Assistant Attorney General William F. Baxter yesterday proposed sweeping changes in U.S. banking laws, including a sharp reduction in federal insurance on deposits.

Testifying at Senate Banking Committee oversight hearings on the financial institutions industry, Baxter advocated elimination of geographical restrictions on branching and limitations on the types of products banks can offer, as well as simplification of the regulatory process required for mergers.

Baxter's recommendations to repeal the McFadden Act and the Douglas Amendment (which restrict branching) and void certain prohibitions in the Glass-Steagall Act--some of which have been in effect since the Depression--constitute one of the most radical approaches yet suggested and put him at some distance from other government officials. He emphasized that his views on competition represent only the Justice Department's thinking; the administration has not yet adopted its final position.

While agreeing that federal insurance sets banks apart from other enterprises, Baxter questioned why large depositors should be protected in case of failure. Without specifying a new maximum for federal insurance, Baxter said he doubted that ordinary, non-wealthy citizens had more than $25,000 in any one account and urged that only they be protected.

Contrary to popular belief that interstate branching would be bad for small, local banks, Baxter said they would benefit from rapid repeal of the law prohibiting such expansion because large, national banks would offer premiums to acquire them. Were the law to be phased out, the small banks' value would be eroded by the progress of technology, which will gradually link the whole country electronically, he said.

Removing Glass-Steagall prohibitions and allowing banks to engage in any financial activities they wish would neither aid nor threaten the safety and soundness of the institutions, Baxter argued.

Although he likened half-way measures to putting "fingers in a dike to preserve an old and crumbling structure," he did suggest two smaller steps in lieu of total repeal of the McFadden Act. He would permit statewide branching by national banks and exempt electronic funds transfer systems from the ban on interstate branching.

Banking Committee Chairman Jake Garn (R-Utah) responded that repeal was a political impossibility at this time since only 30 senators favor it.

Securities and Exchange Commission Chairman John S. R. Shad, observing that "Glass-Steagall and McFadden are being dismantled at an accelerating rate," said he favored prompt congressional action on the "non-bank bank" issue rather than the moratorium announced by the Comptroller of the Currency. However, recognizing the difficulties posed by repeal of the laws, he suggested three minor changes in wording to deal with the immediate problems.

The legal definition of a bank now is an institution that takes deposits and makes commercial loans.

Shad would change one word in the definition of a bank to characterize it as an institution that takes deposits or makes commercial loans. This would effectively eliminate the non-bank bank--which take deposits but does not make loans--which other financial institutions, such as brokerage houses, are buying up to get into the banking business.

He would also extend the Glass-Steagall ban on underwriting corporate securities to any federally insured bank. The prohibition now applies to banks that are members of the Federal Reserve System, and Federal Deposit Insurance Corp. Chairman William M. Isaac has proposed allowing state-chartered banks, most of which are federally insured, to engage in that business.

Finally, Shad would require that non-banking activities be carried out by corporate affiliates, a move he said would go a long way toward creating equality between the banking and securities industries.