GE Capital tells a cautionary tale for shadow banks

General Electric's share price is still a fair way off the $42 highs that the group enjoyed in the 2007 run-up to the financial crisis. But the 9 per cent jump in the stock to $28 on Friday will have heartened shareholders somewhat.

Back in the boom years, you would have needed a compelling growth story to generate that kind of investor applause. Nowadays a compelling shrinkage plan does the job - one in this case that promises to reduce the earnings contribution from GE's finance arm, GE Capital, to less than 10 per cent of the group total. Back in those heady pre-crisis days, before leverage was a dirty word, the unit made nearly 60 per cent of group profits.

Of course the investor response to GE Capital's plan is not unique. As any bank will tell you, retrenchment these days is the new black. The relative valuation the market attaches to earnings generated by an industrial company far exceeds those from a financial company, so boosting the relative weight of industrial earnings will be rewarded. After Friday's stock price pick-up, GE was trading on about 18 times current earnings, compared with 11 times for a big bank like JPMorgan or Goldman Sachs.

But it is an oddly abrupt change of direction for GE nonetheless. After years of gently steering away from some areas of financial services, GE's chief executive Jeffrey Immelt has pulled a handbrake turn.

It wasn't meant to be like this. Many non-banks - from insurers and asset managers to industrial conglomerates - have been rubbing their hands in recent years, relishing the opportunity to steal business from more tightly regulated banks. This "shadow banking" market has been growing fast, just as banks themselves have been getting smaller.

True enough, GE Capital was always likely to be a special case. The unit sent shivers through the broader group back in the crisis. Its reliance on wholesale market funding that threatened to dry up spooked shareholders and rating agencies alike.

In 2009, GE lost the triple-A credit rating it had prized for more than 40 years. To shore up the business, the group was forced to cut its dividend payout for the first time since 1938.

But after trimming its overall ambitions in the wake of the financial crisis, GE Capital still pursued plans for selective growth. In Europe, it even went on the acquisition trail, picking up units from banks that were retrenching, such as the French and German factoring operations of Royal Bank of Scotland, and Credit Agricole's invoice discounting business.

Profits recovered, too. In recent years GE Capital has been generating more than $7bn of pre-tax profit (compared with less than $1.5bn in 2009). Last year's profit at the unit was equivalent to 42 per cent of the group total.

But the blunt truth is that GE Capital is so big - with a $500bn balance sheet and a stubborn reliance on unfashionable capital market funding - that like the banks it competes with, it too has fallen foul of tough post-crisis regulation.

As the only non-financial group to be designated a "systemically important financial institution", GE's capital requirements undermined its profit recovery. Its prospective return on equity of 6 or 7 per cent, based on $80bn of group capital invested in it, is just not impressive.

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The slimmed-down GE Capital, with a target balance sheet of less than $100bn focused on servicing the financing needs of industrial customers, will make GE as a whole look more like its smaller German rival, Siemens. If Mr Immelt is lucky, the financial unit may even end up with a return on equity on a par with the 20 per cent that Siemens Financial Services currently boasts.

But there is a broader message in all this for the "non-bank" financial sector - particularly over the issue of what constitutes a systemically important institution that attracts potentially suffocating regulation. Challenge the banks and steal their lunch, by all means, but get too big and too banklike and it may all end in tears.

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