Banking Reform Is Needed, but Be Careful How You Do It : Deregulation is a false god; restructuring is the better answer

Bank reform will be a major legislative concern next year. We support reform but recommend that Congress carefully weigh each proposal. Taxpayers are wary, and rightly so, given the savings and loan debacle. The foundation of banking--and thus of the economic security of the nation--is safety and soundness. Changes should be cautious, controlled and subject to strict regulation.

Make no mistake, it is time for comprehensive reform. Federal regulations have for some time put the banking industry at a competitive disadvantage domestically and internationally. And Congress’ failure to address these issues puts banks under even greater pressure today. They must compete with a variety of lenders, including nonbanks like, say, Sears Roebuck & Co. Financial deregulation has come at the expense of banks, which have been largely prohibited from entering the securities, insurance and other businesses.

The best reform, however, is not a question of deregulation of the industry but of restructuring. “We need fundamental structural reform,” Treasury Secretary Nicholas Brady said earlier this week. He’s right, but any reform must hold the banking industry to a high degree of accountability and responsibility. That was not the case with the S&L; industry. Hindsight shows what a tragic blunder that was.

Banks are in far better shape than S&Ls; were when they encountered problems in the 1970s and 1980s. The great majority of banks are profitable , thanks to more stringent federal requirements. Nevertheless, pressure for reform is growing stronger because of increasing stress on the Federal Deposit Insurance Corp., which insures bank deposits.

Banking is a riskier business than it was a decade ago. Between 1943 and 1981, the greatest number of banks that failed in any one year was 17 (in 1976). But in the 1980s, the number of failures each year has risen dramatically, reaching a peak of 206 in 1989. This has taken a toll on the FDIC insurance fund.

Increasing competition has reduced the industry’s share of financial - sector assets to 27% in 1987, down from 33% in 1980. Bank portfolios have changed , too. The ratio of loans to assets has grown from 22% in the 1940s to 58% in the 1980s. Meanwhile, real estate loans account for 38% of a bank’s loan portfolio, while commercial and industrial loans--once the sole domain of banks--amount to only 31%.

Tackling bank reform involves psychology as well as practicality. Current laws that tie bankers’ hands stem from the Glass-Steagall Act of 1933, which was enacted to separate commercial banking from investment banking during the Depression. Banks were prohibited from entering the securities business because of questionable lending practices that helped fuel the stock market frenzy preceding the 1929 crash. The purpose of Glass-Steagall was to create fire walls, in effect, around banks. They were put under the supervision of the Federal Reserve Board, the FDIC was created to protect bank depositors, and maximum interest rates were set on all forms of savings and time deposits. A system with little competition evolved whereby banks concentrated on commercial lending, S&Ls; on home mortgages and brokerages on investment banking.

In 1980, Congress passed the Depository Institutions Deregulation and Monetary Control Act, perhaps the single most important piece of banking legislation since 1933. It drastically affected every type of financial institution. FDIC coverage was expanded to $100,000 per account. Interest rate ceilings were phased out. This opened new opportunities to a variety of lenders--except for banks.

But the Fed began chipping away at the fire walls around banks in 1987 when it allowed three bank holding companies to underwrite municipal revenue bonds and mortgage-related securities. Then the Fed went further, allowing J.P. Morgan & Co. to be the first bank holding company to underwrite stocks. The Fed was right to begin, however cautiously, the process of modernizing commercial banking.

Banks in Trouble Number of failed banks 1980-89 1980: 10 1981: 10 1982: 42 1983: 48 1984: 79 1985: 120 1986: 138 1987: 184 1988: 200 1989: 206