Is MasterCard Really Changing The World?

Have you ever noticed that business and news organizations love to compile lists?

The U.S. News and World Report, for instance, draws the attention of the education industry each year with its Best Colleges lists. Forbes generates attention and envy with its World’s Billionaires list. And Dow Jones influences the global markets whenever it changes the composition of the thirty corporations in its Industrial Average list.

Fortune has repeatedly indulged in list compilation activities as well. Its annual Fortune 500 list of the top American companies, for example, has been garnering significant press coverage and scrutiny for decades. And last month, Fortune extended these activities by publishing its first Change The World list.

Change The World? What does that mean? In its Methodology and Credits statement, Fortune explains that the list consists of “companies that have made a sizable impact on major global social or environmental problems as part of their competitive strategy … (and that are) doing good as part of their profit-making strategy … (in order to) improve the human condition.”

That sounds quite noble, doesn’t it? The companies on Fortune’s list should be engaged in extremely impressive activities. And yet, considering its own methodology, at least one of Fortune’s choices may strike us as a bit odd.

Take Mastercard, for instance, which appears at #11 on the list. Along with Visa, American Express, Discover, and every bank that issues debit cards, Mastercard helps people avoid paper currency by paying with plastic instead.

Of course, people have been carrying plastic in their wallets since Diners Club issued the first charge card in 1950, and since Bank of America followed with the first general consumer credit card in 1958. The BankAmericard later went global during the 1970s and was spun off into the firm that became Visa.

But this decades-long progression of e-commerce didn’t deter Fortune from heaping praise on today’s MasterCard for services that simply “distribute social benefits on debit cards … (and thus help people) switch to electronic payments…” In addition, Fortune didn’t mention the ongoing controversies about excessive service fees that some financial institutions have placed on such cards.

To be fair, Fortune does note appropriately that the use of plastic cards in place of paper money can reduce cash theft and deter untaxed “off the books” transactions. But Fortune does not acknowledge that electronic payment systems are often plagued by hackers, thieves, and tax cheats as well.

On the one hand, it might indeed be true that the transition from paper to electronic payment transactions is helping to change the world. But isn’t it a little odd that Fortune has decided to focus its plaudits solely on MasterCard? After all, this is an evolution that has been progressing for well over half a century, and that has been jointly driven by numerous financial institutions.

Don’t they deserve some plaudits too?

Global Banking: It’s The Happy Meal!

Having lurched from one scandal to another during the past year, one would think that representatives of the global banking industry would be eager to improve their public image.

Wouldn’t one?

It thus may come as a surprise that global financial specialists have chosen to publicize a recent trading innovation that has been named after a product for children.

What is the product? It’s the Happy Meal! Named after the meal with a toy at McDonald’s, an investor’s Happy Meal is a bond that is convertible to stock, packaged along with a loan of some shares of the underlying stock.

Either way, an investor in a financial Happy Meal stands to earn a profit. If the issuing corporation performs well, the bond can be converted to equity. And if it doesn’t perform well, the stock loan can be utilized to sell the corporation short.

So which investment vehicle — the convertible bond or the stock loan — is analogous to the food in a Happy Meal? And which vehicle is analogous to the toy?

Regrettably, that distinction is not altogether clear. What is indeed clear, though, is that the naming of an investment innovation after a fast food product for children is not likely to enhance the badly tarnished reputation of the world’s global banks in the eyes of the general public.

Behavioral Finance and Government Regulation

Are you familiar with a field of study called behavioral finance? It focuses on psychological explanations for market behavior. Researchers who specialize in the field believe that personal (and often irrational) attitudes, beliefs, and emotions drive judgments and decisions, which in turn determine how individuals act when responding to events.

So if attitudes determine actions, then conversely, actions should reflect attitudes … shouldn’t they? In other words, if we observe consistent trends in the choices and actions of individuals, we should be able to intuit the underlying beliefs and emotions that have inspired them.

