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Financial Reform’s Effect on Shadow Banking

The Dodd-Frank financial reform law is doing some real good.

There are two big lessons from General Electric’s announcement that the company is planning to get out of the finance business.

First, the much maligned Dodd-Frank financial reform law is doing some real good. Second, Republicans have been talking nonsense on the subject. (OK, maybe the second isn’t really news, but it’s important to understand just what kind of nonsense Republicans have been talking.)

GE Capital, the company’s finance unit, was a quintessential example of the rise of shadow banking. In most important respects it acted like a bank. It created systemic risks very much like a bank. But it was effectively unregulated, and had to be bailed out through ad hoc arrangements that understandably made many people furious about putting taxpayers on the hook for private irresponsibility.

Most economists believe that the rise of shadow banking had less to do with the advantages of such nonbank banks than it did with regulatory arbitrage – that is, institutions like GE Capital were all about exploiting the lack of adequate oversight. And the general view is that the 2008 financial crisis occurred largely because regulatory evasion had reached the point where an old-fashioned wave of bank runs (albeit wearing somewhat different clothes) was once again possible.

The Dodd-Frank Act tried to fix these bad incentives by subjecting “systemically important financial institutions” – or SIFIs – to greater oversight and higher capital and liquidity requirements. And sure enough, GE is, in effect, now saying: If we have to compete on a level playing field, and if we can’t play the moral hazard game, it’s not worth being in this business. That’s a clear demonstration that reform is working.

Now the official GOP line has been, more or less, that the crisis had nothing to do with runaway banks – that it was all about Barney Frank, the former chairman of the House Financial Services Committee, somehow forcing poor, innocent bankers to make loans to “Those People.” And the line on the right also asserts that the SIFI designation is actually an invitation to behave badly, that institutions so designated know that they are too big to fail and can start living high on the moral hazard hog.

But as the economist Mike Konczal noted recently on the Roosevelt Institute’s blog, GE – following in the footsteps of others, notably MetLife – is clearly desperate to get out from under the SIFI designation. It sure looks as if being named a SIFI is indeed what it’s supposed to be: a burden rather than a bonus.

A good day for the reformers.

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