Big Banks Behaving Badly: Will Regulators Crack Down on Commodities?

Source: http://www.flickr.com/photos/ollesvensson/

Source: http://www.flickr.com/photos/ollesvensson/

On Tuesday, the Federal Reserve began seeking comments on possible regulation of the way financial holding companies conduct physical commodity activities. The announcement follows a series of reports, investigations, and settlements involving financial holding companies like Bank of America (NYSE:BAC), JPMorgan Chase (NYSE:JPM), Goldman Sachs (NYSE:GS), and Morgan Stanley (NYSE:MS), which have been accused of violating the spirit, if not the letter, of existing regulation.

Some context

Financial holding companies — or bank holding companies that elect financial holding company status, such as Goldman Sachs and Morgan Stanley — are not traditionally allowed to own or operate non-financial businesses. Under the Bank Holding Company Act of 1956, before the Gramm-Leach-Bliley Act (GLB Act) knocked down some of the barriers dividing investment and commercial banking, banks were only allowed to participate in commodity activities that were “so closely related to banking as to be a proper incident thereto.”

Michael Gibson, director of the division of banking supervision and regulation at the Fed, explained in a testimony prepared for the Senate Subcommittee on Financial Institutions and Consumer Protection that “Under the National Bank Act, the Office of the Comptroller of the Currency (OCC) has authority to approve national banks to engage in commodity-related activities under national banks’ authority to ‘exercise … all such incidental powers as shall be necessary to carry on the business of banking.’”

Enter the Gramm-Leach-Bliley Act

Things changed in 1999, when the GLB Act was passed. The act, which has been pegged by some as one of the precursors to to the late-2000s financial crisis, built on the foundation laid by the National Bank Act and created the modern framework within which financial holding companies can conduct physical commodities activities. There are three key provisions to be aware of, as Gibson highlighted in his January 15 testimony.

The first provision builds directly on the idea that financial holding companies can engage in commercial activities that complement financial activity, as long as certain conditions regarding risk and reward are met. This provision effectively states that as long as the bank can demonstrate that a) the commercial activity complements its financial business, b) it can manage the risk of being involved in that business, and c), as Gibson put it, “performance of the activity can reasonably be expected to produce benefits to the public — such as greater convenience, increased competition, or gains in efficiency — that outweigh possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest, or unsound banking practices,” the bank can granted authority to “engage in expanded financial activities.”

Beginning in 2003, Gibson said during his testimony, authority was granted to a number of financial holding companies, permitting them to engage in commodities-related activities such as physical settlement of commodities derivative contracts, spot trading of certain approved commodities, energy tolling, and energy-management activities.

These are the types of activities that financial institutions like JPMorgan Chase and Goldman Sachs have been accused of abusing recently. Goldman Sachs was accused in 2013 of using its ownership of aluminum warehouses outside of Detroit to game the system for its own financial benefit at the detriment of aluminum consumers. JPMorgan recently settled for $410 million with the Financial Energy Regulation Commission over allegations that it manipulated power markets in California and the Midwest.

Following the incidents, a number of other major banks, including Bank of America and Morgan Stanley, signaled their intention to exit commodities-related business, particularly those that operate overseas and involve oil. Goldman Sachs CEO Lloyd Blankfein, for his part, has argued that physical commodities are a core part of his bank and appears unwilling to back down despite the accusations, investigations, and proposed reforms.

The second GLB Act provision affecting how financial holding companies can conduct commercial activities has to do with the way in which they can make merchant bank investments. Generally, merchant banking investments are time constrained, and the position must be exited after a certain period of time. The investments must also be passively managed, ostensibly preventing financial companies from taking controlling interests in commercial businesses at whim.

The third provision is effectively a grandfather clause that applies to just two companies: Goldman Sachs and Morgan Stanley. Normally, banks are only allowed to engage in commodities businesses equal to no more than 5 percent of tier 1 capital. The grandfather clause, however, allows Goldman Sachs and Morgan Stanley to use up to 5 percent of total consolidated assets, a much higher cap.

Post-crisis

Aptly enough, the financial crisis made an absolute mess of the U.S. financial system. During the chaos, certain financial institutions were forced into shotgun marriages — either by circumstance or by the Fed, depending on whom you ask — that made regulation of the activities of the new combined entities very difficult. For example, JPMorgan acquired Bear Stearns and Bank of America acquired Merrill Lynch. Both of these acquisitions, Gibson points out, were fairly heavily engaged in commodities activities.

Regulators don’t appear to be holding back, either.“This decision, while a step forward, is still overdue and insufficient,” said Sen. Sherrod Brown (D-Ohio) in a statement on Tuesday. “Each day that we wait to rein in these activities means that end users and consumers will pay higher commodity and energy prices, and taxpayers will continue to be exposed to excessive risks at Too Big to Fail banks.”

Although the Fed has no direct role in the regulation of the commodities space, its request for comment signals its interest in pursuing possible additional regulation in the space. The Fed stated that it is seeking comment specifically on:

  • “the nature of risks that physical commodity activities could pose to the safety and soundness of financial holding companies and to financial stability more broadly;
  • the potential conflicts of interest and other adverse effects of engagement by financial holding companies in physical commodity activities;
  • and the potential risks and benefits of imposing additional capital requirements or other restrictions on the commodity activities of financial holding companies.”

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