Bank Bill Is Another Giveaway You Would Think Congress Learned From The S&l Crisis.

Posted: August 01, 1991

If the bank-reform bill recently approved by the House Banking Committee gives you an uneasy sense of deja vu, there's a reason: The bill does nothing to stop tottering banks from gambling with federally insured deposits.

And that means we're rushing toward a replay of the S&L crisis - this time at triple the cost.

Why the worry? Recall that in our last episode of Fiscal Quagmire, the $1 trillion S&L industry was destroyed when hundreds of bankrupt thrifts were allowed to hide their insolvency and let losses mount.

Unlike normal businesses, which close down when they can't pay their bills, these thrifts - armed with Uncle Sam's deposit insurance - simply raised their interest rates higher than the next bank's to attract the cash they needed to stay afloat.

If this sounds like a government-sponsored Ponzi scheme, it was. The result? In the banking equivalent of the "Hail Mary pass," our money was gambled on long-shot investments like cattle farms and junk bonds, designed to dig the troubled S&Ls out of the hole if they paid off. When they didn't, the rest of us (via the FSLIC) picked up the tab.

Now, $200 billion later - and with commercial banks carrying $3 trillion in assets edging toward an abyss that could make the S&L bailout look like a pothole - you would think the primary lesson would have hit home with our leaders: Whatever else bank reform may do, it must stop weak banks from using the insurance guarantee to systematically overbid for deposits that are gambled on high-risk investments.

Amazingly - or predictably - the House Banking Committee's new bill ignores this fundamental point, even while it makes several other smart changes that are overdue.

For example, banks at long last would be permitted to expand freely across state lines, ending the system of local banking cartels created by the McFadden Act in the wake of the Great Depression.

Back then the idea was to protect banks from going under by making sure they faced as little competition as possible. As a result, the U.S. banking system today sports more than 12,000 relatively tiny banks, as opposed to the several dozen behemoths that characterize banking in Germany or Japan.

The House bill's nationwide expansion provisions let banks diversify loan risks. And because expansion will take place through mergers, it will also let banks slash an estimated $10 billion in duplicated back-office costs - increasing by half the $20 billion in profit earned last year by the ailing industry.

But despite this, the startling fact remains: By leaving marginal banks free to bid recklessly for our money thanks to their federal guarantee, the S& L fiasco will probably be repeated - and on a grander scale.

What's the remedy? A proposal from Rep. Charles Schumer (D., N.Y.) could yet save the day. Dubbed "core banking," it assures that banks could not use taxpayer-insured funds to finance notoriously risky loans to, say, Third World monarchs, leveraged-buyout kings or hyperactive real-estate developers.

Schumer would divide banks into insured and uninsured affiliates. The insured (or "core") bank could invest only in low-risk assets like government securities or small-business loans.

In exchange for the federal guarantee, however, the top interest rate the core bank offered depositors would be limited to that being paid on short-term Treasury bills. With one stroke this provision would make it impossible for buccaneer banks to bid for deposits by offering the kind of sky-high returns that only risky investments should earn.

The uninsured bank, meanwhile, could make whatever loans it liked and pay depositors any interest rate it chose. It would enjoy no deposit insurance and would thrive or fail on the open market.

Opponents of core banking say the interest-rate cap goes against the free market - conveniently forgetting that deposit insurance itself stops the free market from functioning whenever bank losses occur.

Others argue that tougher bank supervision is the way to stop abuses, but history is not on the side of that argument.

Bankers, meanwhile, continue to fret that core banking will prompt many of us to flee to higher returns elsewhere. True enough. But they should also admit that they really want American taxpayers to keep taking the risks they were taking before the S&L crisis burned us all.

There's still time for the Bush administration and the House and Senate to rally behind core banking. Let's hope they do before we're forced to confess to our debt-saddled children that we could be so expensively dumb so often.

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