Banks seek change in hard-asset rule Some criticize proposal, saying it will limit disclosure
By Thom Calandra, CBS.MarketWatch.com Last Update: 12:11 PM ET March 12, 2003
SAN FRANCISCO (CBS.MW) - It may be much ado about nothing, but a proposed change to the way commercial banks handle commodities has some hard-asset investors riled up.
The Federal Reserve, at the request of two giant banks, is considering a rule change that would let bank-holding companies take title of nearly all commodities, like barrels of oil, briefly. The request by Citigroup (C: news, chart, profile) and UBS AG of Switzerland (UBS: news, chart, profile) essentially would let banks deal in a wider range of hard assets when they are buying, selling or designing derivatives based on those assets.
Right now, banks on American soil use derivative contracts when they are buying, selling or structuring a loan, swap or other transaction that involves commodities. As U.S. Federal Reserve rules now stand, banks can take title of only precious metals when they are in the world of hard assets.
Commercial U.S. banks are said to hold more than $50 trillion of highly leveraged derivatives on their balance sheets, and even more on behalf of clients. The growing amount of such contracts, which take the shape of forward sales, futures, options and dozens of other paper-linked transactions, led insurance executive Warren Buffett of Berkshire Hathaway (BRKA: news, chart, profile) to declare derivatives "financial weapons of mass destruction."
At the heart of the proposed rule change is the ability of banks to take title to hard goods on an "instantaneous pass-through basis." Critics contend that would limit or eliminate disclosure of derivative trades, say in the haywire energy markets. Such trades, involving billions of dollars of leveraged paper contracts, could ring alarm bells with investors if they became widely known, say some.
"It's just another rule change in a pattern of changes already well established, namely, to bend over backwards to give the banks everything they want regarding derivatives, including no disclosure," said James Turk, a former commodities financier and director of payment transaction company GoldMoney.com. "Basically my reading is that this change to the regulations is consistent with Fed policy to give banks what they want."
The new rule, if it becomes effective later this spring, appears to allow banks to increase their business in the volatile energy markets, where many transactions are actually settled physically by two parties exchanging payment for goods such as crude oil, heating oil or other petroleum-based products.
The Federal Reserve, in comments to the request for a change to so-called Regulation Y, said, "These requests arise in large part because, in certain over-the-counter forward markets (U.S. energy markets, for example), the physically settled derivative contracts traded by market participants do not specifically provide for assignment, termination or offset prior to delivery."
Traders in these markets, said the Federal Reserve in its comments, "generally settle the derivative contracts by temporarily taking and making delivery of title to the underlying commodities." Banks, on the other hand, "generally enter into back-to-back derivative contracts with third parties that effectively offset each other." See: Regulation Y rule change.
Banks, in other words, want the same flexibility that non-bank traders have in energy and other physical-delivery markets.
Offsetting contracts that are used now by banks ensure, theoretically, that on the maturity date of a derivative contract, the producer will deliver the goods and the buyer will accept them. That reduces the banks' risk of actually holding heating oil, or soybeans, or pork bellies.
"Citigroup and UBS contend that a bank-holding company that takes title to a commodity on an instantaneous, pass-through basis takes no risk that is greater than or different in kind from the risk that it has as a holder of a commodity derivative contract that meets the current requirements of Regulation Y," the Fed said in its comments.
James Tu, director of investment research at commodities specialist Gerstein & Fisher in New York, said on the face of the rule-change request, one could interpret regulators are concerned about mounting risk for commercial banks.
According to the U.S. Office of the Comptroller of the Currency, which tracks derivative exposure, U.S. commercial banks held $53.2 trillion of derivatives at the end of the third quarter 2002, up $3.1 trillion from the second quarter. Among individual banks at the end of 2002's third quarter, J.P. Morgan Chase (JPM: news, chart, profile) had the highest derivative exposure, followed by Citibank and Bank of America (BAC: news, chart, profile).
"If their proposal is passed, that might permit banks legally to engage in shorting these commodities without limit," said Tu, who acknowledged he was speculating about the possibilities and had no direct knowledge of possible outcomes of the proposed rule change. "I guess we keep underestimating Fed's ability and willingness to stretch itself in order to save the butt of the big banks."