GE capital and the coyote’s leg


By Peter J. Wallison.


The Financial Stability Oversight Council’s decision to release GE Capital from its designation as a systemically important financial institution (SIFI) was praised by Treasury Secretary Jack Lew for showing that there is an “off-ramp” after a firm has been designated and turned over to the Fed for the special regulation mandated by the Dodd-Frank Act.

This cheery report obscures the real lesson, which is that a firm must become effectively an empty husk before the FSOC will let it go free. And that is exactly what GE Capital has become, having sold off most of its $500 billion in financial assets and promising now to function merely as a finance company for its parent company’s various businesses.

If you are wondering why the recovery from the last recession has been so historically slow, the designation of GE Capital as SIFI, the downsizing of its staff, and the selling off of its assets provides a clue. In this case, the government used the Dodd-Frank Act to remove from the market a major source of financing for mid-size companies and one of the few large lenders that could take risks on innovative ideas. Less dramatically, Dodd-Frank is doing the same in suppressing growth throughout the US economy.

GE’s decision to wind down GE Capital also tells us something important about the nature of the Fed’s regulation. Although a designation as a SIFI might be seen as a government certification that a firm is too big to fail, and thus provide some competitive advantages, the Fed’s regulation is apparently so oppressive that it was better to wind down GE Capital than to keep it in business under the Fed’s control. One is reminded of the coyote that gnaws off its own leg to escape the trap.

GE Capital is an unusual case; it’s a subsidiary of a larger company which is able to operate even though its subsidiary is significantly reduced in size. In other words, GE had more latitude to make the GE Capital wind-down decision than the managements of the only two firms still in SIFI detention, AIG and Prudential Financial.

A third firm, MetLife, had decided to litigate and take the consequences rather than accept designation as a SIFI. Thus far, this looks like the right decision. FSOC was unable to make a compelling case for MetLife’s designation, and several months ago the Federal District Court for the District of Columbia nullified MetLife’s designation. Among other things, the court found that the FSOC did not have sufficient evidence to show that MetLife’s “material financial distress” could cause “instability” in the US financial system. GE Capital could have offered a similar defense. Instead, it paid the price for its timidity.

The irony of all this is that the whole idea for designating SIFIs is based on a faulty interpretation of the financial crisis. The belief that Lehman’s bankruptcy caused the financial crisis and thus that large nonbank financial firms should never be allowed to fail was responsible for the creation of FSOC and the SIFI designation process. The theory was that these large firms were all interconnected, and that the failure of one would drag down the others, triggering a systemic event.

This is not what happened in the financial crisis. No other large firm failed as a result of Lehman’s bankruptcy. The large scale failures which occurred after Lehman—AIG, and the banks Wachovia and Washington Mutual—were caused by their exposure to subprime mortgages fostered by government housing policies. The same policies that brought down Lehman, Fannie Mae and Freddie Mac.

The chaos after Lehman’s bankruptcy resulted not from the fact that Lehman had failed, but from the government’s own shocking and illogical failure to rescue Lehman after bailing out Bear Stearns—a much smaller company—six months earlier. That misplaced and unnecessary rescue created a classic case of moral hazard, with market participants assuming that the government would protect them against another large firm collapse. When the government reversed its policy, allowing Lehman to fail, chaos ensued because market participants no longer knew who was safe and who was not.

Jeb Hensarling, the chairman of the House Financial Services Committee, has proposed a path to prevent SIFI designations from continuing in the future. His comprehensive Dodd-Frank reform legislation would repeal the Financial Stability Oversight Council’s authority to designate SIFIs. If the House enacts this legislation in the current session, it would show that the Republicans mean business about economic growth.

Despite eliminating GE Capital as a significant source of credit, the Council has yet to lay out what will keep a large firm out of SIFI detention, or what—other than a complete surrender of its business—will let it out of Fed’s grasp. Thus, FSOC remains a threat to U.S. economic growth as long as the administration in power believes—against all evidence—that stringent regulation of large firms will prevent financial instability.

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