oversight

Deposit Insurance and Related Reforms

Published by the Government Accountability Office on 1990-09-19.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                  United   States General Accounting   OftIce
                  Testimony




For Release         Deposit     Insurance    and Related        Reforms
on Delivery
Expected at
1O:OO a.m.
Wednesday,
September 19,
1990




                    Statement of
                    Richard L. Fogel
                    Assistant Comptroller  General
                    General Government Programs

                    Before the
                    House Committee on Banking,            Finance        and
                    Urban Affairs
                    House of Representatives




GAO/T-GGD-90-46                                                           GAO Form 160 (12/‘37)
                    Deposit     Insurance      and Related      Reforms
                             SUMMARYOF STATEMENT BY
                                 RICHARD L. FOGEL
                          ASSISTANT COMPTROLLER GENERAL
                           GENERAL GOVERNMENTPROGRAMS
Over the years deposit              insurance     has helped to maintain         stability
and confidence          in the U.S. financial           system.      However, since
deposit      insurance      was initiated       in 1934, the financial          system has
changed drastically              and banks operate        today in a much riskier
environment.           As a result      of the savings and loan debacle and
concerns over the condition                of the banking        industry   and the
insurance       funds,    it has become evident             that insuring
approximately          $3 trillion      in deposits       in the nation's      depository
institutions         is not the relatively           riskless      and inexpensive
proposition        that it once appeared.
GAO is proposing    that three sets of actions     be taken to better
align    the design of our deposit   insurance   system and financial
regulation    more generally  with the realities     of today's markets.
--   First,       steps must be taken immediately                  to stabilize      the
     banking        industry      and insurance      fund and to build much greater
     reliability          into the processes         used to oversee the industry
     and enforce          laws promoting        safe and sound banking practices.
     This can be done by (1) giving                  FDIC the authority            to raise
     assessment         rates beyond those currently                 provided    in FIRREA,
      (2) clarifying           the regulators'        responsibilities          and narrowing
     their       range of discretion          in overseeing          and enforcing      safety
     and soundness regulation,                 (3) providing         for annual on-site
     examinations           of all large and troubled              banks and more frequent
     interim        reviews of large banks, as well as changing certain
     accounting          rules to better        measure the value           of banking
     institutions,            (4) appointing       a special       high-level      panel of
     experts        to thoroughly       evaluate      the quality        of the procedures,
     skills,        resources,       and training       that regulators         need to
     supervise         banks and bank holding            companies,        and (5) providing
     for a greater            role and accountability            for bank managers,
     directors,          and independent        auditors     to ensure that banks have
      information          and other systems in place to adequately                    control
     all aspects of operations,                 accurately      track financial
     condition,          and comply with safety            and soundness regulations.
--   Second, steps are needed to change the economic incentives
     that have allowed      bank owners and managers to abuse the
     deposit  insurance     system.    The best way to accomplish       this is
     through  (1) higher      risk based capital  requirements,       and (2)
     higher  deposit    insurance   premiums for poorly    capitalized      or
     poorly  managed institutions.
--   Finally,   a framework   should be established    to ensure that
     actions  taken to expand the powers of banking organizations
     are c0nsisten.t   with the goal of ensuring    the safety   and
soundness of banks and financial           markets.     In the long run
consideration        should be given to allowing      banks more freedom
in offering      products    in order to better     serve customers,
diversify     risks,     and become more competitive      in world
markets.      However, great care must be exercised           in changing
banking regulations         with an eye always on the safety       and
soundness implications          of actions  taken.
In this regard,        powers should not be expanded for any banking
institution      until   regulators     can credibly        demonstrate        the
ability     to oversee and adequately            enforce    safety    and soundness
regulation,      and the insurance        fund is put on a solid             financial
footing.       Once the Congress is assured of this result,                      new
product     line powers that bear a close relationship                   to
traditional      banking     functions    can be phased in--but           only for
well capitalized,        well managed firms under arrangements                    that
provide     for holding      company support,        consolidated      supervision
by a federal      regulator,       and restrictions        on capital      flows to
prevent an extension           of the federal       safety   net.
Mr.   Chairman              and Members of                 the Committee:


I am pleased                to be here            today      to discuss              deposit           insurance          reform
and related                issues.          As you know,              we are studying                   these    matters
as required                by the         Financial         Institutions               Reform,          Recovery,             and
Enforcement                Act     (FIRREA)          of    1989,      and we plan               to report          on our
results          by early            next       year.       Although            our work         is still          in
progress,             at    this      point        I would         like       to share          with     you some of
our observations                     regarding            how best           to achieve          meaningful             and
practical             deposit         insurance            reform.


