Banking and the social contract.

• Author: Baradaran, Mehrsa
• Position: II. Defining the Social Contract through Conclusion, with footnotes, p. 1312-1342

2. DEFINING THE SOCIAL CONTRACT

   This Part provides the justification for enforcing a social contract between banks and the state. The state needs banks to perform specific functions that enable trade and commerce. Banks, in turn, need both government recognition and a safety net to gain consumer trust. The government safety net involves a permanent system that provides insurance and liquidity for banks to enable them to withstand economic stress and customer runs. This part of the safety net has operated without much controversy since the Great Depression.

   The second part of the government safety net is a more recent phenomenon and involves discretionary emergency bailouts. (163) Though new, bailouts are likely to continue because their primary recipients are the largest U.S. banks that control the majority of banking assets and whose failures would cause many problems. Their status as likely bailout recipients is demonstrated in their epithet, "Too Big To Fail" (TBTF). This Part makes the claim that the full government safety net needs to be accounted for in constructing a social contract suited for the modern banking world.

   1. The State Needs Banks

      Basic economics explains why the government needs a well-functioning banking sector. Adam Smith, in Wealth of Nations, declares: "It is not by augmenting the capital of the country, but by rendering a greater part of that capital active and productive than would otherwise be so, that the most judicious operations of banking can increase the industry of the country." (164) Joseph Schumpeter posits that "[the banker] stands between those who wish to form new combinations and the possessors of productive means. He is essentially a phenomenon of development.... [The banker is] the ephor of the exchange economy." (165) Banks create money (166) and credit (167) as they turn consumer deposits into loans. There is even evidence that banking activity not only enables but spurs real economic development. (168)

      Banks facilitate efficient trade and transaction-making and enable the flow of resources across the economy. Banking is also the medium through which the government, through the Federal Reserve, can implement fiscal and monetary policy. (169) Therefore, the government needs banks to have a stable-growth economy, credit accessibility, and uniform monetary policy. (170) Moreover, banks operate with heightened leverage and their failure is much more problematic than that of other businesses because of systemic risk and monetary supply concerns. (171) Thus, the state has an interest in ensuring against this failure--an interest that doesn't exist for other commercial entities. Governments protect banks because they need them to be stable.

      In his 1980 and revised 2000 essays Are Banks Special?, Gerald Corrigan, former Chairman of the Federal Reserve of New York, places banks at the center of the economy and justifies stringent supervision of banks because of their unique status as intermediaries. (172) He proposed three characteristics that made banks "special." First, they issue transaction accounts (i.e., they hold liabilities that are payable on demand at par and that are readily transferable to third parties). (173) Second, they are the backup source of liquidity for all other institutions, financial and nonfinancial. (174) Third, they are the transmission belt for monetary policy. (175) As Corrigan points out, the functions of a bank are too important for banks to be regulated like other market entities. (176) In his essays, Corrigan states that "the presence of the public safety net uniquely available to a particular class of institutions also implies that those institutions have unique public responsibilities and may therefore be subject to implicit codes of conduct or explicit regulations that do not fall on other institutions." (177)

   2. Banks Need Governmental Support

      Banks invest in long-term, illiquid assets (i.e., loans) and pay for these assets using short-term liabilities (i.e., deposits). (178) Banks provide businesses and individuals with production-driving liquidity by investing in their illiquid assets. (179) This structure exposes banks to runs. (180) Banks rely on the statistical probability that not all depositors will seek to reclaim their funds at one time. (181) But public fears of bank insolvency can sometimes erode depositor trust, causing runs and potentially a bank's bankruptcy. (182) Banks have used various tactics throughout their history to appear trustworthy to their customers who need to be induced to place their hard-earned money in a bank's care. Early banks would display their specie, i.e. gold, for all to see or open the vault door to reveal their piles of currency or build marble buildings and gold safes to give the appearance of unlimited funds. (183) Some art history literature suggests that many banks are made to look like Greek temples to create the appearance that they have always been and always will be. (184) For many years after the Great Depression, banks discouraged their employees from working at night lest the public perceive trouble at a bank. (185) Bankers understood that bank runs were not a result of actual insolvency, but the result of fear, perceived insolvency, or even another bank's failure. (186) Even the safest bank could experience a run if the public's confidence faltered. (187) Therefore, public perception of the safety of banks is the linchpin to a successful banking sector. (188)

      How does the banking system secure public confidence? Through government sponsorship and financial support. The currency of banks is trust. The monetary system falls apart when trust is lacking. (189) Diminished trust in the banking system and in the ability of banks to honor contracts and credit agreement leads to diminished lending and catastrophic financial consequences. (190) An important element of the public's trust in the banking system derives from the public's knowledge that banking is heavily regulated and overseen by the government. People trust banks because they know that the government watches over them closely--for example, that the FDIC inspects banks and enforces regulations. In addition, the government provides a safety net to struggling banks. (191) This is the primary reason that the government bailed out the banking system: to restore trust in the nation's banks.

      The government uses several methods to instill public trust in the banking sector. Some are day-to-day measures, such as oversight and deposit insurance, and some are emergency measures used during times of systemic failure. The various components of the standard and emergency safety net for banks are outlined below. They include deposit insurance, Federal Reserve liquidity support, and bailouts.

      1. Deposit Insurance

         Perhaps the most direct way banks have garnered consumer trust is through government guarantees. Deposit insurance started in the U.S. on the state level in 1829, (192) but it wasn't until the Great Depression that the federal government, through the FDIC, began to insure bank deposits against losses. (193) Deposit insurance immediately reduced bank runs without interfering with the banks' asset liability structure. (194) By removing depositors' fears of loss, deposit insurance effectively eliminates any incentive they might have to withdraw their funds before they are needed. (195) Moreover, deposit insurance reduces systemic risk caused by a lack of confidence in the entire banking industry during times of economic distress. (196)

         Federal insurance has also been more effective than either state or private deposit insurance. Private insurance schemes have not been attempted on a large scale and have not been successfully implemented on a small scale. (197) Economists Diamond and Dybvig, in their seminal work on deposit insurance, conclude that deposit insurance is best administered by the government and that "competitive markets cannot provide this liquidity insurance" (198) for a variety of reasons, but especially because a "private insurance company is constrained by its reserves in the scale of unconditional guarantees which it can offer." (199) State insurance funds have also been unsuccessful. Several states have tried to implement deposit insurance systems, but none were able to survive a systemic crisis. (200) The FDIC has an advantage over state schemes because of its larger size and its ability to access liquidity' through the Treasury Department and the Federal Reserve. (201)

         It is of course possible to have a banking system that does not rely on deposit insurance--one that is closer to a free market ideal. Even today, some industry observers continue to denounce deposit insurance. (202) These free-market advocates would like to see the momentum of the deregulatory era accelerated and fully actualized. Removing deposit insurance, they claim, reduces moral hazard because it allows for market discipline. (203) Removing government support from the banking system would certainly eliminate the moral hazard issues and possibly reduce some of the inefficiencies in banking that excess regulation has caused. But this arrangement would be a reversal of a century-old banking framework. It would be a new relationship altogether--similar to the one that corporations generally have with the state. Corporations are taxed and regulated to prevent harm to consumers, but not protected by the state in the same way as banks. This is not to say that such an arrangement could not be attempted again and perfected, but it would be a marked departure from the banking policy of this country. Most observers agree, moreover, that deposit insurance is the best way to keep the banking sector stable and reliable. (204) Indeed, every developed country has a deposit insurance scheme in place. (205)

         And while this Article makes the case for a renewed and well-defined social contract, some have suggested that in the case of deposit insurance, ambiguity...