Last week, Federal Reserve officials leaked to the Wall Street Journal their tentative plan to limit the ability of Goldman Sachs and big banks to own metals warehouses, power plants, and other physical commodity assets.
But experts say that, if implemented, the policy the Fed is floating would actually expand the rights of all banks to enter these physical markets, by creating an official entrance instead of locking the door shut. Presented like a deterrent, it would also be a novel enabler.
According to the Wall Street Journal, the Fed’s plan would call for balancing out the new right to hold assets with a requirement that banks hold more capital to cover the potential risks posed by these activities. The Fed declined to comment on the report but is expected to make a decision in the coming weeks.
Some experts believe that this additional cost will lead most banks to abandon these lines of business. But it’s an unsafe bet. Not only is it not clear how the Fed would structure these surcharges, there is no guarantee that a steep fee would push banks out. “When you have regulatory costs associated with highly lucrative businesses, the banks just typically pass them through to customers and end users,” said Josh Rosner, managing director of Graham Fisher & Co, who testified in July on a Senate hearing about whether banks should be doubling as oil refiners and coal miners.
The Fed’s given the public no insight into its thinking on this crucial decision, but a surcharge generally works like a tax, meaning it makes sense for banks to continue these businesses if they bring in significant revenue. In other words, a surcharge could actually encourage banks to scoop up warehouses and refineries any time profits from trading metals and oil soar. As Marcus Stanley, policy director at Americans for Financial Reform, explained, “Next time there is a commodity boom, you could get very nice returns even with capital surcharges.”
More than moral hazard
Commodity revenue at banks has tumbled recently, falling from a peak of $14 billion in 2008 to $6 billion last year. The downward cycle gives banks the chance to act like guests leaving a party that’s already over. But cycles are, well, cyclical—there’s no reason to think volatility, the siren song of commodity trading, won’t return.
It’s been well-documented by academics and verified by history that allowing banks to own non-banking businesses introduces a range of economic and political hazards. None of these would necessarily be priced into a surcharge, which generally only prices the risk posed to the bank and banking system itself. For instance, a bank that owns oil tankers would have less interest in lending to competing steamship companies. A surcharge would not address this conflict of interest.
These arrangements also incentivize price manipulation. This summer beer brewers, automakers, and other commercial businesses accused warehouses owned by Goldman Sachs and JP Morgan of hoarding metal and raising the price they pay to produce goods we all purchase, like soda cans and cars, which cost consumers billions.
Changing the rules of play
To appreciate the perversity of how this could unfold, it’s worth recalling how we got here. In 2008, as financial panic gripped the world economy, the Fed made an emergency decision to allow Morgan Stanley and Goldman Sachs to become financial holding companies. At the time the government agreed to backstop the two investment banks, and in exchange the banks had accept the far more stringent rules that apply to other taxpayer-backed banks. The banks were given five years to bring their businesses into compliance, a deadline that expired last month.
In the years since converting, however, Morgan Stanley and Goldman Sachs have argued that their right to own commodity assets is “grandfathered” by a broad, vague, and untested provision of the Gramm-Leach-Bliley Act of 1999. According to lawyers who have met with the Fed, officials there now agree with the banks that this clause protects their right to continue owning their vast stable of commodity assets.
The Fed’s tentative new plan would aim to level the playing field for all banks, but the crux is this: rather than requiring Goldman Sachs and Morgan Stanley conform to existing limits on all taxpayer-backed banks, the Fed would modify those limits to accord with the sweeping rights Goldman Sachs and Morgan Stanley claim they have now.
Citibank and JP Morgan, for example, have special Fed permission to deal in physical goods, like transporting oil and selling electricity, but cannot own physical infrastructure, like warehouses or refineries. Unless the Fed explicitly limited surcharges to Goldman Sachs and Morgan Stanley, the policy would allow Citibank and JP Morgan to own infrastructure too, as long as they paid the fee. In July, the Fed announced it was reviewing the exemptions it handed Citibank and others, though it won’t say when it will issue this specific ruling.
JP Morgan, which has managed to buy assets like warehouses despite the prohibition, put its physical commodity arm up for sale for $3.3 billion this month, citing regulatory hassles. The bank declined to comment on whether a surcharge policy would affect its decision to sell.
The Fed’s legal clout
Congress didn’t address the right of banks to own and deal in physical commodity assets in the Dodd Frank Act, the mammoth financial regulatory law it passed in 2010. A legislative staffer who worked closely on the Volcker rule—a Dodd-Frank provision that would ban speculative trading by banks—said legislators would have written a tighter law had they been aware of banks’ activities in physical commodity markets.
There’s reason to think the Fed isn’t as hamstrung as it seems to be acting. Some banking experts believe the Fed could override the grandfathering clause argument invoked by Goldman Sachs and Morgan Stanley. The Fed’s own broad powers give it ample authority to regulate banks in order to promote soundness and stability—a power the Fed used when agreeing to insure the risks posed by Goldman Sachs and Morgan Stanley in September 2008.
“[I]f the Fed wanted to be more assertive about this, there is no reason for them not to succeed,” said Saule Omarova, a banking law expert and professor at Cornell University School of Law.
As the Fed moves toward its decision, let’s hope it remembers that if it can employ its powers to save the banks, it can also use its muscle to constrict them.
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