Three          sets    of actions               need to be taken                  to align          our deposit
insurance             system--        and financial                regulation            more generally--with
the     realities                of today's          markets.


          me
                 First,           steps      must be taken                  immediately          to stabilize                 the
                 financial            condition            of the banking                 industry         and insurance
                  fund      and to build                much greater              reliability             into      the
                 processes            used to oversee                  the      industry         and enforce              laws
                 promoting            safe        and sound banking                    practices.            This        can be
                 done by (1)                giving        FDIC the authority                    to raise         assessment
                  rates          beyond      those        currently            provided         in FIRREA,              (2)
                  clarifying              the     regulators'               responsibilities                and narrowing
                  their          range      of discretion                 in overseeing             and enforcing
                  safety          and soundness             regulation,                (3) providing             for      annual
                  on-site          examinations              for      all      large      and troubled              banks           and
                 more frequent                  interim       reviews           of     large     banking         firms,         as
         well      as changing               certain      accounting              rules      to better
         measure         the      value       of banking          institutions,                 (4)     appointing
         a special              high-level        panel         of experts           to thoroughly
         evaluate          the      quality       of the procedures,                      skills,
         resources,              and training            that     regulators              need to supervise
         banks       and bank holding                  companies,               and (5)      providing          for    a
         greater          role      and accountability                    for     bank managers,
         directors,              and independent                auditors          to ensure           that     banks
         have information                    and other          systems          in place           to adequately
         control          all      aspects       of operations,                  accurately           track
         financial              condition,         and comply         with         safety           and soundness
         regulations.


    --   Second,          the      economic        incentives             that     have allowed               bank
         owners          and managers            to abuse the deposit                       insurance
         system          should       be changed.               The best          way to accomplish
         this       is    through         (1)    a phase         in of higher               risk-based
         capital          requirements,                and (2) higher               deposit           insurance
         premiums           for     poorly       capitalized              or poorly           managed
         institutions.


    --   Finally,           a framework            should        be established                 to ensure         that
         actions          taken       to expand          the powers              of banking
         organizations                are consistent               with         the goal        of ensuring
         the safety               and soundness           of banks and financial                         markets.
         In the          long      run consideration                should          be given           to allowing

2
             banks more freedom                   in offering              products              in order        to
             better        serve      customers,           diversify              risks,          and become more
             competitive             in world         markets.             However,           great        care must
             be exercised             in changing               banking          regulations             with     an eye
             always        on safety           and soundness               implications.                   In this
             regard,        powers           should      not be expanded                   for     any banking
             institution             until       regulators              can credibly              demonstrate              the
             ability        to oversee            and adequately                  enforce          safety        and
             soundness           regulation,             and the          insurance              fund     is put on a
             solid      financial             footing.            Once the Congress                      is assured          of
             this      result,        new product                line     powers       that        bear      a close
             relationship             to traditional                    banking       functions            can safely
             be phased           in-- but        only      for     well         capitalized,              well    managed
             firms      under        arrangements                that     provide          for     holding        company
             support,        consolidated                supervision               by a federal              regulator,
             and restrictions                  on capital               flows      to prevent             an extension
             of the        federal           safety      net.


In the remainder              of my testimony                    I will         discuss          the     basis        for   our
views     and more specifics                    about      the      recommendations                     we are making
today.


THE TASK AHEAD


All     industrial         countries            regulate          and influence                  the     operation          of
their     financial         markets.             While      the nature              of regulation                differs

3
considerably            across       countries,          one particularly                  im,portant
foundation        of regulation                in all      countries            is avoiding             the
disruptions           associated            with     bank failures.                   Through        such means as
bank examination                 processes          and discount              loans     from        central         banks,
governments           hope to maintain                 public         confidence          in the        continuity
of banking        services           that      is needed            for      a modern      financial               system
to effectively             support          a nation's          commerce.


Over the years,                 our deposit          insurance              system     has helped             to
maintain       stability            and confidence                  in the U.S.         financial             system.
Despite       the oil           problems       and inflation                 of the      1970s and the
recession,        stock          market       drops,      and regional                dislocations             of the
198Os, people             for      the most part              did     not have to worry                 about
whether       their       money was safe.


Although       there       are      benefits         to deposit              insurance,         there         is now
the troublesome                 realization          that--as             a result       of the        Federal
Savings       and Loan Insurance                    Corporation              (FSLIC)      debacle            and
concerns       over       Federal          Deposit       Insurance            Corporation's                 (FDIC)
financial        condition--           our     current          system        of deposit            insurance          has
some drawbacks.                  Insuring          deposits          that     now total         about         $3
trillion       in the           nation's       depository             institutions             is     not     the
relatively            riskless        and inexpensive                 proposition           that       it     appeared
to be when markets                  were more stable                  and slow moving,                 less
competitive,             and less          global      than         they     are today.



