(John Kemp is a Reuters market analyst. The views expressed are
By John Kemp
LONDON, Sept 20 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
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.
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
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.
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
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
"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.
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
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
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
(Editing by Keiron Henderson)