Too little, too late: the President's plan for dealing with a $160-billion problem has merit, but doesn't address the root cause: federal deposit insurance.

The President's plan for dealing with a $160-billion problem has merit

but it doesn't address the root cause: federal deposit insurance.

The current system puts all the risks on the taxpayers,

if the odds are right, even bankers will gamble.

THE BUSH ADMINISTRATION deserves credit for moving quickly to address the Savings & Loan crisis. The proposed changes in bank regulation and in deposit insurance, however, are too little to assure (in President Bush's words) "that this situation is not repeated again." And the proposed schedule for closing or merging the insolvent savings banks is too late to minimize the costs to taxpayers and to other banks.

How did "this situation" arise, in which taxpayers are now obliged to pay some $100 billion to protect the insured deposits in the insolvent savings banks? The primary source of the problem is a very flawed insurance contract between the federal deposit-insurance agencies and depositors. The deposit-insurance agencies were established in 1933 for commercial banks (FDIC) and in 1934 for savings banks (FSLIC). Though Franklin Roosevelt and most of the nation's bankers opposed federal deposit guarantees, they were introduced in the hope of avoiding a repetition of the general financial panic of late 1932 and early 1933.

The basic insurance contract has not changed since then. All banks are charged the same low premium regardless of the risk that an individual institution presents to the insurance agencies. The amount of insurance, initially $2,500 per deposit, has subsequently increased in several steps to $100,000 per deposit. Moreover, if the deposit-insurance agencies have to close an insolvent bank, they usually do so by arranging a merger with another bank and fully protecting all deposits regardless of size.

These generous insurance contracts .create two perverse incentives. First, banks have an incentive to increase their risk exposure as their net worth deteriorates; for a bank with zero or negative net worth, all of the downside risks of questionable loans are borne by the deposit-insurance funds and, indirectly, by taxpayers and other banks. Second, even large depositors now face no risk when placing their deposits in a high-risk bank. These problems are inherent in the structure of the insurance contract.

The problems are only compounded by the unique American system that segments financial institutions geographically and by line of business. Such regulations increase the institutions' vulnerability to difficulties in a specific sector or region. If oil prices fall, Texas banks will get into trouble; if housing demand drops, banks specializing in mortgages will falter. Savings banks are uniquely vulnerable to problems in the housing sector and-because most of their loans are long-term, fixed-rate mortgages while their deposits can be withdrawn on short noticeto an increase in short-term interest rates.

A number of commentators have concluded, quite incorrectly, that the current crisis among savings banks is due to deregulation. In fact, the aggregate net worth of the Savings & Loan industry was minus $110 billion in 1981, before the full decontrol of deposit interest rates and the broadening of asset powers. Continued interest-rate controls would have precipitated a crisis carlier, because both solvent and insolvent banks would have lost deposits to the money-market funds and other unregulated financial instruments, which would have been able to offer investors a better return on their savings. And asset deregulation, including the authority to issue variable-rate mortgages, reduced the potential vulnerability of savings-bank portfolios, even though it also provided new ways for imprudent managers to lose money.

Given the political constraints on closing insolvent savings banks, however, the deregulation of deposit rates did create one new problem. Deposit insurance had long provided an incentive for insolvent and near-insolvent banks to bid away deposits from healthier institutions and attempt to gamble their way out of their problems; the deregulation of deposit rates now gave these institutions the opportunity, by allowing them to offer higher interest to attract more depositors. As long as insolvent banks are allowed to remain open and offer federally insured accounts, deposits will flow from low-risk to high-risk banks, increasing deposit rates at all banks, as well as the potential liabilities of the deposit-insurance funds. Reregulating deposit rates, however, would only compound this problem by inducing a flow of funds from all banks into unregulated financial instruments.

THERE ARE three basic ways to avoid a recurrence of these problems:

1. Restructure banks to eliminate the need for deposit insurance. One creative proposal of this type, by Robert Litan of the Brookings Institution, would require all depository institutions to maintain a reserve of low-risk, short-term marketable securities (such as Treasury bills) to back all deposits. Depository institutions thus would be self-insured by sufficient liquid assets to match any deposit withdrawals. Mortgages and other loans would be provided by other institutions, maybe within the same bank holding company, and would be financed on the general capital market. This may be the most attractive alternative, but it is also the most radical.