4
A generation             ago,      banking        was in many ways a protected                             industry.
Entry      was restricted,                 no interest           was paid              on demand deposits,
and regulation              Q controlled              other      rates.              The barriers          between
banking         and other          financial          services          were clear,                and there      was
little         direct      competition              from     foreign          firms.         Now, most          of these
characteristics,                 which       helped        to deflect               risk    away from          banks,
have been stripped                  away or significantly                           diminished         due to
advances          in technology              and other          factors.               Not only        do banks
compete         with     each other             in a deregulated                    interest-rate
environment,             but     virtually           every      service             they    offer--whether              it
involves          taking        money in or lending                    it     out--has         close     substitutes
offered         by nonbanking              firms.          As a result,


          --    blue-chip          companies          can bypass              banks and go directly                     to
                the securities               market        to finance               their    operations,


          --    money market              and cash management                       funds    offer      what     amount
                to interest-bearing                   checking              accounts        that     have much
                 lower     costs         than    typical        bank accounts                due to      lower
                overhead         and the         absence        of costs             associated         with     deposit
                 insurance         premiums,          required              reserves,        or bank-capital
                adequacy          requirements,


          --     a wide        variety       of nonbanking                  firms      are active        in consumer
                credit       and mortgage             lending,              and



5
    --        insurance          companies              offer      a variety          of     tax-deferred
              savings       products             that      compete         with      bank certificates                 of
              deposit.


These and other             changes             to the      competitive              landscape          have
drastically           altered        the        assumptions             and rules          of the game that
helped        shape the design                  of our deposit               insurance           system       six

decades        ago.      Depository              institutions              have become riskier                      and the
incentives          factored         into        the     business          decisions           that     bank owners
and managers            make are much more worrisome                                than     they      were when
banking        was a protected                  industry.


In considering             changes          to the deposit                 insurance           system,        the
current        environment           within         which         insured         institutions             operate
must be taken             into      account.             However,          there      is no simple               or
obvious        way to do this.                   There          are three         major      challenges             that
must be successfully                     met     in order          to     ensure      a safe,          sound,         and
competitive            financial           system         in the years              ahead.


First,        the condition              of the         banking          industry          and the        Bank
Insurance           Fund (BIF)           must be stabilized.                        As conditions             develop
that      may result         in the         first         recession          in 8 years,              there      are
already        over     1,000       problem            banks      and FDIC's          reserves            (.7% of
insured        deposits)           are     at    an all          time     low.       There       are      increased
risks      within        insured         institutions--                 as evidenced           by the         increasing
percentage            of problem           assets         held      by banking             institutions--and

6
increased        risks      to the              insurance            fund       resulting          from         the     large
number of bank failures                          that       continue            to occur.           If       care       is not
taken,      a similar           situation                to that        which        devastated            FSLIC may
arise--     examiners           failing            to compel            safe        and sound banking
practices        and failing                   to close           banks        because       BIF does not                have
the money to resolve                  problem                  institutions.


A second        set of challenges                        involves         changing           the economic
incentives         that     have allowed                    bank owners              and managers                to abuse
the deposit         insurance                  system          in today's           highly      competitive
financial        environment.                     Since          the adoption              of deposit            insurance,
levels       of bank equity                    capital           have fallen          dramatically                  from     about
15 percent         to approximately                        6 percent.               There     is    little             question
that      banks would           have to put                    up more of their               own money to retain
depositor        confidence               if      it     were not           for     the deposit              insurance
guarantee.          Furthermore,                       deposit        insurance            has made it                easy    for
poorly       capitalized           or high-risk                     institutions             to successfully
attract        additional           deposits               by bidding              up the cost            of       funds.


Third,       a regulatory            framework                   must be established                     that         changes
bank powers          and financial                      holding        company arrangements                           in a way
which       recognizes          the modern                 financial              environment            in which            banks
operate        but does not               place           the deposit              insurance        system             at risk
or jeopardize             the     stability                of financial              markets.             Due to
restrictions             such as the Glass-Steagall                                 Act,     which,          for       example,
prohibits         an organization                       that      owns a bank from providing                               a full

7
range     of securities             underwriting                  services          to its      corporate
customers,        banks      and other              financial            service       firms         are not          fully
able     to respond        to competitive                       challenges          in the United              States
and abroad.          To be sure,              competitive                pressures,            aided        in some
cases by changes             or reinterpretations                         of state            and federal
regulations,         have broken              down many of the traditional                                  barriers
that     have separated              banking             and other          industries.              However,          the
piecemeal,        ad hoc redefinition                           of the financial               landscape          that
has been occurring                 over      the         last     two decades           is,     in our view,
dangerous        because          our     regulatory              system       is neither            equipped           nor
organized        to deal          with      the     changes.


