Who woulda thunk that commodities-especially ones like aluminum-would become such a huge story. Maybe it’s the summer news doldrums, but in the last week there have been two major, related stories using up loads of ink and pixels. The stories are: (1) the Federal Reserve’s announcement that it is evaluating whether to continue permitting banks it regulates trade physical commodities, and own physical assets like storage facilities and power plants used to transform commodities in space, time, or form, and (2) the role of banks like Goldman and Morgan in the industrial metals storage business. The latter story was the subject of an extensive piece in the NYT on Sunday. The stories are related because the metals warehouse controversy is Exhibit A in the case against allowing banks to be involved in physical commodities.
First the warehouse story. I wrote about this issue back in January. There is smoke here. The premiums in physical aluminum above the LME in-store price is an indication of a bottleneck in getting material out of warehouses. The question is whether this bottleneck is being artificially exacerbated by game playing-manipulation, perhaps-by the warehouse operators. The NYT article does cast some light on some mysterious practices, but it does not seal the deal in my mind. Not to say that manipulation is not occurring, just that the NYT piece doesn’t convince me.
One puzzle is that the operators of warehouses, who cannot own physical metal in them, pay third parties a bonus over the LME price approximately equal to the cash market premium in order to put their material in store, and thereby put themselves at the mercy of the loadout queue. Presumably, those taking these deals only do so because they are compensated for the higher storage expenses they incur once their metal gets stuck in the roach motels. If Goldman (or any other warehouseman) paid everyone these premiums, Goldman couldn’t make any money by running the roach motel: it would pay in premium what it collects in storage fees. It would compensate the roaches for the costs of getting stuck in the motel. Which suggests that they only pay some customers the premium to attract metal. What would be interesting to know is how this would permit the warehousemen to collect storage for a longer period from others whose metal is in the warehouses, but who don’t get paid the bonus. Are there side deals with the storers who receive the premiums? Does the mere fact that there is more metal in the warehouses increase the ability of the operators to slow down load-out, and thereby collect storage for a longer period? This seems to be the most curious practice, but the articles I’ve read don’t shed enough light on how they could be part of a manipulative scheme.
Tom Maguire of Just One Minute does a good job at debunking the math in the Times piece: the profits accruing to Goldman and the costs imposed on soda and beer quaffing consumers alleged by the Times don’t withstand scrutiny. To which I would add another point. Namely, these calculations assume that the cash premiums reflect an inflation in price. Any uneconomic act that exacerbates the bottleneck in the transformation of metal in store to metal outside LME warehouses has effects on prices on both sides of the bottleneck: it reduces the price of metal in store, and increases the price at the Coca Cola or Budweiser facility. So even if the premium is inflated, this does not mean that the price paid by consumers (directly or indirectly) is inflated by the same amount because part of the inflation is due to a depression of the in-store price. Those with metal in store, or producers who put their metal into store, bear some of the cost.
Now on to the bigger issue, which the hue and cry over bankers owning metals warehouses is intended to illustrate: namely, whether banks should be involved in physical commodity markets. This is the subject of a Senate hearing today, where one of the main anti-bankers, Ohio Senator Sherrod Brown, is leading the charge to get the banker-squids’ tentacles off our commodities.
I find most of the reasons advanced for keeping banks out of physical commodities, and the ownership of commodity transformation assets, to be unpersuasive. What’s so special about commodities? Are they uniquely risky?
I think not, and believe that there are good economic reasons for banks to enter into the commodities business.
In addressing this issue, it’s important to be specific about the kinds of risk involved. Price risk, spread risk, and operational and reputational risks are perhaps the most important to consider.
The conventional view is that commodity prices are extraordinarily volatile, and hence pose extraordinary risks on those who hold them. One thing to note is that for a leveraged investor like a bank it is possible to transform a relatively low volatility flat price exposure into a much riskier exposure. So one thing that matters is whether, taking leverage into account, bank positions in commodities are riskier than their positions in more traditional lines of business. Moreover, it is risk at the portfolio level that matters, and the correlation between the price exposures and other elements of the banks’ portfolios. A highly volatile position may not increase portfolio risk substantially if it is uncorrelated with other exposures, or negatively correlated.
But there’s a more important point. Most commodity trading by commodity trading firms and banks does not consist of punts on the flat price, on whether the price of oil or copper is going to rise or fall. Instead, most commodity trading is a margin business or a fee business. Money is made on margins or fees in transportation, storage, and processing. These margins-spreads-tend to be much more stable than flat prices. Asset ownership, or contractual control of physical assets (of the type that JP Morgan has over California power plants that have attracted FERC’s ire), is a position on the value and cost of transformation, and spreads and margins measure these values and costs. The riskiness in these spreads/margins, and the ability to manage spread/margin risk through paper trades, is what drives the risk of bank commodity plays. My reading of the coverage has turned up virtually no understanding of this issue.
Moreover, the profitability of physical assets can provide a natural hedge for other bank businesses. Most banking his highly pro-cyclical: it profits when the economy booms, and does badly when the economy tanks. Some commodity assets are countercyclical. Storage is a classic example. The amount of oil or metal in storage-and revenues from storing these things-goes up when the economy weakens. This is basic economics. So metal or oil storage-a fee business-is a natural hedge against the strongly procyclical traditional banking and dealing businesses.
