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.

MetLife and Deutsche Bank: Playing Hide And Seek

Undoubtedly, you’ve heard of the Metropolitan Life Insurance Company, i.e. MetLife. According to the Fortune 500 rankings, they’re the largest life insurance company in the United States. And certainly, you’ve heard of Deutsche Bank AG as well. According to Banker’s Almanac, they’re the second largest bank in the world.

So here’s a question for you: according to the federal government of the United States, which one of these organizations is an insurance company? And which one is a bank?

A rational person might respond “the insurance company is an insurance company and the bank is a bank.” But in the world of federal banking regulations, a rational answer is often a wrong answer. So please guess again!

MetLife: From Insurer to Bank and Back

The Metropolitan Life Insurance Company was founded in 1863 as the National Union Life and Limb Insurance Company, an issuer of policies to military personnel fighting the American Civil War. For almost 150 years, it has been perceived as a quintessential American insurer; in fact, it even utilizes the Peanuts beagle Snoopy as its corporate logo.

But in the year 2000, MetLife purchased a small bank called Grand Bank N.A. of Kingston, New Jersey. Although it renamed the entity MetLife Bank and has been operating it since that time, the division has never grown to become a significant component of its operating activities. And recently, on December 27,  2011, it decided to sell the division’s entire depository business to GE Capital.

Considering the relatively inconsequential size of MetLife’s banking operations, why does the Federal Reserve Bank of the United States list MetLife, Inc. as the sixth largest bank in the nation? It’s because MetLife utilized its tiny bank to reorganize itself as a diversified bank holding company. That helped the firm boost its profits during the bubble economy era prior to the 2008 market crash, but is now proving a hindrance in the new era of Dodd Frank regulations and Federal Reserve stress tests, one of which MetLife recently failed.

So MetLife is now shedding its banking persona, selling off its MetLife Bank operations in a piecemeal fashion. Last year, when it decided to sell its deposits to GE Capital, it declared that “a diversified bank holding company structure was no longer appropriate” for it.

Deutsche Bank: From American Bank to American Subsidiary

Deutsche Bank AG has been operating as a global banking company since its founding in 1870. In 1999, one year before MetLife purchased Grand Bank N.A., Deutsche Bank created a corporate entity called Taunus Corporation (named after a mountain range in Germany) to serve as a bank holding company for its American assets.

Until late last month, there was never any question that Taunus represented a major American banking operation. That’s why the Federal Reserve Bank still lists Taunus as the eighth largest bank in the United States.

So what happened last month? Like MetLife, Deutsche Bank decided that its American operations should try to avoid the necessity of compliance with the new regulations that are being imposed by federal regulators. So it decided to transform itself from: (a) an American bank that is owned by a German bank, to (b) a German bank’s American subsidiary. At first glance, that distinction might appear to be a relatively arcane one, but under American law it will permit Deutsche Bank’s Taunus Corporation to side-step the new regulatory requirements.

Now You See Me, Now You Don’t

As if playing a game of hide and seek, MetLife and Deutsche Bank have each decided to disappear from the watchful gaze of federal oversight. MetLife plans to accomplish this feat by selling off a minor operation that enabled them (while it was beneficial to do so) to classify their entire firm as a bank. And Deutsche Bank plans to achieve the same goal without selling any of their American operations at all.

Are there any other organizations that have slid in and out of the regulatory classification of a banking institution? You bet! Major American corporations such as Harley-Davidson, Caterpillar, and McDonald’s relied on their corporate treasury operations to borrow billions of dollars from the Federal Reserve Bank at the height of the financial crisis. And pension plan entities of all sizes, ranging from the California State Teachers Retirement System to the City of Bristol (Connecticut) General City Retirement Fund, did so too.

Clearly, the conveniences of the reclassification process have permitted many banking organizations (like Deutsche Bank’s Taunus division) to avoid the disadvantages of being regulated as a bank. And clearly, they’ve also permitted many non-banking organizations (like McDonald’s) to enjoy the advantages of such a classification.

So when can a bank call itself a bank? And a non-bank a non-bank? Apparently, in the United States, the answer to these questions is a simple one: whenever the bank (or non-bank) decides it is beneficial to do so.