These three         challenges              must be met in a coordinated                               way.       If        they
are not,       some very           serious          mistakes           could        be made.           For example,
if     the finances        of the           insurance             fund      are not         stabilized           and the
regulatory        system’s           role     in promoting                  safer     and sounder              banking
operations        is not          improved,              steps      taken      in the name of deposit
insurance        reform          to change          the         incentives          of bank managers                   to act
more prudently            will       have little                 credibility          and may be
destabilizing.              Similarly,              if      the powers           of banking            organizations
are expanded          before         the deposit                 insurance          fund,      the     regulatory
system,       and economic               incentives              are fixed,          the      risk     exists          of
repeating        a major          mistake          that         was made in dealing                  with       the
thrift       industry--          allowing          poorly          capitalized            institutions            to take
on new risks          in the         hope of growing                   or diversifying                 their      way out
of problems.

8
THE STRATEGY WE RECOMMEND


Ultimately,          the     strategy           we recommend for              achieving       a more safe
and sound financial                system          is driven          by the need to accomplish
two basic          objectives:             (1)     ensuring          the continuation             of stability
and confidence             in the        banking       system         and (2) greatly             limiting            the
exposure          of American           taxpayers         to the kind          of losses          they       will
bear    as a result             of the      unhealthy            management       incentives             and
mistakes          made in regulating                 savings         and loans.


I would       like     at this          point      to provide           our views      on the        steps           we
feel    are necessary             for      dealing        with       the three      challenges             I have
identified.

Stabilizing  the Bankinq System                           and
the Bank Insurance  Fund


As I stated           at the      beginning           of my testimony,              there      are       five
steps      that      must be taken               to stabilize           the banking         system         and the
Bank Insurance               Fund as well            as to pave the way for                  more
fundamental           reform      of the deposit                 insurance       system.          The first               of
these      steps      involves          strengthening             the    insurance        fund.          The next
three     are concerned             with         strengthening           the regulatory            system            that
is essential           for      achieving          safe     and sound banking.                 The last              of
these      involves          strengthening            the     role      and accountability                 of bank
managers,          directors,           and financial             auditors.          I would        like        to
elaborate          on each of           these      steps.

9
First,          financing       for      the Bank Insurance                        Fund (BIF)             needs        to be
increased           to ensure           its     financial              integrity           and support                the
regulators'             enforcement             efforts.               In our recent            report            on the
condition           of the Bank Insurance                        Fund,l        we found         that        BIF is            too
thinly          capitalized           to deal          effectively               with      bank failures                 in the
event      of a recession.                     The fund          is approaching                the point               where,
even with           a clear       mandate            and the best                intentions           on the           part      of
the      regulators           to enforce              safety          and soundness            regulations,
actions          to close        imperiled             banking          organizations               may not            be
possible           due to limited               financial              resources.             The recent
proposal           by FDIC to raise                   the     assessment            rate      to 19.5            basis
points          (currently        the         rate      is 12.0          basis      points)          is    a step            in the
right      direction.             However,             further           increases          seem necessary                    and,
for      this      reason,       Congress             should          amend FIRREA to authorize                              FDIC
to raise           the assessment               rates         beyond        those         provided         under            current
authority.              While     some further                  increases           in premiums              are both
necessary           and feasible,                I would             caution       that     there         is a limit                to
how high           they      can be raised               at any one time.                     Although            insurance
premiums           have been accounting                        for     less      than      1 percent             of    the
operating           costs       of an average                  bank,      at     some point           high        premium
levels          could       undermine          the      competitiveness                   of the      institutions
that      pay them.             In addition,                 on fairness            grounds,          as insurance
premiums           rise,      raising          all      banks'         premiums           when not         all
institutions                are equally              risky      becomes more of a concern.


1Bank Insurance   Fund: Additional  Resources and Reforms Needed to
Strenqthen   the Fund (GAO/AFMD-90-100,   September, 1990.)
10
Second,         it     is essential              that      the       regulators            act     earlier           and use
the enforcement                  tools        provided           in FIRREA to take                  more forceful
actions         against          safety         and soundness                violations            and capital-
deficient             institutions.               We are concerned                    that        the way Congress
intends         regulators              to use their                authority         is not            as clear        as it
should      be.


Earlier         and more forceful                     intervention               by the regulators                     is
crucial         to stabilizing                  the      banking           industry        and preserving                   the
resources             of the       insurance             fund.         But the success                   of   this
approach             depends       upon the           ability          of regulators               to do in the
future      what they              have been unable                    or unwilling               to do in the past
--namely,             restrict          activities              and take         control          of problem
institutions               on a timely               basis.          For example,                four     large        bank
holding         companies             that      failed          between         1987 and 1989 and imposed
considerable               losses         on FDIC were                identified           as problem
institutions               during         the    early          1980s.          The regulators                identified
such poor management                         practices           as excessive              dividend           payments            by
bank subsidiaries,                      unreasonable                real     estate        loan         growth       policies,
and inadequate                   loan     documentation.                    However,         the        regulators           did
not      take        timely,       adequate           enforcement               actions          to restrict            these
unsafe      practices.