With this relationship in mind, let’s ponder the recent choices and actions of traders in global finance. Last summer, the manipulations of the Libor interest rate exploded across the news headlines; they continue to be the focus of numerous regulatory and criminal investigations.

And within the past two weeks, other long term trends have emerged as well. For instance, several firms are now under investigation for manipulating prices in the energy industry through the use of decades-old tactics that were originally pioneered by Enron Corporation.

Furthermore, the London Metal Exchange is now under fire for enabling Goldman Sachs to manipulate commodity metals prices by purchasing and storing massive amounts of industrial aluminum. The strategy is reminiscent of the schemes that were employed by the Hunt Brothers to “corner” the metals market for silver three decades ago, a plot that ended disastrously on Silver Thursday.

Some banking executives have vigorously defended their actions, asserting that they have broken no laws. Indeed, regulations from the Affordable Care Act to the Dodd Frank Act to the Transfer Pricing Laws of the Internal Revenue Service have long been criticized for their bloated lengths and incomprehensible language.

Nevertheless, the longstanding practices of Wall Street traders appear to reveal an underlying belief that any manipulative strategy is acceptable as long as it is legal. Under such circumstances, what method is available to protect the public interest, other than government laws and regulations?

Global Banking: BIS Disses Our Political Leaders!

Have you heard of the Bank for International Settlements (BIS)? It’s the financial institution that serves as a global clearing house for most of the world’s major national banks. U.S. Federal Reserve Bank Chairman Ben Bernanke, European Central Bank (ECB) President Mario Draghi, and their colleagues on the BIS Board of Directors help the organization coordinate regulatory activities at the international level.

You wouldn’t expect the BIS bankers to be a rambunctious group, would you? And yet, in the 2012 / 2013 Annual Report that they published last week, they heatedly criticized our political leaders for failing to adapt to the new regulatory realities of the post-Crash banking era.

How heatedly? Well, for instance, the text of the Report asserts that “Continued low interest rates and unconventional policies have made it easy for the private sector to postpone deleveraging, easy for the government to finance deficits, and easy for the authorities to delay needed reforms in the real economy and in the financial system.”

Ouch! For a banking regulator, those are fighting words! Clearly, the BIS Directors are peeved that our political leaders haven’t done more to restructure the global banking system.

You may not necessarily agree that our leaders have done too little to implement meaningful reforms. Former United States Representative Ron Paul, for instance, believes that they have done too much to regulate the banking system. In fact, Paul has stated that laws such as the Dodd Frank Act impose “disastrous costs” on Americans.

Whether you side with the BIS or with Ron Paul, though, perhaps you would agree that our banking regulators and our political leaders should coordinate and communicate their strategies more effectively.

Too Big To Fail: Not Just Banks!

Three years ago, Federal Reserve Bank Chairman Ben Bernanke declared that: “It is unconscionable that the fate of the world economy should be so closely tied to the fortunes of a relatively small number of giant financial firms. If we achieve nothing else in the wake of the crisis, we must ensure that we never again face such a situation.”

He made that statement in March 2010; are you concerned about the subsequent pace of reform? Although the wheels of government may grind slowly, they are indeed propelling the engine of regulation forward.

Last week, for instance, Secretary of the Treasury Jacob Lew and his Financial Stability Oversight Council finally agreed to propose that certain “too big to fail” firms be placed under the same governmental oversight entities as global banking institutions.

Which firms? Lew didn’t say, but analysts believe that insurance companies and financial divisions of industrial companies could be declared “systemically important” and thus subject to federal oversight.

Should American citizens be pleased by this progress, or peeved at the length of time that has been required to simply generate this proposal? Indeed, at the present time, it is merely a proposal with no guarantee of conversion into regulatory law.

And yet, coming on the heels of the news that British and American authorities are finally preparing to file criminal charges against the (alleged) perpetrators of the global banking Libor scandal, Lew’s recommendation serves as a signal that the reform movement is making progress. Perhaps slow progress, but progress nevertheless.

Libor Scandal: A Win For The Banks!

