WASHINGTON -- The Bush administration plans to propose radical banking system reforms that would give regulators more power to allow big banks to fail without blanket government protection for the institutions or their depositors, a senior administration official said over the weekend.
The proposal, likely to spark controversy in Congress and banking circles, would infuse greater "discipline" into the system by creating uncertainty over just which banks would be protected beyond the minimum levels required by the government's deposit insurance program, the official said.
If enacted, the administration plan would mean that some banks would no longer automatically receive complete government protection and total depositor insurance in the event of failure. As a result, bank managers would be under greater pressure to follow more prudent business practices, said the official, who requested anonymity.
"Providing constructive ambiguity is at the heart of it," the official said. "The problem is that now, all of the ambiguity has been drained out of the system. We have got to create more uncertainty as to whether regulators will intervene."
To instill that uncertainty, the official acknowledged, the government would let some institutions fail to demonstrate that its new policy is credible.
The plan, expected to be introduced as part of a legislative package in January, would represent a dramatic change in federal banking policy.
Traditionally, Washington has pledged virtually automatic support and blanket protection for the nation's major commercial banks. At those institutions, federal deposit insurance has been extended well beyond the legal limit of $100,000 per account, in part to prevent panic and maintain consumer and investor confidence in the integrity of America's financial system.
But that policy, known in the industry as the "too-big-to-fail" doctrine, has come under mounting criticism for contributing to a growing crisis in the banking system. The doctrine has effectively given bankers an incentive to engage in risky practices, while remaining secure in the knowledge that the government will bail them out if they get into trouble.
Under the the administration proposal, size would no longer provide protection against failure.
"We've got to address 'too-big-to-fail'; otherwise we can't have a real
reform package," the administration official said.
The apparent willingness to abandon the current doctrine comes when the economy is showing signs of recession and the health of the banking industry appears more at risk than at any time since the Great Depression of the 1930s.
Although the commercial banking system is in better shape than the scandal-plagued savings-and-loan industry, many banks have been forced to take losses on real estate loans, and the government's deposit insurance fund has dwindled to a dangerously low level.
In fact, the timing of the proposal would seem to pose grave risks for the administration and might lead to charges that the White House is not living up to its responsibility to protect the soundness of the financial system.
The proposal represents just one component of a sweeping reform package now being prepared by the Department of the Treasury and the White House, following a legislative mandate ordering the administration to propose reforms of the nation's deposit insurance system.
The administration official indicated that a final deposit insurance proposal has not yet been worked out. Several alternatives are now under study, including a plan to limit the number of insured accounts held by any one individual to three.
"We are still looking at a bunch of options on deposit insurance, but we want to shrink it back to its original purpose, which was protecting small savers, letting them sleep at night," the official said.
The overall package, as currently envisioned, would involve much more than a simple reform of deposit insurance, with the administration apparently poised to push for a fundamental change in the commercial banking industry.
"The administration feels strongly that issues of deposit insurance reform, that is, the extent and character of the safety net, are so closely intertwined with questions of reform of the industry's structure, that it makes no sense to treat them separately," Secretary of the Treasury Nicholas F. Brady said Friday.
To address those concerns, the administration plans to propose full interstate banking for the first time, in an effort to spur consolidation among banks that would winnow out the weakest institutions.
Administration officials say the United States has more independent banks than any other country, and they contend the system should shrink to become more efficient.