In 1989,             FIRREA strengthened                      the     regulators'            authority            to
control         problem           banking        organizations.                    For example,               FIRREA
provided             the regulators              the      authority             to prevent              poorly

11
capitalized          banks       from       using     brokered            deposits        to finance              high-
growth       strategies          and clarified             the Office              of the Comptroller                     of
the Currency's              (OCC) authority               to place            undercapitalized               banks          in
conservatorship              to minimize             insurance            fund     losses.


While       insufficient           time       has passed          to fully            evaluate        the
effectiveness              of the      FIRREA provisions,                     we are concerned                that
problems        remain         as illustrated             by     the results            of OCC's recent
closure       of the National                 Bank of Washington                   (NBW).           OCC used its
new conservatorship                   authority          to take          over     NBW while          the bank
still       had some equity                capital       remaining.              However,           the    fact      that
FDIC expects           to spend            about     $500 million--approximately                            30
percent        of NBW's assets --to                  resolve        the case indicates                     that      OCC
did     not act      soon enough              to ensure          that         the costs        to the        insurance
fund     were minimized.


To achieve          earlier,          more forceful              intervention,                the    discretion
available         to regulators               in taking          actions,          such as restricting
growth       or the payment                of dividends,            should         be narrowed.
Furthermore,           because            of weaknesses           in the way the value                      of
financial         institutions              are measured,                when the capital                 position             of
a bank begins              to fall,         regulators           need to take             earlier
anticipatory           steps        for     dealing       with          the    institution.               FDIC,      in
cooperation          with       the       appropriate          chartering             and supervisory
agencies,         should        be required             to perform             what     can be termed
"break-up"          analyses          of banks          that     fall         below    a prescribed               minimum

12
capital         requirement.                  Such an analysis               would        evaluate              the
liquidation               value      of the          firm     and provide            an appropriate                    basis
for      taking        a resolution                action       that     protects             the deposit
insurance            system        from       loss.         We also        believe            it     may be necessary
to give         FDIC additional                    enforcement           authority                 so that      it     can
better         protect         the       financial           integrity       of the                insurance          fund      by
issuing         cease         and desist             orders      to any bank             it         insures,          including
national           banks.


Third,         the     regulators             need to provide               more effective                     supervision
by conducting                 regular         on-site         examinations            of financial
institutions,                 and better             measures          of financial                 condition          also
need to be developed.                             In particular,            the      federal              regulatory
agencies             should       perform          on site,        annual,         full-scope                examinations
for      all      large       and troubled              banks and more frequent                             interim
reviews           of all         large      banks.           To do this,           the        regulators              will      need
adequate             resources           and training.                 To better         measure             the      financial
condition             of troubled             institutions,              accounting                 rules      should          be
changed           to reduce           the     range         of discretion            allowed              under
generally             accepted           accounting           principles           for         recognizing              losses
on nonperforming                     loans.           Furthermore,           these       rules            should        be
modified             to require            that       nonperforming           assets               of troubled
institutions               be valued              on the basis           of a near                 term     rather           than
longer         term       sale       requirement.




13
Fourth,       with             so much depending                 on the       ability         of the          regulators
to take        timely             actions,         we must         insure      that         they     have all          of the
incentives,               procedures,              resources,             and training              that      are needed.
I cannot           overemphasize                the     importance            of ensuring              this      result.
To accomplish                   this     result,        a high-level                panel     of experts              should
be established                    to help       thoroughly            evaluate          the procedures,
skills,        resources,               and training               that      the regulators                 must      now have
to properly               supervise            banks         and bank holding                companies.               This
presidentially                    appointed          panel       would       be charged             with      conducting             a
top to bottom                    evaluation          of the        skills      needed to adequately
conduct        oversight               of banking             institutions              in today's            world.


Finally,           bank managers                and directors                should         be held         more

accountable                for     reporting           on the effectiveness                        of their         internal
control        structures                and for         their       compliance             with     laws       and
regulations                related           to safety           and soundness.               These officials                    are
the first               line      of defense           in making            sure     that      institutions               are
run       in a way that                 protects         the deposit               insurance          fund      and the
public.            It      is essential               that     bank managers                and directors              ensure
that       their         firms         have information                and other            systems           in place          to
adequately               control         all       aspects        of operations              and accurately                  track
financial               condition.             To help           assure      this       result,        it      would       be
useful        to require                that       insured        depository            institutions               have
independent                audit        committees.




14
As we have recommended                     in the       past,      banks         should      undergo       annual
financial         audits      and the          role     of independent                auditors       should          be
expanded         to assess        management's                reporting          and the adequacy              of
financial         information.                In addition,             consideration             should      be
given       to strengthening               auditing           procedures          to assess        an
institution's          ability          to continue              as a going           concern      and
increasing         auditor's          responsibilities                   for     detecting        violations              of
law or regulations.


