It is time to rethink the structure of the financial services industry. Once interest rates rise - and bank profits sink accordingly - the risks of perpetuating on outmoded financial system will become patently obvious.

The two prevailing models for industry restructuring fall under either the "core bank" or "depository institution holding company" label.

The difference between the two is one of degree rather than kind. Each posits a diversified financial services company that includes an insured depository and other lines of business.

The variations between them come from the kinds of activities that could be housed either in the bank or in its parent holding company - with the core bank approach requiring a more constrained insured depository operating in a more diversified corporation than in most versions of the holding company proposal.

Need for Firewalls

Both the core and holding company models share a troublesome problem: Each depends on firewalls to ensure that problems in affiliated activities do not contaminate the insured depository.

Because the two proposals differ on what activities would be allowed in the insured bank, they differ on precisely where the firewalls would be erected and on how high and how thick they would have to be. Nevertheless, each approach relies on prohibitions on integrated funding, cross-selling, and common management as the basic barriers to risk.

While these firewalls improve the appeal of these reform proposals from a policymaker's point of view, they have precisely the reverse effect on a manager of a financial services firm. The same firewalls that limit risk impede efficiency.

The Organic Bank

Another way to reform financial services could be called the organic bank. It is based on a supervisory - rather than a regulatory - approach to containing risk, and is thus based more on securities industry regulation than on the banking approach of the earlier models.

The organic-bank model permits the creation of integrated, efficient, and diverse financial services companies - attractive to policymaker and shareholder alike.

The organic bank would retain its deposit insurance, and would be allowed to operate much like existing commercial banks and S&Ls.

Insured deposits could still be converted into loans for small businesses, mortgages, or other purposes - a key difference from the core-bank proposal, which would generally limit the use of insured deposits to the purchase of no-risk government securities and, in some variations, asset-backed securities (which are by no means low risk).

Limits on Insurance

Meaningful deposit insurance reform is critical to the organic bank. If risk within the new structure is to be limited, then the scope of deposit insurance coverage must be limited, too.

Restricting coverage to no more than $100,000 per person per insured institution significantly reduces the cost of a failure to the government and is therefore essential.

In the organic bank, the distribution system of the insured institution can be used to sell any and all products offered by the parent and its affiliates.

However, products such as mutual funds, which could be mistaken for insured deposits, would be covered by rules designed to prevent customer confusion. The sale of securities, insurance, or other products requiring licenses and similar certifications could be made only by people who meet all the same regulatory requirements that are imposed on sales made outside a bank branch.

The clear penalties associated with coercive tying of sales should be more than adequate to prevent potential customer abuses, especially if the rules are accompanied by the vigorous enforcement on which the success of the organic bank relies.

Variety of Activities

A wide range of activities could continue to be conducted in an insured depository under the organic-bank model. They would include not only conventional lending, but also the trading and servicing operations increasingly associated with the modern bank.

This would avoid the almost Jesuitical arguments over what types of activities should or should not be conducted in conjunction with the business of taking insured deposits.

Yet the organic-bank model is by no means laissez-faire. All activities conducted within the insured depository would be subject to whatever restrictions bank regulators choose to impose.

These could be more stringent than if the same activity were conducted in an uninsured affiliate - an appropriate reflection of the different risk to the government in such cases.

For example, both a bank and a nonbank might choose to engage in foreign exchange trading, but only the bank might be subject to complex risk-based capital rules, trading limits, or similar sanctions. Each institution's management could decide whether the synergy of the relationship to the insured depository was worth the additional regulatory cost.

Safety Test

Under the organic-bank approach, regulators would review all the activities conducted within an insured depository to ensure that they are done in a safe and sound fashion by properly trained personnel under appropriate internal controls. Unless all these tests were met, the activity would have to be moved outside the insured depository.

This standard would permit the organic bank to evolve as the financial markets do, with regulators determining the risk associated with different new financial services. The flexibility of the organic bank ensures that all participants in the financial services industry engage in the market on an equal footing.

As new products are created, companies would be permitted to offer them either inside or outside the insured bank - but they would be allowed to offer the product and thus compete on the basis of the degree of risk presented.

A further constraint on risk would be the controls bank regulators could exercise over the insured depository. While bank regulators would not have the power to regulate the affiliates or the parent, they would be able to supervise, not only any potentially abuses of insured funds, but also any problems that could eventually damage the insured entity.

Again, this approach borrows from securities regulation. Although the SEC regulates directly registered broker-dealer operations in a securities firm, it also has the power to require reports and other data from all of the broker-dealer's affiliates. When it finds that an affiliate is taking undue risk, it can order the broker-dealer to sever its ties.

Under the organic-bank model, the bank regulator would have similar power. However, the new approach would give an institution two options: divest the risky operation or shed its insured depository and transfer all but the deposit-taking function into the nonbanking sections of the company.

Ms. Shaw is president of the Institute for Strategy Development, Washington.

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