How banks are cutting risk by leaving the commodities business

Fed proposal is driving banks out of physical markets, says expert

Marcelo Cruz

In January 2014, the Federal Reserve issued an advance notice of proposed rulemaking (ANPR) in which it raised questions regarding increased limits and restrictions on the physical commodities activities of financial holding companies (FHCs) under the Bank Holding Company Act of 1956.

In the ANPR, the Fed cites recent environmental events as a reason for its review of physical commodities activities by FHCs. The notice cites the Deepwater Horizon oil spill in the Gulf of Mexico, the incident at the Fukushima Daiichi nuclear power plant, and other environmental events to support its concerns that “the costs and liability related to physical commodity activities can be difficult to limit and higher than expected”.

The Fed also raised questions regarding how closely connected physical commodities activities are to permissible financial activities and whether continuing to permit the conduct of physical commodities activities by FHCs is necessary to preserve competitive equality between FHCs and competitors in permissible financial activities.

The ANPR followed the release by the Federal Reserve of a brief statement in July 2013 that it was “reviewing the 2003 determination that certain commodity activities are complementary to financial activities” and thus permissible for FHCs, referring to the Fed’s initial approval of certain physical commodities activities under “complementary” authority. Subsequently, the Senate banking subcommittee on financial institutions held a hearing at which several witnesses criticised the role of financial institutions in commodity markets.

A second hearing examined the physical commodities activities FHCs are authorised to conduct under the Bank Holding Company Act, the economic impact of such activities on the physical commodity and energy markets, and their impact on the safety and soundness of the banking system.

Within the ANPR the Fed has floated three potential policy moves for mitigating the risks of such scenarios: (a) enhanced capital requirements, (b) increased insurance requirements, or (c) caps on the total revenues or assets attributable to physical commodities trading.

Indeed, physical commodities operations are heavily exposed to operational risk. There are many details in such operations that can plague a financial institution with severe losses. For example, suppose that a tanker vessel is supposed to make physical oil delivery in Africa to a few different ports. There are steep penalties for late deliveries, which often occur due to weather and other operational issues. In one single journey delivering oil to African ports, a ship can pay millions in penalties and fees due to minor weather events or even operational issues at ports that might cause this delay.

Banks’ commodities operations own oil vessels, pipelines, oil tanks, power plants and so forth. It is not hard to imagine scenarios in which these operations can go wrong.

There are also image issues. If one of these pipes bursts, it could cause tremendous reputational losses for a financial institution, as television images of the spill are linked to its name and brand. Considering these risks, it is no surprise that banks are anticipating this ANPR and getting out of the commodities business or at least scaling back their role in this market.

JP Morgan Chase has become the latest bank to downsize its commodities business, announcing a deal on March 19 to sell its physical assets and trading arm to Swiss trader Mercuria Energy Group for $3.5 billion in cash. The deal, expected to be completed in the third quarter of 2014, marks the largest ever acquisition made by Mercuria, a closely held company founded in 2004 by Swiss traders Marco Dunand and Daniel Jaeggi that is relatively unknown outside the physical commodities trading industry.

For JP Morgan, the sale marks an abrupt curtailment of its physical commodities business, which the bank spent more than $2 billion rapidly building with an acquisition spree at the end of the last decade.

JP Morgan is hardly alone in this exit from commodities. Other examples in the industry abound. Morgan Stanley agreed to sell its oil storage and trading business to state-backed Russian oil giant Rosneft at the end of 2013. Deutsche Bank, one of the banking industry’s biggest operators in the commodities sector, said in December it would exit almost all of its commodity businesses around the world. Goldman Sachs has reportedly entertained offers for certain units, such as its Metro International Trade Services group of metals warehouses. Royal Bank of Scotland and UBS have also wound down physical commodities trading desks in recent years.

Meanwhile, the mostly privately held commodities houses have been snapping up assets to support their core trading businesses, lock in access to supply and provide a steady income stream; trading houses are not subject to the same regulatory capital requirements as banks.

Marcelo Cruz is the editor-in-chief of the Journal of Operational Risk and an adjunct professor at New York University

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