A growing chorus of banking leaders, academics, and regulators is urging the government to fundamentally rethink its approach to supervising the industry.
The system they propose would generally rely more on the private sector to provide the oversight and policing that were historically the government's responsibility. It would reverse the trend of government banking regulation that began with the Civil War, was expanded during the Great Depression, and was buttressed after the 1980s thrift crisis.
"Markets ultimately are better regulators and provide better incentives than strict regulatory guidelines," said David A. Daberko, chairman and chief executive officer of National City Corp.
Evidence abounds of this move toward-and faith in-a freer banking market:
The House voted in May for the first time to eliminate Depression-era barriers separating the banking, securities, and insurance industries.
Citicorp and Travelers Group, using a legal loophole, plan the first modern merger of a bank and an insurance underwriter.
NationsBank Corp. and BankAmerica Corp. had little difficulty winning regulatory approval this month to form the first coast-to-coast bank.
In Washington, lawmakers plan to debate next month ways to increase reliance on market discipline by requiring banks to issue short-term debt, the price of which reflects an institution's risk profile.
Federal Reserve Board Chairman Alan Greenspan has touted the concept in several speeches over the past two years.
"The appeal of market-led discipline lies not only in its cost- effectiveness and flexibility, but also in its greater adaptability to changing financial environments," he said in May 1997.
This would not mean a total elimination of government oversight. Rather, it means regulators should rely on market-driven approaches whenever feasible, reserving government power only as a last resort.
"We need to rely on the market to tell us where to be," said Robert T. Parry, president of the Federal Reserve Bank of San Francisco. "When we run into trouble, then we look at regulation."
The financial reform bill is just a start. Though providing some relief, it would keep intact much of the supervisory structure that has been built up around the affected financial industries, including separate regulators and capital requirements.
The Bankers Roundtable, the trade group for the 125 biggest banks, advocates a more fundamental overhaul, relying for discipline on short-term subordinated debt and similar methods.
"Market incentive regulation and supervision would use market participants-investors, debtholders, rating agencies, management, and customers-and clearly defined, transparent incentives to act in concert as the primary regulator of all banks," the group said in an April report.
Consumer advocates, however, are appalled at the notion of letting the financial market operate with less government control. They argue that the government must set boundaries to protect the public from abuses.
"The reason in a democracy that we have a government is to ensure that things such as the market don't get to decide overarching matters that affect citizens," said John Taylor, president of the National Community Reinvestment Coalition. "We elect representatives to ensure the market does not work against us."
"You don't want (major policy) decisions made by profit-maximizing corporations," said consumer advocate Ralph Nader. "Corporate values will dominate an issue that affects many people."
This view enjoys strong support among traditional Democrats. "Do you want to ask anyone in Southeast Asia if the market knows best?" quipped Rep. Joseph P. Kennedy 2d, D-Mass.
Others argue that financial stability depends upon the government letting markets operate freely.
Edward L. Hudgins, director of regulatory studies at the Cato Institute, a libertarian-leaning think tank in Washington, said misguided regulation is often to blame for financial disasters.
In his view, interstate banking restrictions precipitated the Latin American debt crisis by making it easier for banks to lend overseas than in neighboring states. Also, he said, the 1980s thrift crisis was caused by what economists call moral hazard-excessive deposit insurance allowed unscrupulous bankers to make risky investments without worrying about depositor losses.
"The point of government is to protect against force and fraud," Mr. Hudgins said. "As long as that is not present, the banking industry should be allowed to do what it wants."
Free markets are seen as a way of correcting problems and imbalances quickly, rather than allowing them to fester as they have in some Asian nations with heavily regulated economies, said William J. McDonough, president of the Federal Reserve Bank of New York.
The thrift and banking crises of the late 1980s and early 1990s required hundreds of U.S. banks to seize collateral, cut dividends, eat into capital, and reduce operating expense. But "the net result is that we went from a damaged American banking system to a robust American banking system in just four years."
The recovered U.S. banks grew strong enough to pursue the megamergers that are reshaping the competitive landscape of the late 1990s-with the market's approval.
Market-based regulation began to take hold with the 1991 prompt corrective action doctrine, which used a widely available, market-driven figure-shareholder equity-to determine the level of oversight given to banks.
The strategy gained momentum in 1996 when regulators dropped plans to require banks to use a government-created model to calculate capital held against unexpected fluctuations in the price of securities, foreign exchange, and other instruments. Instead, regulators gave banks permission to use their own models reflecting their unique risk characteristics.
Congress is considering going even further. The Senate Banking Committee is expected to debate next month the Bankers Roundtable's subordinated debt proposal, which would subject the industry to more scrutiny from the bond market.
"We are going through a period of great redefinition of the relationship between the government and the marketplace," said Daniel Yergin, a Pulitzer Prize-winning author whose book "Commanding Heights" chronicles the struggle between markets and government.
"We are seeing the end of the system of regulatory capitalism that was started at the turn of the century and was really brought into existence by the Great Depression and the belief markets had failed."
In the future, bond rates and stock prices would become primary "enforcement" tools, with government regulation as a backstop.
"Regulation is not disappearing," said Mr. Yergin, president of the consulting firm Cambridge (Mass.) Energy Research Associates. "It is being refined and narrowed in the United States, and there is a drive to seek market solutions. That is the general trend."
Defining where the market ends and the government enters may not be so easy.
Some, such as Terrence J. Murray, chairman and chief executive officer of Fleet Financial Group, argue for a very limited government role. Rules requiring applications to open branches and install automated teller machines are absurd, he said, while those outlawing fraud and requiring banks to operate safely make sense.
"Ground rules are absolutely essential," Mr. Murray said. "But within the framework of regulation, markets should be free to work."
Others said the government needs to be more active to ensure banks do not risk the country's economic health by acting recklessly.
"Whenever you can, you ought to let markets be free," said John H. Biggs, chairman and CEO of the investment company TIAA-CREF. "But I have had too much experience in my financial career. I know that when you take the hands off regulation you will get disastrous effects for the American public."
He recalled the 1933 failure of Missouri State Life Insurance Co., which occurred after the bank that owned it propped itself up by transferring worthless real estate to the insurer in exchange for valuable bonds.
"We want as much freedom for management as possible," he said. "But if you have a structure where there are incentives to take advantage of the situation, you know the market will respond to those incentives."
Community bankers also say they support a free market, but want the government to ensure competition by guaranteeing access to payment systems and ATM networks for all banks.
"When the market works to the point where choice is diminished significantly, then we have reached the line where the market no longer works and you have to take a look at how the government can re-create a competitive environment," said Thomas J. Sheehan, chairman and CEO of Grafton (Wis.) State Bank.
When big banks charge noncustomers to use their ATMs, he said, "banks that dominate certain markets are able to predatorily price their product to make the market turn out differently than it naturally would."
Deregulation will only go so far, said Anthony M. Santomero, a University of Pennsylvania professor who runs the Wharton Financial Institutions Center. Federal deposit insurance, the discount window, and the need for financial stability mean the government will necessarily play a role regulating banks.
"The need for the regulator to intercede and stabilize the economy and stop a panic is still there," he said.