Banking and the social contract.

• Author: Baradaran, Mehrsa
• Position: Introduction through I. History of the Social Contract, p. 1283-1312

INTRODUCTION

"[Government] support cannot go on forever, which underlines why the Social Contract for banks must be redrawn." (1)

--Paul Tucker, Deputy Governor of the Bank of England

Paul Tucker made a prescient comment while perhaps unintentionally coining the perfect terminology to describe the current problem in banking: the social contract between the government and banks is out of balance, due primarily to the increased size and power of a number of banks. This Article will, for the first time, describe the social contract in banking and explain how it has gone awry. The recent financial crisis provides a compelling illustration of my argument. In 2008, Treasury Secretary Henry Paulson sold the Troubled Asset Relief Program (TARP) to Congress and the public as an undertaking that would help relieve Americans' mortgage debts through modifications and other direct relief. Congress passed the Act, and Henry Paulson immediately took advantage of the broad discretion given to him under TARP to inject billions of dollars directly into the country's largest banks by purchasing preferred shares. (2) Paulson reasoned that this was necessary to allow these banks to start lending again. However, the deal struck with the banks provided no requirements or incentives to actually increase lending. (3) Once the banks had money in hand, it became apparent that they had no intention of using the funds to facilitate credit. (4)

In response to the voiced outrage of several Congressmen and public figures over the diversion of funds from the public to the banks, the Treasury Department proposed and Congress approved another program in March 2009. The Home Affordable Modification Program (HAMP), a $50 million TARP carve-out, would go directly to homeowners and fulfill the original purpose of TARP by restructuring mortgages to make them more affordable and decrease the number of foreclosures. (5) Incredibly, these funds also ended up going directly to banks. In fact, HAMP's faulty design caused many problems for mortgage borrowers across the country. When Treasury Secretary Timothy Geithner was asked about HAMP's failures to help mortgage borrowers, his response was one of most telling exchanges of the financial crisis: "We estimate that [the banks] can handle ten million foreclosures, over time.... This program will help foam the runway for them." (6) When asked about the one program that was specifically targeted to help the American public, the Treasury Secretary responded that it would make banks more profitable. (7) This revelatory comment is at the heart of the misunderstanding that has pervaded American banking policy for the past 30 years.

The misunderstanding concerns the nature of the relationship between banks and the state. One consequence of the confusion is the Treasury's assumption that the government's paramount objective is assuring bank profitability. To be sure, regulators should work to secure a profitable and successful banking industry, but bank profitability is a means to an end and not an end itself. The proper end is ensuring that the nation's banks do what the public needs them to do and not the other way around.

The public needs a safe and reliable banking system, without which the economy cannot reach optimal performance. Banks also need government support, without which their customers would lack sufficient trust to permit them to function properly. Thus, banks and the government are engaged in a partnership or agreement. The basic agreement consists of a government promise that it will protect banks from runs, liquidity shortages, and investor irrationality, and a promise made by banks that they will operate safely, play their essential role in financing the expansion of the economy, and serve the needs of their customers and local communities. This arrangement has been effective for much of U.S. history and is still intact with regard to most U.S. banks, but it has fallen apart with the largest and most powerful banks, those that have been called "Too Big To Fail." (8) These banks make up less than one percent of the banks in the country, but control the majority of the country's banking assets and wield a disproportionate amount of political power. (9)

It is these banks that were most involved in unsafe practices and these banks to which the various bailout measures were directed. These large banks are the banks in which the U.S. government is most invested, and yet these are the ones least invested in the public welfare of the country. This is why the social contract must be re-asserted. Populist movements from the right and the left, such as the Tea Party and Occupy Wall Street, have demonstrated, although sometimes vaguely, the people's unease with the current state of the social contract. (10) President Obama has gone so far as to tell Wall Street firms that he is standing "between [them] and the pitchforks." (11)

The recent crisis made clear that bailouts were economic and political necessities and will likely always remain necessities so long as large and systemically dominant firms exist. Therefore, the government will also continue to stand "between [the banks] and the pitchforks." Both sides need to recognize this inevitable relationship. At the same time, the government must reassert and clarify the essential nature of this relationship and demand the reciprocity on which this social contract is premised. In particular, the government must make clear that in exchange for this necessary and continued support, the government will require certain banks to fulfill obligations for the benefit of society.

There is a long and rich philosophical discussion about the social contract between individuals and society. In general, social contract theory posits that individuals consent to surrender some natural liberty in exchange for protection or other benefit conferred by society. (12) This Article does not intend to wade into social contract theory as applied by Hobbes, Kant, Rousseau, Rawls, and others to the individual and society. (13) However, the relationship between the government and banks resembles a social contract because it involves the sacrifice of certain liberties that individuals make for the protection of the state. Here, banks gain specified protections from the government in exchange for operating within the limits of the law, much like the average citizen must do in order for the state to function properly. Acknowledging the social contract does not necessarily require more regulation, especially not of the most complex and costly kinds. It requires instead a new way of viewing the relationship between banks and the state that fully recognizes the obligations on both sides.

This Article asserts that there are three major tenets of the social contract: (1) safety and soundness, (2) consumer protection, and (3) access to credit. Regulators can and should require banks to meet standards in these areas to benefit society even if these measures reasonably reduce bank profits. Implicit in the social contract is the idea that each party must give up something in the exchange. This Article provides policymakers not only the appropriate narrative and justifications needed to frame their regulatory philosophy, but it also provides important textual support from the most prominent acts of banking legislation to give regulators the authority and charge to ensure that banks fulfill the public's needs.

In Part I, this Article provides a historical background of the social contract and demonstrates that the social contract between banks and the government has existed since the inception of banking in this country and has changed several times to meet changing circumstances and needs. In Part II, the Article describes the various governmental measures that protect banks and essentially serve as a safety net and why this government support justifies imposing public obligations on banks. Part III defines the critical elements of any social contract going forward, such as safety and soundness, consumer protection, and access to credit. Part IV demonstrates how regulators can build on existing language and tests in banking legislation to recognize and enforce banking's social contract.

1. HISTORY OF THE SOCIAL CONTRACT

To reveal that a social contract exists, this Article briefly outlines the changing nature of the bank/government relationship throughout various phases of U.S. history. This Part considers banking history in three phases: (1) the colonial and Civil War era "nation-building" phase, (2) the Great Depression and the "New Deal in Banking" phase, and (3) the "deregulatory phase" from the 1970s through the early 2000s. To be sure, banking changed significantly within each phase, but the general contours of the social contract remained roughly the same.

1. The Colonial to Civil War Social Contract

   Banking started in America to aid the colonies in building an economy from scratch. The new world, unlike the more established old world, did not have a financial system or large pools of money to borrow or lend. The first bank created in the new world, the Bank of Pennsylvania, was a public bank created to aid the cash-strapped colonies in feeding the troops during the Revolutionary War. (14) The first national bank, the Bank of North America, was approved by Congress in 1781 and was formed by private and foreign funds. (15) Alexander Hamilton, a then twenty-four-year-old soldier and vocal advocate of establishing a national bank, wrote, "Tis by introducing order into our finances--by restoring public credit--not by gaining battles, that we are finally to gain our object." (16) His time in the army had convinced him that "military operations could not be made more effective without more money, and more money could not be procured without new means." (17) The Bank of Pennsylvania was a public enterprise, (18) but did not become the "national bank" it was intended to be and was...