Get Banks Out of Student Aid : Finance: Essentially, the government already is the lender, so cut the middlemen and save.

The real question in the debate about how to provide student loans is not: Do we want bureaucrats running the program? The question instead is: Do we want those bureaucrats to be bankers?

The Clinton Administration wants to stop funneling federal student loans through banks, proposing instead to provide the loan money to students directly. This plan came closer to reality with its recent approval by the House of Representatives. But banks are pulling out all stops--even, apparently, financing student groups to oppose the legislation--to see that the Senate maintains the status quo.

In defending the existing system, bankers invoke the virtues of free markets and private enterprise. Freedom and enterprise are, however, hard to find in that system. Far from operating as independent, profit-seeking capitalists, banks are little more than bureaucratic functionaries, carrying out legally mandated regulations in exchange for fixed and guaranteed returns. In a real credit market, banks appraise the creditworthiness of borrowers, screening out those who are too risky. When a bank makes loans, its collection efforts are spurred because its own money is at risk.

But in the make-believe market of federally guaranteed loans, the law says that every eligible student is entitled to a loan; bank judgments of credit risk play no part. The interest rate that the bank charges the student and the maximum size of the loan are fixed by the government, as is the return the bank will earn on the loan. Indeed, banks are even protected by the government against the risk that inflation will make the loan a bad investment.

If a student’s loan payments are delinquent, the federal guarantee kicks in. The government, operating through the state guarantee agencies, will make good the bank’s losses. In normal circumstances, the only requirement imposed on the bank is a bureaucratic one: Before it gets paid, the bank must work its way down a checklist of “due-diligence” requirements, demonstrating that it made an earnest effort to track the delinquent student down.

Some market! Fixed prices, inflation-proof subsidies, a government guarantee to absorb losses. It’s no wonder that banks are lobbying hard to preserve this nearly riskless line of business.

It’s tempting to respond to this make-believe world by adding more realism--compelling banks to compete on the interest rates they charge to students and bear the losses when students default. But in a real market, low-interest loans would be available only to affluent students whose parents co-sign. Needy students would have to pay extremely high interest rates or, more likely, would be shut out of the loan market (and of college) altogether. Without federal insurance against defaults, the student-loan market as we know it wouldn’t exist.

So in fact we don’t want the student loan system to act like a market. Like it or not, protecting lenders from losses essentially takes market forces out of the picture. Running the loan program through the banks simply adds more layers to the bureaucracy, making the system’s operation more opaque and less politically accountable and giving the financial interests of the banking community a regrettably large role in shaping student-aid policies.

The mere threat of competition from a direct-lending system has led the banks to offer concessions on interest rates and operating subsidies that they previously wouldn’t have considered just two years ago. The best way to improve student lending is for the government to continue to press for the development of a direct-lending alternative.