It has been a rough year for the global banking industry, hasn’t it? From the revelation that HSBC provided money laundering services to drug kingpins and terrorist organizations, to JP Morgan Chase’s multi-billion dollar losses over a series of trades by the infamous London Whale, the institutions have struggled to win back the trust and good will of the global public.

The biggest scandal of them all, of course, has been the Libor manipulation brouhaha that was first reported in the business press nine months ago. First, the U.S. Commodity Futures Trading Commission successfully fined Barclay’s $200 million for interest rate manipulation in a debt market that is estimated at $300 trillion.

Subsequently, American and British government regulators won settlements from the Union Bank of Switzerland and the Royal Bank of Scotland as well. And many additional investigations are now reportedly proceeding on their paths through the regulatory system.

Last week, however, the banks won a temporary reprieve of sorts, when a New York based Federal District Court judge tossed out a set of multi-billion dollar lawsuits from investors and other parties who claimed to have been damaged by the interest rate manipulations. Does this mean that the banks have been vindicated in the court of law, if not in the court of public opinion?

Legal Technicalities

The plaintiffs of last week’s lawsuits had based their cases on the provisions of antitrust law, a set of regulations that prohibit banks and other parties from colluding with each other when they should be competing for new business and profits. These plaintiffs asserted that the banks engaged in collusive activities, and thus they claimed to have incurred losses as a result of the illegal actions.

The judge, however, decided that the banks had simply taken advantage of a system that permitted them to manipulate the Libor interest rate through the independent submission of rate quotations. In other words, although the judge acknowledged that the banks’ activities may have constituted illegal misrepresentations of interest rates, she asserted that their independent actions failed to meet the legal definition of collusion under antitrust law.

So why did the plaintiffs frame their cases as antitrust actions instead of as fraud actions? After all, it may have been possible for them to win fraud causes more easily than antitrust cases. It is quite likely, though, that the plaintiffs were enticed to do so by the prospect of receiving punitive awards with treble damages. Such awards are available under antitrust statutes, but not under fraud and other statutes.

Many other cases are still progressing through the legal system; furthermore, last week’s settlement may be appealed in a higher court. Thus, last week’s win may prove to be a fleeting one; nevertheless, it is a victory for which the global banks are undoubtedly grateful.

Explicit vs. Implicit Collusion

It’s important to keep in mind, though, that the Federal District Court judge was referring to the absence of explicit collusion. Such collusion often requires competitors to directly communicate with each other for purposes of fixing retail sales prices.

The classic Hollywood film version of such activities, featuring smoke-filled back rooms and dark alleys, is rarely ever replicated in the real world. Nevertheless, explicitly collusive conduct may occur during interactions as brief as limited telephone conversations. One such infamous conversation occurred between the Chairman of American Airlines and the President of Braniff Airways in 1983.

As noted in a Bloomberg Businessweek article last year, flaws in the Libor methodology allowed global banks to “rig” interest rates without explicitly conspiring to do so. Nevertheless, the institutions did indeed collaborate in an implicitly collusive scheme, as described by Michael Kraten in the Businessweek article:

“You have 16 banks employing people who are eating at the same restaurants, drinking at the same pubs. They look at each other as competitors, but also as friends. It’s easy to believe that whether or not they’re explicitly talking to each other, they understand each other well and they’re implicitly colluding.”

Implicit collusion. According to the Federal District Court judge, it isn’t an illegal activity, regardless of the level of damage that it inflicts on the public.

Fraud vs. Antitrust

But what of the other cases that are progressing through the legal system? Will they be dismissed on the basis of such legal technicalities as well?

Probably not, for many of these cases rely on legal claims that are unrelated to antitrust law. The federal government, for instance, is pursuing a case through the quasi-public mortgage finance giant Freddie Mac. This particular case relies on multiple charges of fraud and breach of contract, in addition to charges of collusion. Thus, even if the third charge is dismissed by the courts, the first two charges may indeed proceed to trial.

Considering these events, are you feeling impatient that the global banks have not yet incurred some type of significant punishment for their transgressions? Although they appear to have dodged one such punitive measure last week, they will likely face many more such challenges for years to come.

