When Senate Banking Committee Chairman William Proxmire attacks deregulation of the banking industry, he often uses anecdotes about a small bank in Waterloo, Wis., that helped finance a printing company he once owned. The bank worked hard to keep his business, Proxmire recalled, because it knew "that if we didn't like the service ... we had a bank that was four miles away in Marshall, another that was 10 miles away in Sun Prairie and another that was eight miles away in Watertown."

Treasury Undersecretary George Gould, who has led the Reagan administration's charge to deregulate banking, tells a different story about local banks, whose markets generally have been shaped by laws that keep competitors out rather than by consumer supply and demand.

Contrary to providing competitive rates and services, Gould said, small-town banks often prove to be part of "the small-town oligarchy -- where good credit ratings {have} overlapped with the country club's membership list." Why shouldn't Sears, Roebuck & Co. or Merrill Lynch & Co. be allowed to take deposits, make loans and otherwise compete for consumer banking business in the Waterloos of the nation, he asked.

The question of how well the nation's 14,000 banks serve or do not serve consumers is at the heart of a larger debate on how far banking should be allowed to mix with other industries, from securities underwriting to car manufacturing.

But in an era of free-market philosophy, where the government has deregulated industries from airlines to telecommunications, deregulation of banking poses a unique problem. Should an industry be permitted to take more risks with its money when a major source of its funding is guaranteed by the U.S. government through federal deposit insurance?

So far, many consumers and executives outside the financial services industry have not been much involved in the fight over loosening the reins on banks, but they all have a big stake in the outcome.

For households and businesses it will determine what financial services will be available -- and at what cost. Will impersonal, nationwide banking giants replace locally owned banks that are more willing to take chances on local entrepreneurs? Or would a more impersonal approach be better, as some senior Reagan administration officials say, so that loans are granted on business merit rather than on social standing or other irrelevant concerns?

For taxpayers, the stake is a trillion-dollar liability that has been created for the federal government by the insurance of bank deposits up to $100,000, and by the Federal Reserve Board, which, as the nation's central bank, acts as the "lender of last resort" when financial institutions get in trouble.

For years, bankers have chafed at a host of government laws and regulations that limit what products they can sell and where they can sell them. The securities industry and other groups that would face added competition from bank deregulation have fought equally hard to keep banking laws in place, even as they try to invade the banks' market.

The long-running fight is now moving toward a final round.

Federal banking law increasingly has been undermined by sweeping changes in financial services and technology worldwide. Unwilling to stand idly by, banks have responded to the changes by exploiting loopholes in the laws -- a reaction that has further hastened the changes and now threatens to make current law unenforceable.

Walter B. Wriston, former chairman of Citicorp, the nation's largest bank, long has complained that banks have been unfairly restricted while commercial and securities firms have been able to snatch banking business.

"The federal law in this respect is a one-way street," he recently told Congress. "Banks as institutions cannot engage in commerce, but commerce can engage in financial services."

Proxmire, the savings and loan industry, securities firms and many smaller banks generally oppose deregulation. The Reagan administration, including Gould and many bank regulators, the large banks and many financial service companies such as Sears favor deregulation. But often the lines between the two sides blur.

Robert L. Clarke, comptroller of the currency, said he believes it is in the public interest to have institutions that take deposits insured by the federal government. And he believes government supervision and regulation go hand-in-hand with federal insurance.

But, like many Reagan administration officials, Clarke believes banks can be allowed to expand into securities underwriting and other businesses without exposing insured deposits to greater risk. He envisions a financial services holding company that uses subsidiaries to keep a variety of services separate -- the so-called Chinese Wall theory. The separation would be required by law, with stiff penalties for abuse, he said.

"I think banks are special but I also think they will become very unspecial -- perhaps extinct -- if they aren't allowed to be competitive," he said. "Banking will be a profitable industry long-term only if it can offer products consumers want... . If banks own securities firms why can't securities firms own banks?"

But others such as E. Gerald Corrigan, president of the New York Federal Reserve Bank, wonder if a Chinese Wall can be built tough enough to ensure safety and soundness without so limiting the different activities of a holding company that the very purpose of deregulation is defeated.

Although disagreement is fierce on whether to deregulate or not, nearly everyone agrees that if Congress does not produce a fundamental banking reform law soon, the market will have changed so much that lawmakers will no longer have a chance to rein it in. Some say it's already too late.

