Bush Plans to Seek Cuts in Safety Net for Banks : Finance: Official says that under the proposal not all institutions would enjoy unlimited deposit insurance.

The Bush Administration plans to propose radical banking system reforms that would give regulators more power to allow big banks to fail without blanket government protection for the institutions or their depositors, a senior Administration official said Saturday.

The proposal, certain to spark controversy in Congress and banking circles, would infuse greater “discipline” into the system by creating uncertainty over just which banks would be protected beyond the minimum levels required by the government’s deposit insurance program, the official said.

If enacted, the Administration plan would mean that some banks would no longer automatically receive complete government protection and total depositor insurance in the event of their failure. As a result, bank managers would be under greater pressure to follow more prudent business practices, said the official, who requested anonymity.

“Providing constructive ambiguity is at the heart of it,” the official said. “The problem is that now, all of the ambiguity has been drained out of the system. We have got to create more uncertainty as to whether regulators will intervene.”

To instill that uncertainty, the official acknowledged, the government will have to let some institutions fail in order to demonstrate that its new policy is credible.

The plan, expected to be introduced as part of a legislative package in January, would represent a dramatic change in federal banking policy.

Traditionally, Washington has pledged virtually automatic support and blanket protection for the nation’s major commercial banks. At those institutions, federal deposit insurance has been extended well beyond the legal limit of $100,000 per account, in part to prevent panics and maintain consumer and investor confidence in the integrity of America’s financial system.

But that policy, known in the industry as the “too-big-to-fail” doctrine, has come under mounting criticism for contributing to a growing crisis in the banking system. The doctrine has, in effect, given bankers an incentive to engage in risky practices, while remaining secure in the knowledge that the government will bail them out if they get into trouble.

Under the Administration proposal, at least in theory, size would no longer provide protection against failure.

“We’ve got to address ‘too big to fail,’ otherwise we can’t have a real reform package,” the Administration official said.

The apparent willingness to abandon the current doctrine comes at a time when the economy is sliding into a recession and the health of the banking industry appears more at risk than at any time since the Great Depression of the 1930s.

Although the commercial banking system is in better shape than the scandal-plagued savings and loan industry, many banks have been forced to take losses on real estate loans and the government’s deposit insurance fund has dwindled to a dangerously low level.

In fact, the timing of the proposal would seem to pose grave risks for the Administration, and might lead to charges that the White House is not living up to its responsibility to protect the soundness of the financial system.

The proposal to do away with the too-big-to-fail-doctrine represents just one component of a sweeping reform package now being prepared by the Treasury Department and the White House, following a legislative mandate ordering the Administration to propose reforms of the nation’s deposit insurance system.

The Administration official indicated that a final deposit insurance proposal has not been worked out. Several alternatives are now under study, including a plan to limit the number of insured accounts held by any one individual to three.

“We are still looking at a bunch of options on deposit insurance, but we want to shrink it back to its original purpose, which was protecting small savers, letting them sleep at night,” the official said.

The overall package, as currently envisioned, would involve much more than a simple reform of deposit insurance, with the Administration apparently poised to push for a fundamental change in the structure of the commercial banking industry.

“The Administration feels strongly that issues of deposit insurance reform, that is, the extent and character of the safety net, are so closely intertwined with questions of reform of the industry’s structure, that it makes no sense to treat them separately,” Treasury Secretary Nicholas F. Brady said Friday in a speech in Florida.

To address those concerns, the Administration plans to propose full interstate banking for the first time in the nation’s history, in an effort to spur a massive consolidation among banks that, the Administration hopes, would winnow out the weakest institutions. Administration officials note that the United States has far more independent banks than any other country in the world, and they contend the system should shrink to become more efficient.

But that plan will almost certainly draw fire from smaller banks, who fear they will be swallowed up by the nation’s largest institutions.

The Administration also plans to propose an end to the so-called Glass-Steagall restrictions, which have prevented commercial banks from engaging in stock brokerage operations while prohibiting Wall Street firms from entering the banking business.

The Administration plan would allow bank holding companies to set up subsidiaries separate from their commercial banking units that could enter the securities business, as long as they did so with funds that were not federally insured.

While that proposal might increase the risks being faced by banking firms, the senior Administration official said that the proposal would provide for creation of “fire-walls” designed to prevent financial problems in securities trading operations from harming the commercial banking side of the business.