Saturday, December 06, 2014

Senate Report Reveals Possible Systemic Risk in Bank Involvement with Physical Commodities

A bi-partisan Senate report revealed that three major financial holding companies engaged in the physical commodities market at a time when none of the three firms was adequately prepared for potential losses from a catastrophic event related to its physical commodity activities, having allocated insufficient capital and insurance to cover losses compared to other market participants. In this, the report found that new systemic risks have been introduced into the U.S. financial system. The report was prepared by the Senate Permanent Subcommittee on Investigations, chaired by Senator Carl Levin (D-MI).

The investigation focused on the recent rise of banks and bank holding companies as major players in the physical markets for commodities and related businesses. It presents case studies of three major U.S. bank holding companies, Goldman Sachs, JPMorgan Chase, and Morgan Stanley that over the last ten years were the largest bank holding company participants in physical commodity activities.

All three of the financial holding companies examined by the Subcommittee were engaged in a wide range of risky physical commodity activities which included, at times, producing, transporting, storing, processing, supplying, or trading energy, industrial metals, or agricultural commodities. Many of the attendant risks were new to the banking industry, and could result in significant financial losses to the financial institutions. Those activities included trading uranium, operating coal mines, running warehouses that store metal, and stockpiling aluminum and copper.

The investigation also highlights how the Federal Reserve has identified financial holding company involvement with physical commodities as a significant risk, but has taken insufficient steps to address it. The panel concluded that more is needed to safeguard the U.S. financial system and protect U.S. taxpayers from being forced to bailout large financial institutions involved with physical commodities.

In a worst case scenario, the Federal Reserve and ultimately U.S. taxpayers could be forced to step in with financial support to avoid the financial institution’s collapse and consequential damage to the U.S. financial system and economy.

In the activities reviewed by the Subcommittee, the financial companies often traded in both the physical and financial markets at the same time, with respect to the same commodities, frequently using the same traders on the same trading desk. In some cases, after purchasing a physical commodity business, the financial holding company ramped up its financial trading. Indeed, in some cases, financial holding companies used their physical commodity activities to influence or even manipulate commodity prices.

At the hearing, Senator Levin focused on what he called the ``merry-go- round” transactions in which warehouse clients were paid cash incentives to load aluminum from one Metro warehouse into another, essentially blocking the warehouse exits while they moved their metal. The Senator found that those merry-go-round transactions lengthened the queue for other metal owners seeking to exit the Detroit warehouses, accompanied by increases in the Midwest Premium for aluminum.

In another troubling development, JPMorgan proposed an exchange traded fund (ETF) to be backed with physical copper. In filings with the SEC, some industrial copper users charged that the proposed ETF would create artificial copper shortages as copper was stockpiled to back the fund, leading to price hikes and, potentially, manipulation of market prices.  In addition, in each of the three case studies, evidence showed that the financial holding companies used their physical commodity activities to gain access to commercially valuable nonpublic information that could be used to benefit their financial trading activities.

Essentially, the Senate panel found a current lack of effective regulatory safeguards related to financial holding company involvement with risky physical commodities. Financial holding companies currently conduct physical commodity activities under one of three authorities provided in the Gramm-Leach-Bliley Act of 1999, the complementary, merchant banking, and grandfather authorities.

Despite enactment of that law 15 years ago, the Federal Reserve has yet to address a host of pressing questions related to how Gramm-Leach-Bliley should be implemented. For example, the Fed has never issued guidance on the scope of the grandfather authority that allows financial firms that convert to bank holding companies to continue to engage in certain physical commodity activities. The Senate panel found that failure has allowed Goldman and Morgan Stanley to use expansive readings of the grandfather authority to justify otherwise impermissible physical commodity activities.

The Federal Reserve has also failed to specify capital and insurance minimums to protect against losses related to catastrophic events, nor has it clarified whether financial holding companies can use shell companies to conduct physical commodity businesses as Morgan Stanley and Goldman have done in their compressed natural gas and uranium trading businesses. Procedures to force divestment of impermissible physical commodity activities are also opaque and slow.

One key problem is that the Federal Reserve currently relies upon an uncoordinated, incoherent patchwork of limits on the size of the physical commodity activities conducted under various legal authorities, permitting major exclusions, gaps, and ambiguities.

Recommendations. The Senate report sets out a number of recommendations. Broadly, federal bank regulators should reaffirm the separation of banking from commerce, and reconsider all of the rules and practices related to physical commodity activities in light of that principle. Similarly, the Federal Reserve should issue a clear limit on a financial holding company’s physical commodity activities; clarify how to calculate the market value of physical commodity holdings; eliminate major exclusions; and limit all physical commodity activities to no more than 5% of the financial holding company’s Tier 1 capital.

Also, the panel wants the Fed to strengthen financial holding company disclosure requirements for physical commodities and related businesses in internal and public filings to support effective regulatory oversight, public disclosure, and investor protections, including with respect to commodity related merchant banking and grandfathered activities.

Dodd-Frank. The Senate report lists a number of Dodd-Frank Act provisions that have the potential to restrict or reshape bank involvement with physical commodities. Section 171 requires minimum, risk-based capital and leverage standards for federally insured banks, their holding companies, and affiliates. If bank regulators were to determine that physical commodity activities constitute high risk activities, they could impose minimum capital or leverage standards to mitigate the risk associated with conducting such activities and discourage, reshape, or reduce bank involvement.

Section 165 authorizes enhanced supervision and prudential standards for large bank holding companies with assets in excess of $50 billion. It explicitly permits more stringent rules based on a company’s capital structure, riskiness, complexity, or financial activities.

If bank regulators were to determine that physical commodity activities created sufficient risk, they could impose contingent capital, credit exposure, or leverage standards, concentration limits, stress testing, or other measures to minimize risk and discourage, reshape, or reduce bank involvement with physical commodities. Section 619, which codified the Volcker Rule, prohibits banks and their subsidiaries from engaging in proprietary trading as well as hedging or market-making activities that create client conflicts of interest or high risk exposures. Depending upon implementation of the Volcker Rule’s provisions, this section could also restrict and reshape some of the physical commodity activities now undertaken by banks their holding companies, and affiliates.

Section 111 of the law created the Financial Stability Oversight Council (FSOC) whose mission is to identify and address systemic risks to the U.S. financial system. Section 152 created the Office of Financial Research which the FSOC could task with gathering and analyzing data on possible systemic risks caused by bank involvement with physical commodities. If the FSOC were to determine that bank involvement in physical commodities imposed systemic risks to the U.S. financial system, it could recommend or take measures to restrict or restructure those activities.

Finally, Section 620 requires federal bank regulatory agencies to conduct a study of appropriate banking activities. Work on that study is underway. If the study were to conclude that conducting physical commodity activities, in whole or in part, is inappropriate for federally insured banks, their holding companies, or affiliates, the study could recommend measures to reduce, restructure, or even eliminate some of those activities.

Most of the Dodd-Frank provisions are not fully in effect, and the required Section 620 study is not yet complete. Multiple agencies are in charge of their implementation, and multiple outcomes are possible. Depending upon agency implementation, each of these Dodd-Frank provisions offers tools that could be used to discourage, reshape, or reduce bank involvement with physical commodities.

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