WASHINGTON - Merrill Lynch & Co. is becoming the poster child for deposit insurance reform.

During the first half of 2000 the brokerage giant persuaded customers to move $19 billion from uninsured cash management accounts to insured accounts at two banks it owns. Twelve billion dollars moved in the second quarter alone.

The shift costs Merrill Lynch not a dime, so every added dollar dilutes the reserves held by the Federal Deposit Insurance Corp.

Federal regulators are alarmed.

"You can't just look at the $12 billion for this quarter," said Art Murton, director of the FDIC's insurance division. "You have to see if the rate of change is sustained over time. If $12 billion comes in every quarter, where does that leave the fund?"

The FDIC estimates that Merrill Lynch could move $100 billion, and argues that such a spike in insured deposits without a corresponding increase in premium income is a big reason why the system should be overhauled. (Merrill Lynch disputes the figure but refused to answer questions for this story.)

FDIC Chairman Donna Tanoue launched the agency's reform project in March and is expected to unveil a set of possible changes on July 31. Those options will be debated during the fall and Ms. Tanoue has promised to send her recommendations to Congress by yearend.

One thing the FDIC is sure to advocate: a merger of its two funds - the Bank Insurance Fund and the Savings Association Insurance Fund. Together the funds would be stronger, with $40.1 billion in reserves and their risks more diversified.

But the industry has been clamoring for more comprehensive reform. The issue is important because deposit insurance forms part of the banking industry's foundation. And this particular piece of the debate is particularly significant because as new money becomes insured, the funds' reserves are diluted. Once a fund's reserves-to-deposits ratio falls below 1.25%, by law the FDIC must rebuild by charging higher premiums.

Today the bank fund has $1.35 for every $100 of insured deposits. According to the FDIC, Merrill Lynch alone could cut that cushion in half.

"What happens when really big institutions deposit a lot of money into the system, get the benefits of insurance, and never have to pay a dime for it?" said Robert Litan, director of economic studies at the Brookings Institution, who has been helping the FDIC refine its options. "It's a very legitimate issue that the FDIC is trying to deal with."

James Chessen, chief economist for the American Bankers Association and a former FDIC researcher, called it "a fundamental issue of fairness. & If an institution that grows that quickly were to fail, the industry would pay."

The rash of new banks poses a similar problem. The 870 banks started since 1996 hold $44.5 billion of deposits. Most paid nothing for insurance coverage.

The FDIC's reform project targets these two pricing problems. Currently, banks pay between three and 27 cents per $100 of domestic deposits, based on how risky the FDIC views them. However, since 1996 the vast majority - today it's 92.8%, - are not considered risky and therefore pay no insurance premium.

"There are fast-growing institutions that don't contribute to the fund, while most banks are paying zero for federal deposit insurance, and most institutions are in the same risk category," Mr. Murton explained. "We are asking, 'Does that really make sense?' "

According to Mr. Murton, the agency is considering at least three alternatives: a surcharge levied on new and fast-growing banks; a fixed fee tied to a bank's size that would be paid each year; or a set ratio assigned to each bank based on its size.

In a fixed-fee system, all banks would be required to pay for insurance every year, but risky banks would still pay more. This fee would likely be relatively low, possibly 3 to 8 cents per $100, as was the case before the switch to a risk-based system in the early 1990s. The downside: the fund could become huge. But there would also be a benefit; banks would not have to pay sky-high premiums in bad times when the fund's reserves were drawn down.

Under the third option, each institution would keep a set amount of money in the fund. For example, a bank with $100 million in domestic deposits might contribute $1.25 million. If the bank's deposits did not change, they would owe nothing more. But if deposits increased, a premium would be due to keep the ratio constant. If the bank's deposits dropped, it would receive a credit.

Industry representatives said this option could be a step in the right direction.

"Such a system would be a lot more fair," said Kenneth A. Guenther, executive vice president of the Independent Community Bankers of America. "Merrill Lynch shouldn't be able to issue billion and billions of insurance coverage and not pay anything for it. There is something very wrong in that."

"Either instituting a surcharge or an individual reserve system would solve the problem of banks diluting the system without paying anything," said Robert R. Davis, a managing director at America's Community Bankers.

But many questions remain such as how high to set that ratio. In the interview, Mr. Murton used 1.25% but said that might change. Also up in the air is whether longtime members of the bank fund could count previous payments toward meeting their reserve ratio.

"It could get very tricky," said Karen Shaw Petrou, president of ISD/Shaw Inc., a financial services consulting firm in Washington. "The FDIC would have to look at what percentage of existing funds goes to which institutions, and watch those institutions that have merged since they last contributed."

Pricing is just one of three broad categories the FDIC is studying. Mr. Murton said the reform project is also focused on the nature and appropriate size of the insurance funds and on raising the $100,000 coverage limit per account. The agency is asking how big the funds need to be, and what kind of fund makes the most sense.

Currently, if the reserve ratio were to dip below 1.25%, all institutions would be forced by law to rebuild it via higher premiums. The FDIC is questioning whether it makes sense to hit banks when they are least able to afford it because any decline in the fund's reserves is likely to be caused by an economic recession that led to a slew of bank failures. That's where the fixed-fee system looks attractive. Banks would pay every year - but would not pay more during a recession. The funds would be built up over time, and spent when a crisis occurred.

"Should the fund be built up in good times and then drawn down when things go bad?" Mr. Murton asked. "Or should we continue with a system that when the fund dips below 1.25% all banks are asked to pay high premiums when they can least afford it?"

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