RPT-COLUMN-Reasons to be wary about banks' commodity trading: Kemp

Tue Oct 22, 2013 3:35am EDT

By John Kemp

LONDON Oct 21 (Reuters) - "Bank holding companies ought to confine their activities to the management and control of banks," the Senate Banking Committee wrote in 1955, reporting favourably on legislation that eventually became the 1956 Bank Holding Company Act.

"Bank holding companies ought not to manage or control nonbanking assets having no close relationship to banking," the committee went on.

Bank holding companies were required to divest shares in nonbanking enterprises and forbidden to acquire new ones, with a few carefully limited exceptions.

"The bill's requirement for divestment of nonbanking assets will help to keep bank ventures in a field of their own," the committee concluded (S Report 1095, 84th Congress, 1st Session).

"Exemptions from its provisions have been kept to a minimum. Under its terms, the operations of bank holding companies will not be prohibited, but they will be confined to banking activities and regulated in the public interest."

PROHIBITIONS AND EXEMPTIONS

The 1956 Bank Holding Company Act is still in force, though its provisions were considerably weakened by the movement towards financial deregulation during the 1990s.

Exemptions to the prohibition on mixing banking and nonbanking activities were widened considerably, allowing banks to engage in a much broader range of activities than before.

Some of the largest banks in the United States, including Goldman Sachs, Morgan Stanley, JPMorgan, and Bank of America, now have physical commodity trading arms or have sought permission to establish them, under various exemptions established by amendments to the law.

Most of these physical trading activities have been approved under exemptions allowing activities which are "closely related", "incidental" or "complementary" to banking. Goldman and Morgan Stanley also benefit from a grandfather clause that appears to exempt commodity trading activities they engaged in before 1997.

But after the financial crisis, the deregulatory zeitgeist of the 1990s and 2000s has been replaced by a more cautious approach. The Federal Reserve, as the banks' regulator, and members of Congress, have started to question whether banks should be allowed to engage in physical commodity trading and other nonbanking activities.

Multiple amendments have left the Bank Holding Company Act in a mess; it is far from clear the Fed could push the banks out of physical trading, even if it wanted to do so.

But it is worth asking why, as a matter of principle, policymakers should be wary about allowing banks to extend their activities into owning, warehousing, transporting, transforming and dealing in physical commodities, as opposed to financial derivatives like futures, options and swaps.

EFFICIENCY, LIQUIDITY, COMPETITION

Craig Pirrong at the University of Houston has defended the role of banks in physical commodity markets on efficiency and liquidity grounds.

"I am generally in favour of free entry, and policies that ensure (at least roughly) that costs and benefits are internalised," Pirrong wrote recently on his Streetwise Professor blog. "Banning banks from the business altogether is likely inefficient, and reduces competition. Better to choose capital requirements that price the risk."

"The decision should not be a binary one: banks in, or banks out. Instead, the preferable approach would be to levy capital charges on bank commodity operations that reflected the risks of these operations." Pirrong wrote.

But as Pirrong explains, the devil is in the details. How high should the capital charges be set? "The question is whether the surcharge will be set in a way that accurately reflects the relevant risks, or whether instead it will be set at punitive levels," Pirrong wondered.

The proposal to regulate banks' activities in commodities through capital surcharges "is fine in principle, but could be a disaster in practice," he concluded. "If the Fed really wants to drive banks out of commodity markets, I would much prefer it do so forthrightly, rather than by hiding behind capital surcharges that it chooses to achieve that outcome."

REASONS TO MAINTAIN A BRIGHT LINE

However, there are at least four reasons why regulators and legislators should consider restricting banks' operations in physical commodity markets, or even banning them outright.

First, banks benefit from an artificially cheap cost of capital as a result of the too big to fail problem and their implicit guarantee from the central bank and taxpayers.

Permitting the banks to leverage this advantage into nonbanking areas distorts competition in other markets and leads to an inefficient allocation of resources.

Second, permitting banks to engage in nonbanking activities exposes them to a host of nonbanking risks they may be ill-equipped to manage and, via the too big to fail problem, threatens to pass these risks back to the central bank and taxpayers.

The Deepwater Horizon well blowout nearly proved fatal for BP as investors panicked about the possible scale of damages claims, fines under the Oil Pollution Act and Clean Water Act, and backlash from regulators, politicians and the public.

If the spill had occurred from an oil well, tanker or pipeline owned by a major bank, the ensuing panic might well have triggered a crisis of confidence and a run.

Unlike BP, which had substantial shareholder equity and enormous cashflows from non-financial activities, banks are thinly capitalised and their cashflows depend almost entirely on financial activities.

Banks are uniquely susceptible to a crisis of confidence. Unlike BP, a bank facing a major disaster would probably need to seek protection from the Fed to reassure its counterparties and customers and ensure it could continue operating.

Third, managing nonbanking risks is likely to distract senior management from focusing on the risks in the bank's core banking business.

The recent spate of massive fines and settlements imposed on the banks and the entire sector's near-death experience in 2008-2009 suggest senior managers need to concentrate on managing their core businesses more effectively, not diversify into new areas with unfamiliar risks.

Finally, presuming policymakers want to maintain at least some distinction between banking and industrial businesses, if banks are allowed to engage in physical commodity trading because it is closely related, incidental or complementary to banking, where should the line be drawn?

If banks are permitted to own metals warehouses, why not allow them to own a copper wire fabrication business or go into the business of making aluminium window frames? If they can deal in physical propane and home heating oil, why not allow them to enter the retail distribution business?

And if banks are allowed to enter the physical trading business, why not allow traders like Vitol, Glencore and Cargill to set up their own banking operations?

LESSONS FROM TRANSAMERICA

None of these issues is new. The original 1956 Bank Holding Company Act was passed by Congress in response to concerns about monopolisation in interstate banking, especially by Transamerica Corporation, which had amassed an enormous banking empire, and eventually split off 329 banking offices in 11 western states.

Concerns about commingling banking and nonbanking business were incidental. Legislators were more worried banks would use their control of credit to force customers to buy nonbanking products as well. But Transamerica highlighted the risks of permitting one company to own banking and nonbanking businesses.

When Transamerica split itself in two its "nonbanking interests included five insurance companies, two real estate and property development subsidiaries, a metal fabricating company, (and) a seafood packer," according to a contemporary journal article ("Board of Governors versus Transamerica: Victory out of Defeat" 1959).

Transamerica shows what can happen when banks are allowed to leverage their position into other business lines.

There are sound policy reasons for maintaining a bright line between banking and nonbanking businesses. If an absolute prohibition is impossible, banks should be required to establish a separately capitalised subsidiary with a firewall, no credit subsidies, and freedom to fail, entirely outside the banking system.

But that would be a sub-optimal solution. Better to tell the banks to stick to banking.

Banking really is different. Banks have unique advantages afforded to no other business. But in return they must expect to be regulated differently, and that includes restrictions on undertaking non-banking activities within the same corporate organisation.

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