Federal Reserve Bank of Minneapolis President Gary H. Stern is expected to propose eliminating full government rescues of the largest financial institutions.
A draft policy paper circulated by Mr. Stern recommends that uninsured depositors of big banks lose up to 20% of their deposits above $100,000 if the bank fails, according to the draft obtained by American Banker.
"We propose that uninsured depositors should face some risk, thereby causing depositors to put pressure on banks to operate in a more safe and sound manner," Mr. Stern wrote.
The plan "would lift the de facto risk-free curtain that shields large banks and would force depositors to take a good look inside," the draft reads. "Banks would not only have to compete on the basis of price and service but also on safety and soundness."
Mr. Stern did not define "large banks" in the draft paper.
A Minneapolis Fed spokeswoman declined to discuss the draft except to say it will be published this month as an editorial in a national newspaper.
Under the proposal, the Federal Deposit Insurance Corp. could not declare a bank "too big to fail" and completely repay all depositors and creditors in order to prevent a banking panic.
Because uninsured depositors even at large banks not deemed to big too fail generally lose 10%, critics said imposing a 20% loss would cause depositors to withdraw their money in a crisis.
"If this became the law of the land, then ... people would be quicker to run from a bank thought to be in trouble," said Bert Ely, a financial institutions consultant in Alexandria, Va. "That makes the potential loss from the bank even worse."
An FDIC reform law passed in 1991 severely curtailed the agency's ability to declare a bank too big to fail, but Congress would be unlikely to eliminate that option, Mr. Ely and other observers said.
Mr. Stern drew up his proposal after meeting with representatives of 10 banks from his district. Clashes between big banks and small banks prevented any consensus at the Minneapolis Fed meetings, according to those who attended.
"This is an irresponsible recommendation," said Kenneth A. Guenther, executive vice president of the Independent Bankers Association of America. "This is a tactic to undermine the core deposit base of community banks" because depositors would flee to large banks, which are perceived to be safer.
Mr. Guenther, who did not attend the meetings, accused Mr. Stern of being swayed by big bank interests as represented by Richard M. Kovacevich, chairman of Norwest Corp., based in Minneapolis.
Mr. Kovacevich is vice president of the Bankers Roundtable, a trade organization of the nation's 125 largest banks, which in May proposed abolishing the "too big to fail" policy and other drastic deposit insurance reforms. Mr. Kovacevich, who made similar reform proposals in a Minneapolis Fed publication last year, declined to be interviewed.
Opinions among the heads of midsize banks who met with Mr. Stern were more mixed.
"They are changing a system that has basically worked since the Great Depression," said William A. Cooper, chairman of $7.5 billion-asset TCF Financial Corp., based in Minneapolis. "If it's not broke, don't fix it."
"Not even the regulators have had a very good record of predicting which banks are going to fail and which ones won't," he said. "The unsophisticated depositor is not capable of making that decision."
But Donald R. Mengedoth, president of $4.3 billion-asset Community First Bankshares in Fargo, N.D., said promising full rescues of the largest financial institutions is a major risk to the insurance funds. The Stern proposal is "probably a rational step," he said.