Changinq Economic Incentives    to Discouraqe
Abuse of the Deposit  Insurance   System


To ensure         long-term         stability           of the banking                system,      changes
must be made to the                 incentives            that      have allowed              imprudent        risk-
taking       by depository            institutions,               particularly               by those       that      are
troubled.          Highest         priority           should      go to holding               the owners           and
managers         of banks        responsible            for      the     risks      generated        by the
activities         of their         banks.            While      the more forceful                enforcement
actions         discussed        earlier        are part          of the         solution,        the other
important         ways to accomplish                   this      goal      are higher          capital
requirements          and risk-based                  insurance          premiums.


It   is essential           that      capital          be increased              to put more of a
financial         cushion        between         the decisions                 of bank managers             and the
exposure         of taxpayers,             because        no regulatory               process       can be
expected         to perform         perfectly           in all          situations.            Capital
provides         the best        means of both                ensuring          the continued            stability
15
of     the banking           system       and limiting               the      liability         of the
government            from     losses      in failed           financial             institutions,


While      we are still            evaluating              the nature            of such a changed
capital          requirement,            at the present               time       we believe          it     would


--     gradually         increase         the      current        Basle        minimum risk-based
       capital        requirement:


--     allow      for    greater         use of subordinated                     debt     by all          banking
       institutions             and perhaps          require          a specified            percentage             of
       such debt         for     our     largest       banking             institutions          to encourage
       creditor         discipline;


--     incorporate             measures      of     interest           rate       and perhaps,             portfolio
       concentration             risk;     and


--     be phased          in over        a fairly          long      period         of time      following             full
       implementation              of the       current           Basle       standards         in 1992.


We are mindful                 of the     concerns           that      have been expressed                    about           the
potential           effects        of an increased                  capital         requirement            on the
domestic           and international                competitiveness                   of our banking              system.
However,          we also        recognize          that      many banks              already        have capital
well      above regulatory                minimums           and,      in general,            earnings          tend          to
be higher           at well        capitalized             institutions.                  To lessen          potential

16
problems,         we would           allow          for     a long           transition              period          of at least
5 years.          As an incentive                    for        banks        to obtain             capital,
opportunities              could       be provided                  for      well        capitalized               banks          to
obtain      additional              powers          that        may enhance               profitability                    in future
years,      as I will          discuss.


Creating          incentives           that         foster          safe          and sound banking                      practices
can also          be augmented               by increasing                   premiums             for     banks
demonstrating              higher          risks.           We recognize                   that         there      are
practical          limitations               on the          ability             of a government                    agency         to
accurately          assess          risk      or raise              premiums             enough          to really
compensate          the      fund      for         the     risks          being         taken.           However,            we think
that      increasing          premiums              when capital                   deficiencies                  exist       or where
there       is evidence             of poor           loan       documentation                    or other           breakdowns
in     internal          controls          will       reinforce                  the    importance               of capital
adequacy          and good management.                             It     will         introduce          an element               of
fairness          into      the deposit                  insurance           premium          structure              and will
provide       an added incentive                          for      prudent             operation          of banks.


Our preference               for      relying             on capital               along      with         its      strict
enforcement,              augmented               by variations                   in deposit             insurance
premiums          is based on our view                          that,            compared         to the
alternatives,               the approach                  offers          the      lowest         possibility                of
destabilizing               the system.                   Let me briefly                   discuss          our          current
thinking          on some of the more prominent                                        alternative               reform



17
measures          that     have been proposed:                    reducing        insurance              coverage           and
shifting          the costs         of risk          bearing        to the banks             themselves.


--    Reducing           deposit      insurance             coverage.         We have not                ruled        out
      attempts           to provide          incentives           for    people       to be more careful
      about       where      they     place         their     funds.         However we question,                       on
      grounds        of stability,             whether          reducing       deposit             insurance
      coverage           or imposing          greater          losses      on individual                 depositors
      should       be the centerpiece                   of reform.            We do not             think        that
      heightening            the probability                 of widespread            bank runs              is the way
      to maintain            confidence             in the      safety       and soundness                  of our
      financial           system.


      We do believe,                however,         that      efforts       should         be made to limit
      the coverage            of large          deposit         accounts       directed             by
      professional            money managers.                   These      accounts              include      brokered
      deposits           and possibly           pension         fund      placements              and bank
      insurance           contracts          that      currently          receive          so-called          pass-
      through        insurance          coverage.              Under these           arrangements                a
      deposit        that     may involve              millions          of dollars              is completely
      insured        because         the     deposit         is made in the name of many
      individual            persons.          While         FIRREA provides                for     a prohibition
      on use of brokered                   deposits          to sustain        the operations                    of
      undercapitalized                 institutions,               it    does not provide                   a similar
      prohibition            for     other      types        of accounts            that         receive      pass-
      through        coverage.             We are considering                 whether             similar

 18
     provisions            should     exist           for     those         accounts          and,      in addition,
     whether        pass-through               coverage             on bank          insurance          contracts            and
     similar        types      of accounts                  should        be eliminated               altogether.


