A Good Idea Gone Sour: Can Bank Insurance Fail? : Banking: Step aside, savings and loans. Problems with insurance for commercial banks may cause another crisis. This time, it may be worse.

The collapse of the savings-and-loan industry is already the most costly regulatory failure in the world. But even as that crisis unfolds, another is looming: Federal insurance of bank deposits, once considered an American birthright, may now be a luxury we can no longer afford.

The $500-billion price tag on the bailout of the Federal Savings and Loan Insurance Corporation is bloating the federal deficit, fueling inflationary pressures and putting upward pressure on interest rates. The government fire sale of thrift assets is also wreaking chaos on real-estate markets.

So far the problem has been isolated, in the relatively obscure S&L; industry. But the Federal Deposit Insurance Corporation’s program at the nation’s 14,000 commercial banks is identical to the system used for insuring S&Ls--a; system we know doesn’t work.

In fact, banking experts are now predicting the imminent collapse of the insurance fund that backs the commercial banking industry. Commercial bank failures are on the rise while the FDIC’s losses are at an all-time high, and their loss reserves at near-record lows. The bankruptcy of the FDIC’s insurance fund would be a body blow that even the resilient U.S. economy could not withstand. Economic collapse could ensue.

There is a certain irony in all this. After all, the original purpose of federally-backed insurance for deposit accounts-- one of the proudest legacies of Franklin D. Roosevelt’s New Deal--was to prevent bank failures by ensuring public confidence in the banking system. But government mismanagement of the deposit insurance system has created a set of perverse incentives that have fostered bank failures by encouraging irresponsibility and excessive risk-taking on the part of bank shareholders, management and boards of directors. Far from curing the bank failure disease, government-backed deposit insurance has only masked its symptoms while the disease itself was growing out of control.

The basically sound idea has been twisted by regulatory irresponsibility and ineptitude. Federally backed deposit insurance was supposed to instill public confidence in the banking system by assuring depositors that the money they have in their bank accounts will be available when they need it. Because banks keep less cash on hand than is necessary to meet their obligations to depositors at any given time, in the absence of deposit insurance, there is reason for depositors to worry.

Banks typically keep a high percentage of their liabilities in the form of demand or near-demand deposit accounts. But banks do not keep depositors’ money in their vaults. They invest it in long-term, relatively illiquid assets such as commercial loans and mortgages, keeping only a fraction in cash on hand at the bank to meet depositors’ needs. Consequently, all depositors cannot get access to their funds simultaneously. If they tried, even the healthiest bank would be unable to liquidate its investments in time to meet its obligations to all of its depositors. Normally, all depositors will not want all their cash at the same time. But in a world without deposit insurance, depositors know they can get their cash only if they are among the first through the door during a panic, avoiding the possibility of finding the bank’s cash reserves depleted by others who got there first.

Without deposit insurance, the me-first mentality can also be triggered whenever depositors believe their bank has made bad investments and may not have enough money to pay off all depositors in the future. Banks are vulnerable to rumors about panics and insolvency because depositors can withdraw their money and shift it to other banks easily and quickly. The solution to this problem was federal deposit insurance, which eliminates the incentives of individual depositors to withdraw their funds from banks on the basis of rumors, because depositors know the government will back the obligations.

Unfortunately, embedded within the deposit insurance concept are the seeds of its own destruction. Deposit insurance makes people see little difference between putting their money in banks that are well run and others that are not.

To make matter worse, deposit insurance gives bankers incentives to gamble depositors’ money on excessively risky projects. Normally, any investor, including depositors, will demand to be compensated for investing in high-risk, high-return projects. But depositors will not demand such a “risk premium” if their investments are protected by the federal government. This allows bankers to make excessively risky loans without having to pay higher interest rates to attract depositors. With deposit insurance, the banker who invests in safe investments with low rates of return must pay the same to attract deposits as the banker who invests in risky projects with high rates of return. If these projects do not pan out, the government is left holding the bag.

This problem would be easy for the government to correct. By charging banks a fee for deposit insurance based on the riskiness of their activities, banks would have an incentive to make safer investments with depositors’ funds.

But deposit insurance has been transformed from a program to protect depositors into a program that protects banks. Poorly run banks, like other poorly run businesses, should be allowed to fail. And when a bank fails, the FDIC should handle the problem in the way Congress envisioned when it enacted the Federal Deposit Insurance Act in 1935. It calls for insolvent banks to be closed and liquidated while insured depositors to be paid off promptly and in full. Depositors with accounts in excess of the $100,000 limit on insured deposits are to become general creditors of the failed bank.

Instead, government bailouts of failed banks have become the norm. Banking regulators gradually have expanded depositor protection to include even the largest, most sophisticated depositors.

This misguided policy has its origins in the decision of the FDIC to bail out the Continental Illinois bank in 1984. The FDIC decided that it could not let a bank as large as Continental go under because of the ripple effect that would have on the rest of the economy. The result was that all depositors--even those with deposits well in excess of $100,000 ceiling--were covered. The government announced that some U.S. banks simply were too large to fail.

Soon, principles of fairness and equal treatment for banks of all sizes led the FDIC to promise to bail out all depositors. The size of the bank did the matter. The results have been catastrophic.

The solutions to the current mess are simple. The government should require banks to purchase highly liquid short-term assets so that short-run liquidity crunches will not automatically induce bank failure. The government should vary the price for deposit insurance on the basis of risk. Finally, insolvent banks, regardless of size, should be liquidated.

These changes would protect the public not only from the social costs of bank failures, but also from the social costs of federally funded deposit insurance.