A new administration is in place and one of its nagging problems will be the condition of our banking system. Although current banking news tends to the upbeat, we are still living with the consequences of a major debacle. How could there have been such massive failures of both savings and loans

A bank is not a complex phenomenon. The term originally referred to the bench or counter on which a money changer conducted his business. Before too long, that bench became the place where a person needing ready cash could borrow money under certain conditions or could secure a letter of credit in which the banker substituted his credit for that of his customer. Most commonly these transactions specified a rate of interest as well as a duration of time over which the funds could remain on loan.

At its simplest a bank functioned with little more formality than is found when one person borrows money from another or when one person guarantees the obligation of another. As time passed the banker became the source of funds for borrowers as well as a refuge or a place of safekeeping for the excess funds of others. Thus a working definition: A bank is an intermediary between those with excess and those with deficient liquidity, liquidity being the ability readily to convert assets into cash.

From the earliest days bankers lent their own funds. Consequently there was every incentive to ensure that the funds would be returned. Later, when the banker might well be lending a mix of his own funds and the funds of others, he would be expected to maintain the same level of care and attention. Not too many decades ago a standard negative reply to a loan request was: "I'm sorry, but I cannot commit my depositors' funds to this particular venture." Such a denial might be based on a variety of reasons, most obvious of which was the fear that the borrower could fail and the loan would not be repaid. But a more common fear was that the borrower would require more time for repayment while simultaneously depositors would be demanding their funds of the banker. This shows the two elements essential to a mutually beneficial banking relationship: creditworthiness and liquidity.

During the Great Depression many banks failed because their depositors suddenly, and en masse, demanded the return of their deposits. Since most of any bank's resources are invested in its loan portfolio, the banks were often unable to meet such extreme and unexpected demands. This chain of events is known as a "run on the bank" (remember Jimmy Stewart in It's a Wonderful Life!).

Confronted with such widespread insolvencies, the Roosevelt administration began a radical restructuring of the banking system. Restructuring took a number of forms. First, depositors' confidence was restored by providing a system of deposit insurance funded by regular assessments on all insured banks. In the event of a major underwriting disaster triggered by multiple insolvencies, the fund, as an agency of the federal government, would have ready access to the U.S. Treasury to pay off depositors.

Second, the banking business was also divided between commercial banks and savings and loan associations. The loans that could be made and the deposits that could be accepted by each were distinct. Commercial banks were expected to deal primarily in shorter term loans while the S&Ls, also known as thrifts, were specifically chartered for the purpose of extending long-term mortgages to home buyers; they were excluded from other kinds of lending.

Commercial banks were allowed to offer both savings accounts and checking accounts, although the former could not be accessed by checks. Thrifts were permitted to accept only "time" or savings deposits. Restricting checking privileges limited the depositors' ability to move deposits rapidly. Savings accounts, or time deposits, also carried a provision that, unlike a checking or "demand" account, a withdrawal order could be delayed for a period up to thirty days. As a matter of practice neither a bank nor a thrift invoked this privilege unless it was on the brink of failure. In addition, and most significantly, ordinary savings accounts in both banks and thrifts had limits on the maximum rates of interest they could pay on deposits.

For many years this system served the country very well, especially as the Depression gave way first to World War 1I and then to the spectacular postwar economic boom. However, the system was dismantled by legislation in 1980 and 1982 when the distinction based on loans and deposits was virtually eliminated. But I'm getting ahead of myself.

By the 1970s, a market had grown for outside investors interested in buying long-term mortgage loans. Thrifts commonly sold their loans to such investors while retaining--for a fee paid by the investor--the obligation to collect payments and monitor the health of the loan. The first hints of serious trouble in the U.S. banking system came with inflation and steadily rising interest rates in the midseventies after the Arab oil embargo.

Interest rates for loans rise during inflationary periods to provide assurance that the money received at the end of the loan will retain the purchasing power those funds had at the beginning of the loan. When interest rates suddenly began rising after 1975 to compensate for inflation, lenders found their loans plunging in value, and not because they were likely to be defaulted. Simply put, the loans carried a fixed rate of return and the money market was demanding a higher rate. No investor would buy an older mortgage paying 8 percent when he or she might buy a more recent loan yielding 12 percent. Such a situation could be accommodated only by decreasing or marking down the value of the older, lower yielding loan.