--   Shifting            the costs      of risk-bearing                      to the          banks themselves                 by
     means other            than     increased               capital         requirements               or higher
     premiums.             Several      proposals               have been advanced                      to accomplish
     this      result


     o Narrowinq            uses of          insured          deposits.               If     deposits         are placed
        in a so-called               narrow           bank and if              those         deposits         are
        invested           only     in short-term,                   low-risk              assets     that     earn
        relatively            low rates              of     interest         and that             can be marked              to
        market           on a daily          basis,          the     insurance              system      can clearly               be
        protected           from     loss.            However,            such an approach                   would
        significantly               alter           the     commercial              banking         system.          It     would
        change           many of the patterns                       for     financing             business      loans             and
        would        be likely         to result               in reduced             interest          earnings            for
        depositors.                In addition,                it    would          accelerate          the    reduction
        of      the proportion               of financial                  assets          held     in banks,             because
        many depositors                seeking              higher         yields          would     place     their
        money elsewhere.                     As the          role         of banks          becomes smaller,                 it
        is      likely      that      stability              problems--problems                      that     the
        government            would         still         have to deal               with--would             become more
        acute        outside        of the           banking         system.               Since     other     nations



19
       appear       to be moving              in the opposite                   direction,            it        might    also
       undercut       the competitiveness                        of our financial                    institutions.
       Although       we do not           favor         requiring           narrow        banks,            we do favor
       allowing       depositors              choices          for     protecting            their          funds       that
       would      tend       to move certain                  banks      in that         direction.                  We are
       considering,            for     example,              the possibility              that        depositors
       (such      as hospitals            or small             businesses)            could       set           up
       collateralized                accounts          in excess           of    $100,000            in the           same
       way as is now permitted                         for     many state           and local
       governments.                 (Under      this         arrangement           banks would                  be
       required          to pledge           specific          assets       such as Treasury
       securities            to protect          the deposit.)                   Accounts            collateralized
       by low-risk,            low-yielding                  assets      would      allow        the public              the
       opportunity            to protect           payroll            and similar            accounts                whose
       average       balances          exceed          $100,000.


     0 Private       sector          insurance          arrangements.                 Under this                 approach,
       the private            sector--        or under           other      proposals            the banking
       system       itself     --would          price         and bear          some or all                of    the    risks
       associated            with     insuring          deposits.               We have serious
       reservations             about        trying          such an arrangement                     on a national
       scale      in a manner            that         would      largely         replace         the current
       federal       system.            Nonfederal              systems         have not generally                      been
       successful,            because         they      have not had sufficient                             financial
       resources          to convince             the public             that      the       insured            banks were
       safe.        We are concerned                   about         whether       relying           on a new

20
     private           sector      arrangement                    for     the entire            banking        system          is
     a viable           means of preserving                             confidence         and stability.


     On the other               hand,       if        there        are groups            of banks          or other
     financial           guarantee               firms        that        believe        a combination               of
     higher       capital          and insurance                        premiums        are unreasonable                  in
     relation           to the       true         economic               costs      of providing              deposit
     insurance,            these          institutions                   should        be given       the
     opportunity            to develop                 an effective                 guarantee         mechanism            that
     would       supplement               the FDIC program.                         Any such arrangement
     should       be approved                and supervised                      by FDIC.           Agreements            among
     major       banks      to guarantee                    payments             in the Clearing               House
     Interbank            Payments           System              could        be viewed         as a possible
     model       for      such an arrangement.


     There       is,      however,           one aspect                  of    increasing           private         sector
     responsibility                 for      bearing              deposit         insurance          costs       that
     should       definitely               be implemented.                        This        concerns        the    so-
     called        source        of strength                     doctrine.             This     doctrine,           which
     calls       for      holding          company support                       for     troubled          banking
     subsidiaries,               should           be strengthened                      through       its
     codification               and/or           holding            company indemnification
     agreements            designed              to      limit          FDIC losses.




21
Developinq            a Framework For Allowinq                         Closer         Association
of Banking            and Other Activities


Changes        to insurance              funding,        regulation,                 and economic             incentives
need to be made whether                       or not          changes         are made to the product
offering            powers     of banks            and other          financial          firms.
Nevertheless,                the existing            structure,              which     constrains             the
product        offering          powers       of     financial           institutions,                makes it            more
difficult            for     banks      and other         financial            firms        to use their
capital        in ways that              they       believe       would        best      meet the            needs of
their        customers          and allow           them to compete                  both     in this         country
and overseas.                 Fur thermore,           as I indicated                  earlier         in my
testimony,            the     ad hoc and very                 uneven         expansion          of the activities
of      financial           industry       participants               into     each other's              business              may
well        pose safety          and soundness                risks      to our financial                    system.


