In Wake of Bailout, Why Are We Rewarding Banks? : Banking: The Adminstration’s new plan would make needed repairs to the financial system, but also allow some major plums.

The Bush Administration recently presented Congress with the most important banking legislation of the last 50 years. It will reform the way banks do business. Banking organizations will be granted sweeping new powers, and banks will be permitted to establish branch networks across state lines. The largest, most powerful institutions are wildly enthusiastic. The question is whether this reform will improve the health of the nation’s ailing banks.

The reform effort is called FISCCA, the Financial Institutions Safety and Consumer Choice Act of 1991. It is far different from the Administration’s first effort at major reform of the banking industry--which was just smoke, mirrors and new taxes. The Administration seems serious about restructuring the industry.

Banking needs to be restructured before it becomes obsolete. Depositors and borrowers have alternatives to banks they never had before, and these alternatives are often better and cheaper. Small depositors now might have more money invested in pension funds. When these depositors need liquidity, they are as likely to put their money in money-market funds as banks. In addition, annuities marketed by insurance companies offer intense competition for a commercial bank’s certificates of deposit.

Similarly, small borrowers increasingly turn to credit unions, or to companies such as General Motors Acceptance Corp., to satisfy credit needs. Large borrowers might find it cheaper to raise cash by selling commercial paper or other securities than by borrowing from banks.

In a way, without the elaborate government guarantees provided by law, bank failures of the last 10 years could be viewed as healthy examples of capitalism at work. Market forces are rewarding newer, more efficient ways of providing banking services and weeding out inefficient providers.

While the current proposal is a dramatic improvement over the first attempt, even this may be too little, too late. Moreover, special-interest groups--representing an odd coalition of insurance-industry groups, small banks and anti-development community activists--have succeeded in diluting the proposal and may be able to defeat it outright. So far, it’s politics-as-usual in Washington: The winners are the special-interest groups and the politicians. The losers are consumers, taxpayers and the economy.

The current plan finally recognizes that the federal safety net protecting bank depositors is overextended and, without major changes in deposit insurance, taxpayers will continue to be tapped for money to bail out the federal deposit insurance funds. Unfortunately, responding to interest-group pressures--primarily from smaller banks--the House Financial Institutions Subcommittee has already voted to strike down all the Administration’s efforts to protect taxpayers by limiting deposit insurance coverage to small depositors.

For consumers, the most important aspect of the Bush Administration’s proposal is its reform of deposit insurance. Currently, the Federal Deposit Insurance Corp. charges all banks the same rate for deposit insurance. This means poorly managed, excessively risky banks pay the same rates as prudently run banks--thus subsidizing risky banks while taxing safe banks. Over time, this perverse arrangement has caused prudent bankers to flee the banking industry, by penalizing them, and risk-takers have been encouraged to enter the banking industry.

The Bush Administration, at long last, would require the FDIC to establish a risk-based deposit-insurance pricing system for all insured banks. This reform is needed to prevent the complete bankruptcy of the deposit insurance system. Amazingly, the House Financial Institutions Subcommittee has been persuaded by special interests to allow the FDIC a full 42 months from the law’s enactment to impose risk-based deposit insurance. This long delay is intolerable. The deposit-insurance fund is on the brink of insolvency. Meaningful reform is needed immediately.

Even if the Administration’s plan is adopted at once, it suffers from important shortcomings. The proposal requires the FDIC to use an arcane accounting measure--known as risk-based capital ratios--as the basis for determining how risky banks are, and thus how much they should be made to pay for insurance. These accounting measures are far too crude and easily manipulated by industry to be of real value in sorting out high-risk banks from low-risk banks.

More important, the Administration’s plan is flawed because it does not use market mechanisms to set the price for deposit insurance. Sen. Alan J. Dixon (D-Ill.) has proposed a good alternative pricing scheme that would require banks to negotiate for private deposit insurance on a portion of their deposits. The price charged by the FDIC would be based on the price set by the market.

Dixon’s proposal should be expanded--banks should be offered a menu containing several alternative mechanisms for pricing deposit insurance. Banks that did not want to negotiate in the private re-insurance market could self-insure. Each bank could select the pricing mechanism best suited for it. Thus market-based pricing of deposit insurance need not penalize small banks over large banks or pit regional banks against city banks.

For years, the FDIC has been claiming risk-based deposit insurance is impractical because bank regulators are not capable of categorizing banks on the basis of risk. But bureaucrats’ inability to make these judgments is no reason to abandon the idea. The private market can give the U.S. depositor the best of both worlds: the efficient pricing of insurance available in the private sector and the safety and reliability of federal backing.

Another major flaw in the Administration’s proposal is that it perpetuates the FDIC’s misguided “too big to fail” policy--which permits federal regulators to make direct government investments in banks considered essential to the financial community. This “too big to fail” policy allows even the largest depositors in the nation’s biggest banks to enjoy the benefits of federally backed deposit insurance--though these deposits greatly exceed the $100,000 provided for.

Taxpayers will be most affected by these points, but other provisions to permit interstate branching and to create powerful new mega-banks will have far-reaching effects on the banking industry itself. Under current law, banking regulators cannot allow banks to establish interstate branch networks for national banks. Few states allow their own banks to branch across state lines, and fewer still permit out-of-state banks to branch into their states. Under the Administration’s proposal, national banks could establish intrastate branching. Thus, a national bank could establish a branch in every state--with as many branches in each state as that state permits its own banks. This change aims to strengthen the banking system by allowing firms to streamline organizations, implementing efficiencies that come from providing products in multiple markets.

In addition, the Administration’s proposal creates a new corporate entity, the Financial Services Holding Company. These super-bank corporations will be able to engage in securities trading, real-estate brokerage and mutual fund and insurance sales. This gives banking firms unprecedented new powers.

Far from punishing the banking industry for the billions and billions of bad loans now causing failures that will burden U.S. taxpayers--and their children and grandchildren--for decades, the Bush Administration proposes to reward the industry with sweeping new powers and new risk-taking opportunities. If this is not coupled with meaningful reform of the deposit-insurance system the consequences will be catastrophic. The Administration’s proposal will have thrown out the baby but kept the bathwater of banking regulation, and the next bailout will make earlier ones look trivial.