Banking expert speaks about regulatory changes

October 9 2007

A Federal Reserve Bank of Chicago consultant said necessary changes in the U.S. banking regulatory system come down to one word - prompt.

The current system of deposit insurance sets up banks for failure, according to George Kaufman, the John F. Smith Professor of Finance and Economics at Loyola University in Chicago. If an entity does not bear the full cost of its behavior, it will act differently; it takes excessive risks, Kaufman told an audience of students, faculty and bankers during a presentation Monday (Oct. 8) at Indiana State University’s College of Business, and when it fails, the cost is far too expensive.

During the savings and loan failure in the 1980s, the government put up $160 billion to rescue the deposit insurance agency. The agency guarantees Americans’ bank deposits up to $100,000.

“My proposition is to eliminate the losses instead of shifting the losses,” Kaufman said.

That is done, he said, through four prompt actions: legal closure while there is still positive capital to minimize the losses; accurate estimates of losses and prompt assignment of those losses to various parties; promptly re-open most failed banks with prompt account access; promptly re-privatize banks taken over by the government regulator.

“The key to all of these steps is prompt,” he said.

Closing the banks - legally, but physically leaving them open - would protect small depositors, prevent borrowers from losing lines of credit and reduce the chances that failure would spread to other banks and result in runs on the banks, he said.

Kaufman contrasted the fates of two banks, NetBank that is based in Alpharetta, Ga., and Northern Rock, which is in Great Britain. Federal regulators took over NetBank in late September, but kept the bank open with customers having virtually no break in access to their accounts. Most of the on-line bank’s assets were quickly sold during the largest failure of a savings institution since 1993.

Conversely, in early September amid reports of shaky finances at Northern Rock customers made a run on the bank pulling their money from accounts.

“Runs are one of the great, frightening aspects of bank failures,” Kaufman said.

Northern Rock continues on unstable ground, but he said other problems loom if no other bank steps up to buy it. In Great Britain it can take years of legal tangles to close a bank and it also takes longer to pay depositors any insurance claims. The public cost of a failure is greater, as is the cost to depositors and borrowers from delays.

“There was chatter in the spring, but nobody did anything,” Kaufman said.

In the end, it takes too many different entities working together to rescue ailing banks in Britain.

“If a country has an appropriate legal structure and regulations with awareness and political will to resolve bank insolvencies efficiently, it will not only minimize the cost, but the bank deposit insurance problem decreases in importance,” he said.

Jim Tanoos, a lecturer of management in the organizational department of the ISU College of Business, called Kaufman’s presentation “very informative.”

“A lot of concepts he discussed are ones that are hot button issues in the financial world,” he said. “He seems to have pinpointed many of the nuances of the banking world. I learned more in an hour than I could have learned in two weeks.”

John A. Tatom, director of research for Networks Financial Institute at Indiana State University, said George Kaufman has been a leader in banking policy since the 1960s, when he completed his Ph.D. “It’s almost like he’s written the whole field single handedly,” Tatom said in introducing Kaufman, whose appearance at Indiana State was sponsored by Networks Financial Institute.

Photo:
Prescription for reform George Kaufman, professor of economics and finance at Loyola University in Chicago and a consultant to the Federal Reserve Bank of Chicago, outlined during proposals intended to cut the cost of bank failures during a presentation Oct. 8 in the ISU College of Business. (Tony Campbell/ISU)

Contact: John A. Tatom, director of research, Networks Financial Institute at Indiana State University, (317) 536-0281, ext. 712 or john.tatom@isunetworks.org.

Writer: Jennifer Sicking, assistant director of media relations, Indiana State University, (812) 237-3743 or jsicking@indstate.edu

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Story Highlights

George Kaufman, professor of finance and economics at Loyola University in Chicago and a consultant to the Federal Reserve Bank of Chicago, told an audience at the ISU College of Business that current U.S. banking regulations set up banks for failure. Kaufman's speech was sponsored by Networks Financial Institute.

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