The lessons for finance in the GE Capital retreat

More than 10 years ago, the kinds of investors who seek out weak companies were circulating presentations on Wall Street that argued that General Electric's enormous lending business was a ticking time bomb.

The financial crisis of 2008 proved those sceptics right, and on Friday, they appeared to have the final laugh. General Electric announced that it was selling most of the loans inside its financial division, GE Capital, leaving a GE that will be dominated by industrial businesses. The shift, to be completed by 2018, would end one of the riskiest experiments in finance. It also indicates that regulations intended to limit destabilising financial practices are starting to bite.

In a statement on Friday, GE Capital mentioned the weakness that drew criticism all those years ago - and was behind the plan to shrink. "The business model for large, wholesale-funded financial companies has changed, making it increasingly difficult to generate acceptable returns going forward," the company said.

The important term there is "wholesale funding." That is industry parlance for borrowing in the markets, as opposed to raising money from deposits. Borrowing for short periods in the markets is tempting because it can be a cheaper source of funding for lenders than issuing longer-term debt. Lenders take the cheap, short-term money and lend it for higher rates to companies and individuals.

As profitable as that strategy might be for certain periods, it can be precarious. In the 2008 tumult, investors who lent in that short-term market fled, leaving the financial firms that borrowed there without funding. It was a Wall Street version of an old-fashioned bank run. As a result, the Federal Reserve had to step in and provide short-term loans to firms that could no longer get them.

GE Capital had short-term borrowings that were equivalent to nearly a third of its assets going into the crisis. That left it in a position where it had to rely on the government. It was a humbling moment for a company that had a triple-A credit rating at the time.

The weakness of GE Capital and others alerted regulators and Congress to the risks posed by large financial firms that were not regulated banks. The overhaul therefore gave the Fed the power to designate a large nonbank financial company as important to the system - and then regulate it like a bank.

As GE Capital adapted to the new regulatory regime, it began to operate with more capital and less short-term borrowing. Measures of profitability slumped. Its return on equity, for instance, was a meagre 8.6 per cent last year. By selling many of its loans, GE stands to avoid being designated as a "systemically important" institution, and it said on Friday that it would work with regulators to shed that title.

"GE's decision today shows that some of the financial reform measures regulators have taken are working," Dennis Kelleher, the president of Better Markets, a group that has often asserted that the overhaul is inadequate, said in a statement. "Firms that threaten America's financial system - like Wall Street's too-big-to-fail banks - have to be made to bear the costs of their risky business so taxpayers don't have to pay the bill when their risks explode like in 2008."

GE Capital had $500 billion of assets at the end of last year, making it the seventh-largest financial firm in the country. It had $69 billion of short-term borrowings. That sum was substantially lower than before the crisis, but even that may be too high in the new regulatory environment. The Fed is preparing new rules that would mean extra constraints for companies that use a lot of wholesale funding.

"Since the crisis, we've been making GE Capital smaller and safer, and it's a really strong business," Seth Martin, a GE spokesman, said. One of GE Capital's biggest businesses is lending to medium-size companies. Martin said that activity was not particularly risky.

One concern raised by GE Capital's plans is that large amounts of financial assets might be moving from regulated entities into firms that the Fed and others have little power over. The Blackstone Group, the private equity firm, is buying some of GE Capital's assets, for instance. But if Blackstone were to grow to a certain size, it, too, could come under the Fed's regulation as a "systemically important" institution.

In many ways, GE Capital is a remnant of a heady, hubristic era in the markets that gave birth to entities like Long-Term Capital Management, the giant hedge fund that had to be rescued in 1998, and Lehman Brothers. GE Capital did not implode in the same spectacular manner as those two, but its game was more or less up.

©2015 The New York Times News Service