For a long time, General Electric had a black box that always let it just beat its earnings targets. That black box got bigger and bigger, though, and in 2008 it almost killed GE. Despite that, they kept it because it normally made them so much money. Well, at least until now. The black box has so many new rules attached to it that it's not worth keeping around anymore.
In other words, GE is selling most of GE Capital—its black box—and going back to being an industrial company. Score one, kind of, for Dodd-Frank.
Now when you think about GE, you probably think about light bulbs or washing machines or airplane engines. But that's not where it's made most of its money in recent years. At its peak, GE Capital, the company's finance arm, accounted for 60 percent of group profits. That came down a little after the financial crisis, but only just; it was still 42 percent in 2014. Put simply, GE had become a financial services company with a side business in manufacturing. But how did GE Capital make all this money? Well, by doing everything that banks do, just without all the regulations that banks have. That's because, as Mike Konczal points out, GE was able to get around more restrictive rules by buying a savings-and-loan bank in Utah that let its financial activities come under the lighter touch of the Office of Thrift Supervision.
So GE Capital was able to make commercial loans, provide credit cards, and become one of the biggest mortgage insurers and car leasing companies without facing the same kind of regulatory scrutiny that other banks did—because it technically wasn't one. It was a "shadow bank." That meant it borrowed short and lent long, which is the definition of what banks do, but it didn't call itself one, so it was able to avoid tougher rules. This was a good business to be in, not least because GE could use GE Capital's easily manipulated earnings to beat Wall Street's expectations for the company as a whole with metronomic frequency. Now, as you can see in the chart below from Barry Ritholtz, former CEO Jack Welch did this much more aggressively than current CEO Jeff Immelt has—although GE had to pay a fine for accounting fraud under the latter—but in both cases, GE Capital has been the black box that let its parent company smooth out its earnings. A very good business indeed.
At least until 2008. The problem with shadow banks isn't just that they're free to take bigger risks than their more regulated counterparts, but also that they don't have the same safety net that regular banks have if they do fail. Specifically, they don't have deposit insurance and they can't borrow overnight from the Fed. So what happens if things start to look bad? Panic. People rush to pull their money out before everyone else, so they don't lose their money. Shadow banks, in other words, are susceptible to old-fashioned bank runs, just with mouse clicks instead of lines outside. And that's what happened during the crisis. Subprime losses started a run on the shadow banking system that turned into a run on the regular banking system that, at its worst, threatened to make it so that everyday companies couldn't borrow the money they needed to, say, meet payroll or stock their shelves. GE Capital was no exception. It needed to be bailed out to the tune of $139 billion in government-guaranteed debt.
The question, then, is what to do about too-big-to-fail shadow banks. The Dodd-Frank financial reform does a lot of things, but it doesn't do anything to set up the kind of regulate-and-insure system that regular banks have. Instead, it says that big shadow banks, usually with $50 billion or more in assets, are "Systemically Important Financial Institutions," (SIFIs) that have to keep more capital on hand. The idea is to force these lenders to be safer because they don't have a safety net, and if they do fail, they could drag down everyone else. Now, conservatives have argued that lenders will want to be designated as SIFIs, since that would supposedly signal that they'd be bailed out the next time. But GE Capital's sale shows that this isn't true. GE only wanted to be a bank if it didn't have to play by the same rules that other banks do. Once it did, it decided that the cost of actually being regulated wasn't worth the benefit of its $500 billion lending business—especially when investors already thought being a bank was too risky for them.
The good news is we know how to make the big banks safer, whether or not they call themselves banks. The government doesn't have to break them up itself. It just has to give them incentives to do the job themselves—and they will. Things like making banks hold even more capital the bigger they get, which would offset the unfair subsidy they get for being thought of as too-big-to-fail, would make shareholders push management to downsize their financial empires to avoid the stricter rules. But we shouldn't forget that this is just moving risk around, not eliminating it. Take GE Capital. Some of its parts are being sold to Wells Fargo and the private equity firm Blackstone—in other words, to banks and shadow banks. This, as Greg Ip points out, could leave us in a world where the big banks become safer but the financial system as a whole becomes less so. In effect, hiding the risk in shadow banks that could bring down the regular banks rather than in the regular banks themselves.
And that's the part we still haven't really figured out: how to make the shadow banking system less dangerous. Maybe it'll be enough to regulate the big ones more. But maybe it won't. Maybe lots of small shadow banks failing all at once, like they would if there's another run on the system, would be just as devastating as a few giant ones going under. That was the case in the 1930s, when thousands of Main Street-sized banks going out of business was enough to send the economy into a death spiral even though the big national banks survived.
There are still a lot of black boxes out there. They're just not in GE anymore.