditionally deemed a few banks "too big too fail." But in the brave new world of interstate banking, many of the surviving players could fall into that category.

To be sure, most observers agree it will take several years before the U.S. banking industry achieves radical consolidation. But some experts say there's an urgent need to overhaul the federal safety net now, while the industry is in good health and the population of megabanks is still small. "Until we solve issues surrounding deposit insurance and too big to fail, all of the banking industry's priorities are jeopardized," says Richard Kovacevich, chairman and chief executive of Norwest Corp.

All avenues to take risks at the government's expense should be shut off, he says. Regulations should be slashed and banks should have greater power to expand the types of products they offer, he adds.

The issue cuts to how the government behaves when big banks get in trouble. In several major crises of the past decade, the Federal Reserve System issued multi-billion dollar advances to failing banks. It acted in the name of averting widespread panic and preserving systemic stability.

Recipients such as Continental Illinois Corp., Chicago, and First RepublicBank Corp., Dallas, used the funds to pay off panicky uninsured depositors and other short-term creditors. When the institutions failed, the Federal Deposit Insurance Corp. was left holding the bag. It had to protect insured depositors as well as backstop district Federal Reserve Banks on advances used to protect technically ineligible creditors.

This practice came to be viewed as a subversion of the deposit insurance system. The FDIC was forced to bear the full costs of averting market panics. But the agency is officially charged only with the protection of depositors. And the potential costs of systemic risk is not included in deposit insurance premiums.

"The insurer probably went too far in being an engine of stability," says Roger Watson, director of research at the FDIC.

The FDIC Improvement Act of 1991 appeared to address the problem. The law limited the conditions under which the Fed can make emergency loans. It stripped protections from bank holding companies. And it specified early intervention guidelines forcing regulators to act at the onset of crises.

The law contained an escape clause, however, leaving open the question of whether the government is really serious about disciplining big banks. In instances of threatened systemic risk, protections can be provided to uninsured depositors and other creditors, with the costs billed to the banking industry in the form of a special insurance premium assessment.

Each invocation of this special protection requires a two-thirds approval of the Federal Reserve Board and the FDIC board, plus the concurrence of the Secretary of the Treasury and the President. These codifications are so onerous they provoke outcries from veteran regulators, who say financial crises don't happen according to formulas and can't be properly addressed by formulas.

"We need flexibility and the power to exercise judgment, but instead they installed benchmarks, and procedures and rules," says Michael Bradfield, former general counsel for the Federal Reserve Board.

Other observers contend the law's escape clause would be readily exercised in times of crisis - and, indeed, facilitates the process. In practice, they say, the government is ready to continue offering special treatment to big banks and their creditors. "The too big to fail doctrine is alive and well, and we need to get rid of it," says William Isaac, the former FDIC chairman who is head of Secura Group, a Washingtonbased consulting firm.

Softening the issues somewhat are the banking industry's current health, prospective enhancements that are expected to come from large-scale interstate banking, and market forces that act as brakes on the pace of consolidation. Tanya Azarchs, a bank rating analyst at Standard & Poor's Corp., says the portfolio diversification afforded by large-scale interstate banking would "enormously enhance the safety and soundness of the banking industry," lessening the odds that megabanks will require special federal attention.

John B. McCoy, chairman and chief executive of Banc One Corp., Columbus, adds that the dissolution of regional boundaries would facilitate economical expansion, market penetration, and product delivery. Alluding to McDonald's Corp., Mr. McCoy says: "If you can make a fortune selling hamburgers in Illinois, why shouldn't you go on to the next state and do the same?"

As for the pace of consolidation, L.M. "Bud" Baker, chief executive of Wachovia Corp., predicts the flow of deals "will be far more measured and controlled" than what some observers expect. On top of pricing and portfolio issues, Mr. Baker says, interstate acquirers have to deal with managerial and operational complexities, all of which will slow the emergence of nationwide banks.

Deliberation, in turn, hopefully will enhance construction quality at nationwide banking companies, mitigating risk issues. But these salutary factors in no way lessen the urgency surrounding too big to fail and deposit insurance, contends Norwest's Mr. Kovacevich.

Absent the complete eradication of special protections for big banks, he says, the politically powerful community banks "will never agree to a roll back of deposit insurance."

And absent a roll back of deposit insurance, he says, "Congress will continue to constrict banking industry powers and expand burdensome regulation?'

Moreover, experts say nationwide banking offers no guarantee that future crises won't erupt.

All too soon, they say, the federal safety net could again loom as a potential significant determinant of which institutions can access short-term funding and stay alive, perhaps to the detriment of smaller, lesser-protected rivals.

"I would say nationwide banking companies would have the same propensities for risk-taking as their predecessors - and the bigger they are, the harder they fall," says Mr. Bradfield, who works in the Washington offices of Jones, Day, Reavis & Pogue.

In that light, experts say, the passage of interstate banking legislation only heightens the need to assure that disciplinary and insurance mechanisms aren't tilted in favor of big banks.

"Full interstate banking should lead to the creation of more very large institutions, and they all will be candidates for special treatment under too big to fail," says Stuart Greenbaum, director of banking research at Northwestern University, Evanston.

"This will force a more forthright confrontation of issues surrounding the safety net."

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