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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.

Big Worry
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 securities business.

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 operations.

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?

Similar Institutions
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 money back.

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 losses.

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 fund.

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:
  • Allow banks to set up branches directly in other states.
  • Allow financially healthy banks to enter financial businesses like insurance and securities.
  • 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.
Source: U.S. Department of the Treasury, "Modernizing the Financial System: Recommendations for Safer, More Competitive Banks," February 1991.

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