Deposit-insurance reform is key to banking system overhaul - editorial

Nation's Business, July, 1991

Comprehensive reform of the financial-services industry has many facets, but the initial goal must be the successful restructuring of the deposit-insurance system.

That system cannot be considered sound as long as well-run banks and poorly run banks pay the same premiums for deposit insurance and as long as taxpayers are responsible for the system's liabilities of about $2.7 trillion.

Warnings of a potential banking and deposit-insurance crisis not far down the road have been issued repeatedly by the leaders of the Federal Deposit Insurance Corp., the government entity that manages the deposit-insurance fund.

These warnings have prompted numerous legislative proposals, but most of them would simply burden depositors and banks with new regulations and costs.

For example, the administration has proposed new limits on the deposits per individual that the government would insure. It has also proposed stricter requirements on the amount of capital that banks must have on hand.

Both of these recommendations would ultimately hurt banks, depositors, and the deposit-insurance system. New limits on insured deposits would encourage depositors to shift funds from bank deposits to other investments. Higher capital requirements would force banks to sell assets; because lowest-risk assets are most saleable, banks would be left with their more risky assets, further exacerbating their woes.

To achieve the administration's and Congress' goal of strengthening banks, Congress should adopt an approach to deposit-insurance reform that would increase bank discipline and make banks and the deposit-insurance fund sounder. Such an approach could use the private sector to establish the accurate pricing of deposit insurance and to provide for adequate, sustained capitalization of the deposit-insurance fund.

Today, all banks pay the same federally set premium for deposit insurance whether they are well-run or poorly run. Thus, the government-run deposit-insurance system as it is now operated favors losers.

Private-market pricing could correct this problem. Achieving market pricing would involve establishing a mechanism to allow the market to determine what individual banks should pay for insurance. Well-run institutions would pay relatively lower rates. Poorly run institutions would pay higher rates.

Sen. Alan Dixon, D-Ill., has introduced a bill (S. 261) to establish such a market-set, risk-based premium system. In doing so, his Deposit Insurance Reform Act of 1991 would provide a strong step toward reform of the deposit-insurance system. Accurate pricing of deposit insurance would remove the subsidy that is essentially transferred now from well-run banks to poorly run banks.

One private-sector approach to shoring up the deposit-insurance fund that should be considered would involve "cross guarantees." Strong banks would form a consortium, apply market standards in granting insurance, and share the loss if an insured bank failed.

Such a system would provide for the pricing and financing of deposit insurance by the industry. Today, the insurance fund is financed by taxes and government borrowing.

In reforming the deposit-insurance system, Congress must also address the current policy of viewing some large banks as "too big to fail." Under that policy, the federal government views massive support to keep such banks in operation as preferable to the impact that their failure would have on the overall financial system.

Provisions should be made to ensure that insurance coverage for such institutions is governed by accurate risk assessments and premium charges so that taxpayers don't end up paying the price for a bank's poor management.

Moving toward a system of private deposit insurance would ultimately benefit banks, depositors, and taxpayers. Market pricing would be a good first step toward comprehensive reform of the increasingly troubled deposit-insurance system.