Government regulatory agencies should be empowered to develop a credit rating system and make the results public as one way to improve declining confidence in banks and other financial institutions, New York economist Henry Kaufman told a congressional subcommittee yesterday.

Kaufman, who painted a grim picture of deterioration in the quality of credit "in the present-day casino-like atmosphere of the markets," said that public disclosure of the real health of banks and savings institutions "would encourage the managements of financial institutions to take strong remedial actions, as well as preventive steps."

Asked during a separate session with reporters at The Washington Post how his proposed rating system would work, Kaufman said that institutions might be rated on an ascending scale of 1 to 10. If an institution had, say, a rating of 8 that then declined to a 6, it could be told that if it showed no improvement in six months, the rating would be made public.

Currently, commercial banks are rated by federally regulatory agencies on a descending 1 to 5 scale -- with 5 the rating for those in the worst shape. These "problem lists" are not made public.

In testimony before the House subcommittee on telecommunications, consumer protection and finance, Kaufman recommended other steps to offset what he said were the negative results of deregulation procedures of recent years. He called for Congress to establish a National Board of Overseers of Financial Institutions, which would set uniform accounting standards and improved reporting procedures.

Members would be drawn from the Federal Reserve System, other regulatory agencies and "a select number from the private sector." A companion board would be set up to coordinate multinational financial institutions, superseding the informal responsibility now assumed in this area by central banks.

In time, the National Board of Overseers "could take on greater importance than the Federal Reserve Board, as the distinction between money and credit continues to blur," he said.

The main rationale for Kaufman's proposal, he told The Post's reporters, is that reregulation is unlikely -- "you can't put Humpty Dumpty back together again" -- but that new safeguards can be installed to limit abuses in the present system.

He argued that financial institutions differ from other private organizations in that they have a special responsibility to protect the public's savings, even while as entrepreneurs, they seek to maximize profits. "For financial institutions to work, the public's perception must always be that they are managed by people who merit public trust and who are dedicated to the preservation of the integrity of credit," he said.

Some argue that the best way to discipline banks and other institutions is through market forces in a fully deregulated system -- often referred to as "a level playing field." But Kaufman said that, "in essence, there cannot be a true level playing field in our financial system. The financial system would look more like a zoo with the bars let down, and all of the attendant adverse consequences would follow."

Kaufman's proposals, including a call for improving the quality of regulatory agency personnel, were broadly endorsed by another witness at the House hearing. Former Securities and Exchange commissioner Bevis Longstreth told the committee that "in a time of budgetary restraints and overall disillusionment with government intervention, market forces seem to offer a seductive solution to secure soundness."

Longstreth, noting former FDIC chairman William Isaac's tally on April 29 that more than 950 banks were on the FDIC's "problem" list -- far above the previous peak of 385 in 1976 -- said that "the picture these statistics paint is one of progressive fragility." Longstreth reiterated a point he has made on other occasions: "Market discipline can only assure soundness in an environment where institutions are permitted to fail."

A third witness, Harvard Law School Professor Charles Clark, said he "wholeheartedly agrees" with Kaufman's suggestion on improving the regulatory agencies, which need "more economically sophisticated approaches" to their assignments. But he said that while the expansion and conglomeration of financial institutions both have some troublesome aspects, the trends "are basically benign."