August 18, 1991
"Without Reform First Aid, Banks will Keep Bleeding"
San Jose Mercury News
By Timothy Taylor
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NOBODY'S CRYING for bankers, but it's a fact that profits in the industry
are sinking. The average bank earned profits equal to 0.77 percent of assets in
the 1970s, but that had fallen to 0.55 percent by the late 1980s.
Perhaps more wounding is the current estimate that about 400 banks with total
assets of perhaps $170 billion will fail in 1991 and 1992, according to the Federal
Deposit Insurance Corporation.
Downright irritating is the fact that taxpayers are likely to end up paying
for some of those losses. When a bank goes bankrupt, the federal government guarantees
that depositors will get their money back, at least up to $100,000. The money
for that deposit insurance is supposed to come from premiums paid by banks.
S&Ls: The Sequel?
But after 55 consecutive years in the black, the Bank Insurance Fund of the FDIC
has had three consecutive years of losses. It's predicted to be out of money in
a few months. After that, taxpayers could be on the hook. Check your local listings
for "The Savings and Loan Bailout: Part II."
The bank reform bills now before the House and Senate are both based on a proposal
by the Treasury Department. Along with some changes in the bank regulation bureaucracy,
Treasury made proposals in four broad areas: interstate branching, allowing banks
to enter new lines of business, bank ownership, and reforming deposit insurance.
Banks have been officially prohibited from setting up branches in other states
since the McFadden Act of 1927, but it does not seem at all controversial to lift
these restrictions, in either the House or Senate. This is probably because it
has already happened.
In recent years, bank "holding companies" have been allowed to own
banks in more than one state. As a result, at the end of 1990, there were 160
interstate bank holding companies operating at least 465 bank subsidiaries, according
to David Mengle of the Federal Reserve Bank of Richmond.
The main justification for interstate branching is that banks with many branches
are less likely to go broke and cost the taxpayers money.
Interstate banks can spread their risks more widely; for example, if Texas
banks had been allowed to do business in other states, not so many would have
gone bankrupt when the price of oil went down.
Interstate banking is also a good deal for consumers. It brings new competition
into the market. New services are offered; for example, it becomes easy to write
an out-of-your- state check, since the bank can be in another state, too.
The main worry about interstate branching is that a few big banks will dominate
the market. While the government antitrust regulators should keep an eye on the
situation, there probably isn't much reason to worry. In the enormous California
economy, for example, where branch banking has been allowed within the state since
1909, there are still 430 banks. BankAmerica, Security Pacific, Wells Fargo, First
Interstate, and the other big players haven't driven out everyone else.
Although allowing banks to enter states is not controversial, allowing them
to enter other lines of business certainly is. The Treasury proposal would allow
banks that meet a high standard of financial fitness to enter the insurance and
The fear about this proposal is that the overall company could profit from
owning the bank in good times, but when bad times come around, it could just let
the bank go broke and let the deposit insurance fund foot the bills. To prevent
this scenario of heads-the-company-wins, tails-the-government-loses, the Treasury
plan tries to set up "firewalls" between the bank and any other financial
But this raises a related problem. If the banks must be kept completely separate,
then are they actually being allowed to enter other industries? Moreover, since
banking is not especially profitable now, why would insurance or securities firms
rush to pour their own money into the banking industry?
Although it's not clear that changing the rules will make much immediate difference,
it does make sense to recognize that insurance and securities and banking are
all institutions that take deposits from people, pay a return, and invest the
funds in the rest of the economy. Financial innovations have allowed these services
to draw ever close, and the government shouldn't be trying to create artificial
divisions between them.
Both the House and Senate seem currently disposed to allow banks to enter these
other businesses, but defining the firewall provisions is certain to take up a
lot of lobbyists' time and legislators' ink.
The most controversial idea in the Treasury proposal is to allow commercial
and industrial firms outside the financial sector to own banks. Financial guru
Henry Kaufman recently attacked this idea, for example, on the grounds that it
"will hurt free enterprise and lead to a corporatist state."
In fact, many large corporations have already taken on some bank-like functions:
car companies offer loans, brokers offer home mortgages, everyone offers credit
cards. But Kaufman and others are concerned that a bank owned by a company might
feel compelled to offer unwise deals to its owner, or to its owner's customers
or suppliers. If the bank goes broke as a result of such sweetheart deals, the
deposit insurance fund (or the taxpayer) could end up footing the bill.
The House appears willing to let industrial corporations run banks, as long
as those banks are kept financially healthy; the Senate is less eager. The debate
will be over whether it is possible to build firewalls that will protect the safety
of banks, while still making it attractive for industrial firms to own one.
The Treasury plan proposed reforming deposit insurance in several ways: reducing
the coverage of deposit insurance; setting up risk-based premiums; and enforcing
capital requirements more strictly.
In big banks, those with more than $10 billion in assets, more than half of
the total deposits are not technically insured. They are over the $100,000 limit.
But in the last five years, the FDIC has arranged matters so that even when the
bank goes under, 99.5 percent of these technically uninsured depositors get their
Do They Mean It?
The Treasury, House and Senate all claim a desire to enforce the $100,000 limit,
but it's not clear that they mean it. When big uninsured depositors start squawking
or when they start pulling out their money and causing banks to collapse, one
suspects that the regulators will be forced to step in.
Treasury proposed that banks with especially high amounts of capital could
pay a lower insurance premium. Of course, the risk of bank failure drops with
higher capital. This idea is so obviously good that the real question is why it's
not already happening.
Treasury also proposed setting up a set of five "zones" to measure
financial stability. Only banks in the highest zone would be allowed to sell insurance,
get lower deposit insurance premiums, and so on. As banks moved down through the
zones, they would come under tighter regulatory control.
The problem here is that although the Treasury plan spells out what can be
done, it does not specify what must be done. If bank regulators have discretion
to decide who is in what zone and whether the bank needs to take painful steps,
they will be subject to political pressure to hold off. As illustrated by the
firm of Keating, Cranston, and Assorted Senators, this pressure can be very costly.
Thus, the job for the House and Senate is to set up firm procedures for enforcing
capital standards, and ensuring that the FDIC has the manpower and resources to
do the job. Any exceptions to the standard rules should be made in a hot glare
of public scrutiny, not behind closed doors.
The Way to Reform
Bank reform must be considered as a comprehensive package. If banks don't receive
the freedom to enter other states and to form new ties with financial and industrial
corporations, they will continue to go broke. The deposit insurance fund will
run out, no matter whether it is reformed, and taxpayers will be stuck with the
On the other hand, if banks were to receive new freedoms without a reform of
deposit insurance, at least some of them are likely to abuse their freedom. As
in the case of the S&L's, that would also lead to losses for the deposit insurance
The banking crisis isn't exactly like the savings and loans -- good sequels
always have new twists -- but it's about as close to instant replay as the real
world ever offers. If Congress can't learn from history and pass a comprehensive
reform of banking laws this fall, taxpayers may be doomed to yet another bailout.
The Treasury Department has proposed a comprehensive plan for reforming the banking
industry. Versions of the plan are being considered by the House and Senate, with
the goal of passing a bill sometime this fall. The original Treasury proposal
includes provisions that would:
Source: U.S. Department of the Treasury, "Modernizing the Financial System:
Recommendations for Safer, More Competitive Banks," February 1991.
- Allow banks to set up branches directly in other states.
- Allow financially healthy banks to enter financial businesses like insurance
- Allow commercial and industrial firms to own banks.
- Reform deposit insurance by restricting coverage, changing the structure
of premiums, and enforcing capital standards more strictly.
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