But let me explain. Let's say an ordinary commercial loan of $100,000 was made at 8 percent and due in a year. Two interest payments of $4,000, the first due at the end of 180 days and the second at maturity, are required. When the loan would come due at the end of twelve months, the borrower would have to hand over $104,000. But let's suppose that after six months the lender suddenly needs the face amount of the note. The lending institution's problem is that in those six months the prevailing interest rate has gone from 8 percent to 12 percent and of course nobody wants to buy the 8 percent loan from the bank. A solution is for the bank to discount the selling price of the note to $98,113.45 so that the new buyer, after investing that amount, will receive in six months $104,000 from the original borrower. By discounting the loan, the seller offers the investor a payoff that equals 12 percent on the $98,113.45 investment. The borrower, meanwhile, will almost certainly never know that all of this happened.

Such an investment strategy is not unlike that of retailers who discount less desirable goods to move them out of inventory. We find ourselves with a financier's rule of thumb: when interest rates are rising the value of existing loans declines and when interest rates are declining the value of existing loans rises. Consequently, at the outset the banking crisis was not so much one of creditworthiness on the part of the existing borrowers as it was one of marketability or liquidity for the loan itself.

Bankers found their position even more complicated as depositors came to expect higher interest on their time deposits. The interest payments an institution was making to depositors could well exceed the interest income being earned from its loan portfolio. Worse, the institution which set out to sell an older, less desirable portfolio confronted immediate losses because these lower yielding assets were sharply discounted in value when put up for sale to outside investors.

It is true that after/forty years the New Deal banking reforms had become a thicket of laws and regulations. By about 1975 a cry for the deregulation of both the banks and the thrifts was widespread. The thrifts, which were locked into low-interest mortgage loans, especially sought release from their illiquid and unremunerative portfolios and access to more profitable opportunities. This was accomplished with much fanfare in the Rose Garden of the White House by enactment of the Garn-St. Germain Banking Act of 1982 which radically redefined the nature of a thrift while, for the most part, doing little to open up wider opportunity to commercial banks, something that the bill's proponents liked to call "leveling the playing field." At the same time it became much easier to obtain a charter to open S&Ls. While few would deny that the system needed reform, the effect of Garn-St. Germain was to clear cut the forest rather than to clean out the underbrush. Additionally, the Reagan administration began a massive cutback in the number of bank examiners and the frequency and extent of examinations, leaving a new situation essentially without effective oversight.

The new rules put the S&Ls in direct competition with commercial banks. And what a competition it was! Not only were the thrifts free to pay any rate on deposits, a privilege they had gained in 1980 (The Depository Institutions Deregulation and Monetary Control Act), but with Garn-St. Germain they were suddenly empowered to invest in almost any kind of venture that came along. A cardinal rule of prudent banking practice had once held that bankers lent money only in their own market areas. But after Garn-St. Getmain thrifts could lend anywhere and for almost any purpose. In the past they had been forbidden to make commercial loans of any duration; now it was possible to lend both in the short term and in the long term to commercial borrowers.

Loans to construct commercial real estate, a time-honored form of commercial bank lending, were an arena the thrift industry almost universally/round attractive. Traditionally, the initial loan is made with several conditions or covenants essential to the success of the loan. First, a contract is agreed to by which the relatively short-term construction financing will be paid off at the completion of construction by being sold to one of the traditional lenders in the real estate market, usually a life insurance company or a pension fund. Second, if the value of the project depends on having tenants in place, then the developer seeking the loan will provide firm leases for either part or all of the space as part of the collateral package. Finally, there is a standard requirement that the proceeds of the construction loan be disbursed incrementally and then only with proper and appropriate certification that the work has been done, that all employees and suppliers are paid, and that the job is progressing according to plan.

In the newly deregulated environment these conditions were often improperly or inadequately negotiated. As a result, most of our cities have one or more maj or construction projects standing nearly empty or unfinished. The failure to negotiate a bona fide loan package turned out at times to be the result of fraud. But just as frequently such failures were the result of inexperience and gullibility. This is not surprising because the transition to the new powers permitted by Garn-St. Germain occurred without time or opportunity to train existing personnel or to hire additional lending officers with experience in commercial real estate.

In this atmosphere the so-called junk bonds appeared. Junk bonds were not new. Only the name and the fact that they were marketed to the general public--widows and orphans included-was new. While a senior executive of a thrift might hesitate to make a direct loan to a major national or even international corporation, by buying that company's notes or bonds from a broker he was in fact making a long-term commercial loan. Many of these loans were generated as a funding mechanism for leveraged buyouts. These transactions proceeded on the cheery assumption that a company could increase its profitability without interruption while carrying the burden of substantial new debt. This unfortunate assumption gave the loans a quality of risk that not enough people appreciated.

