Banking and the Social Contract

By Baradaran, Mehrsa | Notre Dame Law Review, January 2014 | Go to article overview

Banking and the Social Contract


Baradaran, Mehrsa, Notre Dame Law Review


II. 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.

A. 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)

B. Banks Need Governmental Support

Banks invest in long-term, illiquid assets (i. …

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