Net Net: Promoting innovation and managing change
Net Net: Promoting innovation and managing change

Senate panel to peek inside bank commodities operations

The Capitol Building in Washington D.C.
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If you're wondering why a few very large banks in the United States play such a big role in the commodities markets, you aren't alone. Most people reading the New York Times' article on Goldman's weird, confusing and very profitable role in warehousing aluminum probably found themselves scratching their heads a bit.

Traditionally, banks in the United States were kept out of commercial business. The reason for the separation of commerce and finance was two-fold: to protect the soundness of the financial system from turbulence in the broader economy and to protect the broader economy from being dominated by finance.

This latter point is particularly important. Allowing the same institutions that control access to credit to also control access to the basic units of production threatens to grant those institutions disproportionate control over the entire economy.

And yet, here we are. Goldman Sachs, JPMorgan Chase and Morgan Stanley are now major merchants of physical commodities and energy. How did we let regulated banks get a hold of this part of our economy? And what are they doing now that they are commodity and energy merchants?

The answer to the first question is relatively straight forward: 2008 happened. That's when Goldman and Morgan Stanley—which already had commodity merchant businesses—transformed themselves into bank holding companies in order to avail themselves of better protection from the Federal Reserve. That year, JP Morgan acquired Bear Stearns, which was a major energy player. So the current situation is, at least in part, a fallout from the financial crisis.

The second question is trickier. Goldman, Morgan Stanley and JP Morgan say almost nothing at all about their commodities and energy businesses. They're required to disclose just one thing to regulators: the total value of the commodities they hold on their balance sheet. But other than that, we're in the dark.

Goldman Sachs to blame?

The New York Times article describes Goldman shipping metal between various warehouses it owns. This somehow makes Goldman a lot of money—but despite the length of the article it appears that no one at the Times ever figured out exactly how this makes Goldman money. FT Alphaville—which has been reporting on the banks and commodities story for quite some time—makes a stab at describing what Goldman is up to, which seems to involve something called "dark inventory." The banks themselves aren't being very helpful here, generally issuing "no comment" response to press inquiries.

A subcommittee of the Senate banking committee is set to hold a hearing Tuesday morning that may, if things go well, shed some light on what's going on. One of the panelists will be Saule Omarova, an associate professor of Law at the University of North Carolina at Chapel Hill law school. Omarova pretty much wrote the book on banks as commodities merchants—almost literally, in fact. The draft of his 77 page paper describing the incursion of banking into the commodities business is a must read for anyone seriously interested in the subject.

One of the constant themes in his paper is the lack of detailed and reliable information about the transformation of banks into energy and commodities merchants. This lack of information, in turn, stifles public deliberation and may conceal serious public policy concerns.

Omarova also points out that the Federal Reserve, the primary regulator for the largest banks, lacks the adequate expertise to regulate and supervise companies that own things like oil pipelines, shipping vessels, and metal warehouses. The Fed may be a competent financial regulator but there's no way it can ever really be an everything-regulator. And we wouldn't want it to be even if it could.

Which leads to another point made in Omarova's paper—are these firms even governable? Most are led by men who are experts in one way or another in finance. The further their businesses get away from finance, the less likely the corporate leadership is to be able to understand and control the risks taken in energy and commodities markets.

It appears that one reason that banks have done so well—and grown so quickly—in the commodities business is that they are able to be "risk takers." That is to say, they can take risk off the balance sheet of other institutions and put it on their own. One reason for this is that banks have access to cheap financing and government support. In other words, the banks aren't just playing a large role here because they are somehow more efficient—they're playing a large role because they are too big to fail.

Tuesday's panel, of course, can only be the beginning. It will take a lot more than a hearing attended by a couple of academics and some folks from a beer company to crack the enigma wrapped around the mystery of bank commodity merchants. But at least it is a beginning.

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