In every lending situation there are at least a few questions to which the lender must receive adequate answers. But all such questions come down to: "What are the sources and methods of repayment?" By not asking this question, or even worse, by not understanding or ignoring the implications of its answer, many bankers condemned their institutions to failure. Many loans, for example, were to be paid off by liquidation of the collateral. A commercial bank's loan customer needed to convert its inventory to accounts receivable by billing and then convert those bills to cash. Obviously, the value and the marketability of the collateral was critical. In other words, someone had to buy the product produced with the borrowed money. This was also true in lending for the construction or improvement of real estate. But too often and for a number of reasons the finished product could not be sold or rented at a price commensurate with its cost of production. What had once seemed a good deal became a house of cards.

Risk is a relative thing. In good times each day can bring new heights of prosperity--"Real estate only goes up," was frequently heard--and ventures that might ordinarily seem dangerous are swept along by the rising tide. Even something quite doubtful succeeds simply because everything else succeeds. However, the business cycle is merciless and a prudent person in good times never forgets bad times and vice versa. While such wisdom is so conventional as to be a cliche, a good part of a generation of financiers forgot it. By the mid- 1980s lending institutions found themselves with increasing portfolios of nonperforming assets, at first delinquent loans and then later foreclosed collateral in the form of properties that could neither be sold nor rented, at least not at the prices originally expected.

But the plot thickens. At the outset bankers hit by this turn of events, rather like Mr. Micawber hoping that something better might turn up, offered higher and higher rates of interest to attract the deposits needed to keep their rapidly sinking balance sheets afloat. This meant that by the mid-1980s not just high-rolling borrowers and financial executives were greatly benefiting from the deregulation of Garn-St. Getmain. Indeed, large numbers of quite ordinary, law-abiding citizens found their rates of return on savings accounts as well as 1ong-term certificates of deposit reaching levels no one had ever expected. Long-term deposits began to pay more than 14 percent, even rising to highs of nearly 20 percent. Suddenly, a major activity for the retired parents of many of us was maintaining separate deposit accounts, each no larger than the stated insured level, at as many institutions as their stamina permitted. And in the line at the teller's cage an observer would have found not only retirees looking for a higher return on savings, but treasurers and money managers from corporations of every size and description. The new deregulated deposits came in the form of IRA accounts, guardianship accounts for the care and education of minor children. and the cash reserves of charities, churches, and schools, to mention only a few.

If, as Calvin Coolidge said, the business of the country is business. then for a time the business of the country was to gather the largesse falling like manna with the morning dew. Any need to question the soundness of the institution was eliminated by the fact that the deposits were fully insured to a maximum of $100,000 by a governmental agency. To compound the problem, the notion quickly got abroad that in the event of failure all deposits would be covered by insurance, regardless of size. In addition, it began to appear that the various regulatory bodies would go to virtually any length to prevent the failure of a key bank. Some institutions came to be perceived as too big--or too important--to fail. Bankers who should have known better, or who should at least have never surrendered their native skepticism, devoutly came to believe that the government in some mysterious way would protect them from their own folly. By 1984, institutions began aggressively to seek new deposits not only in their traditional market areas but nationally and even globally through a network of eager brokers. Virtually all of these deposits were limited to $100,000, the maximum that could be insured. Simultaneously most of these deposits were for relatively short periods of time, usually less than one year. In such an environment a deposit could depart as easily as it had arrived. Such deposits quickly became known as "hot money" for the very simple reason that the depositor could have liquidity needs that had no relation to the area in which the thrift or bank conducted its business. The net effect of maintaining a rapidly expanding asset portfolio of increasingly dubious quality on a base of such volatility compounded the fact that the institutions were borrowing short and lending long, a practice that when carried to these extremes became a prescription for disaster.

A significant transfer of wealth occurred thanks to these high rates on deposits guaranteed by the deposit insurance of kindly old Uncle Sam. Those who benefited were not only large borrowers of greater or lesser integrity, but also the aged and the not-so-aged, the sophisticated and the naive, all of whom congratulated themselves on their remarkable ability to earn high rates on cash reserves. Because of the reluctance to address the multiple problems of failing loans when they were discovered, this transfer continued well beyond the time that the underlying assets could support liabilities of such a magnitude.

Why did institutions remain in business, running up interest expenses, when they were dead in the water? That is the question that every American must ask loudly and persistently because it was this simple failure to act that permitted the interest meter to go on running.

