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Bank reform: the enduring issues.

The combination of a difficult aggregate economic environment, an increasingly competitive market for the delivery of financial services, and troublesome trends in both bank profitability and failure rates has focused national attention on bank reform. This article overviews several of the enduring issues that dominate bank reform proposals. The article then discusses the need for deposit insurance, the too-big-to-fail doctrine, and the entry of banks into nontraditional lines of business. The role of market discipline and bank survival in the 1990s is also considered. Less of a regulatory burden coupled with renewed market discipline are necessary for the banking industry and the economy to prosper during the reminder of the 1990s.

WITHIN THE AMERICAN business system, banks are treated as special economic units. Collectively they now occupy a unique position in the private sector that importantly extends to public sector policymaking. Other competing financial institutions neither enjoy nor are privy to such a lofty, purposefully planned, and protected combination of private involvement and public decisionmaking.

Owing to the breadth, power and responsibility of such influence, the country rightfully expects a lot from the commercial banking industry. That is precisely why the citizenry and their government have reacted with alarm to the near-term deterioration of the industry's financial condition.

The outcome of this alarm is the call for comprehensive banking reform. Interestingly enough, both the banking industry and the federal government agree that reform is necessary. The details of the reform package, however, contain the seeds of disagreement. This paper overviews several of the key elements that dominate reform proposals.


A brief review of the main business functions that banks perform coupled with an understanding of the U.S. financial system removes much of the argument that favors bank "uniqueness." Essentially, banks are involved in three main commercial activities.

First, by acting as a financial intermediary, banks help transform an economy from dependence on direct finance to indirect finance.(1) All financial intermediaries share a common characteristic. They offer their own financial claims called indirect securities (like certificates of deposit) to economic units (say households) with excess savings. The proceeds that banks receive from selling their indirect securities are used to purchase the financial claims of other economic units (like a household mortgage or a business loan).

The existence of financial intermediaries distinguishes the complex system of financial markets associated with developed countries from those associated with lesser developed countries. A sophisticated financial market system that includes intermediaries involves many small savers in the process of capital formation and, ultimately, provides for a greater level of societal wealth. But, commercial banks do not possess a monopoly on issuing indirect securities. Stock mutual funds, money market mutual funds, life insurance companies, and credit unions all offer similar financial services stemming from the presence of indirect finance.

The second key business function performed by banks involves the creation and processing of information about firms. The bulk of this information flows from the lending process. Banks create and process more unique information about small firms than large ones. Large firms have greater access to the nation's capital market system than do small firms. This larger access involves the use of investment bankers, bond rating agencies, and financial analysts at brokerage houses.

It follows that the use of these other financial market participants dilutes the uniqueness of any information about the firms that are jointly serviced by, say, a major investment banking house and a major commercial bank. From another perspective, banks create and process information that is more unique the smaller the customer being served, the less their lending is geographically diversified, and the more regionalized is their customer base. Unfortunately, extreme regulatory limitations that inhibit unrestricted branching simultaneously tie a given bank's loans to a specific region.(2) While this lack of loan portfolio diversification may increase the uniqueness of information created and monitored by the bank, it may also impair its profitability.

The third major business function involving banks concerns their role in the country's payments mechanism. By reducing the number of cash-for-cash settlements, the banking industry increases the efficiency of the nation's financial system. The payments-system function is the one least eroded by competition from other institutions that deliver financial services.[3] Still, the insulation from competition is not complete. Other private sector companies like American Express and Sears provide a medium of exchange through their credit card operations. Settlements handled by these and similar firms circumvent the more socioeconomic embedded traditions long handled by commercial banks.

The banking industry's "claim" on the three functions identified above has clearly been eroded by institutional adjustments across competing firms over the past twenty or so years. Two facts, however, related to the banking industry continue to contribute to its uniqueness among financial-services delivery mechanisms. First, the commercial banking industry is the major vehicle through which Federal Reserve monetary policy directives are effected. Second, the regulatory nature of the industry, which constricts its ability to be creative, causes it to stand apart from its key competitors.

