GE Doesn't Want to Be a Big Bank Anymore
It's Passover, so here is a Planet Money story about Manischewitz, the giant of the matzo industry, which "might be the most heavily regulated business in the world." One takeaway from the story is that the rules that Manischewitz has to follow to make its matzo kosher for Passover are complicated, and cost the company a lot of money and trouble. A bigger takeaway, though, is that this is great for Manischewitz: It's a huge barrier to entry for anyone else. If you want to start your own matzo business, you have to bring in rabbis and build special machines and spend a lot of money and time on making it kosher, money and time that can only be justified if you're already selling a lot of matzo. Big Matzo has a deep moat, full of shellfish.
The analogy is obvious. Planet Money's Adam Davidson:
This reminds me of something, Alex, that you and I kept hearing when we started covering the financial industry, that financial firms always say, oh, there's too much regulation; it's too complicated. But many of the biggest financial firms, one of the advantages they have is they have all of these lawyers and other experts on staff able to maneuver around those crazy complexities of government regulation.
The matzo story aired in 2012, and one of the big themes in the financial industry since then has been a slow tentative shift in that dynamic. Regulators and politicians have realized that regulation creates economies of scale that can drive banks to get bigger and perhaps riskier. So they have consciously set out to create dis-economies of scale to balance things out. Some of the dis-economies of scale are sort of ad hoc -- if you are a big bank, you will be more insistently pestered and fined for mortgage fraud and Libor manipulation than if you are a little bank, in part just because those sorts of misbehavior are mostly available to big banks -- but the main ones are clear and intentional and keyed directly to size. Regulators impose higher capital requirements on the biggest and most interconnected banks, and the biggest financial institutions are designated as "systemically important," subjecting them to more burdensome regulation than non-systemic banks.
The result is, one, complaining. But also, two, a rise in competition in financial services. The story of this competition is less about small banks challenging the big banks than it is about non-banks challenging the big banks. Small banks need less capital to support their loans than giant banks do, but they still need some capital to support their loans. Lending Club isn't a bank, and isn't subject to bank capital regulation, so it and its peer-to-peer lending, um, peers, are a big threat to banks' consumer and small-business lending. Non-banks are edging in on leveraged bank loans, commercial mortgages, derivatives market-making, all the businesses that are capital-intensive for banks but that non-banks can do cheaply.
So if you've got a computer and an idea, you can start a business to compete with the big banks. But if you have a giant well-respected company with a good credit rating and the ability to raise lots of money cheaply, you can definitely start a business to compete with the big banks. Go borrow a lot of money cheaply in the short-term funding markets, lend it out for longer terms at a premium, and undercut banks because they are subject to capital regulation and you aren't. It can't lose.
What should we make of GE's announcement this morning that it is going to more or less get rid of GE Capital, its giant financial arm? One simple story is that 2015 would be a wonderful time to start a business like GE Capital, but not a great time to have a GE Capital already lying around. GE Capital isn't a big bank, or really a bank at all, but it's been around so long and grown so important -- largely under Jack Welch in the 1980s and 1990s -- that it's an honorary big bank, and being an honorary big bank is no fun these days.
Here is the sad boring tale of GE Capital, from GE's most recent 10-K:
GECC is a regulated savings and loan holding company and in 2011 became subject to Federal Reserve Board (FRB) supervision under the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA). In 2013, the U.S. Financial Stability Oversight Council (FSOC) designated GECC as a nonbank systemically important financial institution (nonbank SIFI) under the DFA. As a result of this change in supervision and designation, stricter prudential regulatory standards and supervision apply to GECC. On November 25, 2014 the FRB proposed for comment enhanced prudential standards that would apply to GECC as a nonbank SIFI. This proposal would, among other items, require GECC to comply with rules on capital and liquidity adequacy that apply to large bank holding companies, market terms requirements for intercompany transactions and enhanced risk management and governance requirements. The proposed standards would also apply stress testing and capital planning requirements to GECC under the FRB's comprehensive capital analysis and review (CCAR) regulations.
Here is another version of that tale, from GE's presentation this morning:
In 2008, GE Capital was in the business of borrowing short to lend long with little equity and lots of leverage. In 2014, GE Capital is in the same boring slog as the big banks: It has a third as much short-term borrowing as it did seven years ago, with twice as much cash on hand, 2 1/2 times as much common equity and a third the leverage.
So that's the first premise of GE's decision, that "the business model for large, wholesale-funded financial companies has changed, making it increasingly difficult to generate acceptable returns going forward." Here's the second premise:
“The successful IPO of GE’s retail finance business, Synchrony Financial, and other recent business exits have demonstrated that our financial services assets can be more valuable to others,” said GE Capital Chairman and CEO Keith Sherin. “GE Capital’s businesses are excellent, and this is a great market for selling financial assets. Our people are world-class. We are confident these businesses will thrive elsewhere.”