2. Restructure deposit insurance to reduce both the incentive and the opportunity for excessive risk-taking. Charging each bank a deposit-insurance premium based on the expected risk to the insurance fund would minimize the incentive for excessive risk-taking, but would probably require more information than is realistically available to federal authorities. Reducing the total insurance to $40,000 per depositor (ftom $100,000 per deposit), as recently recommended by the Reagan Council of Economic Advisors, would substantially reduce the opportunity for high-risk banks to attract additional deposits; this proposal would also require that only insured deposits be transferred in any subsequent sale of insolvent banks.

3. Increase the level and enforcement of capital ratios to reduce the probability that any bank will become insolvent. The most detailed proposal of this type is by professors George Benston of Emory University and George Kaufman of Loyola University of Chicago. Two changes in current practices are necessary for this approach to be effective. Federal regulators must be prepared to implement a progressive increase in sanctions as the capital ratio of an individual bank falls below the required level, and the regulators must be prepared to force reorganization of a bank before it becomes insolvent. Second, bank accounting rules must be improved to measure more accurately the market value of the net worth of banks.

The Bush "reform" plan adopts the general structure of the Benston/Kaufman proposal, but most of the details have yet to be worked out. The savings banks are, within two years, to have capital ratios that are "not less stringent" than those applied to commercial banks, but changes in commercial-bank capital ratios are now under consideration. The deposit-insurance agency would be required to control the growth of assets by savings banks that do not meet the higher capital standards and would have the authority to terminate deposit insurance; but no schedule of intermediate sanctions has been developed. Savings banks would be required to use "generally accepted accounting principles," but not the more stringent market-value accounting. Congress has already eroded the higher capital ratios in tbe Bush plan, Furthermore, the proposed increase in the flat-rate deposit-insurance premiums for both savings and commercial banks would actually increase the cross-subsidy from safe banks to more risky banks by reducing the rates banks can responsibly pay depositors.

Even if these issues are worked out, savings banks will still represent a greater risk to the deposit-insurance fund than do commercial banks. At best, savings banks will still be uniquely vulnerable to conditions in the housing industry and to the interest-rate risk of long-term fixed-rate mortgages.

It is important to recognize, however, that the depositinsurance fund for commercial banks is also in serious trouble. During 1988, for example, the number of commercial-bank failures came to within one of matching the number of savings-bank failures, and the FDIC used 20 per cent of its reserves to sort out the problems of one Texas bank. An independent group of financial-regulation experts estimated that the currently booked and unbooked losses of the commercial banks would all but exhaust the remaining reserves of the FDIC. And the regionally segmented commercial-banking system is vulnerable to problems in the agriculture, energy, and manufacturing sectors as well as the problems of foreign debt. If Mr. Bush secures a second term, he will face a meltdown of FDIC similar to that of FSLIC.

FINALLY, THE PROPOSED SCHEDULE for closing the insolvent savings banks is too slow. The Bush plan proposes to spend $50 billion over the next three years. But the liabilities of insolvent savings banks that remain open are expected to increase at a 20 per cent annual rate. Since the Federal Government can borrow at a 9 per cent rate, borrowing and committing the full $50 billion this year would minimize the cost. Earlier closure of these banks would also strengthen the remaining banks by reducing the rates they must pay on their deposits. The losses have already been incurred; there is no reason to delay a formal acknowledgment of this public debt.

In summary, tbe Bush plan is a good start, but only a start. Congress deserves more information about capital standards and regulatory authority before approving the plan. The banks deserve clearer guidance about the conditions under which specific regulatory sanctions would be imposed. Taxpayers deserve a plan that minimizes the costs of the bailout, and also minimizes the prospect of another deposit-insurance meltdown. The American public deserves some honest answers about the trillions of dollars of implicit liabilities that the Federal Government has been acquiring in the form of off-budget loans, loan guarantees, and pension and deposit insurance. On the way toward "a kinder and gentler America," we might also hope for more honest government.