What has to be emphasized is that banks are unique because they have been legislated to be unique. The regulatory shell is tested from time to time by financial market reactions to new information such as high failure rates. A significant portion of current, widespread discussions about bank reform stems from this new information.


One of the more controversial issues in the "reregulation" of the U.S. banking system is the role of deposit insurance and the Federal Deposit Insurance Corporation (FDIC). When created in 1933, the FDIC was publicly charged with the administration of a deposit insurance program designed to protect the principal balances of small depositors. The program has been very effective during the ensuing sixty years. No depositors have lost any principal and, equally important from a macroeconomic prespective, no bank runs have occurred.(4)

Soon after its creation, the FDIC became responsible for assuming a preemptive role in bank regulation when they obtained statutory permission to arrange merges between solvent banks and those in danger of failing. The sheer number of bank failures and mergers and acquisitions between strong and weak banks since the deregulation legislation of 1980 and 1982 put severe pressure on the solvency of the FDIC's Bank Insurance Fund (BIF). The BIF was forced to absorb assets and liabilities from the "weak" banks that the "strong" banks did not want.(5)

In reviewing all the proposed changes to bank regulations, there has been virtually no serious consideration given to lowering the level of deposit insurance coverage below the current $100,000 ceiling per account. It is almost as if this limit, expanded repeatedly since its inception in 1934, has become ingrained as an inalienable right in the public psyche. It now resembles an "entitlement." Between multiple account coverage and the ill-defined "too-big-to-fail" doctrine (discussed later), the existing law protects virtually all deposits, regardless of size, from loss when banks fail. Sadly, this level of protection is not the result of careful actuarial study, but rather the result of political compromise.(6)

Federal deposit insurance, by guaranteeing the full value of deposits, theoretically reduces the threat of bank runs.(7) By so doing, however, a very important market mechanism has been removed. Without deposit guarantees, the threat of withdrawal by uninsured depositors concerned about the safety of their deposits would provide a disciplinary role by forcing banks to maintain sufficient capital and limit their risk taking.

This lack of market discipline actually encourages banks to reduce their capital-to-asset ratios and pursue high-risk investments. As increased competition has reduced the value of bank charters in recent years, the tendency to take more risk has increased. This failure to impose adequate regulatory discipline is reflected in the unprecedented losses and FDIC assistance stemming from recent bank failures (See Figures 1 and 2).

If market discipline is to be restored, it must be fueled by two factors. The first is depositors be provided with sufficient information to enable them to evaluate the performance of their lending institutions. The second factor requires that depositors have sufficient motivation to want to evaluate the management and financial strength of their banks. Without arguing about the benefit of the self-correcting mechanism provided by the market, a central question appears to have been missed. What will be the result of a less restrictive bank regulatory environment in the absence of increased market discipline? Likely, the result is an unacceptable number of bank failures.

If it is to be left to the market to produce a safer and more efficient banking industry, then all of the factors relating to the previous protective regulatory environment must be removed or altered. Heading the list of changes should be lowering the level of deposit insurance per account, thereby causing bank depositors to want to evaluate the performance of their lending institutions. Bank depositors must think like bank equity investors. Such an outcome will reduce the direct loss to taxpayers from bank failures and improve the allocation of financial capital. A less complacent bank consumer would provide the motivation to develop a more efficient banking system.


The concept of too-big-to-fail (TBTF) figures prominently in all discussions of bank reform. It is important because its application may act as a deterrent to market disequilibrium, and because it has a direct bearing on deposit insurance levels.

When most banks fail, only deposits up to $100,000 are paid off at the time of failure. In theory, depositors with balances beyond the insured $100,000 must stand in line with other creditors and await the results of the bank's liquidation. This is a lengthy process. When federal regulators deem a bank too-big-to-fail, they pay off all depositors 100 cents on the dollar, even though deposits in excess are technically not insured.

