Banks trading in Commodities: Regulation, regulation and regulation is the key:-
By Rakesh NeelakandanYou have been a deposit-taking bank for a long time. You have been involved in banking operations like facilitating savings, lending against collateral, charging customers for vaulting and storage and a bunch of other activities.
But eventually, you see that a booming economy has created so much of wealth that you have surplus money, and you see that you have got many businesses to invest including commodity businesses. You also see a number of derivative trades wherein you can profit from, including commodity trades.
Now, the regulators will not allow it and you do some campaigning; high-end. Finally, you have your way as the market realities are favourable. So far so good!
But you invariably had another agenda. You can now trade in commodities. You also control a part of commodity supply-chain, for instance an oil tanker business. Given that the commodity futures are susceptible to supply-demand influences, you can, you being the proprietor of your oil tanker business, ask the tankers to skip or delay a few trips.
It may not have a significant impact on the markets in a quantitative sense. But it can have a psychological impact on markets; investors for once believe that the supplies are susceptible to disruption. The crude oil futures would soar to extreme heights. And in no time, you have raked in some money; of course, a week before instructing the delays, you had gone long on crude oil!
This is just one of the possible ways by which you can make money. Now, what if you own a set of mines, a port, a group of pipelines. And yes, you still continue to take deposit money from people! You would say, sky is the limit!
Now, on an alternative note, what if your tanker business goes bust, an oil spill occurs, or some or the other calamity takes shape disrupting your whole business. You are suddenly in need of funds and you decide to dip your hands in the honey pot! You take some of the money out from depositors account. In no time the rumour spreads that you are as good as broke. A bank run follows...similar bank holding companies also come under scanner...they too lose the trust...
So much for the fiction! But the fact that some of this fiction could be very close to plausible reality is what that is giving regulators sleep less nights.
A decade back, the US Federal Reserve had given authorisation to some of the Bank Holding Companies like JP Morgan, Morgan Stanley and Goldman Sachs to indulge in commodity trades. The Federal Reserve also possibly let them take hold of supply-chain in commodities as well, although it is not on record.
Now, The US Federal Reserve is reviewing the 10 year old rule of allowing a deposit-taking bank trade in physical commodities.
Mum on profits
The ten of the largest banks in Wall Street raked in revenues to the tune of $6 billion from commodities last year.
This was inclusive of deals in physical materials, as well as from trading in financial products related to them. Goldman Sachs held $7.7 bn worth commodities at fair value as of March 31 even as Morgan Stanley held $6.7 billion in the same way.
The firms are mum on profits from trades.
“Each day, a fleet of trucks shuffles 1,500-pound bars of the metal among the warehouses. Two or three times a day, sometimes more, the drivers make the same circuits. They load in one warehouse. They unload in another. And then they do it again.
This industrial dance has been choreographed by Goldman to exploit pricing regulations set up by an overseas commodities exchange, an investigation by The New York Times has found. The back-and-forth lengthens the storage time. And that adds many millions a year to the coffers of Goldman, which owns the warehouses and charges rent to store the metal. It also increases prices paid by manufacturers and consumers across the country.”
The article argues that by controlling the entire value-chain--warehouses, pipelines and ports--the banks gain invaluable market intelligence, according to analysts. This may provide them an edge when trading commodities.
In June four Democratic members of US Congress, in a letter queried Ben Bernanke, the US Federal Reserve Chairman, how the regulators would account for bank runs in the event of a tanker owned by a bank spill oil. We have already seen a plausible scenario in this regard playing out.
“When Wall Street banks control the supply of both commodities and financial products, there’s a potential for anti-competitive behavior and manipulation,” Sherrod Brown, an Ohio Democrat was cited by Bloomberg as saying.
The Fed gave JP Morgan approval in 2005 to get involved in commodity markets. However the bank was prohibited from expanding into warehouse and storage businesses. But, as per a
Bloomberg report, the bank entered into the business of storage in five years time. The review is thus double surprising given that the Fed, back then did not give any approvals in this regard.
Lax regulation
If one looks at the American history, one can see a tradition of lax regulations which has given financial institutions a great deal of overconfidence. Besides, being the too big to fail, the very overconfidence lend them enough of audacity to indulge in questionable practices.
“They are like naughty kids. If they feel that their menaces are not being punished, they continue to indulge in menacing behaviour. These guys know that they can get away, come what may,” a seasoned financial analyst told us.
The Fed's silent approval of JP Morgan's activities in storage businesses can be seen in this light.
Congressional testimony
Meanwhile, Committee On Banking, Housing, And Urban Affairs Subcommittee On Financial Institutions And Consumer Protection met in open session on Tuesday to conduct a hearing entitled “Examining Financial Holding Companies: Should Banks Control Power Plants, Warehouses, and Oil Refineries?”
Experts provided their views.
“To expect the regulators to understand the web of relationships that exist here is not rational,” said Joshua Rosner, a bank analyst at New York-based Graham Fisher & Co. to Bloomberg.
But, how did the Federal Reserve end up giving approval on a subject they may not have expertise to deal with? That is puzzling.
The testimony also saw views coming in that risks in bank's commodities businesses can be mitigated if curbs on volumes and type of commodities to be traded are introduced, Randall Guynn, head of the financial institutions group at law firm Davis Polk & Wardwell LLP, said.
Yes, there could be a diversity of views in this regard.
Critics “don’t provide a shred of evidence to support the view that these potential dangers are likely to be realized,” Guynn said at the hearing and was
cited by Bloomberg as saying. “The connection between banking and commodities is not a new development.”
He said there are good thing associated with allowing banks to carry on with their commodity business. It can help “the prices in the derivatives markets and the pricing in the physical markets to converge, which is actually a good thing.”
If banks are able to wield enormous powers and are able to play the markets in an erroneously regulated environment, then chances galore that the next financial mishap would be just around the corner. On the other hand, if there is nothing wrong in what they have done or what they are about to do, it should be up to the regulator to seek an upgrade of regulatory mandate and update on its competency.
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