Tim Weiner, global risk manager of commodities and metals at MillerCoors LLC, smells a rat in his supply chain. He believes bank holding companies, through their control and ownership of stores of aluminum, are inflating the metal’s prices. Testifying at a Senate hearing on Tuesday, Weiner said the aluminum he purchases for the packaging of the company’s beer is being held up in warehouses that are controlled and owned by U.S. bank holding companies.
“These bank holding companies are slowing the load-out of physical aluminum from these warehouses to ensure that they receive increased rent for an extended period of time,” he said. MillerCoors has to wait as long as 18 months for the metal or pay a high premium. Weiner believes the practice is keeping aluminum prices higher than they should be in a market where there has been “massive oversupply and record production.”
Tuesday’s hearing of the Financial Institutions and Consumer Protection Subcommittee of the Senate Committee on Banking, Housing & Urban Affairs detailed other instances in which large U.S. banks have diversified into commodities-markets operations, stretching the limits of rules designed to separate banking and commerce. The upshot: the high prices and price volatility some commodities have experienced may in part stem from banks’ heavier involvement in the storage, transportation and trading of “physical” commodities (as opposed to their participation in the “non-physical” futures and options markets.)
According to Professor Saule Omarova, associate professor of law at the University of North Carolina, the practice of mixing banking and commerce has undergone a “qualitative change” in the past decade. Large financial holding companies (FHCs), particularly Goldman Sachs, JPMorgan Chase and Morgan Stanley, have become “major merchants of physical commodities and energy, despite the legal wall designed to keep them out of any non-financial business.” That might not be so bad, of course, if financial institutions didn’t control payments, credit allocation, bond markets, futures and options markets — virtually all the channels through which money flows.
Under U.S. banking laws, banks’ participation in the commodities markets must be related to an underwriting or investment-banking activity. In addition, “even though [a financial holding company] is permitted to acquire full ownership of a purely commercial firm, the principal purpose of its investment must remain purely financial: making a profit upon subsequent release or disposition of its ownership stake,” said Omarova.
But banks have been chipping away at the wall between commerce and banking. In 2003, Citigroup was the first FHC to get Federal Reserve Board of Governors’ approval to purchase and sell oil, natural gas, agricultural products and other commodities in the spot market. The bank was also allowed to take physical delivery to settle commodity derivative transactions.
Then in 2008, Royal Bank of Scotland lobbied for expanded powers in the commodities business in connection with acquiring a 51 percent stake in Sempra Energy of the United States. “The [Federal Reserve] Board significantly relaxed the standard limitations … and allowed RBS to take and make physical deliveries of nickel, even though nickel futures were not approved for trading on U.S. futures exchanges,” Omarova said. (And thus, Omarova implied, the activities could have no conceivable connection to the business of underwriting or investment banking.)
And on and on. During the decade Morgan Stanley acquired full ownership of a global operator of commercial tankers, and Goldman gained control of “one of the largest metals warehouses in the global storage network of facilities approved by the London Metals Exchanges,” said Omarova.
Why be so concerned that financial institutions are involved in the trading and transportation of crude oil, gas, electric power, metals and other physical commodities? The primary fear is market manipulation, resulting in higher costs to commercial businesses. Through bank ownership of a commodities business, a financial institution can place its hand on the scale of supply and demand for a commodity and distort the free market. And a bank can not only affect the price of the commodity, it can also make profitable bets on its direction in the futures markets.
That control poses an integrity problem in derivatives markets. By owning a warehouse business in the aluminum industry, Goldman Sachs, for example, could potentially move commodity prices in a way that benefits its derivatives positions, Omarova said. It could also increase its sale of derivative contracts just by causing higher volatility in a commodity’s price — volatility that drives greater demand for derivative instruments from hedgers that want to transfer the underlying risk to a financial institution.
Even if a bank has little power to move price, ownership of a commodities business gives it informational advantages, said Joshua Rosner, managing director of Graham Fisher & Co., in his pre-hearing statement. While financial institutions are supposed to maintain a Chinese wall between trading and other businesses, “ineffective controls [on separation of the businesses] … can allow a firm’s trading desk to gain market information about underlying financial contracts or securities that can be used to benefit the firm or its customers or disadvantage customers and competitors,” he said.
(Goldman Sachs issued a statement on Tuesday saying recent news reports “have inaccurately accused [its metal warehousing company] of deliberately creating aluminum shortages,” and its trading desks have no information regarding warehouse operations. Goldman’s lack of such information is verified by regular independent audits, according to the firm.)
In what is perhaps a more blatant form of tying together financial services and commercial business, Rosner points out, a bank that owns a commodities business could choose to deny lending or underwriting to a competitor of that commercial business or even lend at preferential rates to its own commercial commodities business.
Banks, no doubt, think all this outrage about their role in physical commodities is overblown.
On Tuesday, Randall Guynn, partner and head of the financial institutions group at Davis Polk & Wardwell, said banks’ relatively new power in these markets “is only an incremental expansion of the physical commodities powers that banks or their non-bank affiliates have exercised in this country for more than 200 years.” As Guynn went on to point out, physical commodities and finance have been inextricably linked since the beginning of recorded history, with grain, salt, shells and pieces of wood used as the first money in Mesopotamia, Egypt, China, Japan and other ancient civilizations.
That might not sound like a valid justification for banks’ current activities. But we have certainly traveled back in time on this issue.
Commodities analysts estimate that the physical commodities businesses generated $1 billion in revenue in 2012 for the 10 largest global investment banks, mostly through storage and transportation. But how would anyone know how involved banks are in the physical commodities business? Or know if the accusations of a company like MillerCoors are correct.
As Omarova pointed out in pre-hearing testimony, there is a scarcity of information about banking organization’s assets and activities related to physical commodities and energy. “To the extent that FHCs include in their regulatory filings financial information specific to their commodities operations, such information usually pertains to both commodity-linked derivatives operations and trading in physical commodities,” she said. “Most financial information reported under the commodities rubric relates to the derivatives business, leaving one to guess what is going on in the firms’ physical commodities businesses.”
The presence of financial institutions in commodities markets and the lack of knowledge about the extent of their involvement is troubling. We’ve already seen the ability banks have to bring down entire markets and systems. Without knowing it, companies could be exposed to a whole new kind of bank counter-party risk via their supply chains. To get a handle on that exposure, regulators need to force banks to be more transparent about their commodities’ operations and divest them where appropriate.
Photo: Agência Brasil, Creative Commons License Attribution 3.0 Brazil