VIEWPOINTS : DEPOSIT INSURANCE SHOULD BE ROLLED BACK : TAKE FEDERAL SUPPORT AWAY, AND BANKS AND THRIFTS WILL DO A BETTER JOB

Most Americans consider deposit insurance a birthright. It also is considered a source of stability in our financial system. Without the calming influence of deposit insurance, the argument goes, in hard times banks and thrift institutions could be wiped out by nervous customers. Best of all, since thrifts and banks pay the premiums for deposit insurance, taxpayers get a free ride.

All of this, however, is more myth than fact. By virtue of its promise to back all bank and thrift accounts up to $100,000, the federal government soon will have to liquidate or merge several hundred--perhaps as many as 1,000--sick financial institutions carrying insured deposits. The recent rash of bank and thrift bailouts in the Southwest alone is overwhelming the insurance funds.

The result: A big bill is coming due for taxpayers. Last week, in fact, the American Bankers Assn. urged the federal government to pledge up to $100 billion in tax revenue to rescue sick thrifts. And Sen. William Proxmire called for the next Congress to approve a $20-billion appropriation for that purpose. With the cost of bank and thrift rescues becoming increasingly apparent, the once-unthinkable idea of rolling back deposit insurance to reduce the government’s liabilities eventually will win enough support to become a reality.

Deposit insurance was begun in the 1930s for two purposes: to protect the poor and unsophisticated as well as to prevent runs on financial institutions by nervous depositors. The way circumstances have changed, neither reason carries much weight anymore.

To begin with, the $100,000-per-account coverage is largely benefiting wealthy, sophisticated investors. By spreading their money around in various accounts, these investors can keep fortunes protected under the umbrella of deposit insurance.

In addition, deposit insurance isn’t the best way to prevent runs on banks and thrifts by depositors, which can disrupt the entire economy. The Federal Reserve already has the means to stop such runs--it can lend emergency funds to keep healthy institutions in business in the face of panics. During the Great Depression, the Fed botched up by keeping its purse strings tight, a mistake that prompted the establishment of deposit insurance. The Fed isn’t likely to make that same mistake again.

In any case, deposit insurance appeared to do its job well for nearly 50 years, mainly because it never was seriously tested. During the 1980s, though, the system has buckled. Interest rates soared unexpectedly and the Federal Savings and Loan Insurance Corp. lacked the reserves to shut down the thousands of thrifts that sank into insolvency. Making matters worse were the Southwest’s plummeting real estate values and bank fraud.

If we do not roll back deposit insurance, the current crisis will not be our last. Thrifts and banks are increasingly fragile not just because of volatile interest rates and other unexpected shocks but also because dramatically improving computer and telecommunications technology are eroding their traditional businesses.

Thrifts were hit first. New technology allowed their mortgage loans to be pooled into mortgage-backed securities that now are held by many types of investors. Thus, the thrifts lost their dominance in the mortgage business.

Banks, meanwhile, have seen their share of the traditional lending business shrink by more than 30% since 1970. The widening use of commercial paper, subordinated debt and high-yield (“junk”) bonds has dampened the demand for their traditional loans. Asset-backed securities will hurt banks in much the same way mortgage-backed securities have hurt thrifts. This trend, along with bank failures due to regional economic downturns, will cost the Federal Deposit Insurance Corp. far more than its $15 billion in ready funds and $3.5 billion in annual income.

The contraction of the traditional thrift and bank businesses leaves Congress with no choice but to continue on its course of deregulation. If financial institutions were re-regulated, they would be hamstrung further and even harder pressed to stage a comeback. Re-regulation could prompt thrifts and banks to do such things as hold fixed-rate mortgages without proper hedges, a tact that already has been a money-loser.

Once you deregulate banks and thrifts further, there is less justification for comprehensive deposit insurance. Deregulation increasingly puts thrifts and banks into direct competition with other kinds of companies, companies that can’t attract funds from investors with the promise of deposit insurance. To prevent an unfair advantage for banks and thrifts, deposit insurance needs to be curtailed.

That outcome is not as scary as it might seem to some people. The poor and unsophisticated can be protected with deposit insurance of $25,000 per individual, for example. The Fed, moreover, could prevent runs amid banking crises by properly exercising its role as lender of last resort.

Beyond that, shifting the burden of periodic thrift and bank failures from taxpayers to uninsured depositors would impose needed discipline on the market that regulators can’t provide. Limited deposit insurance would force well-off depositors to begin watching their thrifts and banks closely to protect their money. Private agencies would emerge to provide these depositors with better information about thrift and bank performance. Armed with that information, big depositors would shun many ailing financial institutions, and institutions would respond by curbing their risk-taking.

Like most deregulation, deposit insurance reduction will spring from powerful, unstoppable and desirable economic forces. Banks and thrifts are increasingly inefficient. The asset-backed security is doing to thrifts and banks what the internal combustion engine did to the horse and buggy. Under deregulation, depositors will benefit from a wider range of financial products at lower costs. In the long run, there will be greater economic growth and more wealth.