Global Banking: Limit The Liabilities!

Some ideas that revolutionize society are proposed by our greatest leaders. Jean Monnet, for instance, was already an accomplished global banker and politician when he first described the “Common Market” that would evolve into the European Union. And Steve Jobs of Apple had already transformed the music and mobile technology industries when he introduced the iPad.

Other revolutionary ideas arise from the fringes of our society. Mohandas Gandhi, for instance, was an unknown South African barrister when he began to develop the techniques of nonviolent resistance. And John McConnell was working in a plastics factory when he first conceived of Earth Day as a global celebration of the environment.

Sometimes, though, new ideas are generated from the fringes of leadership, i.e. from individuals who work directly for our leading institutions but who are not widely known outside of the corridors of power. Last week, Daniel Tarullo emerged as one such figure.

The Federal Reserve

Professor Tarullo was a professor of law at Georgetown University in Washington, DC. Three years ago, he became a member of the Board of Governors of the Federal Reserve System, America’s national bank.

Ben Bernanke, of course, is the Chairman of the Federal Reserve System; he serves as the public face and chief spokesman for the organization. Yet when the Fed determines critical policy issues, each Board member casts a single vote for decision making purposes; thus, Bernanke’s opinion carries the same weight as any other Governor’s.

That’s why the opinions and proposals of the individual Governors attract the attention of the global financial system. And last week, in Philadelphia, Tarullo proposed an innovative approach to limiting the size of the global banking giants. Instead of direct constraints, he suggested, why not try an indirect approach?

A Biological Analogy

Since the global economy crashed a few years ago, many financial leaders have proposed conventional approaches to limit the risks that “too big to fail” banks impose on the financial system. Former Citigroup CEO Sandy Weill, for instance, recently suggested that the banks should be split into independent entities. And former Federal Reserve Chairman Paul Volcker first proposed what is now known as the Volcker Rule, a regulation that prohibits banks from entering certain lines of business.

Governor Tarullo also believes in limiting the size of the global banks. But instead of following conventional strategies of dismemberment or prohibition, he proposes a novel approach. If we can limit the sources of wealth that the banking giants rely on to generate growth, he reasons, we can indirectly prevent that very growth. In fact, we may even be able to compel the banks to “downsize” their existing organizations.

For a biological analogy, consider the options that are available to an obese individual who seeks to lose weight. He can opt to undergo liposuction. Less dramatically, he can try to avoid certain restaurants. But why, instead, should he not simply adopt a low calorie diet?

Non Deposit Liabilities

Similarly, Tarullo proposes to limit the non deposit liabilities of global banks. Such liabilities, he believes, provide the proverbial calories that banks ingest in order to grow their asset bases.

The classic accounting model defines the net worth of any organization as the difference between its asset values and its liability values. When a bank borrows $1.00 and invests it in an asset that grows in value to $1.20, it can repay the $1.00 liability with $1.00 in assets and thus expand its asset base by a marginal $0.20. Thus, if a regulator restricts the bank’s ability to borrow the initial $1.00, its asset base is precluded from expanding by $0.20.

Interestingly, Governor Tarullo only proposes limitations on non deposit liabilities, and not on all bank liabilities. Why? Because, he reasons, banks that accept cash deposits for services like savings and checking accounts are engaging in low risk activities. Such deposit liabilities represent “healthy” sources of wealth for the banks, and thus Tarullo proposes no limitations on them.

Would It Work?

Regrettably, simple limitations on non deposit liabilities may not succeed at fully eliminating such sources of wealth that banks now utilize to fuel growth. That’s because the banks have grown adept at utilizing “off balance sheet” liabilities, i.e. liabilities that never appear on their own books and records, and that are thus not subject to accounting limitations.

Nevertheless, regulators have grown more adept at requiring banks to disclose the impact of their off balance sheet obligations to the general public. In essence, they are endeavoring to bring off balance sheet liabilities back onto the balance sheet, thereby enhancing the potential effectiveness of proposals like Governor Tarullo’s.

Regardless of the fate of this particular proposal, we can certainly applaud the emergence of creative suggestions from the fringes of our governmental institutions. Such “outside the box” ideas provide evidence that our leaders are seeking to identify flexible solutions to our most pressing economic and social problems.

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