Open-Bank Assistance Can Work
The traditional method of handling a failing bank involves waiting for it to deteriorate until no one can doubt its insolvency, closing it, and then selling the franchise to the highest bidder, with the insurance fund absorbing the losses on the bad loans.
This approach has a lot to commend it and has served us reasonably well. But the widespread problems in the banking industry and the resultant strains placed on the human and financial resources of the Federal Deposit Insurance Corp. almost demand that newer, more creative approaches be found for resolving troubled institutions.
One objective should be to encourage banks to face up to problems earlier, when they can be dealt with at lower cost. Another should be to keep troubled assets, to the extent possible, in going, private-sector concerns - operating under proper incentives to minimize losses.
Proponents of the various early-intervention schemes being considered in Congress are motivated by an understandable desire to address problems earlier. Thus they would require regulators to close an institution when its capital falls to 2% of assets, instead of waiting for it to reach zero.
There are many flaws in this approach, not the least of which is that it wouldn't accomplish much, other than perhaps oblige regulators to implement their standard programs a few months earlier.
Banks would continue to employ every possible means (selling good assets, deferring losses, and hyping income) to postpone the day of reckoning. We would still be totally dependent on the exam and supervisory processes to identify and deal with problems, and regulators would still be reluctant to take actions that might be deemed precipitous.
And when failure finally occurred, the resolution would at best be only marginally less expensive than it would have been with a capital threshold of zero.
Deposit Insurance Reform
The best long-term solution is to reform the deposit insurance system to impose a degree of discipline on depositors above the insurance limit. This would force banks to strengthen their balance sheets and avoid excessive risk taking.
But we can't get from here to there overnight. Any changes in deposit insurance would need to be enacted with a delayed effective date if we were to avoid unacceptable short-run instability.
We can do something in the meantime to accelerate the resolution process and reduce the unacceptably high cost of bank and thrift failures. The time has come to implement a carefully designed open-bank (or thrift) assistance program.
The FDIC has always been reluctant, for good reasons, to entertain open-bank assistance plans.
The agency doesn't want to create a windfall for shareholders and creditors. Moreover, it doesn't want to provide financial assistance unless and until it's certain the assistance is necessary. It wants the private sector to play a major role in any transaction. Finally, it wants to avoid propping up crippled firms and preserving excess capacity in the industry.
The regulators are considering an open-bank assistance plan that would address these legitimate policy concerns while encouraging troubled institutions to come forward at an earlier stage than at present.
T. Timothy Ryan, director of the Office of Thrift Supervision, has been the most visible advocate of the idea, but he's far from alone among the regulators in recognizing the necessity of a new approach.
The plan would encourage shareholders and creditors of a seriously troubled institution to participate voluntarily. They would be treated fairly, while keeping any possible windfall to a minimum.
The FDIC's financial assistance would be on a standby basis, with outlays triggered only if necessitated by events. The investment of substantial private capital would be required, with mergers strongly encouraged, and there would be incentives to minimize losses to the FDIC.
I have felt for some time that a program along the lines now being considered would make sense and would reduce failure resolution costs very substantially. The regulators' inclination to move in this direction should be supported - provided that the plan, in both its design and application, avoids doing violence to time-honored objectives of public policy.
Mr. Isaac, a former chairman of the Federal Deposit Insurance Corp., is managing director and chief executive of the Secura Group, a Washington-based financial services consulting firm.