In the midst of the worst string of bank failures in half a century, the collapse of a small minority-owned bank in Harlem is turning out to be a pivotal event that could shape the way the government handles problem banks for decades to come.

When Freedom National Bank closed its doors Nov. 9, the Federal Deposit Insurance Corp. stepped in immediately and began paying off all depositors who had accounts of up to the $100,000 FDIC insurance limit.

That decision is seen in Congress as the most serious political blunder the FDIC has made in years.

In the vast majority of the 800 bank failures in the last four years, the FDIC did not simply pay off insured accounts. Instead, the agency usually has arranged for new owners to take over the failed banks so that all the customers get all their money back.

That wasn't done in the case of Freedom National, a decision that has led to sharp bipartisan criticism in both houses of Congress, where Freedom National has become the symbol of how unfair deposit insurance can be.

"The regulators blew it," said Rep. Floyd H. Flake (D-N.Y.). Flake, a member of the House Banking Committee, said the flaws in deposit insurance revealed by the Freedom National incident will ensure that Congress passes deposit insurance reform legislation this year.

The losses suffered by Freedom National's depositors contrast with what happened to customers of Bank of New England in Boston last week. No depositor lost a dime at Bank of New England, one of the biggest bank failures in history.

The $100,000 limit on FDIC coverage is meant to ensure that deposit insurance protects small savers rather than the wealthy. But the $14.7 million in accounts of more than $100,000 at Freedom National did not belong to fat cats.

The List of Losers There were only 17 individuals among the 114 big accounts, but there were 37 nonprofit groups and charities, including several community organizations that had deposited government grant funds in the bank.

On the list of losers are Columbia University, the United Negro College Fund, the National Urban League and 11 churches, including Abyssinian Baptist and Canaan Baptist, two of the biggest congregations in Harlem.

Facing the biggest loss is Turner Construction Co., a major New York building firm that kept a $1 million account at Freedom National as a gesture of support for the struggling bank.

Those depositors got their first $100,000 back from the FDIC and were paid 50 cents on the dollar for amounts above the limit because that was all the money that was left when the bank closed.

It would have cost the FDIC about $8 million to pay the uninsured depositors in full, while the agency had to spend more than $200 million to cover accounts over $100,000 at Bank of New England.

The contrast between the FDIC's treatment of customers at Freedom National and Bank of New England is apparently so unfair that no one in either the Bush administration or Congress makes any effort to defend it.

"It is unfair," FDIC Chairman L. William Seidman told the Senate Banking Committee last week. Unfair or not, he said the government had no choice but to pay off all depositors in Bank of New England to keep the collapse of the bank from sending shock waves through the fragile economy of the Northeast.

Wanted System Changed Seidman reminded the Senate panel that, during its hearings on his confirmation five years ago, he testified that the system of paying off all depositors in banks that are considered "too big to fail" was unfair.

"I said I would try to change that and I haven't been able to do it," said Seidman.

Seidman may be able to do something about the depositors of Freedom National, however. After a bipartisan outcry from both houses of Congress, the FDIC chief has told his staff to review the Freedom National case and has put the matter on the agenda for an FDIC board meeting next week.

Flake wants Congress to vote the money to bail out the Freedom National depositors if the FDIC doesn't do it.

Though Seidman testified last week that the FDIC could find no legal authority for protecting all of Freedom National's depositors, congressional banking lawyers disagree. They say the savings and loan reform law passed by Congress 18 months ago specifically gave the FDIC authority to pay off uninsured depositors and other creditors of failed banks at its own discretion.

But if the FDIC reverses its initial decision and does pay off accounts of more than $100,000 at Freedom National, that will only complicate arguments over the fairness of the system. It would show that the question of who loses in bank failures is influenced not only by the vagaries of the marketplace and regulations, but also by political pressure.

Despite his reservations about doing it, the practice of bailing out all depositors in bank failures has become the rule rather than the exception during Seidman's tenure at the FDIC. Previously, when bank failures were rare, the FDIC generally bailed out big depositors only in banks that were considered "too big to fail."

That phrase was coined after the collapse of Continental Illinois National Bank in 1984. The FDIC protected everybody who had money in the big Chicago bank, because many of the accounts of more than $100,000 belonged to little Midwestern banks that would have failed themselves if they had lost their money in Continental Illinois.

Technically, to invoke the "too big too fail" doctrine, the FDIC has to determine that survival of a bank is "essential" to maintain financial services in the community. Seidman said Freedom National didn't meet the test because there are lots of other banks in New York.

That view is challenged by Flake, Rep. Charles B. Rangel (D-N.Y.) and other members of the Congressional Black Caucus, who contend Freedom National played an essential role in the Harlem community that cannot be filled by New York's big banks.

The FDIC also has the authority to transfer all deposits in a failed bank to another financial institution when that would be cheaper than simply paying off depositors. No other bank wanted to take over Freedom National, however, so that power couldn't be used, Seidman said.

Rangel and Rep. Charles E. Schumer (D-N.Y.) say the FDIC did not do enough to find new owners. Rangel said he learned the bank was in trouble only a few days before it was closed and that private rescue efforts might have succeeded if given more time.

Memos from federal bank examiners show Freedom National's executives acknowledged the bank was doomed months before it closed its doors.

The documents show the federal Office of the Comptroller of the Currency allowed Freedom National to stay in business for at least two years after it could have been declared insolvent.

Backing Big Depositors Ironically, nearly everyone in Congress who is complaining about the losses suffered at Freedom National supports deposit insurance reforms aimed at ending the practice of paying off all depositors.

Congressional banking leaders and the Bush administration say that forcing big depositors to take a hit would make them more careful about where they put their money and would reduce the cost of bank failures, which have depleted the FDIC insurance fund.

But until the law can be changed, the government should try to treat all depositors as fairly as possible, the lawmakers say.

As Schumer warned in a letter sent to Seidman on Friday: "The integrity of the FDIC has been damaged by the appearance that the Freedom depositors alone have been singled out to shoulder the burden of a shrinking bank insurance fund."