Why Major Banks Are Gradually Beginning to Exit Commodity Trading

Guild Investment Management  |

We believe that the world’s major banks do not need to be involved in commodities trading, and that their involvement in commodity markets increases risks of bank failure, and increases the chance that they might manipulate commodity prices. The fact that major banks are voluntarily exiting from some of their commodity trading activities is good news for the world banking system.

We’ve written before on the difference between good and bad regulation -- good regulation which can reduce systemic risks through judicious oversight, and bad regulation which can smother productivity and growth and create opportunities for cronyism. We believe moderation is the key, and where we see moderate, intelligent regulation, we see one more support for growth.

The reduction of regulation could be good, or could be bad -- depending on what kind of regulations are being removed. As investors, we stay aware of regulatory developments in the sectors that currently interest us the most. This is one set of data points among many that shape our view of emerging trends.

Banks and Non-financial Businesses

For most of the past century, banking regulations kept a barrier between finance and commerce. That changed after the erosion and final repeal of Depression-era legislation in 1999. Since then, there have been even more regulatory changes which have weakened the historical restrictions on banks’ commodity trading activities. Fed regulations currently allow banks and other financial institutions to engage in commodity trading under several different authorizations made over the past decade. Some institutions that reorganized during the financial crisis (so that they could gain access to stabilizing liquidity from the Federal Reserve) were permitted specific “grandfathered” exceptions -- including Morgan Stanley ($MS) and Goldman Sachs ($GS).

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For almost a year now, regulators -- including both the Federal Reserve and the Commodities Futures Trading Commission (CFTC) -- have been discussing banks and bank holding companies who trade in physical commodities, and wondering about the risks this may pose to consumers and to the stability of the wider economy.

Regulators Look for Stability Risks

Last year, the discussion was mainly about the potential for price manipulation. But now the questions have widened to include various ways in which banks’ trading in commodities could expose the financial system to unexpected and destabilizing risks.

The focus on stability makes sense given the experience of 2008. Regulators want to make sure that banks aren’t exposed to some “black swan” event that will embroil them in another systemic crisis. The Fed drew particular attention to the BP ($BP) Deepwater Horizon oil spill as one example of catastrophic risk connected to commodities trading.

The Fed also points out that financial institutions have been voluntarily curtailing their commodity activities over the past year. This under- mines the argument that banks need to be able to trade in commodities if they are to compete with non-financial competitors who “find innovative ways to combine financial and non-financial activities.”

In any event, regardless of the interplay among the various regulatory bodies (Congress, the Fed, and the CFTC), it looks like banks will eventually face more limits on their ability to engage in commodity trading. We think that with the profitability of their commodity operations already down, and the regulatory writing on the wall, banks are already beginning to curb their trading.

We are confident that the profits of many big banks will continue to be robust, and we’re pleased to see that they’re shedding potentially risky activities outside their central competencies -- whether driven by the market, by regulators, or by both.

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