(Corrects Omarova’s affiliation in 20th paragraph.)
The Federal Reserve’s review of its decision to let banks store, transport and trade raw materials signals a potential rebuilding of the wall between banking and commerce that legislation and rulemaking have eroded.
The central bank said July 19 that it’s reviewing a decade-old decision that physical commodities are “complementary” to banking, allowing lenders such as Citigroup Inc. (C:US) and JPMorgan Chase & Co. (JPM:US) to operate in both industries. Goldman Sachs Group Inc. (GS:US) and Morgan Stanley may be less at risk from the review as some businesses owned before the firms became bank holding companies in 2008 are grandfathered.
The move into physical commodities exposed the biggest banks to additional risks and allegations of price manipulation, creating potential legal liabilities and threatening to damage their reputations. The shift also weakened the barrier between government-insured banks and other commerce established by the 1956 Bank Holding Company Act.
“What the Fed has to do, what they are doing, is setting boundaries where the banks really will pull back into what their primary business is,” said Marty Mosby, an analyst at Guggenheim Securities LLC in Memphis, Tennessee. Regulators are “trying to re-envision how they should draw these boundaries. They got kind of blurred.”
The Senate Banking Committee’s Subcommittee on Financial Institutions and Consumer Protection, led by Ohio Democrat Sherrod Brown, is holding a hearing today on banks’ investments in physical commodities assets.
The 1999 Gramm-Leach-Bliley Act added exemptions for certain commodities units that previously weren’t allowed under the 1956 holding company law. One was for businesses that the Fed could determine were complementary or incidental to the bank’s financial activities. The first of those decisions came in 2003, when the Fed allowed Citigroup to continue dealing in physical commodities.
The other exception was for firms that became banks after 1999 and had physical commodities businesses that predated Sept. 30, 1997. That rule is relevant because Goldman Sachs and Morgan Stanley (MS:US) converted to bank holding companies amid the 2008 financial crisis. The Fed gave them five years to divest businesses that didn’t comply with the Bank Holding Company Act.
Morgan Stanley said in its 2012 annual report that it was in talks with the Fed over whether the company’s physical commodities businesses would be given a grandfather exemption or if it would have to sell any units by the end of the five-year grace period. The New York-based firm said it didn’t expect the regulator to force it to make any sales that would have a material effect. Goldman Sachs faces the same deadline if any of its investments are deemed noncompliant.
The exceptions granted by Gramm-Leach-Bliley represent “incremental expansions” of banking powers, rather than a “radical departure” from previous rules, Randall Guynn, head of the financial institutions group at law firm Davis Polk & Wardwell LLP, said in written testimony prepared for today’s hearing.
“There has been a close relationship between banking and physical commodities since the dawn of history,” wrote Guynn, who has advised the six largest U.S. banks about changes to financial regulations. “I am not aware of any evidence that their activities undermined the safety or soundness of the U.S. financial system.”
In addition to the two exemptions, banks also can invest in commodities businesses through a merchant-banking exception. Lenders typically must sell such investments within 10 years, Guynn wrote.
Physical commodities businesses generated $1 billion in revenue in 2012 for the 10 largest global investment banks, according to data from industry analytics firm Coalition Ltd. That was down from $1.47 billion in 2011 and represented one-sixth of overall commodities revenue.
Storage and transportation of oil, such as tanker businesses, accounted for more than half of the physical revenue each of the past two years, said George Kuznetsov, head of research for Coalition. Banks also generated revenue from electricity and natural gas production facilities, power grids, warehouses for storing base metals and vaults to house precious metals, he said.
Goldman Sachs and JPMorgan, both based in New York, own base metal warehousing companies. In 2010, Goldman Sachs acquired Romulus, Michigan-based Metro International Trade Services LLC and JPMorgan bought Liverpool, England-based Henry Bath & Son Ltd. as part of its purchase of assets from RBS Sempra Commodities LLP.
JPMorgan also received oil and metal investments and European power and gas assets in that acquisition. The bank inherited U.S. electricity sales arrangements when it bought failing investment bank Bear Stearns Cos. It also runs a precious metals vault unit.
JPMorgan, whose commodity business is run by Blythe Masters, 44, is close to a settlement with the Federal Energy Regulatory Commission over allegations that the bank manipulated electricity prices in California and the U.S. Midwest, the Wall Street Journal reported.
Morgan Stanley, whose commodities business is run by Simon Greenshields and Colin Bryce, both 57, owns electricity-generating facilities in the U.S. and Europe and markets electric power in the U.S. It also owns Denver-based TransMontaigne Inc., a petroleum and chemical transportation and storage company, and Heidmar Inc., based in Norwalk, Connecticut, which manages more than 100 oil tankers, according to its website.
The banks don’t break out revenue and profit from the commodities units. Goldman Sachs’s 2012 annual report doesn’t show that it owns coal mines in Colombia, a stake in the railroad that transports the coal to port and part of an oil field off the coast of Angola.
Morgan Stanley said in its annual report that the bank’s commodities businesses expose it to “significant costs and liabilities” that may come from regulation or catastrophic events. Goldman Sachs cited risks from climate change to terrorist attacks on its physical commodities business.
“Existing public disclosure is woefully inadequate to understand and evaluate the nature and scope of U.S. banking organizations’ physical commodities trading and assets,” Saule T. Omarova, a law professor at the University of North Carolina at Chapel Hill, said in testimony prepared for today’s hearing. “When it comes to energy and other key commodities, what is hidden from the public view may be highly consequential.”
Banks’ ability to compete in nonfinancial businesses while benefiting from the government’s safety net on deposits gives them an unfair advantage, Josh Rosner, a managing director at Graham Fisher & Co., said in written testimony.
“There’s a subsidy that spreads out from anything having to do with the protection of too big to fail and deposit-taking in particular,” Harvey Rosenblum, executive vice president of the Federal Reserve Bank of Dallas, said in an interview. “It’s a continued abuse of the federal safety net to the advantage of the large financial companies and to the disadvantage of Main Street America.”
Current rules prevent banks from passing on funding advantages of deposit insurance to nonbank affiliates, wrote Guynn, the Davis Polk lawyer.
Some banks have cut back in commodities amid higher capital rules and pressure to reduce costs to boost profitability, Coalition’s Kuznetsov said.
“We definitely see a reduction of certain banks’ presence within commodities,” Kuznetsov said. “With physical commodities, it’s very difficult to find any synergies with the rest of the franchise other than with commodities itself. Plus, on top of that, you have regulatory pressure.”
Morgan Stanley Chief Executive Officer James Gorman, 55, said in an interview last week that he’s open to different structures in the commodities business. Morgan Stanley held talks last year with Qatar’s sovereign-wealth fund about selling a stake in the business.
Goldman Sachs, whose top three executives trace their roots to commodities trading division J. Aron, has said it plans to remain active in the industry. Commodities trading at Goldman Sachs is led by Gregory A. Agran in New York and Magid N. Shenouda in London.
“We strongly believe that being in the commodities business is important to our clients,” Goldman Sachs President Gary Cohn, 52, a former silver trader, said in May. “Many more of our clients today have commodity exposure than they ever had before, or they ever realized they had.”
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