Modified |Narrow Bank' Is Best Reform Plan

With the Federal Deposit Insurance Corp.'s reserves nearing exhaustion, Washington and the banking community are gripped by a sense of urgency. The Treasury Department has responded with a reform proposal that could be the basis for the most sweeping banking legislation since 1933.

The Treasury claims that it seeks through its proposal to promote the global competitiveness of U.S. banks, reduce taxpayer exposure from deposit insurance, and restore stability to the industry.

The Treasury is not alone in the business of proposing banking reforms. The Congressional Budget Office has listed 22 other reform proposals of recent origin.

The prescriptions fall into four categories:

* The status quo ante.

* Laissez-faire.

* Indirect asset restriction.

* Direct asset restriction.

Though a return to the stability and safety of the past has widespread appeal, we must recall that the calm of yesterday was based on impediments to entry and competition and on large subsidies. Though the beneficiaries of that system are a sizable constituency, restoration of earlier barriers to competition is hard to imagine. And so is public willingness to subsidize as before.

The status quo ante is therefore an unlikely option, despite the exhortations of special interests and nostalgia buffs.

Laissez-Faire Argument

At the other extreme, laissez-faire advocates propose to eliminate governmental deposit insurance.

The idea is not wholly without merit. Safe investments are more readily available to consumers today, so the need for insured deposits is diminished.

Moreover, the Federal Reserve's discount window should be able to alleviate the liquidity problems of banks, and the governmental insurance of deposits results in tenacious economic distortions. Failed institutions must be allowed to disappear.

Still, the arguments for abandoning government deposit insurance will almost certainly fail. There is a lot of skepticism about use of the discount window, if only because of past administrative ineptitude. Deposit insurance is therefore seen as a cost-effective backstop, an optimal redundancy.

Direct Asset Restriction

In any case, concern about the payment system is rooted in credit risk, and deposit insurance undeniably reduces the probability of payment-system gridlock. Moreover, the deposit insurance system can be restructured in a way that will sustain confidence at relatively modest cost. And, since so many view deposit insurance as an entitlement, its elimination is politically unthinkable.

The two remaining proposals would retain governmental insurance but seek to curb banks' high-risk activities.

The more direct proposal would restrict the assets that can be financed with insured deposits but liberalize bank use of uninsured funds. By circumscribing the use of insured deposits, public regulation could be considerably simplified.

The "narrow bank" idea, in its numerous variants, falls into this category.

The most restrictive variant would separate credit granting from deposit creation.

The preferred "modified narrow bank" would continue to let banks finance higher-quality private credits with insured deposits.

The modified narrow bank restricts the use of insured deposits to financing "investment grade" assets. This opens the door to possible losses, but exposures are narrowly circumscribed, reducing the scope of regulatory and supervisory discretion. Capital requirements would remain, but they can be safely reduced from current levels. Similarly, deposit insurance premiums could be restored to their earlier, far lower levels.

Indirect Restriction

The alternative, indirect asset restriction, provides the banks with greater freedom in asset choice, but relies on more intrusive regulation and pricing incentives to reconcile the disparate risk-taking proclivities of the deposit insurer and the insured banks. Although the indirect approach does not prescribe asset choices, it could be more constraining since its strictures typically apply without regard to the bank's choice of insured or uninsured funding.

Indirect asset-restriction proposals are clearly the most popular. Those of the Treasury and of most financial institution trade associations fall into this class. Many academics also favor the indirect approach.

Proponents of indirect asset restriction propose a variety of reconciling mechanisms, such as risk-based capital requirements, risk-based deposit insurance premiums, risk-based bank powers, and more dependence on private insurance and capital markets. All are aimed at giving private banks the incentive to do what is right while preserving their freedom to do otherwise.

An Information Obstacle

But indirection typically requires information that is costly or unavailable. Required data include on- and off-balance-sheet asset and liability values, variances and covariances; these data are needed for claims that are not actively traded.

It is this weighty and probably unrealistic informational burden of the indirect approach that threatens a heavy dependence on discretionary regulation.

In turn, discretionary regulation carries the subtle threat of expropriation, a kind of sovereign risk that elevates the banks' cost of human and financial capital and thus undermines bank competitiveness.

Direct Restriction Wins

The direct approach dominates on every desideratum. Restrictions on the use of insured deposits would give banks virtually unlimited freedom in their uninsured activities.

Similarly, the direct approach dramatically reduces the need for discretionary regulation. The informational burden of regulators is trivialized, since there is no need to cure information asymmetries and to price bank risks. This should eliminate the sovereign risk arising from regulatory caprice. The cost of capital would fall and bank competitiveness would benefit.

The modified narrow bank would obviate the need to limit insured deposit coverage, and all payments would be insured. This would promote safety and soundness in a system where insurance coverage is capped, and payments are effected with uninsured as well as insured deposits.

|Too Big to Fail'

Taxpayer exposure would still depend on how "too big to fail" is addressed. Neither the direct nor the indirect asset restriction approach cures this problem, since it is not inherently an insurance issue. Rather, "too big to fail" is a broader issue of the bounds of governmental prerogative.

"Too big to fail" is nevertheless complicated by deposit insurance and payment system considerations. The advantage of the modified narrow bank's direct approach is that it isolates payments and deposit insurance issues. This separation should elevate the quality of public debate, and may even result in more intelligent decisions in the realm of "too big to fail."

The indirect approach mixes the issues by linking insured and uninsured facets of the banking business. Those uninsured thereby attain an undeservedly exalted status in "too big to fail" considerations. The safety net is expanded in a way that is unnecessary, unwarranted, and unattractive to taxpayers seeking to limit their exposure.

On considerations of bank competitiveness, taxpayer exposure, safety and soundness, and "too big to fail," the direct asset-restriction approach of the modified narrow bank offers striking advantages. To be sure, the uses to which banks can put insured deposits are narrowed, but this liberates the use of uninsured liabilities while reducing the need for discretionary regulation.

Mr. Greenbaum and Mr. Boot are on the faculty of the J.L. Kellogg Graduate School of Management, Northwestern University.

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