Easing Banking Laws: Clinton’s Pandora’s Box : Economy: Using bank loans to fix the economy, an idea offered at the recent summit, could produce a greater disaster than the S&L; bailout.

A remarkable sleight-of-hand took place during President-elect Bill Clinton’s recent economic conference in Little Rock, Ark. Before the summit, it was generally understood that many of the nation’s banks were, at best, extremely fragile. Until the summit, conversations in policy circles had focused on whether the industry could even survive the 1990s. Less than three years ago, the only interesting issue seemed to be whether the taxpayers’ tab for the bank bailout would be bigger or smaller than the $100-billion tab for the savings-and-loan bailout.

But during the Clinton summit there was no talk of bailouts, or even of a banking crisis. Instead, the conversation centered on how to enlist the assistance of the nation’s banks to pump money into the rest of the economy. Vice President-elect Al Gore wanted to discuss how to ease bank regulations in order to “free up a lot of money that entrepreneurs could get a hold of to expand and so forth.” Gore wondered “(w)hat order of magnitude stimulus could come from easing those bank regulations.”

The Clinton Administration, assisted by low interest rates, has deftly removed the nation’s banks from the intensive-care ward and thrust them into surgical garb. It is now telling them that they must join in finding a cure of the nation’s economic ills. Not surprisingly, the banking industry heard the clarion call for deregulation and reacted with enthusiasm.

Clinton nodded encouragingly as bankers advocated jettisoning recently enacted safety and soundness laws like the Financial Institutions Corporation Improvement Act of 1991--described by one conference participant as a “Draconian rollback of the ability of financial institutions to lend.” This is a law that encourages higher capital levels for the nation’s banks and requires the prompt closure of insolvent financial institutions. Other speakers cynically argued that abandoning the existing safety rule would inject a huge amount of capital into inner cities and small businesses, two important targets for Clinton.

From Clinton’s perspective, banks are a particularly attractive candidate to play the role of economic witch doctor. After all, the budget deficit will bar new government spending programs to stimulate growth. In the short run, easing restrictions on banks would allow Clinton to have his fiscal cake and eat it, too, by holding government spending down and letting the banks stimulate the economy.

The problem with this strategy is that it ignores the fact that any new lending to be done by U.S. banks will be funded by deposits. These are insured by the federal government. Thus, the government remains the ultimate guarantor of any new lending in the wake of deregulation, and Clinton would only be encouraging yet another round of uncontrolled, government-guaranteed spending if he rolls back the new safety and soundness regulations. This is what happened when the S&Ls; were deregulated. The chickens will come home to roost when these new loans go into default and the banks making them begin to fail. Then, the government will step in to bail out the depositors, and the budget deficit will mushroom.

Looking at the new bank regulations attacked at the Clinton summit reveals the incoherence of these arguments in favor of deregulating the banks to fix the economy. Rules designed to make banks safer were mysteriously lumped together with other regulations, masquerading as consumer-friendly, though really promoting narrow special interests.

But unlike the safety and soundness rules, which appear to be up for grabs in the Clinton Administration, the consumer rules were strongly endorsed by Clinton throughout his campaign--though these rules are drowning the banking industry in a sea of red tape. For example, they impose costly notice requirements on banks seeking to close a branch.

Meanwhile, the soundness rules mandating minimum capital levels for banks are essential to safeguard the federal deposit-insurance funds. Not only have fewer banks failed since these rules were put in place, but failures that have occurred posed less of a burden to the deposit-insurance funds.

Without a major reform of the deposit- insurance system, which Clinton is not likely to attempt, it would be foolhardy to jettison recently enacted safety regulations. Deposit insurance insulates banks from having to compete for funds on the basis of how safe and well-managed they are. It allows even poorly run, undercapitalized banks to attract depositors’ dollars since those dollars are insured by the government.

Clinton must remember that the 1991 regulations caused banks to raise record levels of capital during 1992. Even with these reforms, banks are still woefully undercapitalized. Banks maintain average capital levels of slightly more than 5%. But in the 1930s, before deposit insurance was enacted, banks had capital levels of almost 25%, and even that figure drastically understated the true level of protection for depositors, because bank shareholders were usually subject to personal liability to depositors of an amount up to their initial investment if their banks became insolvent.

Of course, it is not politically feasible to curtail federally insured deposit insurance beyond the current $100,000 level, despite the fact that this figure probably is far higher than it should be. It is equally senseless for Clinton Administration officials to discuss curtailing existing safety and soundness regulations.

On the other hand, drastically curtailing the consumerist special-interest legislation that is tacked on to every major banking law like ornaments on a Christmas tree would be a terrific idea. This legislation not only increases the costs of the banking business, it also hurts taxpayers by raising the costs of the bailout.

Under these consumer rules, the government is not allowed to sell the property seized from insolvent thrifts to the highest bidder at market prices. Instead, the government must give certain favored buyers, who claim to represent low- and moderate-income groups, first refusal on certain properties. The rules also delay the disposition of assets of failed banks by imposing waiting periods.

Such rules often do more harm than good, even for consumers. For example, supposedly, under the Community Reinvestment Act, banks that do not have an outstanding record of lending in their local communities will be prevented from merging or expanding with other banks. But in practice, this could mean that a bank with as much as 70% of its loans in the local area would not pass muster. That raises the cost of doing business for minority-owned banks in poor urban areas by preventing such banks from expanding into more affluent areas.

Unfortunately, the consumerist groups will not let Clinton abandon his commitment to the inefficient regulation they favor. On the other hand, many bankers support the repeal of recently enacted safety and soundness regulation. But Clinton should ignore them. For, if he follows their advice, he will only succeed in recreating the S&L; crisis of the ‘80s, on an even bigger scale.