COLUMN ONE : A Risky System for Deposits : The link between insured savings and reckless lending isn’t new. Yet politics and economics will make it hard to revamp the process that led to the S&L; crisis.

Oil speculator W. L. Norton wasn’t Oklahoma’s most skilled banker when he bought Columbia Bank & Trust Co. in 1908, but he had a hunch that a new state scheme called deposit insurance could quickly line his vaults with millions.

He was right. With the state pledging to make up any losses, Columbia offered high interest for savings and uncapped a gusher of deposits that almost overnight made the once-stagnant lender Oklahoma’s biggest bank. Norton recycled some of the proceeds as loans to his own risky oil deals.

Columbia failed 11 months later, bringing down several smaller banks and nearly unhinging the state deposit insurance system. And, as similar failures swept farm states in the ensuing years, many came to a view expressed by the usually impassive journal of the Texas banking lobby:

“We know what a nightmare and mockery and unsound thing this guaranteeing of deposits is,” the Texas Bank Record warned. “It encourages more and poorer investments, and more and poorer bankers.”

Congress overlooked such warnings when it set up a federal deposit insurance system in 1933 to promote public confidence and prevent bank runs. But the issue is back before it today with the greatest urgency, for deposit insurance was arguably the single most important cause of the savings and loan crisis, which it is estimated will cost taxpayers as much as $500 billion, and it is now at the center of a wholesale re-examination of the nation’s banking system.

Deposit insurance’s tendency to foster reckless lending has been known and debated in this country since at least the early 19th Century. But because of potent special interest politics, and some deeply held American views about banking, legislators and regulators have overlooked its dangers and repeatedly extended the scope of its guarantees.

Only recently has it become apparent what a heavy burden this legacy will be. Congress and the Bush Administration are considering a variety of reform proposals, including limiting coverage to $100,000 per depositor, enlisting private investors or insurers to monitor banks’ risks and replacing government guarantees with a system in which banks insure one another.

For political and economic reasons, the system will be extremely difficult to overhaul, and many experts expect the current debate to yield only regulatory tinkering. Many experts believe that, if there aren’t major changes, taxpayers might eventually face a bailout of the nation’s 13,000 banks that would be even more expensive than the crisis that has engulfed so many of the 2,500 U.S. thrifts.

“Deposit insurance is like a nuclear power plant,” said L. William Seidman, chairman of the Federal Deposit Insurance Corp., which manages the system. “If you handle it right, it can do you some good. But if you let it get out of control, it can melt down and take you with it.”

The deposit-guarantee system has done a good job, accomplishing most of its goals, and for its first half century did not receive much criticism. By standing ready to reimburse any losses, the FDIC has maintained public confidence--and lubricated the system of savings and investment that the economy needs for health and growth.

While the system has usually provided stability, it has had a central flaw that, like a misshapen cog at the heart of a giant clockwork, always threatened to wreck the entire machine. Experts call it the “moral hazard” of deposit insurance.

Moral Component

By insuring deposits against losses, the government removes any reason for depositors to worry about whether to pull their money out of an institution. But without the threat that nervous depositors will flee, there is much less incentive for managers to worry about reckless investment, particularly if they have little of their own capital at stake in the institution.

The thrift industry’s travails in the 1980s provide the ultimate proof of this risk. When interest rates rose in the early 1980s, thrifts were often collecting under 10% interest for most of their home mortgages but in some cases paid nearly 20% to attract funds.

So, with the blessing of Congress and regulators, they began putting money in such high-yielding investment as junk bonds, artwork, luxury-car dealerships, mushroom farms and real estate.

As with W. L. Norton’s Columbia Bank, the lenders that offered the highest deposit rates were often the most reckless. But they sucked in deposits by the billions, often through brokerage firms that divided investments into insurable $100,000 chunks and, using computers, dispatched them to the S&Ls; paying the richest premiums. Funds treated in this new way were called “brokered deposits.”

As their risky investments proved to be losers, thrifts began to go under in a death-dive that is expected to shrink the industry to about 1,900 survivors from 4,000 S&Ls; in 1980.

In turn, the failure of the thrifts bankrupted the Federal Savings and Loan Insurance Corp., the agency that ran a deposit insurance fund for the S&Ls.; And it forced the U.S. government bailout that is expected to cost taxpayers as much as $500 billion over 30 years.

Since last year, when a newly created Office of Thrift Supervision took over the FSLIC, thrift deposits have been insured by the same $13.5-billion FDIC fund that guarantees deposits held in banks.

System’s History

How did Congress adopt a system with such risks? With surprising ease.

The chief advocates of the system in 1933 were small banks, which then, as now, possessed enormous leverage in Congress because there were bankers in each congressman’s district.

