COLUMN-Industry report on banks and commodities fails to convince: Kemp

Fri Sep 20, 2013 12:20pm EDT

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(John Kemp is a Reuters market analyst. The views expressed are his own)

By John Kemp

LONDON, Sept 20 (Reuters) - If the Securities Industry and Financial Markets Association (SIFMA) hoped to convince U.S. policymakers banks should be allowed to carry on trading physical commodities by commissioning a report from independent consultants then it is set to be disappointed.

"The role of banks in physical commodities," a 70-page report funded by the trade group for major banks and financial firms in the United States, published on Thursday, provides a thorough overview of the multiple roles banks play in contemporary commodity markets.

But it fails to provide a convincing explanation for why banks should be allowed to continue making and taking delivery of physical commodities, owning pipelines, warehouses and storage facilities, even oil refineries, when they are prohibited from engaging in other non-banking commercial activities by law.

The report is flawed because it fails to distinguish between the banks' traditional role as suppliers of capital and credit in the commodity markets (which is a core banking function) and their more recent and growing role as traders and intermediaries (which can be and has been filled by other traders, dealers and brokers).

Throughout, it is never made clear why banks, with their Fed-subsidised low cost of capital, should be allowed to leverage that advantage to compete in adjacent markets for non-banking services, distorting competition and exposing taxpayers to increased risk in the process.

MULTIPLE FUNCTIONS

From the start, the report conflates banking and commercial functions when it talks about the roles banks perform, combining them in the same breath, as if there were no difference.

"Banks play an essential, if poorly understood, role in assuring the smooth functioning of the commodity markets," according to the authors. "They do so by providing capital, enabling companies of all kinds to manage risk, and by bringing disparate buyers and sellers together."

Supplying capital is one of the defining functions of a bank. But providing advice on risk management, brokering deals between buyers and sellers, and making markets as a principal, are all functions that can be performed by non-banks.

Traders such as Vitol, Glencore, Trafigura, Mercuria, Gunvor, Cargill and Koch, energy firms like BP, as well as much smaller brokers, all provide many of these services. Non-bank trading firms and energy companies provide these services without the artificially low cost of capital that comes from taxpayer backing.

Crucially, in the event a major deal goes wrong or there is a serious industrial accident like a refinery explosion or an oil spill, a trading company or an energy firm can be allowed to go bankrupt. Even after the financial crisis, major banks remain too big to fail. It is this asymmetry which should make policymakers sceptical when banks seek to leverage their role into other businesses.

NATURAL EXTENSION?

According to the report:"(Banks) directly provide capital, and assist in the raising of capital, for our commodities and resource producers, converters and manufacturers and end users."

It goes on: "As a natural extension, banks help these same companies manage their commodity price risks through hedging, and other related risk-management services, to enable planning, financing and sustaining the large capital projects required in these industries over a full business cycle."

But are these really "natural extensions"? Or are the banks using their muscle in the provision of credit to dominate adjacent fields?

The 1956 Bank Holding Company Act specifically states "no bank holding company shall ... engage in any activities other than those of banking" (12 USC 1843(a)). It was deliberately written to prevent banking and commercial business being conducted by the same firm.

There are limited exceptions for activities that are properly "incidental" to banking (1843(c)(8)) or which are "complementary to financial activity" (1843(k)(1)).

But if the Bank Holding Company Act's prohibition on mixing banking and non-banking business is to mean anything, a line must be drawn somewhere.

Banks provide large amounts of capital to many other enterprises, including utilities, supermarkets and car makers; that does not mean they should be allowed into the grocery business or the provision of retail electricity and gas, let alone stock auto parts.

Unfortunately, the report does not offer any logical explanation for why banks should be allowed to own oil refineries but not department stores, other than the fact these are "natural extensions", completing the circularity in the argument.

ALTERNATIVE PROVIDERS

"If banks were not participating in physical commodity markets ... It is not at all clear who could replace them or to what extent," the report observes.

But that's not entirely true. Trading houses have already stepped into the void created as the banks have scaled back their involvement in commodity markets.

Until relatively recently, most risk management, brokerage, market-making and storage services were performed by specialist brokers and dealers. Banks were restricted to providing capital and inventory financing.

In the last 15 years, many of those brokers and dealers have been swallowed up by the banks themselves in the quest to create a full-service offering.

If banks were forced to withdraw from physical trading, or required to scale back, existing trading houses and energy firms would probably expand to fill the gap, and specialist brokerages and dealers might flourish again.

Nearly all the arguments that the report makes for allowing banks to participate in physical commodity markets in fact apply to all middlemen, not just banks.

Banks cite economies of scale in the provision of large credit facilities and hedging programmes. But perhaps it would be better to have a large number of smaller firms, which could be allowed to fail, rather than concentrate all the risk in a few large ones that must be bailed out.

The report laments the potential loss of liquidity if the banks were forced to withdraw or scale back. But other institutions could enter the market to fill the gap.

And if liquidity is being provided at an artificially low cost because of taxpayer subsidies, it may be better to separate the assessment and provision of credit from the provision of hedging and dealing services.

EFFECTIVE SUPERVISION

The report hints that pushing physical trading out from the banks to non-bank firms would have the perverse effect of weakening oversight of commodity markets. Of the firms who might replace the banks, the report states "some would be more opaque, less-transparent entities, based outside the United States."

"Others could be large competitors to the small and medium sized companies being served by the banks. Moreover all would be much less regulated than banks, which are among the most highly-regulated entities in the United States," it adds.

"Banks operate under a different, more complex and, in many ways, more rigorous regulatory framework than commercial companies."

The report makes much of the fact that banks are regulated as banks by the Federal Reserve and as publicly listed companies by the Securities and Exchange Commission (SEC), in addition to being supervised by commodity market regulators such as the U.S. Commodity Futures Trading Commission (CFTC) and Federal Energy Regulatory Commission (FERC).

But in their commodity operations, trading houses, energy firms and other dealers are subject to precisely the same oversight by the CFTC and FERC. And the Fed and the SEC regulate the financial operations of the banks. They have no experience in the commodity business.

In the week when JPMorgan Chase and Co has been hit by record fines for failures linked to "London Whale," and with Congress probing the banks' involvement in aluminium warehousing, policymakers may question just how effective Fed/SEC oversight is in reality. It could be argued managing sprawling commodity businesses distracts both senior bank management and regulators from focusing on core banking risks.

In practice, pushing banks out of physical commodities will be hard for U.S. regulators, even if they want to do it. The Bank Holding Company Act is a mass of contradictory prohibitions, exceptions and exemptions which do not provide clear guidance on where to draw the line between banking and commercial activities.

But if "The role of banks in physical commodities" was supposed to make the economic and political case for allowing the banks to retain all their current commingled roles, it has failed. It makes a good case why physical commodity markets need intermediaries, but not why those intermediaries should be banks. (Editing by Keiron Henderson)

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