The shift to financial modernization which has inched along since the early 1990s is slowly gathering steam. Since the publication of the "Building Better Banks" report from BAI and McKinsey & Company, Inc. last year making the case for performance-based regulation, policymakers and regulators have continued to embrace and support the concept. Congress passed the Economic Growth and Regulatory Relief Act which frees well- managed and well-capitalized banks from filing applications to set up ATMs (which used to take six weeks), expand headquarters, and other activities. The Office of the Comptroller of the Currency (OCC) published Part 5, which defines the corporate activities of national banks. The message was similar: a well-managed bank would become an OCC-eligible bank and be rewarded for its efforts. Other regulatory examples suggest similar reinforcement for the effort.

A break in the barriers

In the latest development, The Treasury Department's report on financial reform, due at press time, will probably encourage Congress to allow limited mergers between banks and non-financial firms. Under Secretary John D. Hawke Jr., who publicly advocates aggressive action, is quoted as saying that "the elimination of full-scale barriers between banking and commerce is necessary to bring major players in the financial services industry under a common set of guidelines."

Outgoing FDIC chairman Ricki Helfer doesn't see it that way. She opposes privatizing the Federal Deposit Insurance Fund (FDIC) to free the industry from legal and regulatory constraints. Helfer declined to be interviewed.

The issue of performance-based regulation is both political and controversial. To begin with, at least two top banking regulators don't want to give the impression that the FDIC is impeding financial reform. In recent testimony before the House of Representatives Banking Committee's capital markets subcommittee, FDIC Chairman Ricki Helfer and Comptroller of the Currency Eugene A. Ludwig refuted a recurring argument by Federal Reserve officials that deposit insurance gives direct bank subsidiaries an unfair advantage over nonbank competitors. Though she was in favor of letting banks invest in nonbanking companies, Helfer warned against removing obstacles between banking and commerce. Besides lacking experience in running commercial firms, Helfer argued that banks could be tempted to make risky loans to buttress an affiliated company in difficult economic times.

This is a minority viewpoint. Even House Banking Committee Chairman James M. Leach has admitted that completely prohibiting the mix of banking and commerce was not "politically realistic." Within the banking industry, the Independent Bankers Association of America (IBAA) is the only trade group holdout against legislation that would allow banking and commercial firms to own each other.

The argument to allow banks and commercial firms to own each other is rooted in the contention that government-based anti-bank bias because of the FDIC hinders banks. "Some people in Washington don't believe banks should operate like other companies because there is a 'too big to fail' issue. As long as it is there, banks will never be competitive with nonbanks," says J. French Hill, executive officer of First Commercial Corp., Little Rock, AK, and chairman of the BAI regulatory affairs council.

Privatizing the FDIC would eliminate the need for regulation justified by the "too big to fail" coverage at the heart of the FDIC, according to Richard M. Kovacevich, chairman, president and CEO of Norwest Corp., MN, who was also involved in the report.

Kovacevich, who has referred to the FDIC as a "monster" in the past, says the "too big to fail" idea is to blame for the savings and loans crisis of the late 1980s, and that the only way to prevent a recurrence is to eliminate the moral hazard inherent in the government-sponsored deposit system. What is more, the concept by definition discriminates against smaller banks. "(Small banks) are allowed to fail though they have paid into the fund for years, and depositors do not get all their money back," he says.

In the speech to BAI about federal insurance, Helfer said that the BAI/McKinsey plan can't work because it rests on a misconception that moral hazard created by federal deposit insurance can be eliminated through privatization. "Any form of insurance faces the problem of moral hazard, regardless of its ownership or management. The problem of moral hazard occurs when insurance induces the insured to take more risk."

consumers are taking more risks

On the contrary, banks would be more stringent about monitoring banks if they financed the fund themselves. With their own money on the line, banks don't want to be responsible for bad players, says Hill.

One traditional FDIC argument points to the fund as providing stability and consumer confidence in the system. The other side says that the insurance industry effectively insures itself, so why not banks? Talk of bank runs in the past is countered by the privatization proponents' claim that the industry can match the capitalization of the current government fund.

Then comes the question of how much the FDIC matters to today's consumer. Despite FDIC insurance, banks lost 50 percent of their market share in liquid household financial assets between 1975 and 1995. That money went to non-insured products, such as mutual funds, stocks, etc. "Consumers vote with their feet. They are seeking a higher return and taking on more risk," Hill says.

Since so many people are in the stock market for the first time, they have not weathered a downturn, warns a regulator who requested anonymity. The industry has yet to see how these investors will react to a correction. Risk may again become a big factor in where these investors put their money, he predicts.

Norwest's Kovacevich counters that only depositors with accounts of less than $100,000 should be protected anyway. Financially sophisticated owners of uninsured deposits should be at risk when they deposit their money in a bank just as they are at risk when they invest in stocks, bonds, or other financial instruments.

Some sources close to the situation say that financial modernization and privatization of the FDIC are two separate events. Performance-based regulation is already in place and will continue to grow, regardless of any regulatory changes. A lot can be done without legislation: the OCC has wide discretion about how to supervise banks and create incentives without changing the law. The financial structure and how it changes is another thing entirely.

Proponents of performance-based regulation say that today's fragmented financial structure will not serve the financial services needs of the 21st century. "The power of private property rights operating through a market economy is that, if consumers want something and are willing to pay the price, producers will find a way to supply it," according to a statement by Jerry L. Jordan, president, Federal Reserve Bank of Cleveland, in the BAI report. "Regulatory constraints impede market adjustments to shifting demands and emerging technologies. Ingenuity will ultimately get over or around those regulatory barricades, but it will take time and absorb resources. In short, regulation 'gums up the works'. (It) will not prevent producers from satisfying consumers desires except at the margin, where higher costs and prices convey the burden of regulation to the consumers who must bear it."

Nevertheless, in contrast to the vocal proponents of privatizing the FDIC to help streamline regulations, senior officials at the FDIC, OTS, and the Treasury Department referred to privatization as a very sensitive issue and refused to speak directly on the issue for publication.

Politics may be at the root of all this side-stepping. As one industry expert puts it: "This issue comes up with the Fed. If they were king of the world, what would they do with deposit insurance? They (might) want to do things that the FDIC would not agree with, (like) shrink the guarantee and narrow the bands of responsibility of the federal government."

Another explanation is that longer term brand of politics which keeps banks bound to duplication and confusion in terms of regulation may be at play: the turf consciousness of the many-layered banking regulatory system itself. In 1984, President Bush tried to rationalize the regulatory structure and failed; ditto the Clinton administration.

The Federal Reserve was created in 1913, the FDIC in 1933. They have different but complimentary roles. Add to that the multiple types of charters that banks are subject to. One industry watcher wonders whether the banking industry needs all these regulatory trappings. Banks should have one system with one model financial services charter, he says.

Sorting out the extraneous elements will take leadership in the industry or by the Treasury, Federal Reserve, or a combination with a common vision of the future. It's the kind of thing that usually doesn't happen easily in regulated businesses.

The great irony is that GE Capital, Merrill Lynch, et al have it figured out, banking experts say. They have the best of all worlds: one level of regulation, a single charter, no product restrictions on how to serve customers, plus one strategy and one safety system. What banks aspire to, these financial services firms have today. - bosco tfn.com

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