The small banks saw deposit insurance as a way to give themselves the same fiscal strength that attracted depositors to big city banks. In those years, the debate on the issue was framed as a choice between a system of “unit” banks--those allowed to have only one branch--that would have deposit insurance, and a system of multibranch institutions that would not have insurance.

The small banks contended that unit banks could better serve their communities than branches of far-off banking behemoths.

In this contention, they tapped a deep-seated Populist view that regarded large banks with mistrust and associated them with the Byzantine and oligopolistic financial structures of Europe. The small-bank lobby often found allies among farmers and farm-dependent businessmen, and it was no accident that the prairie Populist William Jennings Bryan was a strong proponent of deposit guarantees.

Big city banks actively campaigned against the idea, and leading politicians of both parties expressed grave misgivings. “We do not want to . . . put a premium on unsound banking in the future,” Franklin D. Roosevelt said in his first press conference as President.

The public didn’t seem to be aware of the issue or to be represented in the discussions. “The debate was mostly between bankers,” said Eugene N. White, an economics professor at Rutgers University in New Jersey. The idea that the interests of the small depositor were foremost in the lawmaking “is a great big myth,” he said.

The clause that created the FDIC was written into the bill by Sen. Henry B. Steagall, a cranky Alabama Democrat and small-bank partisan who got his way by agreeing, in a horse-trading session safely removed from public view, to support banking reforms proposed by other legislators.

Congress unquestionably needed some steps to stabilize the system, for with 4,004 bank failures, 1933 marked the peak of the Depression-era closures. But recent history then should have persuaded Congress to be wary of deposit insurance.

Past Lessons

From 1908 to 1917, seven states, mostly in the Great Plains, had adopted state deposit insurance systems. Some had performed creditably for a while, as World War I boosted agriculture prices and fortunes of the region.

But when farm prices and oil prices plunged in the 1920s, one by one the systems failed, draining bank insurance fund contributions and drawing down state treasuries.

In some cases, the reason for the failure lay with men such as Norton, the Oklahoma bank speculator, who in personality and ambition seems akin to the thrift executives of the 1980s. Norton was a man known for a ready smile and a manner as slick as his pomaded hair.

“He was a clever, likable fellow . . . a phenomenal business-getter,” wrote Thomas B. Robb in his 1921 work, “The Guaranty of Bank Deposits,” quoting a legislative committee that investigated the Oklahoma banking bust.

Norton was part of a clique of speculators who had stakes in two smaller banks in the Oklahoma oil patch when they took control of Columbia. The group had borrowed heavily to buy the banks and make other oil investments, and the plunge of oil prices was more than sufficient to bring them down.

Yet, then as now, fraud was not the primary reason for the failures of the period. “It was really the perverted incentives of the system,” said Charles W. Calomiris, an economics professor at Northwestern University. “Deposit insurance encourages fraud, because it can bring a big payoff; but it also encourages risk taking--and raises the tolerance of the system for fools.”

Calomiris contrasts the failures of deposit insurance systems like Oklahoma’s with the successes in such states as Indiana and Iowa, where banks were liable for others’ uncovered losses and had a strong incentive to try to prevent risky lending by their peers.

The 1980s were like the early decades of the century in the way that the rapid sequence of boom and bust threatened the deposit insurance systems. In the 1920s, it was a cycle of boom and bust in farm prices that toppled banks; in the 1980s, it was real estate.

And the last decade mirrored the early part of the century in the way that Congress reacted to the distress of small lenders.

Pressured by a panicked S&L; industry, Congress in the early 1980s eased the rules governing how much of their own capital thrifts had to invest; with less of their own money at risk, thrift executives could earn a higher rate of return and had greater incentive to gamble with depositors’ money.

Congress and the regulators also relaxed rules calling for quick closure of troubled S&Ls.;

There was wide support in the early 1980s for the easing of rules to help the thrifts out of their interest rate bind. But many experts believe Congress went far beyond its duty to the distressed thrifts in 1981 when it quietly raised the deposit insurance coverage limit to $100,000 per account from $40,000.

The maneuver was arranged by former Rep. Fernand St Germain (D-R.I.), then head of the House Banking Committee, at a conference committee session with no debate on the issue. St Germain, who has since been investigated for his ties to S&L; executives, was responding to pressure from large California thrifts that were concerned by the flight of deposits to investment firms’ money market mutual funds.

The change was “very mysterious, almost a subterfuge,” said Rep. Henry B. Gonzalez (D-Tex.), current chairman of the House Banking Committee.

