Renewing his fight against the "too big to fail" doctrine, Federal Reserve Bank of Minneapolis President Gary H. Stern is urging lawmakers to require banks to privately insure some deposits.
Private insurers, which would cover up to 5% of deposits, would scrutinize a bank's investment strategies and set rates depending upon the amount of risk a bank has incurred, Mr. Stern said. This should discourage banks from acting recklessly, he said. Private companies or individual investors could provide the insurance, he said.
"There is a compelling need to adopt policies that dampen the incentive to take on too much risk," Mr. Stern said Friday at the Economic Education Winter Institute in St. Cloud, Minn.
Mr. Stern opposed completely privatizing deposit insurance, saying only a federal government-sponsored safety net can eliminate the instability and economic costs of bank panics.
The limited private insurance proposal received cautious support from the industry. "This is an idea that deserves more exploration," said Richard M. Whiting, acting director of the Bankers Roundtable. "We need to get increased market discipline into the process."
Private insurance was one of three ideas Mr. Stern touted to combat "too big to fail," which is the belief that some banks are so large that the government must cover all their debts, including deposits above $100,000, to avoid a financial panic.
Some worry that this implicit government guarantee encourages large banks to take excessive risks.
Mr. Stern has been railing against "too big to fail" for nearly two years.
Besides private insurance, Mr. Stern said the government could require banks to issue subordinated debt or could bar the Federal Deposit Insurance Corp. from paying more than 80% of deposits that exceed $100,000.
These last two issues formed the backbone of a reform proposal he issued in April.
"The idea, then, is to require by law that depositors and other creditors at all banks, even those considered 'too big to fail,' bear some risk of loss in the event of the failure of the institutions and to incorporate the market signals that this policy generates into the current regulatory regime," he said.
The subordinated debt plan has generated considerable support, including favorable comments from several Federal Reserve Board governors.
It would require a bank to regularly issue a small amount of subordinated debt, the market price of which would reflect the investment community's assessment of the institution's appetite for risk.
Mr. Stern cautioned that the subordinated debt proposal is not a "free lunch." The market for subordinated debt could become illiquid, he said.
Also some subordinated debt plans do not require frequent refinancings, he said.
The "too big to fail" doctrine is garnering increasing attention as the banking industry consolidates.
There are nearly 4,000 fewer banks than in 1990 and 64 banks now have more than $10 billion of assets, Mr. Stern said.