Undoubtedly there was massive fraud and misappropriation by borrowers and managers in the banking industry; immense sums of money were improperly if not fraudulently advanced through loans that could never be repaid. Fortunes were amassed in very short order and under entirely suspicious circumstances. But the sobering fact remains that ordinary depositors who accepted inappropriately high rates of return must be counted among those who contributed to what eventually would be recognized as a raid on the Treasury.

As I indicated before, at the same time that the nature of the banking business was changing, the method of government regulation also changed. In previous years, every bank and every thrift that accepted deposits from the public was examined annually. The purpose of this examination was to assure the regulators that the institution did in fact possess a degree of liquidity sufficient to meet the demands of its depositors and that the quality of its assets, especially its portfolio of loans, was satisfactory.

Obviously the examination gave assurance to the insuror-- the Federal Deposit Insurance Corporation (FDIC) for the banks and the Federal Savings and Loan Insurance Corporation (FSLIC) for the thrifts--that there was little risk of an underwriting loss by insolvency. In other words, just as the lending institution determined the creditworthiness of its borrower, so too the regulators--the central bankers and the writers of depository insurance--determined that the bank itself was creditworthy.

Unfortunately, during the Reagan years, this pattern of detailed and hands-on review was sharply curtailed as a measure of economy--probably the most costly example of penny-pinching in history. It was anticipated that the institution's own internal review and audit functions and those of its outside accountants would suffice. That may have been the expectation and in many cases it actually did work. But at the same time the absence of a regular, and usually unexpected, adversarial examination permitted the most outlandish examples of unsound banking to flourish.

Now what? The move to deregulate, in itself, is not now nor was it in the beginning a bad idea. The problem occurred when the babies suddenly began to go out with their bath water. More recently the term "deregulation" itself is in bad repute and we hear talk of "reform."

The new thrust, at least as envisioned by bankers, is again to permit broader powers and enlarged opportunities for business. The most prominent item on their agenda is interstate banking. By consolidating not only the ownership of at least several banks but also the actual management of these banks, it is possible to achieve very substantial economies of scale. Other areas that are very attractive as new kinds of business activity are the selling of investment securities and various kinds of insurance. A less welcome element of the new reform for bankers, and this has already been imposed, is the requirement of capital adequacy ratios substantially higher--at least for some banks-- than those prevailing only a few years ago.

Capital adequacy has been addressed by the FDIC Improvement Act of 1991 (FDICIA) in response to the massive banking defaults of the 1980s. This federal legislation establishes guidelines according to which "prompt corrective action" will be taken as an institution becomes undercapitalized. The regulation specific to this became effective on December 19, 1992. Very simply, an institution with a capital ratio of less than 2 percent of assets will be classified as "critically undercapitalized" whereas a "well capitalized" institution will have a ratio greater than 5 percent. Such scrutiny should serve as a real deterrent to the kind of abuses prevalent in the 1980s.

There has been widespread fear that the problems of S&Ls would also turn up in the operations of larger commerical banks. But at least for now it seems that major commercial banking disasters have been averted by the merger of Manufacturer's Hanover and Chemical Bank in New York and in California the merger of Security Pacific and Bank of America. While rumors persist that one or another major bank might be on the verge of failure, it is virtually impossible to predict such failure without a detailed internal analysis of a bank's position. The greater significance of these rumors is, first, that they were closely associated with last fall's presidential campaign and, second. that these rumors flourished because of a popularly held conviction that the health of the banking system had been seriously compromised by political leaders who profited by deregulation. Any political manipulation of the banking system is, I think, an extremely grave situation and must be remedied as quickly as possible.

When all is said and done, the ultimate insuror has now been met and he is us, the American taxpayer. Market economics and the rhetorical appeal to some kind of inherent ethical good sense did not prevent disaster. There can be no alternative, in my view, but to restore and responsibly implement the mechanisms of regulation. A banking system that had been cobbled together in haste to meet the exigencies of the Depression was hardly perfect. But it did operate in the awareness that a regulated industry was necessary to preserve the entirely legitimate interests of the body politic. Nothing short of a return to such a public policy of mandated fiduciary responsibility can be tolerated. To the best of my knowledge, a laissez--faire approach to something so basic as a nation's money and its use cannot possibly work because such a posture requires that the nation and its citizens accept the risk of periodic massive and widespread failures. Seen differently, to accept such a risk is to accept the fact that many depositors, both large and small, will be destroyed or that the Treasury will be decimated. I suggest that such a risk is entirely unacceptable to any prudent person, government, or society.

Harold Isbell, a graduate of the University of Michigan Graduate School of Bank Management, was an officer and director of The Continental Bank & Trust Company in Salt Lake City. His books include Ovid: Heroides (Penguin).