Indeed, some have blamed the move for stimulating huge growth in the $65-billion “brokered deposits” business that fed the rapid expansion of S&Ls; in the 1980s--and hugely raised the cost of their cleanup. Raising the coverage limit stimulated this new business because government rules did not put a limit on how much interest could be paid on $100,000 sums, as they did on the smaller amounts.

Federal Liability

The government’s liability for deposits doesn’t stop at $100,000 per depositor. Not only can depositors open insured accounts at as many institutions as they wish, they can also, at each institution, designate special joint husband-wife accounts and multiple trust accounts for spouses and children.

Thus, a family of four can legally open 14 insured accounts worth $1.4 million at a single institution.

The government’s guarantees don’t stop there. When the government saved Chicago-based Continental Illinois Bank in 1984, it covered the losses of all depositors, not just those in accounts of under $100,000. It picked up the tab for losses by creditors as well.

The move, prompted by fears that Continental’s failure could bring runs on other banks, led to a widespread assumption that the government was backing all liabilities at big banks--a doctrine known as “too big to fail.” In the interest of fairness, the government has since extended the doctrine to cover smaller banks as well.

The government had, with little effort, extended a net of unlimited coverage that also gave taxpayers unlimited liability. In almost all cases, uninsured deposits have been covered when banks or thrifts failed.

Rolling back the net will be far more difficult. Congress must worry about the stability of the fragile banking system and the international competitiveness of American banks--not to mention their political power to block change they don’t like.

Few believe, for example, that there is any hope for proposals to roll back coverage limits to $50,000 per account, because of fears that it would set off runs that could ruin many marginal banks and S&Ls.;

Treasury Secretary Nicholas F. Brady has said that, as part of a study of the system, his agency is considering capping coverage limits at $100,000 total per depositor.

Wealthy individuals would be unable to make multiple $100,000 deposits at different institutions, with each account insured. The Treasury would like to cut the government’s $2.5-trillion liability while simultaneously freeing banks to sell insurance, underwrite stocks and take on other financial activities to give them the greater diversification that presumably would mean more financial stability.

Many experts, however, wonder whether such a $100,000 cap could be feasible. It would involve setting up a huge data-gathering operation, akin to the Social Security system or the Internal Revenue Service. And, even with such a system, many experts think that depositors could find ways to elude the insurance ceiling.

The proposal could also wound small banks, as depositors moved their money to presumably safer large banks on an assumption that the government would never let them fail.

Some people close to the deliberations believe Congress will in the end try to mend the system by regulatory changes that would require earlier closure of weakening institutions and force bank owners to keep more of their own capital in their institutions. Early closure could sharply limit the government’s losses, and increased capital would presumably make bank managers more cautious about their investments.

But some experts, pointing to the blunders of the last decade, question whether regulators would be inclined to hold banks to tough rules or shut them down in a crisis, often in the face of congressional opposition.

It may be impossible to forecast how the reform debate will end, for, if a recession and a worsening of the real estate markets were to deepen losses of banks and thrifts, Congress may turn to a radical solution.

“No one can see how this will turn out,” said Peter J. Wallison, a Washington lawyer and the Treasury Department’s general counsel from 1981 to 1985. “But when the shouting ends, if there’s been no more than tinkering, in five or 10 years we may be doing all this over again, from an even weaker position.”

STRETCHING DEPOSIT INSURANCE Although federal deposit insurance is limited to $100,000 per account, here is how families can extend their coverage at a single bank or savings and loan. $500,000 of insured deposits for a family of two Individual accounts Husband: $100,000 Wife: $100,000 Joint accounts* Husband and wife: $100,000 Testamentary and revocable trust accounts Husband as trustee for wife: $100,000 Wife as trustee for husband: $100,000 Total: $500,000 $1 million of insured deposits for a family of three Individual accounts Husband: $100,000 Wife: $100,000 Child: $100,000 Joint accounts* Husband and wife: $100,000 Husband and child: $100,000 Wife and child: $100,000 Testamentary and revocable trust accounts Husband as trustee for wife: $100,000 Wife as trustee for husband: $100,000 Husband as trustee for child: $100,000 Wife as trustee for child: $100,000 Total: $1 million $1.4 million of insured deposits for a family of four Individual accounts Husband: $100,000 Wife: $100,000 First child: $100,000 Second child: $100,000 Joint accounts* Husband and wife: $100,000 Husband and first child: $100,000 Wife and second child: $100,000 Both children: $100,000 Testamentary and revocable trust accounts Husband as trustee for wife: $100,000 Husband as trusteee for first child: $ 100,000 Husband as trustee for second child: $100,000 Wife as trustee for husband: $100,000 Wife as trustee for first child: $100,000 Wife as trustee for second child: $100,000 Total: $1.4 million * joint account with right of survivorship