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


By John Kemp

LONDON, Oct 21 (Reuters) - "Bank holding companies ought toconfine their activities to the management and control ofbanks," the Senate Banking Committee wrote in 1955, reportingfavourably on legislation that eventually became the 1956 BankHolding Company Act.

"Bank holding companies ought not to manage or controlnonbanking assets having no close relationship to banking," thecommittee went on.

Bank holding companies were required to divest shares innonbanking enterprises and forbidden to acquire new ones, with afew carefully limited exceptions.

"The bill's requirement for divestment of nonbanking assetswill help to keep bank ventures in a field of their own," thecommittee 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 willnot be prohibited, but they will be confined to bankingactivities and regulated in the public interest."


The 1956 Bank Holding Company Act is still in force, thoughits provisions were considerably weakened by the movementtowards financial deregulation during the 1990s.

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

Some of the largest banks in the United States, includingGoldman Sachs, Morgan Stanley, JPMorgan,and Bank of America, now have physical commodity tradingarms or have sought permission to establish them, under variousexemptions established by amendments to the law.

Most of these physical trading activities have been approvedunder exemptions allowing activities which are "closelyrelated", "incidental" or "complementary" to banking. Goldmanand Morgan Stanley also benefit from a grandfather clause thatappears to exempt commodity trading activities they engaged inbefore 1997.

But after the financial crisis, the deregulatory zeitgeistof the 1990s and 2000s has been replaced by a more cautiousapproach. The Federal Reserve, as the banks' regulator, andmembers of Congress, have started to question whether banksshould be allowed to engage in physical commodity trading andother nonbanking activities.

Multiple amendments have left the Bank Holding Company Actin a mess; it is far from clear the Fed could push the banks outof 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 theiractivities into owning, warehousing, transporting, transformingand dealing in physical commodities, as opposed to financialderivatives like futures, options and swaps.


Craig Pirrong at the University of Houston has defended therole of banks in physical commodity markets on efficiency andliquidity grounds.

"I am generally in favour of free entry, and policies thatensure (at least roughly) that costs and benefits areinternalised," Pirrong wrote recently on his StreetwiseProfessor blog. "Banning banks from the business altogether islikely inefficient, and reduces competition. Better to choosecapital requirements that price the risk."

"The decision should not be a binary one: banks in, or banksout. Instead, the preferable approach would be to levy capitalcharges on bank commodity operations that reflected the risks ofthese operations." Pirrong wrote.

But as Pirrong explains, the devil is in the details. Howhigh should the capital charges be set? "The question is whetherthe surcharge will be set in a way that accurately reflects therelevant risks, or whether instead it will be set at punitivelevels," Pirrong wondered.

The proposal to regulate banks' activities in commoditiesthrough capital surcharges "is fine in principle, but could be adisaster in practice," he concluded. "If the Fed really wants todrive banks out of commodity markets, I would much prefer it doso forthrightly, rather than by hiding behind capital surchargesthat it chooses to achieve that outcome."


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

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

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

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

The Deepwater Horizon well blowout nearly proved fatal forBP as investors panicked about the possible scale ofdamages claims, fines under the Oil Pollution Act and CleanWater Act, and backlash from regulators, politicians and thepublic.

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

Unlike BP, which had substantial shareholder equity andenormous cashflows from non-financial activities, banks arethinly capitalised and their cashflows depend almost entirely onfinancial activities.

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

Third, managing nonbanking risks is likely to distractsenior management from focusing on the risks in the bank's corebanking business.

The recent spate of massive fines and settlements imposed onthe banks and the entire sector's near-death experience in2008-2009 suggest senior managers need to concentrate onmanaging their core businesses more effectively, not diversifyinto new areas with unfamiliar risks.

Finally, presuming policymakers want to maintain at leastsome distinction between banking and industrial businesses, ifbanks are allowed to engage in physical commodity tradingbecause it is closely related, incidental or complementary tobanking, where should the line be drawn?

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

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


None of these issues is new. The original 1956 Bank HoldingCompany Act was passed by Congress in response to concerns aboutmonopolisation in interstate banking, especially by TransamericaCorporation, which had amassed an enormous banking empire, andeventually split off 329 banking offices in 11 western states.

Concerns about commingling banking and nonbanking businesswere incidental. Legislators were more worried banks would usetheir control of credit to force customers to buy nonbankingproducts as well. But Transamerica highlighted the risks ofpermitting one company to own banking and nonbanking businesses.

When Transamerica split itself in two its "nonbankinginterests included five insurance companies, two real estate andproperty development subsidiaries, a metal fabricating company,(and) a seafood packer," according to a contemporary journalarticle ("Board of Governors versus Transamerica: Victory out ofDefeat" 1959).

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

There are sound policy reasons for maintaining a bright linebetween banking and nonbanking businesses. If an absoluteprohibition is impossible, banks should be required to establisha separately capitalised subsidiary with a firewall, no creditsubsidies, and freedom to fail, entirely outside the bankingsystem.

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

Banking really is different. Banks have unique advantagesafforded to no other business. But in return they must expect tobe regulated differently, and that includes restrictions onundertaking non-banking activities within the same corporateorganisation.

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