The policy of not letting large banks fail raises the issue of fairness on a variety of levels. One of the more obvious is the arbitrary practice that allows discrimination among large banks that may be candidates for a bailout. A second issue asks why small banks, which are often better capitalized, more profitable, and better managed, have to operate at a greater risk than the nation's largest banks? The TBTF policy encourages people to transfer money to big banks and away from banks deemed small enough to fail.(8)

Another equity issue questions tapping into the Bank Insurance Fund every time TBTF is implemented. Since the BIF is financed exclusively from premiums banks pay on deposits, the application of TBTF means that the industry is paying for what amounts to a public policy matter, not an insurance issue.

In the face of the obvious inequities surrounding TBTF, the rationale behind continued implementation of the policy needs exploration.(9) Halting systemic risk is cited as the chief objective behind saving large banks. This includes the potential for "silent" bank runs and panics.(10) It also includes the risk that large uninsured deposits, especially money from other banks placed in large banks, will be lost, causing these other (usually smaller) banks to fail.

Figure 1 shows the number of banks that have failed between 1980 and 1991. Figure 2 reflects total assets of these failed banks for the same period. These statistics suggest that, because the assets of failed banks are increasing while the absolute numbers of failed banks are decreasing, it is the larger banks that are failing. This fact makes it clear that the inequities of the TBTF doctrine must be addressed.

It is difficult but necessary to assess the potential impact of bank runs on the economy. George G. Kaufman, a Loyola finance professor, suggests that "the short-run costs are quite minimal."(11) He points out that most banks reduce their exposure through spreading their deposits around at several banks. Even "silent runs" might only be a redistribution of money from risky to safe banks. While a TBTF policy decreases the risk that one failure might lead to others, it increases the likelihood that banks will carry riskier portfolios. These points support the argument favoring elimination of TBTF. Regulators, though, are unwilling to gamble on the outcome of not being able to apply TBTF.(12)

The American Bankers Association has proposed a "final settlement" procedure that would pay off all uninsured depositors a large percentage of their deposit at the time of a bank's failure.(13) The precise percentage would be determined by the FDIC's five-year recovery rate in all bank liquidations. The federal government would be reimbursed through the bank's liquidation. All-in-all, this is one of the most volatile and complex of the issues that comprise bank reform.


Bank deregulation instituted during the early 1980s changed the competitive environment for barriers to entry by permitting the creation of new interest-bearing consumer checking accounts and eliminated ceilings on time and savings deposit interest rates. The effect was to remove banks' virtual monopoly control over zero-interest bearing checking accounts and low-interest consumer savings deposits.[14] Figure 3 shows the shift away from banks to nonbank products that took place during the 1980s. Commercial banking assets accounted for 32 percent of the total assets of major types of financial intermediaries in 1990, compared with 37 percent in 1980. The market share of pension funds, mutual funds and money market funds also rose over the decade.(15)

The steady erosion of market share and corresponding diminished profitability have motivated many of the risky banking practices now being fingered as the causes of crisis in the system.(16) Because they are largely barred from the securities, insurance and real estate businesses, banks cannot maximize benefits from their huge branch networks. Coupled with their current cost structure, including rising deposit-insurance premiums and the requirement to hold reserves against deposits at the Federal Reserve, many banks are finding it difficult to remain competitive.

Proposed cures are many and, as noted, unanimity of opinion lacking. The general trend, however, appears to be moving toward further easing of restrictions and allowing banks to enter into new lines of business. Included here would be removal of the current geographic restrictions under the theory that confining financial intermediaries to specific areas concentrates credit risk and limits the diversity of funding bases.(17)

Reform proposals also suggest allowing banks to sell popular financial products like insurance and mutual funds and to engage in securities underwriting. Other changes might allow commercial firms to own banks (with appropriate "firewalls" in place). If such practices become widespread, it is possible that banks will become open participants in a financial services marketplace such that consumers may take care of their banking, brokerage and insurance needs at the same location. The only niche that would remain indigenous to the banking industry as it has historically existed would be small-business lending and check clearing.

