03/22/2012 09:57 am ET Updated May 22, 2012

Trust, but Verify: Recent Revelations Make the Case for More Responsive, and Responsible, Banking

The recent resignation confessional by a (now) former Goldman Sachs executive offers just the latest insight into the way that some bankers may view their customers: as a means to higher bank profits, regardless of what is in the best interests of those clients. Greg Smith, a former Goldman Vice President, suggests that the practices at Goldman risk jeopardizing customer trust in the institution. But the allegations about the culture at that investment bank are just the most recent of a stream of embarrassing revelations about bank practices to have come to light in recent years, allegations that suggest that banks have a lot of work to do to improve their image, let alone to do right by their clients.

In order for banks to be trusted, they must be trustworthy, and what customers need today are mechanisms for gauging the extent to which banks are engaging in responsible practices, the types of practices that could prevent the next financial crisis and lead to greater trust by the general public in those institutions. Several municipalities across the country are exploring the possibility of adopting so-called "responsible banking ordinances," and such legislation could help serve as a means by which local governments, and even individual consumers, can ensure that the banks with which they do business engage in practices designed to promote sustainable economic development and not simply bank profits.

The revelations contained in the former Goldman executive's missive were not the only ones about bank practices coming to light last week. Last Monday, the Inspector General of the Department of Housing and Urban Development released the results of investigations into the foreclosure practices of five of the biggest banks. Each of these studies revealed that the banks failed to have the internal controls necessary to prevent so called "robo-signing": the widespread falsification of documents related to foreclosures of allegedly delinquent borrowers. These new reports show that bank officials and their lawyers routinely fabricated documents in thousands of foreclosure cases, and that these banks did not have a systematic way of ensuring these practices did not occur. The report regarding JP Morgan Chase revealed that the bank even shut down its quality control division precisely at the time when foreclosures were heating up. With Wells Fargo, low-level bank officials raised their concerns about the banks' foreclosure practices with higher ups within the bank. But the bank didn't just ignore those concerns. No, it went ahead and made the bank's procedures even more streamlined: read, they cut even more corners instead of requiring more stringent controls and more careful practices.

Of course, in a bygone era, banks cultivated long-term relationships with those that borrowed from them. In the fast-paced world of mortgage securitization that reigned during the mid-2000s, however, customers were a means to an end, and robo-sign practices were simply a symptom of that culture. Instead of trying to modify mortgages and work with borrowers in distress, banks tried to process tens of thousands of foreclosures, cutting corners and playing fast and loose with the rules. Some may argue that the robo-sign scandal is a mere distraction from the fact that the borrowers impacted by these shoddy practices probably were in debt anyway, and should face foreclosure even if all of the legal niceties were not followed in every case. But HUD's findings seem to suggest that we really have no idea the extent to which borrowers were really in debt; in one analysis of 36 mortgage records, HUD found that in 35 of these cases it could not confirm the bank's allegations about borrower indebtedness.

These revelations of bank practices in the lead up to and wake of the financial crisis are similar to other reports that have come to light in recent years about the ways in which banks sometimes treat their customers.

Last year, the Securities and Exchange Commission agreed to settle several investigations against some of the biggest investment banks, including Goldman Sachs, in which those banks were accused of rigging mortgage securitization deals to help some clients at the expense of others. Essentially what the SEC accused the banks of doing was setting up mortgage pools that were loaded with such flawed mortgages that they were doomed to fail from the outset. But these mortgage pools were securitized and hawked to some of these banks' customers nevertheless. Why? So that other bank customers could place wagers, in the form of credit default swaps, that the mortgages would go belly up. And the banks were typically paid fees on both sides of the transaction -- by the customers unwittingly investing in the pools that were designed to fail and those who would take positions that the pools would do just that: fail. For the banks it was, I guess, good work if you could get it.

Another example of a bank apparently treating its customers with contempt emerges from the fair lending context. Smith's piece charges some of Goldman's employees of referring to its customers as Muppets. At Wells Fargo, it appears, the names it called its customers were not quite as cute and fuzzy.

At the height of the subprime mortgage frenzy of the last decade, subprime lending had a distinctly racial tinge. African-American borrowers, with similar economic profiles as White borrowers, were nearly twice as likely to be steered into subprime loans as their White counterparts. In a series of lending discrimination lawsuits filed against Wells Fargo, affidavits of former employees allege that bank officials routinely referred to African-American borrowers as "mud people" and subprime loans as "ghetto loans." Those lawsuits, filed by the Mayor and City Council of Baltimore, M.D., and by the City of Memphis and Shelby County, TN, have moved into the phase of the litigation where the plaintiffs will have access to bank records, emails and other internal correspondence. It is possible that only more damning evidence will surface. Of course, the borrowers for whom bank officials appeared to have such deep contempt are usually called something else: customers.

All of this evidence points to the need for individual and institutional investors to have a means to hold banks accountable for their conduct, a method by which they can measure the trustworthiness of banks. At the urging of groups like New Bottom Line and the PICO National Network, several major cities, including Boston, Chicago, San Jose, CA, and Portland, OR, are exploring adopting responsible banking ordinances. The Association for Neighborhood and Housing Development is promoting such an initiative in New York City. The Los Angeles City Council has already set the stage for the full adoption of such an ordinance by directing the city attorney there to draft appropriate legislation for the City of Angels. Generally speaking, these ordinances direct banks to report on their lending, investment, and services, such as their branch network and foreclosure practices within city limits. Cities then can respond to those reports by investing city-controlled funds -- pensions, operating fund accounts, etc. -- with those banks engaged in responsible practices: i.e., those that enhance, and not destroy, long-term and sustainable community economic development. Think of it as a "Move Your Money" campaign for the institutional investor.

Whether these ordinances take hold in these and other communities across the country, and whether they can really have a long-term impact on bank practices, remains to be seen. In any event, to the extent they shine a light on bank practices, foster a dialogue about them, and enhance the ability of city officials and other investors to develop metrics by which to gauge the responsible -- or irresponsible -- nature of such practices, they can only lead banks to be more responsive to their customers, especially their large, institutional ones.

Is there a need to make banks more responsible citizens, and more responsive to their customers' interests and needs? It would appear that the timing could not be better for such efforts. And responsible banking ordinances are a modest way to shed light on -- and maybe even improve -- bank practices, one community at a time.