Treasury Department Proffers Blueprint for US Banking Reform

AFTER 800 failures of financial institutions and billions of dollars in bail-outs, the federal government has introduced reforms to make the United States banking industry competitive and less vulnerable to mammoth losses. Secretary of the Treasury Nicholas Brady, who unveiled his package on Tuesday (see box), said reforms would help reverse the industry's weakness domestically and its eroding competitiveness internationally. ``Today, only one of the world's top 30 banks [Citibank] is American,'' he said. ``Just 20 years ago, the three largest and nine of the top 30 banks were American.''

Mr. Brady's plan lays the groundwork for a group of competitive big banks that offer a variety of financial services, ranging from underwriting securities to selling insurance.

``A weak banking system hurts the economy,'' Secretary Brady said, ``particularly during difficult economic times. Businesses must be able to count on banks in bad times as well as good times.''

Banks are weak for several reasons. They have lost significant market share in home, car, and other financing to lending sources, such as home-mortgage institutions, car dealerships, department stores, and credit unions.

In order to stay afloat, banks have entered into high-risk, highly leveraged business deals. Junk bonds, foreign exchange trading, and speculative real estate loans, for example, are the prime examples. Overwhelmingly, over-valued real estate deals represent the greatest portions of loan portfolios for banks that have gone bad.

Consumer confidence low

Consumer confidence in the system is at a low ebb, leaving would-be individual depositors reluctant to entrust banks with their savings. Their attention may increasingly shift toward money-market funds managed by brokerage houses. Brokers expect even more business if Congress passes Treasury's proposal to cap the value of insured deposits a person can have in an institution to $200,000 - a regular account of up to $100,000 and a retirement account of up to $100,000.

Even corporate clients, another important source of bank activity, have taken their business elsewhere. Instead of borrowing from banks, large US companies issue their own commercial paper for necessary financing.

``Over the next few years, banks won't be able to raise capital, much less make a profit,'' says Christopher Whalen, a Washington-based financial consultant. ``Now Treasury wants the Federal Reserve System to loan money to cover banks that are too big to fail. The Fed is already spending that money somewhere else. The temptation is for the Fed to expand its assets - to print money to cover the costs, which is inflationary.''

Bigger and fewer banks are the wave of the future, says Mr. Whalen. Consumers will be left with the choice of banking with an insured facility that pays less interest or an uninsured institution that pays high interest. ``The government's got to stand back; it can't regulate this effectively,'' Whalen says.

Gary Gorton, finance professor at the University of Pennsylvania's Wharton School of Business and a former senior economist with the Federal Reserve Bank of Philadelphia, agrees. ``The best thing that could come from the new proposal is that it would provide the impetus for the banking industry to compete, and a shakeout will occur. Banks need to get into the habit of merging and regulators need to let them. It's difficult, however, to merge when you're weak, like many banks are. The market should decide whether banks fail.''

The shakeout will likely pit community and regional banks against such big banks as Chemical Bank, Chase Manhattan, and Manufacturers Hanover Trust.

Priorities questioned

The Treasury Department views these and several other big banks as ripe for mergers. Kenneth Guenther, executive vice president of the Independent Bankers' Association, which represents 6,300 community banks nationwide, worries about the department's priorities.

If the planned recapitalization of the Federal Deposit Insurance Corporation (FDIC) goes toward the merger of big banks, the smaller, sounder banks will suffer, he says.

``The problem with Treasury's proposal is that it doesn't do away with `too big to fail.' If Treasury doesn't handle this correctly, its program will increase insurance inequities,'' Mr. Guenther says. ``The plan gives big banks an implicit 100 percent deposit insurance and the right to branch wherever they see fit. That means they'll bank on regional turf and pre-empt community and regional banks. They'll be able to offer an insurance product that no one else will have - that they're too big to fail.''

He argues that if the federal government ``rescues the weakest bank in a hopelessly over-banked area by coming in, cleaning up bad assets, and sending it back strong into the market, it's the death knell for the rest of the local banking community. By bailing out the sickest, it puts the previously healthy at peril.'' By funding merger partners for big banks and offering them 100 percent insurance and entrance into local markets, Treasury would threaten regional banks, he says.