The factors concerning banks entry into new lines of business have been identified, but their resolution is far from complete. The first step must be a public policy decision addressing whether the banking industry is to remain restricted and protected or change to become part of an expanded financial services marketplace. The only unacceptable choice is to do nothing.


The introduction to this analysis pointed out that both the banking industry and the federal government are congruent concerning the need for commercial bank reform. The details are the focus of the disagreement. In our view, the banking industry will survive the transition years of the 1990s provided a good dose of market discipline is injected into the system.

Surprisingly, the bulk of the objections to greater market discipline come more from legislators and regulators than from practicing bankers. The call by practitioners for less egulation and more competition is not new. Back in 1978, Walter B. Wriston, then Chairman of Citicorp, said:

The financial services business is no different from any other: Either you provide what the customer wants, or he or she looks for another supplier. The biggest problem facing commercial banking today is not the new competition, but the old regulation.(18)

More recently in its 1990 Annual Report the Federal Reserve Bank of Cleveland went on record:

We think that the market system can do a better job than is commonly supposed. The growth of the nonbanks and a more seasoned interpretation of the history of bank failures support this idea and, if taken to the extreme, make a strong case for the total deregulation of the banking industry.(19)

Even though the statements above by Mr. Wriston and the Cleveland Fed were separated by twelve years in time, they argued for exactly the same twin outcomes: increased market discipline and fewer regulatory restrictions. One outcome absent the other, by the way, will not work to the economy's net benefit. Less regulation without increased market discipline will only result in an increased number of bank failures.

In addition to deposit insurance, too-big-to-fail, and the entry into new lines of business previously discussed, two approaches that directly provide for a strong infusion of market discipline into the system have been proposed. The first is to increase bank capital requirements further, but to permit subordinated debt (i.e., subordinate to FDIC claims) to count as the equivalent of equity capital.(20) The second is to release to the public regularly the results of a given bank's most-recent safety and soundness examination.[21] Both suggestions hold promise with regard to reducing strain on the Bank Insurance Fund and upon taxpayers.

It is highly likely that a comprehensive banking bill will make its way through the U.S. Congress within the next two years. For the economy and the banking industry jointly to benefit, such legislation should encourage increased market discipline within the industry and remove some regulatory shackles from the bank decisionmakers.

Bankers, too, have to realize that they "can't have it both ways." Practitioners must prepare for the possibilities of losing some deposit insurance protection, less reliance on the TBTF doctrine, and public release of information concerning the condition of individual banks.


(1)A complete discussion about financial intermediation and the roles of direct and indirect finance within financial markets can be found in J.D. Martin, J.W. Petty, A.J. Keown and D.F. Scott, Jr., Basic Financial Management, 6th ed., Englewood Cliffs, N.J.: Prentice-Hall, Inc., 1991, pp. 657-664.

(2)This concept of a regional credit view is examined in depth in K.A. Samolyk and R.A. Wetmore, "Financial Fragility and Regional Economic Growth," Federal Reserve Bank of Cleveland Economic Commentary, September 15, 1991, pp. 1-4.

(3)See the Federal Reserve Bank of Cleveland Annual Report, 1990, p. 11.

(4)The runs on Ohio banks during 1985 involved institutions insured by a state insurance program, not the FDIC.

(5)On November 27, 1991, Congress approved legislation known as the FDIC Improvement Act of 1991 that provided an additional $70 billion for the BIF. Prior to this recapitalization, the BIF was projected to be insolvent by the end of fiscal year 1992.

