U.S. Weighs Backing Bank Debt: Removing Deposit Insurance Limits Also on the Table

By DAMIAN PALETTA, CARRICK MOLLENKAMP and JOHN D. MCKINNON

WASHINGTON -- The U.S. is weighing two dramatic steps to repair ailing financial markets: guaranteeing billions of dollars in bank debt and temporarily insuring all U.S. bank deposits.

If the two moves come to fruition they would mark the government's most extensive intervention yet in the financial system, as officials ponder increasingly far-reaching measures to stem the sprawling crisis.

The top economic officials of the Group of Seven leading industrial nations will meet starting Friday in Washington where they intend to discuss a proposal from the U.K. government to bolster bank lending. Problems in the credit market have led to widespread dislocation in the financial system and the broader economy.

Under the U.K.'s recently announced plan, which it is now pitching to the G-7 members, the British government would guarantee up to £250 billion ($432 billion) in bank debt maturing up to 36 months. The British concept to expand its proposal to other countries has a lot of support from Wall Street and is being pored over by U.S. officials, according to people familiar with the matter.

White House spokesman Tony Fratto said the U.S. "is reviewing the idea and discussing it with our British counterparts."

The move to back all U.S. bank deposits, which is only in the discussion stage, would be aimed at preventing a further exodus of cash from financial institutions, including small and regional banks, some of which are buckling under the strain of nervous customers. In recent weeks, customers have pulled money out of some healthy community banks under the assumption that the government will only insure all the depositors of larger banks in the event of a failure.

To remove the ceiling on deposit insurance, multiple government agencies would first need to agree that there was a "systemic risk" to the economy, thereby invoking a rarely used legal power. Amid repeated efforts by the federal government to prop up ailing institutions, some bank regulators say the move is justified.

It's not clear that either idea will become reality, and U.S. officials downplayed expectations of any announcement this weekend. But as the crisis deepens and stocks continue to tumble, pressure is building on the Bush administration to find a solution that goes beyond the $700 billion financial rescue plan recently signed into law. Having the government back bank lending would effectively entail the U.S. being the backstop for the country's financial system.

Western industrial powers have taken various ad hoc steps to stem the global crisis. Central bankers have cut interest rates, governments have agreed to strip toxic assets out of banks, and regulators are mulling how to directly inject capital into the banking sector. So far, the moves have failed to calm markets.

They have also been mostly one-country-only solutions that lack a broad coordination, despite the fact that the global financial system is linked. A move by one country has lately forced the hands of others, as happened when Ireland moved to insure its bank deposits last week. The European Union has struggled to develop a common approach to the crisis, exacerbating the problem.

"The interdependence of the major global financial markets has been established beyond the slightest doubt," said H. Rodgin Cohen, chairman of the law firm Sullivan & Cromwell and a top adviser to Wall Street firms. "As a consequence, it is essential that the major countries act collectively and cooperatively."

One major flaw in the global banking system, and a sign that problems extend beyond whether U.S. homeowners can pay their mortgages, is the fact that banks don't trust each other enough to loan beyond an overnight period. That means that cash isn't being circulated through the financial system and banks are relying too heavily on short-term loans, which does little to help pay off looming debts. Banks are hoarding cash, both to cover their debts and to improve their year-end books.

The plan in the U.K. was hammered out by Treasury Chief Alistair Darling as well as the chief executives of major British banks earlier this week after a sharp drop in U.K. bank stocks.

In the U.S., some $99 billion in just one type of bank debt is coming due between now and the end of the year. Hundreds of billions of dollars will need to be paid in the U.S. and Europe. Government backing would make it easier to issue new debt to help pay for that.

The problems in so-called interbank lending, or short-term loans made between banks, date to August 2007. Markets froze after a little-known German lender called IKB Deutsche Industriebank AG ended up with big debts it couldn't pay. More recently, the bankruptcy-court filing of Lehman Brothers Holdings Inc. sparked a new freeze in the interbank-borrowing market when money-market funds, laden with Lehman debt, yanked their cash out of the commercial-paper market, a vital cog in how companies fund their short-term obligations.

The U.K.'s decision to guarantee bank debt sparked talk that the U.S. would need to make the same move. On Thursday, the three-month dollar London interbank offered rate, or Libor, hit 4.75%. On the Friday before Lehman filed for bankruptcy protection, the three-month rate was 2.81875%. A surging Libor could exacerbate larger economic problems because many mortgages are tied to rates that fall or rise depending on Libor.

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