Taking these factors into consideration, it is wrong to believe that commodity businesses are unduly risky, compared to other banking activities.
Operational risks are perhaps more problematic. A major oil spill, for instance, leads to substantial costs on the operator of the ship or pipeline or terminal that spills it. A bank that owns or charters a tanker that ends up on a reef is potentially exposed to a substantial risk of loss. But much of this risk can be passed on to insurance companies via the insurance market. What’s more, the risk doesn’t go away if banks can’t touch physical oil: someone has to bear it. The question is whether banks are less efficient bearers of this risk than others (where others include insurance companies).
Many of the stories that have come out in recent days focus on the reputational and legal risks associated with commodity trading. For instance, JP Morgan’s impending settlement with FERC of allegations that it manipulated the California electricity markets has received considerable play. Well, this is not a problem unique to commodities. Traditional banking businesses, and other less traditional activities now widely considered to be legitimate activities for banks, have huge reputational and legal risks. Consider Libor. Or the Toure trial. Or mis-selling. Or mortgage servicing/foreclosures.
I could go on. And on. And on. If you think that keeping banks out of commodities you’ll reduce their rep or legal risks, I have a bridge to sell you.
Furthermore, even if it is shown that banks have engaged in dodgy activity in commodities, that doesn’t mean that getting banks out of commodities will eliminate the dodgy activities. Consider the warehouse issue. If LME rules and cash market frictions make it profitable for warehouse operators to manipulate markets, forcing banks to sell off these assets won’t reduce the manipulation: the new owners will take ownership of the strategies along with the storage sheds. Note that Glencore-not a bank!-has been accused of playing similar games. Keeping banks out of commodities may affect who plays dodgy games, and profits therefrom, but won’t have much of an impact on the amount of dodginess in the markets. That dodginess ultimately derives from economic opportunity (which is driven by frictions in the market) and regulation (flawed rules and rule enforcement mean that market participants calculate there’s a substantial probability of escaping punishment for misdeeds). Barring banks from the market won’t change either of these things. If crime pays, someone will commit it. If you care about reducing the deadweight losses from manipulative activities, you shouldn’t really care about who profits from them. You need to fix the problem at the level of incentives and enforcement of rules: keeping banks out of the market doesn’t do that. Period.
The foregoing is basically a rebuttal-or at least a skeptical questioning-of the case against bank ownership of commodity assets, or participation in physical commodity markets. What about the affirmative case for such participation?
For several years, in response to shrieks about the evil effects of the “financialization” of commodity markets, I’ve made the following basic point: a good deal of commodity trading is about allocating commodities over time, and allocating risk. Both of these are fundamental financial functions: finance is about trading off the future and the present, and allocating risks. Banks are linchpins of the financial system, and engage in intermediation of risk and of resources over time. Why should we exclude them from a sector where the allocation of resources over time and the allocation of risk are vitally important? That is the comparative advantage of banks: why keep them out?
Indeed, banks have gained market share in commodities in large part because they can perform the time- and risk-allocation functions more efficiently than others. If banks have the lowest funding costs, it makes sense that they fund some inventories. Banks have expertise in risk management and hedging, making it sensible that they utilize this expertise in the management of commodity price risks. In other words, the success of banks in commodities is a feature, not a bug, because it reflects their comparative advantages in allocating risks and resources over time.
Moreover, there is often a synergy between financing and risk management activities, and banks can exploit these synergies. For instance, one physical market activity that banks engage in is offtake agreements, whereby they provide say crude oil to a refinery, and receive the refinery’s output which they market. This bundle of transactions involves a funding element-the bank is basically providing working capital to the refinery. It also involves a risk management element: the bank is managing the price risks on the crude and refined product side (as well as the logistical/operational risks).
Crucially, by taking on the risk, the bank is reducing the moral hazard that would be involved if it was providing working capital financing to the refinery. Yes, if it just extended loans or credit lines to the refinery, the bank would presumably impose requirements on the refinery to hedge its risks, but there are inherent agency problems associated with such an arrangement that can be avoided by putting the price risks on the bank. Moreover, the operational and logistical risks cannot be hedged, and pose a potential moral hazard.
The most telling objection that might be raised against these arguments is that banks have gained market share in commodities because they are subsidized as a result of too big to fail. I would note that the investment banks that made the first and biggest forays into commodities-Morgan Stanley, Goldman, Bear-did so when they did not have access to insured deposits for funding or to the Fed window, though one could argue that they still were subsidized by the belief that they were too big for the Fed to allow to fail.
But even if you buy into the subsidy argument, that’s no reason to single out commodities. The subsidy leads to an excessive expansion of big banks generally, across all lines of business. Meaning that keeping them out of commodities will not materially reduce the perverse effect of the subsidies. Implicitly or explicitly subsidized banks will exploit that subsidy to the hilt, and if they can’t do it in commodities, they’ll do it somewhere else. TBTF has to be tackled at the roots, not the branches or the leaves-and particular lines of business like commodities are the latter.
One last point. It is beyond ironic that the banks are under attack for their commodity dealings. GFMA wanted to hamstring banks’ competitors in commodity trading-namely, the commodity trading firms. Perhaps they should have paid more attention to making the affirmative case for their participation in these markets, than they did attempting to raise their non-bank rivals’ costs.
The word karma comes to mind.