Global Banking And The Bizarro World

Are you aware of the Bizarro World?

It was first described in a 1960s story line in the Superman comic book series. The Bizarro World was a reverse image of Earth, a place where good people could meet their bad equivalents. Superman and Lois Lane, for instance, were always platonic friends and colleagues on Earth, but they consummated their relationship, had children, and fought relentlessly on the Bizarro planet.

The key plot device that drove the popularity of the story line involved the sheer implausibility of separating the good from the bad. The good Superman, for instance, would inevitably recognize some degree of goodness in his (supposedly) bad Bizarro counterpart. He would also recognize some degree of badness within himself.

Wouldn’t it be nice to purge all that is bad, and keep all that is good? It’s a pleasant concept, but Superman and his Bizarro counterpart demonstrate that such efforts generally prove to be futile.

And yet if that is true of people, then why are our government leaders continuing to discuss the creation of good and bad corporations?

Organizational Behavior

You may recall U.S. Republican Presidential candidate Mitt Romney’s famous assertion that corporations are people, my friend. Although his Democratic rivals pilloried the comment as a “shocking” caricature of a heartless business tycoon, Romney was attempting to explain that corporations are embodied by people and managed by people, and then distribute profits to people. In other words, they manifest the behavioral tendencies of people.

Thus, if organizations “behave” like complex human beings, a good corporation that is managed by ostensibly good people will nevertheless sprout bad characteristics. Conversely, a bad corporation will sprout some good characteristics.

The issue of good and bad corporations was hotly debated during the 2008 / 09 global financial crisis, when all three of America’s automobile manufacturing firms approached the federal government and warned of the collapse of the domestic industry without some form of public support. What was the result of their lobbying initiative?

See The USA In Your Chevrolet

Chrysler was acquired, with the support of explicit governmental financing, by the Italian automaker Fiat. And although Ford did not receive direct government support, it indirectly benefited from the support that was extended to various suppliers of the three automakers.

But what of the bankrupt General Motors? The federal government divided it into a Good GM and a Bad GM. All of the productive manufacturing and brand assets, including the Chevrolet and Cadillac franchises, were placed in the good corporation. And all of the unproductive and toxic assets were placed in the bad one.

In the short term, many praised the Obama Administration for saving the American automobile industry, while candidate Mitt Romney was ridiculed for having proposed that the government should  “Let Detroit Go Bankrupt.” But four years have now passed since that transaction occurred; what are the long term outcomes?

A Mixed Bag

On the one hand, the Good GM has indeed emerged as a viable firm in the global automobile industry. Industry experts have praised the hybrid Chevrolet Volt and the fuel efficient Chevrolet Cruze as indicative embodiments that the new GM can compete in the world markets.

But on the other hand, there are increasingly troubling signs regarding the Good GM. The Volt’s sales volume has been consistently weak in comparison to the Pruis, Toyota’s bestselling hybrid vehicle. And after a strong start, sales of the Cruze have plummeted, perhaps as a result of GM’s decision to establish prices that are $2,000 higher than those that are offered by their primary competitors.

High prices? Unpopular automobiles? Those were the bad characteristics that afflicted the pre-split General Motors! They now appear to be re-emerging in the new Good GM as well.

The Banking Strategy

In the United States, the federal government designed the Citigroup bail out in the same manner as the General Motors bail out, dividing the firm into a good bank and a bad bank. But this strategy did not set the stage for sustained success at the institution.

Meanwhile, in the European Union, the Irish government established the National Asset Management Agency to serve as its national bad bank. And just last week, Bank of England Governor Mervyn King proposed that the Royal Bank of Scotland be divided into good and bad entities.

So how has the Irish economy fared under the good bank / bad bank strategy? The results, once again, can best be characterized as a mixed bag. On the one hand, the Irish economy is expected to grow more robustly than the remainder of the European Union during the next two years. But on the other hand, Ireland’s growth rate is expected to average a meager 1.65%, while the EU economy actually shrinks in size.

