Remedy for Shaky Banks

CONVENTIONAL wisdom now holds that deposit insurance coverage by the Federal Deposit Insurance Corporation should be cut back. A major report on reforming bank regulation and deposit insurance, recently released by the Treasury, advocates this position. Many in Congress seem ready to support it. This conventional wisdom is misguided, but the idea has a great deal of surface appeal. After all, the public has suffered grievously because of the excesses of hundreds of imprudent savings and loan associations, and taxpayers may well have to bear additional costs in cleaning up hundreds of insolvent banks.

The public outlays are being used to honor federal insurance guarantees to depositors. With reduced coverage, the government's future exposure to losses would be lower. And depositors would be expected to be more cautious about where they place their funds, thereby exercising ``market discipline'' on wayward banks and further reducing the government's costs.

But would reduced coverage really work this way? I think not. First, if effective coverage per account were cut back, many people and companies would just break their deposits into smaller packets and spread them among more banks. There would be more telephone calls, more postage, more ``deposit advisers,'' but little reduction in government exposure.

Second, suppose the insured deposit limit were changed to a fixed amount per person that applied system-wide across all banks. Would this limit apply during a person's entire lifetime? What about separate accounts for separate family members? Record keeping and enforcement could be a nightmare.

Third, can we really expect many depositors - even business depositors - to be knowledgeable enough about bank accounting and finances to exercise informed market discipline?

Most important, to the extent that a cutback in coverage is effective in exposing depositors to potential losses, those depositors will become more skittish, and we are likely to see many more runs on banks and greater instability in our financial system.

More widespread depositor runs would be an inevitable consequence of reduced coverage. The bank regulators already know this to be true. That is why they have consistently protected the large depositors in major banks and ignored the current $100,000 limitation on insurance for those depositors. But no one in Washington is prepared to acknowledge openly this connection between proposed reduced coverage and the bank runs that will surely follow.

Wouldn't the Federal Reserve, as a lender of last resort, damp down runs? Maybe. But if the Fed is prepared to lend to banks without receiving adequate collateral in return, it has become a de facto federal deposit insurer.

Wouldn't private deposit insurance fill the void? Not really. Even if private deposit insurers were to spring into existence (which is far from certain), depositors would soon want to know who would guarantee the private insurers' ability to honor their obligations - especially after the recent failure of private insurance in Rhode Island and earlier failures in Maryland and Ohio.

I believe a radical counter-proposal is in order: Instead of cutting back on deposit insurance, the federal government should expand coverage to 100 percent of all deposits. We would thus put an end to the specter of bank runs, once and for all. We would also put an end to the disparate and arbitrary treatment of large depositors (including charities, churches, and nonprofit organizations), who have been covered in the failures of major banks such as Bank of New England but exposed to losses in the fail ures of smaller banks such as Harlem's Freedom National.

An important side benefit to complete coverage would be the opening of bank supervisory and disciplinary proceedings to public scrutiny. Bank regulators (as well as the banks themselves) have resisted such transparency in the past, basing their secrecy on their fear of bank runs.

With the costs of the current cleanup already so high, can we afford the potential cleanup costs of broader deposit insurance coverage? Yes, because the numbers and costs of future insolvencies can be drastically reduced if expanded coverage is accompanied by a package of tough reforms in the safety-and-soundness regulation of banks (and of S&Ls and credit unions).

These regulations should include: (1) better accounting information to be provided to bank regulators, focused on current market values rather than on historical costs; (2) better net-worth (capital) standards, based on market value accounting information, so that owners of banks would have a larger stake in their enterprises and would be more concerned about protecting the insurance; (3) risk-based deposit insurance premiums to discourage risk-taking; and (4) stronger powers for bank regulators to inte rvene earlier in a shaky bank's downward slide.

To bring more market discipline to bear, the regulators should require banks to issue long-term subordinated debt - explicitly uninsured - to knowledgeable institutional holders, such as insurance companies, pension funds, and mutual funds.

Though this package may appear ambitious, consider the alternative: the Treasury's recipe for bank runs and financial instability. Can we really afford that?