By John Kemp
LONDON, July 29 (Reuters) - JPMorgan Chase & Co said on Friday it was pursuing “strategic alternatives” for its physical commodities businesses, including its assets and physical trading operations, following an internal review.
In one sense, the bank is simply confirming that it will comply with the law.
JPMorgan has reorganised its physical trading businesses as a “merchant banking” activity to get around restrictions on a bank engaging in non-banking operations. But in this form, the law allows these assets to be held only “for a period of time” for the purpose of “appreciation and ultimate resale or disposition”. (12 USC 1843(k)(4)(H))
The bank has confirmed it will “explore a full range of options over time including but not limited to: sale, spin-off or a strategic partnership”, which is pretty much what the Bank Holding Company Act requires it to say. It must convince regulators the physical trading assets and operations are only being held “on a reasonable basis” prior to resale or realisation of their value.
In practice, JPMorgan, like the other major commodity dealing banks, appears to be going further and re-evaluating its future as an owner and dealer in physical commodities rather than just a plain derivatives dealer, market-maker and provider of trade finance.
The disposal process for JPMorgan and the other major commodity banks is likely to be slow.
Even when it is complete, they are likely to remain deeply intertwined with physical markets as dealers, suppliers of inventory and trade finance and perhaps even through joint ventures and a more limited range of physical trading desks.
But the most visible and controversial aspects such as ownership of warehouses, pipelines, tankers and power contracts, may be scaled back to reflect changing attitudes.
Like Goldman Sachs and Morgan Stanley, which are also trying to exit some physical businesses, JPMorgan is responding to heightened scrutiny from banking regulators and politicians.
Following the financial crisis, the pendulum has swung from the hands-off approach that prevailed under the Greenspan Fed to a much more challenging regulatory environment.
Embedded bank examiners on site at all major banks are now being encouraged by policymakers to take a more sceptical and questioning approach to the riskiness and amount of capital banks set aside to cover activities such as physical trading and asset ownership.
The profitability of the physical trading operations at many of the commodity banks has always been something of a mirage.
Between 2002 and 2010, profits were flattered because the banks, like non-bank trading companies, were in a strong position as middlemen with access to commodities that were in short supply.
Banks built up substantial portfolios of financial derivatives and physical assets while holding remarkably little capital against the risks.
Neither condition still applies. The capital regime is becoming stricter, while the commodities super-cycle has peaked and prices appear to be turning down.
Physical commodity trading is capital-intensive and operates on thin margins. The banks simply do not operate on the scale needed to make money consistently and spread their overheads over enough transactions.
Compared with non-bank traders such as Vitol, Glencore , Gunvor and Mercuria, the banks’ physical operations have always been relatively small in most markets and are getting progressively smaller as regulations tighten.
Commodities are just not profitable enough to justify the reputational risks and political pressure that the major banks are now coming under.
Entering the physical commodity markets has forced the banks to deal with a much larger number of new regulatory authorities, often in areas where they have limited expertise.
After banks started operating in markets for the underlying commodities, they have been required to deal with a vastly greater number of rule-writers and enforcers ranging from the U.S. Federal Energy Regulatory Commission (FERC) and the Pipeline and Hazardous Materials Safety Administration (PHMSA) to state power authorities.
Globally, they have needed to retain many more lawyers and technical experts to ensure they comply with a host of different rules and laws that apply in different jurisdictions.
Market participants need to ensure staff comply with the rules and lobby for advantageous changes, as well as maintaining effective management and control at senior level. Only very large physical operating companies and traders have the time and money to deal with such a complex regulatory environment.
The banks were fairly large participants in physical commodity markets overall, but they were fairly small in individual physical markets, except for a few areas. The string of enforcement actions and fines been levied against the big commodity trading banks recently suggests they were struggling to supervise and control their activities properly.
Physical commodity operations are only really profitable if an institution is large enough to dominate a particular market and its regulatory environment. The only way for a company to guarantee it wins the game is to help write and shape the rules.
In most areas, banks lack the scale to do this effectively. It makes sense to pull back from some of the smaller and less profitable areas to concentrate on aspects of the business where the banks hold the upper hand.
Banks are unlikely to exit physical trading completely. There are important synergies between dealing in financial derivatives and being able to make and take physical delivery of the underlying raw materials, including owning some storage and logistics assets.
Trading physical commodities is often the only way to understand the supply and demand dynamics that help drive derivatives prices. But the scatter-gun approach, in which every bank tried to trade every physical market without achieving economies of scale, has passed its sell-by date.
The major problem may be finding buyers at a time when the commodity cycle has already turned and the market is crowded with sellers.
If assets are sold to the big non-bank trading houses or industrial companies, concerns will be expressed about market concentration.
If sales are to smaller or start-up non-bank traders, these operations typically lack the required capital to own assets and carry substantial inventories.
One possible outcome is that banks and non-bank traders launch a wave of joint ventures, similar to the arrangement between Citigroup and Phibro. But Citigroup’s joint venture had an unhappy ending and has been much criticised. It would not satisfy critics of the banks’ involvement in physical trading.
Sovereign wealth funds have the cash to own physical trading operations; but whether they would be comfortable with the risks including the reputational risks remains uncertain.