Thus, one might wonder why Governor King continues to support the bad bank concept. If the good cannot be segregated from the bad in Ireland, in the United States, or in the Bizarro World, why does Governor King believe that it can be achieved in Britain?

Bank Stress Tests: Calling A Mulligan

Are you familiar with the concept of a mulligan? It’s a “do over,” i.e. an activity that erases the results of a previous action when a person performs it a second time.

Amateur golfers often perform mulligans to erase the effects of their damaging physical and mental gaffes. President Bill Clinton, for instance, employed mulligans on golf courses so frequently that commentators began to refer to them as billigans. But who could argue with a President who insisted on the right to replay a poor swing?

Mulligans are permissible in a few other settings as well. The Japanese children’s card game Pokemon, for example, incorporates a “do over” option. And any retailer that permits a customer to return a recently purchased item for a full credit towards a future transaction is effectively offering a mulligan on the initial sale.

So although “do overs” are somewhat rare, they indeed exist in a variety of circumstances. Recently, however, the Federal Reserve Bank of the United States (the “Fed”) decided to institute a mulligan policy in a manner that may raise concerns involving the public interest.

Stress Testing

The Fed’s new policy involves the practice of performing stress tests on global banking institutions. They began to apply such tests in the financial services sector after the global market crash of 2008 and 2009. After American and European governments bailed out the “too big to fail” banking institutions, their regulators began to require the banks to predict whether (and, if so, how) they would survive future economic collapses.

So how do these stress tests function today? On a periodic basis, regulators provide the global banks with theoretical descriptions of future crashes, and require the institutions to develop and defend their own hypothetical plans to survive those crashes. If the regulators determine that a bank’s hypothetical plan is not feasible, they announce to the public that the bank has “failed” its stress test.

Three weeks ago, in the aftermath of President Barack Obama’s Election Day victory, the Fed quietly announced a new “mulligan policy” for such stress tests. But how will this new policy be implemented? And will it serve the public interest?

Failure vs. Success

In accordance with its new policy, instead of simply announcing that a bank has failed a stress test, the Fed now intends to invite the institution to modify its (previously submitted) hypothetical plan in order to retroactively convert its failure into a success. For instance, if a bank had previously indicated that it would plan to maintain its dividend or stock repurchase policy during a crisis, the Fed will now permit it to modify its hypothetical future policy “just enough” to avoid failing the stress test.

It is important to note that the banks are not required to comply with any of their own hypothetical policy statements in the future. If any stressful scenario ever comes to pass, the banks will be free to ignore their prior stress test policy declarations as they see fit. In other words, both their initial “failed” policies and their retroactively defined “successful” policies represent theoretical declarations with no legally binding ramifications.

Therefore, with this new mulligan policy in place, it is difficult to envision any prospective scenario when a global financial institution might fail a meaningful stress test. And thus it is reasonable to wonder whether stress tests will serve the public interest at all in the future.

Pension Policy

A similar degree of skepticism can be expressed about recent policy revisions in the field of pension plan management. Until recently, most pension plan managers abided by the “rule of thumb” that investment asset balances that are available to pay current and future retiree obligations should never fall below 80% of the present value of those obligations.

For instance, imagine a plan that is obligated to pay current and future retirees $100 million in present value terms. Until recently, its managers would have been branded “failures” if they ever permitted the plan’s investment assets to fall below $80 million. And because asset values fluctuate on a day-to-day basis, its managers would (again, until recently) strive to maintain asset balances of $90 to $100 million, so that a traditional “bear market” decline of 10% to 20% could not reduce assets below $80 million.

But when the market crisis of 2008 and 2009 imposed far greater declines on asset values than traditionally experienced in bear markets, this 80% rule of thumb became a more challenging guideline. So how have pension managers responded to this new challenge? They have simply rewritten the guideline; in fact, many now accept coverage ratios of 70% or less.

