By John Kemp
LONDON Oct 21 "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
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of the 1990s and 2000s has been replaced by a more cautious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
"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
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
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
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
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
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
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