A new majority at the Federal Reserve has been aiding the banks with a series of permissive interpretations of what banks are permitted to do, none of which has been successfully challenged in court. Without congressional action, the courts likely will continue to decide how far banks can go.

At the same time, longstanding barriers to branching by banks within states and across state lines are crumbling. All but half a dozen states allow some type of out-of-state ownership of banks within their borders.

Finally, nonbanking firms are rapidly using a major loophole to get into the banking business, from which they in theory are barred. The so-called nonbank bank, or limited-service bank, loophole may never be closed if legislation before Congress is not passed, Proxmire and others agree. If the loophole stays open, the required separation between banking and commercial activities that has been on the books for more than half a century will continue to become meaningless.

(Nonbank banks offer checking or commercial loans, but not both. They thus avoid the definition of a full-service bank that under federal law bars nonbanking companies from owning banks.)

All these issues arise because banking is a peculiar business. A bank is supposed to take a depositor's money and keep it safe while simultaneously pooling it with that of other depositors and loaning it to borrowers who may or may not pay it back.

That creates an inherent conflict: Bankers are supposed to limit the risks they take by carefully choosing to whom they lend money. But while limiting risk and keeping institutions safe and sound, bankers also are expected to take chances on budding entrepreneurs who can put the depositors' money to work and create new jobs.

They are expected to support community business, even when economic downturns in, say, the farm or oil states can jeopardize the ability of most borrowers to repay loans on time.

Some bankers also are perfectly happy to make riskier loans and engage in other more chancy activities in return for higher profits.

Couple these hazards with a fraudulent banker or two and it's no wonder that hundreds of banks have failed in the United States in recent years, regulators said. A hundred banks have failed so far this year, and regulators expect the toll will reach 200 by year's end.

The savings and loan industry is even worse off. A record number of S&Ls have failed since 1980. The problem has been compounded by a regulatory agency that is unorganized and too closely controlled by the industry it is supposed to supervise, and by an insolvent S&L deposit insurance fund that lacks the money to close failed institutions and pay off depositors.

After the collapse of banks nationwide during the Depression, the federal government sought to limit risks taken by banks -- and, by extension, depositors and the U.S. economy. Speculation in stocks and other involvement with more strictly commercial businesses was then believed to have played a significant role in the failures. So the laws from the 1930s built a high wall between commercial banking and other "commercial" activities, such as manufacturing, retailing and investment banking, including the underwriting of most securities.

Many bankers have been rebelling ever since, but especially in recent years as many large, creditworthy corporations have found they can borrow money more cheaply by going directly to financial markets rather than through commercial banking middlemen.

Commercial loans, once the core business of banks, will probably never again yield the profit they once did. Most banks must rely more and more on fee income to compensate for the lost business. That is why many bankers want to enter businesses such as securities underwriting, which produces fat fees.

But even bankers do not agree on deregulation. Most agree they want greater freedom to underwrite government securities. Unlike the big banks, however, many smaller banks think they will never be able to afford to offer one-stop financial services, from checking accounts to mortgages to securities and real estate.

These smaller banks fear that if Citicorp, Sears and Merrill Lynch are free to offer all financial products anywhere in the nation, consumers will flock to these larger companies and put many smaller banksout of business.

Others said that as long as consumers -- both individuals and companies -- benefit, the market shakeout would do more good than harm.

The big banks and big financial service companies have powerful allies in the Reagan administration, which generally believes market forces provide better discipline than federal law.

They have also found a sympathetic ear among regulators, even among a majority of the seven-member Federal Reserve Board that favors giving banks the widest possible leeway in interpreting banking law.

But there are powerful opponents as well. The securities and savings and loan industries, which do not want added competition from banks, have mounted massive lobbying efforts to head off new powers for banks.

The major banks hope President Reagan will make good his threat to veto the banking bill Congress is considering. The bill would close the nonbank bank loophole and temporarily freeze banks from engaging in new securities products.

Between now and March, when the freeze expires, Congress is supposed to try once again to settle the question of how blurry the separation between banking and commerce should get. But many administration officials are skeptical Congress will have any better luck now than it has had during the past seven years, when every attempt to reform banking law has failed.

Instead, the freeze on new bank powers could very well be extended indefinitely, as many predict it will be. And though the bill would prevent new nonbank banks from being created, it permits 168 existing loophole banks to stay open.