In other words, stress test bankers and pension plan managers are now redefining “success” and “failure” in a fashion that redefines yesterday’s failures as today’s successes. If measurements of success and failure can be redefined in such a manner, though, what purpose is served by defining these measurements at all?

Energy Independence: The American Future

Last week, the International Energy Association (IEA) predicted that the global community is merely five years away from witnessing the emergence of a new leader in oil production. That can hardly be welcome news to Saudi Arabia, of course, the world’s largest oil producer at the present time, or to Russia, its longstanding runner up.

So which nation is preparing to accede to the throne? Is it Canada, with its fields of oil sands in the western province of Alberta? Or Brazil, with its newly discovered wealth of off-shore crude? Or perhaps China, Vietnam, or the Philippines, with their recent discoveries in the South China Sea?

To the surprise of many industry analysts, the IEA predicted that the United States will soon become the world’s greatest oil producer. In addition, the Association forecast that America will supply all of its domestic energy and become a net exporter no later than the year 2030.

Imagine, if you can, a world in which the United States no longer needs to import oil from the Middle East, from Venezuela, or from any other nation. An American economic super power with a stable, secure, inexpensive, and solely domestic source of energy? It could well guarantee the extension of Uncle Sam’s global dominance throughout the 21st century.

Envious Rivals

Of course, America continues to compete with a wide variety of rivals for economic dominance in global affairs. Nevertheless, none of its rivals can visualize a future of energy self-sufficiency.

China, for instance, is aggressively continuing to develop relationships with African nations in order to ensure future access to energy resources. And as a result of the Fukushima nuclear power disaster, Japan continues to struggle with its reluctant transition from nuclear power to alternative sources of energy.

Of all of the major global economic powers, Germany appears to have made the most progress thus far in transitioning from imported fossil fuels to domestic renewable energy sources. But its green energy projects continue to be plagued by massive operating costs that require significant government subsidies.

In contrast, the IEA noted that new discoveries of natural gas fields in shale rock within the United States will likely supplement its surging oil field capacities and convert America from an energy importer into a fuel exporter. The world’s largest economy, an energy exporter? For American corporations and consumers, it certainly represents an enviable future.

The Global Markets

Considering the current configuration of the global energy markets, though, it is important to note that an energy independent America would not be invulnerable to market disruptions in other nations. Indeed, the price of oil is established in the global market place, and it is influenced by factors that influence supply and demand around the world.

That has been true since the middle of the last century, when seven global companies — known as the Seven Sisters — seized control of the supply and the price of oil. Then, in 1960, effective control of supply and price began to shift towards the governments of oil producing nations when Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela formed the Organization of the Petroleum Exporting Countries (OPEC).

OPEC certainly does not exert full control over all global oil prices; West Texas Intermediate (WTI) crude oil, for instance, is traded as a commodity on the Chicago Mercantile Exchange (CME). Nevertheless, because traders and other investors can buy and sell most of the varieties of oil (as well as futures and other derivatives) that are produced around the world, the market price of oil that is both produced and consumed in the United States is affected by industry events elsewhere.

The Isolation Option

The past few years have been markedly turbulent ones for the global economy, of course, with once-reliable market pricing mechanisms struggling to adapt to new conditions. Might an energy-independent America be tempted to withdraw its oil and gas resources from the global markets and isolate itself from the price effects of external supply disruptions?

The scenario is not an implausible one. After all, domestic energy producers in the United States are already prohibited by law from selling large amounts of oil and gas resources to customers overseas. And conservative Republican politicians such as Ron Paul have long advocated for the dismantling of global market institutions such as the Federal Reserve Bank of the United States.

Likewise, many global financial analysts believe that the monetary zone of the European Union is destined to splinter because of centrifugal forces that are pulling apart nations like Germany and Greece. If the world’s financial markets fracture into national entities, the world’s energy markets may do so as well.

Would an American economy with a self-sufficient energy supply and a domestically controlled market mechanism be able to survive on its own? Conversely, would the rest of the global economy be able to survive without it?

These may represent mere rhetorical questions at the present time. In the near future, though, they may become immensely important policy issues.

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.