Banking as a Social Contract

Abstract

The narrative that has emerged in the aftermath of the COVID-19 financial crisis has focused on non-bank financial intermediation as the primary vulnerability that plagued financial markets starting in March of 2020, and the exogenous nature of a public health crisis as a unique precipitating event. As a result, the crisis has largely been viewed as vindication for financial regulation as it applies to banks, with the Federal Reserve playing the role of heroic rescuer of the financial system. This article offers the first critical analysis of the performance of systemically important banks during the financial system component of the COVID-19 crisis, and alternative narratives for the destabilization that occurred, as well as the Fed’s role in financial stability regulation and financial system rescues.

This article frames the function that systemically important banks serve as a form of “social contract” with the public sovereign to provide liquidity to “real” economy households and businesses. This article charts the course of this relationship from the New Deal era’s banking framework, to financial modernization and the Global Financial Crisis of 2008, to the landmark reforms of the Dodd-Frank Wall Street Reform and Consumer Protection Act, and concludes with the COVID-19 financial crisis. This critical analysis reveals the disconnects between the policy objective of financial stability and the actions taken by policymakers, and yields important insights into the political economy, regulatory philosophy, and substantive impacts underlying how the Fed deploys its regulatory and “safety net” lending authorities.

In recent decades, banking’s social contract has frayed, as the Fed has emphasized “tailored” regulation. This policy approach has failed to prevent two major financial crises, as well as intermittent, and recurring, disruptions. As a result, the Fed has played an ever-expanding role supporting a range of “shadow banking” markets. This status quo is rife with misaligned incentives and distributional consequences, as systemically important banks produce great profits that exacerbate inequality in good times and disclaim their social responsibility in bad times. A better framework would hold the systemically important banks that occupy a singular position in the U.S. financial system to the social contract by ensuring that they are able to withstand a range of ongoing and emerging threats to financial stability.

Keywords: Banking, Financial stability, Systemically important banks, Too big to fail, Macroprudential regulation, COVID-19, Shadow banking