Banks look to turn out the lights on commodities

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US regulators are dedicating increasing levels of scrutiny to the physical commodities interests of investment banks just as a law allowing Wall Street banks to maintain a presence in the product area comes up for review.

A number of investment banks have been hauled in front of regulators for their commodities trading businesses, and the US Senate held a hearing earlier this month at which it debated whether banks should be allowed to own, finance and hold stakes in physical assets such as power stations and oil refineries.

This followed an announcement from the US Federal Reserve on July 19 that it was reviewing a 2003 decision that defined physical commodities as ‘complementary’ to banking, allowing Wall Street firms to store, transport and trade raw materials.

Banks’ commodities activities span the derivatives business, where they trade contracts, which regulators are less concerned about, and the physical ownership and trading of assets, which regulators are looking to clamp down on.

Regulators and some politicians argue that ownership of these assets is an encroachment on the economy that has little to do with banking, and when taken in tandem with their commodities trading activities, encourages banks to manipulate prices and supply to the detriment of consumers.

Regulators are also concerned that following the global financial crisis, banks’ ownership of physical assets poses a systemic threat to the economy in the event of a collapse by a “too big to fail” financial institution. There is also political motivation after some recent fears regarding price manipulation.

Against this backdrop, Wall Street banks are already making tough decisions about what to do with their commodities businesses. Critics of banks say the Fed’s review is an overdue move to separate banking from commerce, but there is also support in some quarters.

Craig Pirrong, a professor at the University of Houston and an expert in commodity markets, says: “Financing commodities, moving resources through time by storage and allocating risk are activities fundamental to the banking industry.”

Banks have invited criticism through a lack of transparency over how much they earn from commodities – revenues from the activity are reported within the broad group fixed income, currencies and commodities (FICC), but analysts and experts suggest the decision to off-load their operations might have more to do with commercial reality than political pressure.

“Before new capital rules came into being, banks could make money from what was a niche business,” says a source at one commodities trading firm.

The punitive costs of Basel III and the flattening of the commodities cycle could be bigger drivers.

Pirrong doesn’t think that regulators will necessarily need to introduce legislation banning banks from owning physical commodities – the unappealing economics of the business to banks have done that for them.

“Existing rules over bank capital and risk-weighted assets are forcing banks to look at their physical commodities holdings,” he says.

The Fed-backed physical commodities regulation itself might not be a game-changer, with one analyst estimating that commodities revenue has averaged around 20% of FICC revenue since 1Q-2011 and fallen in recent quarters, while physical commodities could represent as little as 5% to 10% of FICC revenue.

Whether or not the Fed revokes its decision, Pirrong believes that as physical assets and banking are complementary, any retrenchment will simply encourage other non-bank financial institutions to enter or expand the market. Wall Street will focus solely on the financial trading of contracts.

Meanwhile, the regulatory uncertainty continues. Pirrong adds: “Banks are criticized for their lack of transparency regarding their commodities holdings, but regulators beat them hands down when it comes to opacity on the likely action they might take.”

In any case, the physical commodities businesses is caught in the cross-hairs of the rising costs of regulation, across the board. Some politicians think banks should be banned from owning physical assets, and the prevailing regulatory wind is supportive.

Anything that involves bringing the banks to account is seen as popular by some US lawmakers, says one consultant. Too-big-to-fail institutions have a blizzard of new regulations to deal with. The move to centralized clearing for derivatives is driving up costs in their trading businesses, while Basel III rules, requiring banks to set aside more capital to fund illiquid assets, is forcing them to focus on activities that consume less balance-sheet resources.

In addition, new limits forcing big banks to operate with a leverage ratio of at least 5% is also focusing minds. As a result, the physical-commodities business consumes capital and could also bring reputational damage, for example, in the event of a bank-owned power station failing.

All of this may be sufficient to convince banks that physical commodities are just not worth the hassle, irrespective of a specific ban on this activity.

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