The president has said he will veto the bill because it does not open up the financial arena as the administration wishes. He also objects because the bill provides only $8.5 billion to shore up the insolvent Federal Savings and Loan Insurance Corp., the federal fund that insures deposits at S&Ls.

The White House estimates that at least $40 billion is needed for the fund to close several hundred "brain dead" institutions, which are insolvent but open only because the government cannot afford to close them.

In any event, the bill does not address the fundamental issue in banking regulation: Can market forces be counted upon to discipline bankers when the federal government ultimately may bear the risk of the losses they incur?

Gould stirred up a storm recently when the New York Times reported he and the Reagan administration would like to see a handful of American "superbanks" operating internationally to offer strong competition for foreign banks here and abroad.

In an interview two weeks ago, Gould denied the Treasury or the administration has a policy or a plan to promote superbanks. What he was trying to say, Gould said, was that the need for capital could force a restructuring of banks seeking to compete in the world's financial markets.

Gould points out that the securities industry restructured itself in recent years to raise sufficient capital to compete in global markets, with the largest investment banks going public or being acquired by companies with deep pockets: Dillon Read & Co. was acquired by The Travelers Insurance Co.; Kidder, Peabody & Co. by General Electric Co. and Dean Witter Reynolds Inc. by Sears, while Goldman, Sachs & Co. and Morgan Stanley & Co. have gone public. A major Japanese bank not long ago made a large investment in Goldman, Sachs, injecting still more capital.

"This is an observation of what happened to the securities firms," Gould said. "It's not a Treasury plan {for banks}." He said that while banks may be forced to raise more capital, that does not mean they must increase in size. Big organizations with hordes of assets and armies of employes are not necessarily the most efficient and profitable, he said.

Nor does he expect banks to be acquired by nonfinancial companies. Instead, expanding into products like securities, selling stock and selling off existing business divisions are among the ways commercial banking giants will raise enough new funding to compete worldwide, he said.

He said such a trend among international competitors would not diminish the need for medium-sized and smallerbanks across the nation, he said.

Just about everyone involved agrees that banks need more capital as a cushion against possible losses. In fact, the Federal Reserve has increased requirements for capital in the past few years. The disagreement is over where banks should be allowed to get it.

But even Gould wants to go slowly in tearing down the already eroded wall between banking and commerce and banking and securities underwriting. He and other administration officials say they want to proceed one step at a time to test the safety and soundness of breaking down such barriers.

Others, like the U.S. League of Savings Institutions, however, see Gould as a wild proponent of deregulation that the White House is unable to control.

Philip Gasteyer, who runs the league's Washington office, last month told a gathering of D.C. bankers that Gould was the "Ollie North of the Treasury."

New York Federal Reserve Bank President Corrigan has taken the lead in trying to preserve some of the restrictions on bank activities, especially the separation between commerce and banking.

He sees such limits as necessary to protect the nation's financial system, including the tab taxpayers might be saddled with if deregulation fails.

But he acknowledges that changes in the market cannot be undone. Not long ago he told the Senate Budget Committee, "Whether we like it or not, the globalization of financial markets and institutions is a reality. Since that reality has been brought about importantly by technology and innovation, it cannot be reversed in any material way by regulation or legislation.

"Moreover, while this process of globalization and innovation is producing important benefits to suppliers and users of financial services, it also produces anomalous results. To cite an example or two, Japanese securities companies -- whether owned by Japanese or foreign firms -- cannot generally engage in foreign exchange trading and position-taking in Tokyo but they do it in London and New York; U.S. banking companies cannot underwrite corporate debt and equity securities in the United States, but they do it in London or elsewhere," Corrigan said.

Corrigan said he believes there are substantial risks to the public in the sort of sweeping deregulation some bankers have in mind.

"The first set of risks are historic concerns about concentration, conflicts, unfair competition and breaches of fiduciary responsibility. Indeed, I would note that even most proponents of blending banking and commerce acknowledge those risks are present," Corrigan said.

The Reagan administration wants the market to hold sway to the maximum extent possible. Corrigan highlights the fundamental difference between a bank with federally insured deposits and access to the Federal Reserve for loans and other types of business, and the risks that are borne by taxpayers.

Congress has not been able to sort its way through the maze in the past, and it may fail again.

Meanwhile, other financial firms will keep taking bites out of the banks' traditional businesses, and the banks will keep looking for loopholes to exploit.