|Too Big to Fail' Is Clearly Unethical

The "too big to fail" doctrine was born when Continental Illinois National Bank of Chicago needed assistance because of the failure of Penn Square Bank in June 1982.

Fearing the worst, uninsured depositors - particularly from foreign countries - started a run on Manufacturers Hanover in New York. To stop the run and to help protect Continental, federal regulators insured all depositors and creditors, at both the bank and holding-company levels.

Unfortunately, the policy was the beginning of the great give-away of taxpayers' funds. It was also a mistake that has contributed, along with the current deposit insurance regulation, to a decline in the overall condition of the banking system.

The "to big to fail" doctrine is unethical because small banks are allowed to fail, inefficient for big banks since it reduces the need for market discipline, and unnecessary in protecting the stability of the banking system since other alternatives exist.

Recognizing the problems, the U.S. Treasury in its deposit insurance reform proposal has asked Congress to eliminate the doctrine.

As a provider of financial ratings on banking organizations, I have had many corporate treasurers say to me: "Why do I need a bank rating service when all I have to do is put our money in a big bank? The feds won't let them fail."

Such a policy is certainly unethical as it applies to smaller banks: Not only are they allowed to fail, but the policy also shifts funds away from smaller banks or raises their cost of funds, or both.

The policy also raises insurance costs for smaller banks. The failure of small banks is not causing depletion in the Federal Deposit Insurance Corp.'s insurance fund. For the most part, the depletion arises from the cost of paying off uninsured depositors at larger banks.

A Need for Market Efficiency

The doctrine is inefficient since it does not provide market incentives to eliminate risk-taking or to ensure strong capitalization. What uninsured depositor, for example, did not know that Bank of New England was going to fail?

I believe all knew but felt safe because of the "to big to fail" doctrine. They stayed with the bank because of lower-priced services or higher returns on their deposits. The payoff to uninsured depositors was reported to be over $3 billion.

Insurance Versus Stability

The responsibilities of rescuing a bank and rescuing the financial system should be kept separate. It is unfair to ask bankers to pay deposit-insurance premiums to protect a financial system that is available to all citizens.

Separation of these issues should aid in deciding on the levels of deposit insurance. The result should be a clearer policy on when a bank is to be saved to protect the rest of the financial system.

Congress has not adopted a clear policy for dealing with large-bank failures, leaving the problem to federal regulators.

It is hard to blame L. William Seidman, chairman of the FDIC, for failing to take a stand on allowing a large bank to fail. Such a position could find Mr. Seidman remembered as the cause of the banking system's collapse.

Federal Reserve's Role

The Federal Reserve System has always been responsible for the financial stability of the banking system. The handling of bank failures is mainly the responsibility of the FDIC because of the insurance fund.

If a banking organization is insolvent - or close to it - the FDIC should decide whether to give regulator support or allow the bank to fail.

The Federal Reserve System has always had the authority to provide liquidity to the banking system through the discount window. It should take a more active role in assuring the liquidity needs of the financially weak but solvent banks, since they face the risk of runs on deposits.

If, for any reason, the Federal Reserve System finds it necessary to assure depositors or creditors, at any level, to maintain the stability of the financial system, the costs of this assurance should come out of the Federal Reserve System's budget.

There are clearly too many banks in this country chasing too few accounts. Concentration in banking will occur in the 1990s. Inefficient banks should be allowed to go out of business - without taxpayer assistance.

The country and, for that matter, the banking industry cannot afford to continue the current costs of bailing out S&Ls and banks.

Mr. Putnam is president of Lace Financial Corp., Frederick, Md., a bank and thrift rating service. A 16-year veteran of the Federal Reserve System, his final position was manager of the surveillance section in the division of bank supervision, overseeing monitoring of the financial condition of commercial banks and bank holding companies.

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