Emphasis added, and the market backs him up: As of early this afternoon, GE's stock was up as much as 11 percent, suggesting that GE Capital's businesses are worth about $22 billion more in other people's hands than they are in GE's. It's expensive for GE to run GE Capital's businesses, because GE Capital is burdened by regulation. It's less expensive for other people to run GE Capital's businesses, because those other people will be less burdened by regulation. Quite explicitly:
GE has discussed this plan, aspects of which are subject to regulatory review and approval, with its regulators and staff of the Financial Stability Oversight Council (FSOC). GE will work closely with these bodies to take the actions necessary to de-designate GE Capital as a Systemically Important Financial Institution (SIFI). “We have a constructive relationship with our regulators and will continue to work with them as we go through this process,” Immelt said
Emphasis, again, added. To make this work you probably can't just spin off GE Capital and change the name; you also need to split it up so it's no longer systemically important and so not subject to big-bank-like capital regulation. And that seems to be the plan: In addition to announcing the overall plan today, GE took some first concrete steps to shed GE Capital piecemeal, selling most of its real estate to Blackstone, Wells Fargo, and other buyers. Splitting up GE Capital gives up some value from scale and cheap funding, but, again, the market seems to think that's worth it.
From a certain angle, the life cycle of a GE Capital looks like:
- Start a non-bank business to borrow short, lend long and compete with the banks at lower cost.
- Grow huge and prosper.
- Get so big that you start being regulated like a big bank.
- Split up and start over.
An obvious question is: Will this catch on? One apparent purpose of tougher regulation of systemically important financial companies is to encourage them to break up into smaller, less systemically important pieces, and you often see calls to break up big banks from politicians, regulators, investors and sometimes even other big banks. We've discussed, for instance, Goldman Sachs's call for JPMorgan to break up in order to reduce its systemic-importance regulatory burden, which was based in part on the idea that a JPMorgan diced into smaller chunks would have lower total capital requirements than the existing unitary JPMorgan. But while a lot of banks have been shrinking their less successful and more capital-intensive business lines, so far there hasn't been much enthusiasm among the banks for breaking themselves up completely.
GE is the first big bank to jump enthusiastically into breaking itself up, and it seems significant that it's not quite a bank. A non-bank financial company has some disadvantages, compared to the banks -- harder to get cheap deposit funding, less obviously government-guaranteed -- but it ought to have a big advantage, too, which is that it's not subject to bank capital regulation. A non-bank financial company that is subject to the same capital regulation as the biggest banks has the worst of both worlds, and it makes a lot of sense for its owners to find it a less-regulated home. For the actual big banks, though, whose businesses are so tied up with their systemic importance and their regulatory status, I'm not sure a breakup will have the same appeal.
Also what should we make of GE's font? It appears to be called GE Inspira, which is a relief, because I first thought it might be Comic Sans.
That's debatable: GE is not a bank holding company in the U.S., but it is a savings and loan holding company, and it has "nine deposit-taking banks outside of the U.S. and two deposit-taking banks in the U.S. -- Synchrony Bank (formerly GE Capital Retail Bank), a Federal Savings Bank (FSB), and GE Capital Bank, an industrial bank (IB)." Its funding includes over $60 billion in bank deposits, and it used a Fed program to support its borrowings in 2008. It is regulated as a systemically important non-bank, not as a bank, but it's notably bankier than a lot of other non-banks.
Here's the FSOC designation, finding that GE Capital "is a significant participant in the global economy and financial markets and is interconnected to financial intermediaries through its financing activities and its funding model," and so should be regulated like a big bank.
Though I'm not sure how much; GE itself will continue to guarantee GE Capital's existing debt and commercial-paper programs. I don't know exactly how this will play out as GE sells; presumably some of the businesses will be sold without funding attached and the buyer will need to provide new un-guaranteed funding, while other businesses will retain the GE guarantee even in someone else's hands.
I should make clear that I am probably exaggerating the regulatory aspects of this divestiture -- though, to be fair, so are GE and everyone else. Obviously part of what's going on here, and the market's reaction, is just that making jet engines and making commercial real estate loans are very different businesses, with very different risk profiles, and capital markets tend to reward focused management teams and comprehensible businesses. Even without the regulatory drag of the last few years, GE and GE Capital might be worth more separately.
By the way, "GE will retain its 'vertical' financing businesses -- GE Capital Aviation Services, Energy Financial Services and Healthcare Equipment Finance -- that directly relate to its core industrial businesses." This is about getting rid of an extracurricular quasi-banking business, not about getting rid of financial businesses that directly relate to the company's industrial business.
Both of those, to be clear, are only partially true of GE Capital (see footnote 2).
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