Banking and the Social Contract

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. …