(6)In a debate on bank reform published in the Harvard Business Review, July-August, 1991, p. 150, Mr. Thomas C. Theobald, Chairman of the Continental Bank Corporation argued that less than 3 percent of American households hold over $100,000 in a single bank.

(7)Some argue against the need for deposit insurance to prevent bank runs. See. M.D. Bordo, "The Lender of Last Resort: Alternative Views and Historical Evidence," Federal Reserve Bank of Richmond Economic Review, January-February 1990, pp. 18-29. Bordo cites evidence that other industrialized countries have managed to avoid widespread bank runs without deposit insurance.

(8)Mr. Kenneth Gunther, Executive Vice President of the Independent Bankers Association of America, noted that "large banks have de facto 100 percent deposit insurance coverage." See Investor's Business Daily, May 15, 1991, p. 36.

(9)Between 1985 and 1991, the FDIC carried out the too-big-to-fail policy six times at a total cost of $883 million.

(10)Silent runs can occur when major firms just electronically transfer funds out of troubled banks; it is suggested that this process imperils the savings of individual investors and small businesses. A discussion is provided by S. Mufson, "The Banking Industry's Golden Parachute Covers Only the Giants," The Washington Post, July 15, 1991, p. 16.

(11)See "The Risks and the Benefits of Letting Sick Banks Die: The Case for Attrition," The New York Times, February 20, 1991, pp. A-1, C-6.

(12)Federal Reserve Board Chairman Alan Greenspan recently told a House Banking Subcommittee: "We don't like the too-big-to-fail doctrine. I don't suspect, however, any of my colleagues would like to see it eliminated."

(13)This ABA proposal is summarized in B. Benham, "Banks May No Longer Be "Too-Big-to-Fail," Investor's Business Daily, May 15, 1991, pp. 1, 36.

(14)A useful review is provided by D. Humphrey, "Productivity in Banking and Effects from Deregulation," Federal Reserve Bank of Richmond Economic Review, March-April 1991, pp. 16-28.

(15)G.D. Short, J. Gunther, and K. Klemme, "A Perspective on Banking Reform," Federal Reserve Bank of Dallas Financial Industry Issues, Third Quarter 1991, pp. 1-4.

(16)Such a perspective is offered by T. Heagy, "On Restructuring Financial Services: Reaching for Reform," Financial Executive, November-December 1991, pp. 7-9, 20.

(17)E. Laderman, R. Schmidt, and G. Zimmerman, "Bank Branching and Portofolio Diversification," Federal Reserve Bank of San Francisco Weekly Letter, September 6, 1991, pp. 1-3 cite evidence suggesting that banks in states with unrestricted branching typically have developed more diversified loan portfolios than similar banks in restricted states.

(18)This statement by Mr. Wriston is found in the introduction to W. R. Sparks, Financial Competition and the Public Interest, New York: Citicorp, 1978, p. 6.

(19)Federal Reserve Bank of Cleveland Annual Report, 1990, pp. 20-21.

(20)Excellent arguments in favor of including subordinated debt in a given bank's capital requirements are found in D. D. Evanoff, "Subordinated Debt: the Overlooked Solution for Banking," Federal Reserve Bank of Chicago Fed Letter, May 1991, pp. 1-4; and G. J. Benston, "How to Forestall a Taxpayer Bank Bailout," The Wall Street Journal, April 16, 1992, p. A-24.

(21)Analyses concerning the public release of bank ratings are found in D. F. Scott, Jr., R.E. Spudeck, and W. G. Jens, Jr., "The Secrecy of CAMELS," The Bankers Magazine, September-October 1991, pp. 47-51; and "Give Public Access to Taxpayer-Funded Secret Bank Ratings System," Challenge: The Magazine of Economic Affairs, November-December 1991, pp. 58-60, by the same authors.
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Author:Scott, David F., Jr.; Jens, William G., Jr.; Spudeck, Raymond E.
Publication:Business Economics
Date:Jul 1, 1992
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