To address             these     concerns,           we have concentrated                       on trying            to
define        the conditions               under       which      banking            and other          financial
services            could      safely      move into            closer        association             with     each
other.         These conditions                    include       both        the     types      of powers            that
could        be allowed          and the           regulatory           structure            that     would         be
appropriate.


Before        implementing              any changes             in the        relationship              between
banking        and other             activities,             the measures              I have discussed                   to
stabilize            banking         and to change              incentives            under         deposit
insurance            need to be in place.                       Then,        only      those        institutions
22
whose capital                 is considerably                    in excess         of regulatory                    minimums
and that             are well         managed should,                    through         case-by-case                 approvals,
be allowed             to engage                in nonbanking             activities.


If   organizations                   gaining            additional          powers           are to be able                 to take
advantage             of opportunities                       to use their           capital          efficiently,                some

flexibility             should             be    permitted             in how these              activities               are
structured--that                     is,        in     the     bank itself,           in a bank subsidiary,                           or
in a holding                 company subsidiary.                         Furthermore,               if     banks          are to be
allowed         entry         into         other        areas,         on fairness             grounds         other         types
of organizations                     should            be    allowed      entry       into        banking.


It   should           also     be     recognized                that     banks      compete              against          financial
firms         that     are not             subject            to the     interstate              branching
restrictions                 now in force                   under      the McFadden Act.                      If     an
environment              is created                  in which          banks      can compete              more
effectively              and safely,                   we believe          that     such restrictions                        should
be removed             for     banks            that        are well       capitalized              and that              can
demonstrate              good management.


We have not              completed               our work           and reached               conclusions             on the
various          combinations                   of powers,             corporate             structure,             and
regulatory             controls             that        would       be needed         to provide                   adequate
protection              to the deposit                       insurance      fund        if      powers        of banking
organizations                 were to be expanded:                         however,             certain            elements       are
clear.           One is that                federal            regulators          of entire              organizations

23
that     own banks must provide                        adequate       capital             enforcement           and
supervision.                 Furthermore,          assurance          is needed              that     flows       of
funds        from     insured      banks       do not provide                 unfair         competitive
advantages            to these          banking        organizations               or put      the deposit
insurance            fund     at undue risk.               Controls           such as sections                  23~ and
23B of the            Federal      Reserve         Act,      which        limit        the transactions
between        a bank and its               affiliates,            help       provide         such assurances.
However,        we are particularly                     concerned          that        the    regulator           for     the
entire        firm     be able          to track        and enforce               these      and other
provisions            designed          to control         capital         movements            between         the
parent        and its         subsidiaries             and among subsidiaries.                         Finally,           the
supervisory            tasks      must be as simple                  as possible              while     still           being
effective.             Along      these       lines,       we are concerned                   with     the
complexity            of multi-bank            holding           companies          and believe            that         some
of     the    firewalls          that      have been introduced                     into      bank holding
company regulation                 may be unnecessary.


Finally,         any modernization                 changes         must       be phased             in so that           any
use of expanded                powers       does not         outrun         the     capability           of
regulators.                 In addition,          we believe           that        the deposit            insurance
system        finances         should       be established                on a sound basis                 before
changes        in bank powers               take       effect.




24
CONCLUSIONS


In summary,           we are at a crossroads                      in coming          to grips         with     the
future     of our financial                industry.            We must         address         the
challenges        presented           by the many changes                    which     have occurred               over
the past       decade        to reestablish               the health          of our financial                 system

and allow        our      institutions             to compete           successfully            in the       future.
We have outlined              today       a strategy           for      achieving       a more safe              and
sound     financial          system.            In the     short-term           we believe            that
actions      are needed to stabilize                         the banking         industry         and the Bank
Insurance        Fund.        Then,       additional            steps       must be taken             to change
the economic            incentives          that       have allowed           imprudent          risk-taking
in the deposit              insurance           system.        Finally,         a framework             should       be

established           to ensure          that      actions        taken      to expand          the powers           of
banking       organizations              are      consistent         with     the goal          of ensuring
the safety         and soundness                of banks        and financial            markets.            The
success       of this        strategy           will    depend upon the ability                        of bank
managers,        directors,           regulators,              independent           auditors          and market
participants            to each do their                part      and work       together             to meet
these     challenges.


As I stated            earlier,       our work           is not      complete.           We are
continuing         to work on several                    issues      relating         to the          insurance
treatment        of different             types        of deposits,           the     appropriate
regulatory         structure          and responsibilities                    under      expanded            powers,
capital        regulation         of holding             companies          and their       subsidiaries,

25
and the       types       of firewalls          needed.        We are also        considering
reciprocity           issues     relating            to how nonbanking          firms     may engage    in

banking       activities         and steps            needed   to level        the playing      field   on
which       competition        between       depository         institutions            and other
financial        firms      takes    place.


                                         ---------




This    concludes          my prepared          statement.         My colleagues           and I will
be pleased         to answer        questions.




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