Last bastion of capitalism falling?
In the wake of the financial crisis, opponents of the banking industry are always eager to find new sticks with which to beat the villains of Wall Street. The latest one they have stumbled upon is banks’ participation in physical commodities.
On July 19, the US Federal Reserve Board issued a statement saying it was reviewing a 2003 determination that paved the way for banks to increase their involvement in the transport and storage of physical commodities. Separately, Goldman Sachs and Morgan Stanley have both made disclosures that suggest the Fed is reviewing the additional latitude the two banks have to engage in physical activities – a legacy of their pre-2008 status as investment banks.
These developments have come amid a torrent of criticism from commentators, politicians and regulators. At a one-sided US Senate hearing on July 23, banks’ physical commodity trading was linked to an array of negative consequences, including inflated commodity prices, rising systemic risk and even a potential shortage of beer cans. The most disgraceful performance came from senator Elizabeth Warren, who fretted about the country’s largest financial firms “adopting a business model that was pioneered by Enron”, as if banks are somehow guilty by association with the bankrupt Houston-based energy giant. Warren, a former professor at Harvard Law School, should know better.
What is this big fuss about banks being involved in physical commodities?
1. Being active in both physical and financial commodities increases the information banks have at their disposal and encourages pricing in the two markets to converge, assisting price discovery.
2. It enhances banks’ ability to extend financing to physical commodity producers and can help them structure a range of useful risk management tools for firms such as airlines, refiners and power generators – companies that might otherwise be left at the mercy of volatile commodity prices.
3. Banks participation in physical commodities ultimately benefits clients – including firms such as refiners, utilities, airlines and mining companies – that rely on them to help manage the risk associated with volatile commodity prices.
4. It is a fact that a lot of information in the commodity markets is not available purely in prices. Hence, it’s very important to receive, on a regular and timely basis, information about the conditions of the physical infrastructure, inventory levels, the backlog of orders, and all the other information that you can’t get just by watching prices on the screen. Not being able to trade physical commodities could threaten the ability of banks to enter into a range of transactions, including physical supply-and-off take agreements, in which banks typically supply crude oil to a refinery and agree to purchase its output. Effectively, such deals are a way of extending working capital to refiners, as well as providing a hedge. They mean refiners do not need to hold oil and product inventories on their balance sheets, while eliminating the need for them to take out a line of credit to purchase crude oil feedstock.
5. Most importantly, banks pullback from physical commodities would also hamper their ability to provide long-term hedges for new power plants, along with the financing needed to pay for their construction. Those two things are deeply intertwined, because nobody would pay the cost of building a new power plant unless its revenues can be guaranteed for a period of five or more years. Those revenue hedges are critical to the development of those projects. In order to provide these long-term hedges, the ability to trade physical power is a requirement as it’s an inherently physical part of the business that has been a tremendous benefit to the North American economy.
Concerns about bank proprietary trading and market manipulation are frankly completely unfounded.
It is a fact that banks have done a poor job at defending their activities. Their secretive approach to commodities makes it difficult for them to discuss the benefits of their work and inflames the paranoid fantasies of their harshest critics. It is high time though to turn up the volume.
Clearly, banks engage in supply-and-off take deals with refiners and tolling agreements with power plants to make profits, but that isn’t necessarily cause for alarm. The banks want to manage relationships with their clients across many different product lines. They want to provide services across different markets and different locations, and of course, they do it for their own benefit. Do they combine participation in the supply chain, in funding and hedging, with speculation? Of course they do. They will not admit it directly, but they do, and this is not necessarily a bad thing. The market needs liquidity. Somebody has to step in and manage risks.
There are clearly legitimate reasons for regulators to be concerned about banks straddling the line between physical and financial markets. Regulators probably fear that big financial institutions participating in both the financial derivatives markets and the physical markets can push some critical price benchmarks on the physical side to take advantage of big, highly leveraged positions in derivatives. If you look at recent manipulation cases, this doesn’t mean the solution is to expel banks from the physical markets. To me, the solution would not be to create barriers to entry for some market participants. My response would be more aggressive market oversight and enforcement of anti-manipulation rules.
Even if the Fed has second thoughts about its 10-year-old decision to allow FHCs to trade physical commodities, it will find it difficult to put the genie back in the bottle.
Experience with physical commodities trading activities since 2003 suggests that the Federal Reserve’s original rationale for finding that the activities are permissible for FHCs is correct – physical commodities trading is complementary to financial activities, and it does not pose a substantial risk to depository institutions or the financial system generally. The Federal Reserve would therefore be required to overcome substantial evidence in order to demonstrate that its original conclusions… were mistaken..
Bottom Line: Banks fear that regulators and politicians, in their zeal to stop speculative trading and manipulation, will inadvertently stop the useful work financial institutions can perform for clients by trading physical commodities. Let’s not though forget: Not all physical transactions are the same – some are proprietary in nature, and some come as a result of the normal bank-client relationship. Not sure Regulators should throw the baby out with the bath water…. Doesn’t make any sense.
As Winston Churchill used to say: “The inherent vice of capitalism is the unequal sharing of blessings; the inherent vice of socialism is the equal sharing of miseries.”
Last bastion of capitalism falling? Go figure…
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