On restructuring financial services: reaching for reform.

The past several years have brought with them a heightened sensitivity to the health of the financial system in the U.S. The costly fall of the thrifts, dwindling reserves in the bank insurance fund, and loss of market share to foreign institutions have led to calls for structural change. Although debate in this area has simmered for some time, it reached full boil this fall as Congress contemplated a comprehensive proposal from the Treasury Department to reshape the industry.

The path to today's banking precipice has been paved with years of severe economic change, short-sighted regulation, and heightened competition.

Recent developments raise questions about the role banks can play in the future of financial services and what American institutions need to strengthen their position.

During the past three decades, domestic financial institutions have gradually lost their competitive edge on both sides of the balance sheet. Loan and deposit products are no longer the sole province of banks; many are now provided directly by the capital markets through brokerage firms, credit companies, or other intermediaries. Checkable money market funds, private charge cards, and mortgage-backed securities are but a few examples of products that have become substitutes for traditional bank offerings.

According to the Federal Reserve Bulletin, bank loans and securities as a percent of total debt outstanding have dropped from 51 percent in 1949 to 42 percent in 1969 to 34 percent in 1989.

The steady erosion of market share diminished profitability and motivated many of the risky banking practices now being fingered as the causes of crisis in the banking system. The search for higher returns led banks to LDC, REIT, LBO, and commercial real estate lending, areas that looked good for a while but proved costly in the long run. While current headlines have been the most dramatic, recent American banking results must be viewed as the culmination of years of fundamental deterioration.

At the same time, foreign presence on our shores has grown to the point where overseas institutions now control almost 25 percent of U.S. banking assets. Overseas banks have been by and large immune to the problems confronting U.S. banks, and so have maintained better earnings, ratings, and capital. Why? Because the regulatory hoops through which they must pass are considerably wider than those put before banks in the U.S. Thus, we can learn a great deal from their success if we recast the domestic banking system.

Management myopia 

As it is presently constructed, the American banking system is on the verge of becoming obsolete. Regulatory and managerial myopia share the blame for this dismal prognosis. Several key areas need to be addressed:

* Geographic restrictions must be eliminated. Federal and local laws place severe constraints on where banks can do business. Compared with other economies, the United States has many more banks per capita. Look at the comparison in the figure below.

Such a structure prevents the realization of production efficiencies that can add to competitiveness. A McKinsey study estimated that $10 billion each year in duplicate operations could be saved if full interstate branching were allowed. This would translate into great benefits for banking customers, counter to the arguments of local bankers who fear encroachment. In addition, it would help eliminate bloated expense structures, which motivate the pursuit of high-risk business lines that can be so damaging to the health of the system.

Further, confining financial intermediaries to specific areas concentrates credit risk and limits the diversity of funding bases. The spate of bank failures in Texas and the fall of the Bank of New England demonstrate the vulnerability of such a structure. Other industries take nationwide operations for granted, a presumption that should be afforded to bankers as well.

Barriers to consolidation have gradually been breaking down, but at a slow pace. Banks may now purchase out-of-state institutions, but may not branch freely; consolidation through acquisition can be slow and expensive. Nonetheless, the drive to reduce the industry's excess capacity has accelerated with the combination of Bank of America and Security Pacific, among others. More mega-mergers are likely in the months ahead.

* More association should be allowed between banks and non-financial companies. Product line deregulation merits serious consideration. The repeal of the Depression-era Glass-Steagall Act has been the subject of intense lobbying for many years. Banks feel they are unfairly prevented from entering business lines that would complement their core operations, while non-financial companies are making inroads into financial services.

Banks have become more like underwriters, originating loans but not holding them. They should, at the very least, be freed to offer investment banking services without restriction. Movement in the opposite direction may also be significant; allowing commercial firms to own banks (with appropriate firewalls" in place) could provide capital and create synergies that would benefit the industry. Again, these are freedoms that foreign institutions already enjoy; European consumers can often take care of their banking, brokerage, and insurance needs at the same location.

