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Tuesday, March 18, 2014

Banks and the Social Contract

“Banks ought to consider it as a principle object to promote beneficial public purposes…. A bank is not a mere matter of private property, but a political machine of the greatest importance to the State.” -Alexander Hamilton, 1781, letters to George Washington about the advisability of forming a bank.

“My own judgment is that a bank is a public-utility institution and cannot be treated as a private affair, for the simple reason that the public is invited, under the safeguards of the government, to deposit its money with the bank, and the public has a right to have its interests safeguarded through organized authorities. The logic is beyond escape. All banks in the United States, public and private, should be treated as public-utility institutions, where they receive deposits.” --Louis Brandeis, 1914,  “Other People’s Money”

 “The presence of that public safety net implies unique public responsibilities on the part of banks and would further seem to imply that if we are no longer willing or able to segregate essential banking functions into an identifiable class of institutions, then the public safety net should be made universally available to any institution that provides a banking function, or it should be eliminated altogether.”--Gerald Corrigan, Former New York Fed Chair, 1983, “Are Banks Special?”

 “Make more loans? We’re not going to change our business model or our credit policies to accommodate the needs of the public sector.”--John C. Hope III, the chairman of Whitney National Bank in New Orleans and recipient of $300 million in TARP funds, 2009, as reported here.

In 2008, Henry Paulson sold TARP to Congress and the public as a way to relieve average 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. Paulson reasoned that this was necessary to allow these banks to start lending again.  However, the deal struck with the banks neither required or incentivized them to lend more. Once the banks had money in hand, it became apparent that they had no intention of using the funds to increase credit.

There was voiced outrage over this diversion of funds from the public to the banks so Treasury rolled out HAMP in March 2009. HAMP, a $50 million TARP carve-out, was intended to go directly to struggling homeowners. Incredibly, these funds also ended up going directly to banks. When Geithner was asked about HAMP’s failures to help mortgage borrowers (as reported by Neil Barofsky’s Bailout) 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.”  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. This one comment probably best reveals the misunderstanding that has pervaded American banking policy for the past 30 years.

The misunderstanding is about the nature of the relationship between banks and the government.  The Treasury and other federal regulators have been operating under the assumption that the government’s paramount objective is assuring bank profitability.  To be sure, regulators should work to secure a 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 don’t trust them (trust is the currency of banks).  So banks and the government are engaged in a partnership or agreement—a Social Contract.  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 has fallen apart with the largest and most powerful banks, those that have been called “Too Big To Fail.” 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.

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. The social contract must be re-asserted.

After the Crisis, President Obama told Wall Street firms that he is standing “between [them] and the pitchforks.” It is likely that the government will continue to protect banks during the next crisis too so long as large and systemically dominant firms still exist. 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 banks to fulfill obligations for the benefit of 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. Here, banks gain needed protections from the government in exhange for operating safely and increasing access to credit for businesses and individuals.  One example of the skewed social contract is in the deterioration of safety and soundness regulation in the last two decades. Another is in access to credit: 40% of the population is unbanked and must look outside the regulated  (and protected) banking industry to get the credit and services they need to survive from day-to-day. In fact, the federal government’s investment in the banking sector is the greatest it has ever been while at the same time the number of people that are shut out of the banking sector has also never been greater. 


Posted by MehrsaBaradaran on March 18, 2014 at 11:59 AM | Permalink


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> The Treasury and other federal regulators have been operating under the assumption that the government’s paramount objective is assuring bank profitability.

Is it the literal corruption of revolving doors or the perhaps more insidious problem of cognitive capture?

Posted by: anon | Mar 18, 2014 12:20:34 PM

I think it's more about ideological or cognitive chapter. During deregulation in the 1980s, this rhetoric seeped in and hasn't really been questioned. When regulators ask questions about whether a new activity is "safe and sound," they are often asking if it's profitable. Same with merger approvals, etc.

Posted by: Mehrsa Baradaran | Mar 18, 2014 4:35:13 PM

Well, it's the sort of 'cognitive capture' which involves
the officials in question being paid large sums of money.
I'd prefer the more accurate term 'bribery'.

Posted by: Barry | Mar 21, 2014 9:59:13 AM

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