Buried deep in the tax bill President Clinton signed on Aug. 10 was the most significant change in federal deposit insurance since its original enactment in 1933: the depositor preference provision.

Though it was sold merely as an alternative to levying federal examination fees on state-chartered institutions, depositor preference in fact will have many far-reaching and unintended consequences.

One of the most startling is the effective enactment of the "core," or "narrow," bank concept. Fortunately, the core bank, as created by depositor preference. will be vastly superior to another form of it advocated by Lowell Bryan of McKinsey & Co., Rep. Charles Schumer of New York, and many academics.

Two Approaches to Core Bank

In their version, a bank's or thrift's deposits could be invested only in very safe, liquid assets. The accompanying chart contrasts the two types of core banks.

Depositor preference gives a liquidation priority over almost all nondeposit liabilities of a failed bank or thrift. Uninsured domestic depositors and the FDIC, standing in the shoes of insured depositors, will now be paid in full before junior creditors receive a penny.

Likely Junior Creditors

Put another way, junior creditors will be wiped out before the FDIC and uninsured domestic depositors suffer any loss.

Who are a bank's or thrift's most likely junior creditors? Foreign deposits in the case of many large banks, fed funds lenders, holders of bankers' acceptances, unsecured lenders, landlords, and counterparties in swaps, options, and futures transactions (subject to netting rules).

In fact, just about every type of bank creditor is now junior to domestic depositors except secured lenders, employees, and a few trade creditors.

This liquidation preference in a bank or thrift failure effectively created what could be called a core-bank-within-a-whole-bank because depositors and the FDIC now get first crack at a bank's or thrift's most liquid assets.

Larger banks always have effectively invested their domestic deposits in highly liquid assets. As of March 31 of this year, for example, commercial banks with more than $500 million of assets held total cash and liquid securities in their U.S. branches equal to 42% of their total domestic deposits.

These assets plus the high-quality, readily saleable loans these banks own usually exceed their domestic deposits. Hence, the core-bank-within-a-whole-bank, at least initially, delivers the functional equivalent of the academic version of the core bank.

Smaller Institutions

Thrifts and smaller banks generally hold fewer liquid assets than larger banks, relative to their domestic deposits, but most versions of the academics' core bank would have exempted smaller institutions.

The core-bank-within-a-whole-bank (right side of the chart) has two major advantages over the academics' core bank left side). First, it was implemented instantaneously with the stroke of the President's pen.

By contrast, the academic version of the core bank would have required years to implement because it would have demanded the complicated division of existing large banks into two legally distinct institutions. The legal costs alone would have been a lawyer's dream.

Second, the core-bank-within-a-whole-bank, unlike the academic core bank, will not create the mother of all credit crunches. Since the academic version would have forced a core bank to invest all of its deposits in highly liquid assets, none of its assets could have consisted of locally originated, illiquid loans. Many small to medium-size businesses would have lost their financing.

Further, because the finance company sibling to the academics' core bank would not have been federally insured, it too would have had to hold substantial amounts of liquidity.

Burgeoning Liquidity Needs

I estimate that the academics' core bank would have increased the liquidity needs of core banks and their related finance companies by $750 billion to $1 trillion, assuming they did not shrink.

Existing banks forced to divide themselves into a core bank and an uninsured finance company would have raised that liquidity by calling loans, selling loans outside the banking system, and going through the very expensive process of securitizing not easily securitized assets. These actions would have devastated the economy.

Fortunately, the core-bank-within-the-whole-bank creates none of that turmoil. But all is not bliss with depositor preference, for it will trigger numerous structural changes within banks and thrifts while highlighting serious regulatory weaknesses.

An Edge for Big Banks

Depositor preference lessens the importance of that already dubious concept of depositor discipline. In large banks with substantial nondepositor funding, supposedly uninsured depositors as a practical matter now face no risk of loss. This fact will give large banks an edge over small banks in attracting deposits over $100,000.

Nondepositor creditors will soon grasp that Congress wants them to pay for regulatory errors, a notion they will not eagerly embrace. Many will begin to extend credit or assume counterparty risk only on a collateralized basis, thereby jumping ahead of depositors on the priority ladder if the bank or thrift fails.

Unsecured bank borrowings, such as uninsured bank notes, may begin to include "acceleration clauses" that will let the lender pull its money out of the bank before FDICIA's prompt corrective action kicks in.

Of course, once acceleration clauses trigger funding outflows, uninsured depositors will not be far behind. Depositor discipline will soon consist of closely watching a bank's or thrift's uninsured creditors.

Boosting Capital Ratios

Because of the likely use of acceleration clauses, depositor preference will broaden the base of funds set to run from a bank long before regulatory sanctions kick in. Banks consequently may feel compelled to raise their capital ratios to deter false negatives -- that is a run on a solvent bank.

Higher capital, in turn, will accelerate the shrinkage of banking due to a shrinking pool of assets on which banks can earn a sufficient return to cover the cost of more capital. Banks will be able to avoid asset shrinkage only by acquiring higher risk assets that demand more capital backing. Some banks would then begin to resemble junk bond funds.

The greater likelihood of runs on banks by junior creditors probably has increased the number of banks considered to be "too big to fail," since these runs will destabilize the markets for a broader range of financial instruments.

Pulling Deposits Out

This risk of runs exists because sophisticated nondepositor creditors of banks and thrifts will respond more quickly and dramatically than depositors to troubling news about a large bank or thrift. No regulator, of course, will specify which banks are "too big to fail," further heightening uncertainty of a type that rattles financial markets.

The structural changes depositor preference will trigger in bank balance sheets raise some interesting questions. For one, if depositor preference will sharply reduce deposit insurance losses, why regulate banks so intensely? Also, what is the impact of depositor preference on risk-based capital standards?

Should risk-based premiums for large banks drop sharply since these banks now pose almost no risk of loss to the FDIC? And if depositor preference sharply reduces the FDIC's risk, what regulatory future does it have and who should step into that void? The Federal Reserve? The Office of the Comptroller of the Currency? The Securities and Exchange Commission?

Depositor preference also will make largely irrelevant many tools regulators now rely upon. Bank call reports provide very little data about collateralized borrowings and absolutely nothing about acceleration clauses that could destabilize the financial system.

Audited financial reports are little help either. How can anyone today measure the liquidity risk in individual banks that depositor preference elevated conderably? Is anyone even thinking about these questions?

Despite these concerns, depositor preference will deliver two long-term benefits to banking, and therefore to the economic First, this mild experiment with the core bank has killed the more dangerous version of core banking most recently advocated by the commission that analyzed the Federal Savings and loan Insurance Corp. fiasco.

Second, and much more important, depositor preference will force a long-overdue debate on fundamental reform of bank regulation and deposit insurance. People inside and outside of the Beltway have been avoiding any discussion of the inherent failings of federal deposit insurance that Roosevelt warned about in 1933. Time's up.

As many readers of this fine newspaper know, I am a long-time advocate of privatizing deposit insurance and all of the increasingly irrational and harmful regulation that accompanies it. Depositor preference, a measure I did not champion, moves us closer to that day.

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