* The regulatory tax burden must be reduced. The combination of reserve requirements and FDIC insurance premiums raises the costs of bank deposit offerings and puts them at a competitive disadvantage against other investment products.

The FDIC'S reserves have been shrinking for the past several years, the result of record bank failures. More important than this nominal trend is the diminished relationship between the insurance fund and the deposits it covers. (See the figure to the left.)

Evidence of this type has led some to predict that a taxpayer bailout will ultimately be needed, but that is a remote possibility at this time. Overall, the banking industry is still quite healthy and should be able to handle insurance renewal internally with higher premiums. The down-side is that the added costs will undoubtedly be passed along to consumers and may lead them to consider non-bank financial products.

As it is presently constituted, the insurance system will continue to motivate risky activities that can threaten the system's stability. Bringing insurance costs under control will require basing deposit premiums on institutional risk. This would be long overdue recognition that the cost of protection ought to correspond to potential exposure.

Thought has also been given to holding down cost by introducing a deductible to deposit insurance coverage, a practice in place in Great Britain. Under such a regime, depositors would be reimbursed fully to a certain level and partially above that level. This would also have the ancillary benefit of introducing more market discipline without unduly alarming core depositors. Partially privatizing insurance, with the government offering some protection and insurers providing the rest, is also an intriguing alternative.

The maintenance of reserves has also become burdensome. Intended in part to assure liquidity to cover depositor demands, current reserve levels are woefully small in relation to the potential demand for them. Banks more commonly rely on the money markets for assistance when needed. Reserves also allow the Federal Reserve system to manage the money supply; while this is an essential facet of our monetary system, the costs of maintaining these balances should be covered by interest payments from the Fed. This would reduce the implicit tax that banks currently bear.

As a footnote in the area of regulation, the maze of agencies that oversee financial institutions invites problems of consistency and creates enormous overlap. Satisfying all of them can be unduly burdensome, especially during the industry's ongoing consolidation. Unifying oversight authority (perhaps under the Federal Reserve) is important not only in and of itself, but also as a prerequisite for implementing any other structural changes.

The combination of these impediments places domestic institutions at a disadvantage against foreign competition. Overseas banks consequently have better capital, higher ratings, and a more significant market presence. At this point, they are clearly better positioned to profit from globalization and the changes in the industry that American banks are hindered from exploiting.

But international competition and ownership of U.S. banks is not at all undesirable. The competition is forcing the consideration of the structural change discussed above, and the acquisitions have provided much-needed capital. In addition, the internationalization of financial services is consistent with the global nature of other industries and with the business orientations of bank customers.

Any optimists around?

As a step toward leveling the playing field, the reform outline submitted by the Administration is remarkable for its breadth. It recognizes the inter-relatedness of issues that have traditionally been discussed separately. Yet, to paraphrase a former Chicago alderman, "maybe we ain't ready for reform." Even as preliminary academic arguments were being formulated, political maneuvering to sink the bill was already underway. Small bankers object to the opening of interstate borders, while insurance industry representatives want to keep banks out. Provincial regulatory interests are also anxious to protect their turf.

As a result, passage of comprehensive legislation remains uncertain. The Administration, whose docket is full of other initiatives, may not be able to push too hard for passage. To a certain extent, the design of the package may doom it to failure; by trying to do so much at once, it opens itself to criticism from a variety of special interest groups.

The optimist would suggest, however, that just raising these issues in a very public way may accelerate the pace of natural change that will improve the health of the industry. In addition, the insurance reform issue may be spun away from the others and stands a good chance of receiving action later. While not ideal to reformers, these results would probably be palatable to most within the industry.

Going forward, it is essential that bankers, regulators, and legislators realize that the forces of change will only intensify. Without legal and regulatory action to level the playing field for American banks, their profits and capital will remain vulnerable to the risky business lines needed to produce adequate returns. In a competitive industry, only the fittest survive. To respond, we have to get into better shape.

Mr. Heagy is vice chairman of LaSalle National Bank in Chicago.