It may sound like a riddle: What do JP Morgan, Barclays, Deutsche Bank and Credit Suisse have in common? The answer is: they are all investment banks and they have all been winding down their physical activities in markets for commodities since the end of 2013. Financial regulators may have encouraged this move in order to reduce the systemic risk that the interconnection between banks and commodities induces. Nonetheless, some still believe that banks have an important role to play in this field because of their expertise, the hedging services they provide to their clients and the competitive pressure they exert on other commodity trading firms.

Leaving the market for commodities

There are two arguments usually put forward to explain the current massive exodus of banks from the market for commodities. Firstly, a wave of regulations including Basel III (2011) and the Dodd-Frank Act (2010) has made the ownership of commodities assets by banks more capital-intensive because of increased capital risk weightings. Put simply, physical assets such as pipelines or warehouses are given heavier weightings in the assessment of a bank’s overall risk exposure. As a consequence, more capital has to be put aside in order to comply with the official regulatory capital ratios, which makes these assets more expensive to hold [1].

This situation, in turn, implies that the rate of return on commodities assets has to be sufficiently important for banks to stay in this segment. If the corresponding return on investment starts to shrink, there is a significant opportunity cost for banks because they could have used their capital more effectively in less risk-weighted assets that would have brought a better return. That brings us to our second point which is a decline in profits. According to Bloomberg, commodities revenue at the 10 largest banks fell in 2013 because of a less volatile environment.

The combination of stringent capital requirements and low volatility seems thus to be the key to explain why the likes of Barclays, JP Morgan and most recently Credit Suisse have all wound down their activities in the market for commodities.

Good reasons to divorce

Since banks got physically involved in the market for commodities in the 1980s, not only trading these goods but also owning infrastructure such as warehouses and tankers, there has been some outcry regarding this type of activity which seemed very remote from the core business of banks.

From an ethical point of view, one could argue that speculating on the price of crude oil or other basic commodities is more reprehensible than speculating on the share price of a multinational corporation. Goldman Sachs and JP Morgan, for instance, were accused in 2013 of manipulating the price of aluminum by hoarding huge amounts of this commodity in their warehouses, creating supply shortages that contributed to a rise in the price of aluminum. However, new regulations such as the Volcker rule in the US (2010) have been precisely designed to put serious restrictions on the speculative activities of banks for their own account (i.e. what is known as “prop trading”) and that includes trading on commodities.

More importantly, the interconnection between banks and commodities is said to pose serious systemic risk for the entire economy as banks could be more directly affected by unfortunate events such as natural catastrophes hitting the supply and demand of particular commodities. Therefore, many consider that banks should not bear these additional risks, not only for their own sake but mainly for the stability of the whole economy.

Good reasons to stay together

However, despite the arguments cited above, we firmly believe that the positive impact of banks on the market for commodities should not be underestimated and that banks still have a decisive role to play in this field.

Banks play a crucial if not indispensable role as hedging services providers. Consider for instance a steel company that is willing to undertake major investments in the future that are going to be partially financed by its cash flows. The steel company might be willing to lock in sales prices in order to be hedged against steel price fluctuations. A bank can provide such a hedge by offering the company a forward contract by which it agrees to buy a certain amount of commodities at a certain delivery price. If there were no banks, the company would struggle to look for some other counterparty in the market with the exact opposite position, i.e. a company that would have to buy exactly the same amount of the exact same asset for the exact same period of time. Such loss of time and resources is fortunately made redundant by the active participation of banks because the latter help smooth the relationship between buyers and sellers. That is what some analysts mean when they say that banks add liquidity to the market for commodities. Also, in order to provide customized products for their clients and have the utmost understanding of what is going on, banks must be physically present in these markets. This implies that they must hold commodities stocks and assets as would any other standard commodity trading firms.

Better the devil we know?

Through their active participation, banks also stimulate competition in a sector that would otherwise be largely regulated by a set of prominent multinational commodity trading companies such as Vitol, Glencore Xstra ta or Trafigura. Without the physical presence of banks, the market for commodities would thus be even more oligopolistic than it already is, driving up prices and harming end consumers. Furthermore, these trading firms are far less controlled than banks are. Regulations such as Basel III and the Dodd-Frank Act do not apply to them. Letting these companies gain too much clout could therefore also pose a new kind of systemic risk and lead to another potentially “too big to fail” industry. So, if we had to choose, shouldn’t we opt for the devil we know? This is the question financial regulators around the world should be asking themselves right now.

[1] The formula used in the US in the context of Basel III is : “Risk-Based Capital Ratio (%) =  Regulatory Capital/ Risk-Weighted Assets” (http://usbasel3.com/tool/)

[2] http://www.bloomberg.com/news/2014-04-22/barclays-plans-to-exit-most-worldwide-commodities-activities.html

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