Streetwise Professor

September 25, 2013

Kemp Fails to Convince

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis,Politics,Regulation — The Professor @ 6:51 pm

My frequent sparring partner, John Kemp of Reuters, reads the IHS study justifying the benefits of bank involvement in commodity markets, and is not convinced. I agree that the report is rather lame, but am not convinced by Kemp’s critique, and the policy implications he draws.

One of Kemp’s points is that banks are not essential to the purchase, sale, transportation, storage, or processing of commodities.  Other entities, most notably commodity trading firms like Vitol or Glencore or Trafigura, can provide the same services as the banks.

This is true, but beside the point.  There are few types of firms that are utterly essential, with no substitutes.  Even banks are not irreplaceable in the functions that Kemp, and others, agree is appropriate for them.  Their core function of providing credit can be performed by the capital markets.  Or loan sharks.

The fact that banks can profit as a result of their activities in physical commodities should create a rebuttable presumption that they are providing economic value.  In a reasonably competitive market, where costs and benefits are internalized, firms that survive do so because they can provide a good or service of equal or better quality at equal or lower cost to other potential suppliers.  Indeed, in these circumstances, all active sellers have marginal costs that are approximately equal: cost functions determine the relative outputs of the active suppliers.   Driving out suppliers who can profitably service part of the market will drive up prices, reduce output, and reduce welfare: some of the output supplied by the eliminated firms will go unproduced, and the rest produced at higher cost.

Competition is not the issue. The market for commodity intermediation is highly competitive: even the big banks account for a relatively small share of activity, and the biggest players account for no more than 5-6 percent of trading activity in any major commodity market.  And even if banks accounted for a big share, that could be due to a cost advantage.

Which brings me to Kemp’s second objection, which potentially has more merit.  The above says “where costs and benefits are internalized.”  Kemp brings up, quite properly, the possibility that banks get a subsidy as a result of too big to fail, and hence the true costs of their activities are not internalized.

The immediate implication of this is that banks are too big, and that there market share in physical commodity activities is too big.  But “too big” does not mean that the right share is zero.  Banning bank participation in physical commodity markets, or excluding them from certain activities, is likely to be an overreaction, not a Goldilocks (“just right”) strategy.  They might be too big now, but zero is almost certainly too small.

Note too that eliminating banks from physical commodity markets, or restricting their participation, does not eliminate the TBTF subsidy.  Yes, they might not be able to exploit the subsidy by getting too big in commodities, but they are not going to let the subsidy money burn a hole in their collective pockets.  Won’t let them exploit the subsidy in commodities?  They’ll find someplace else to do it.  Restricting activity in one market segment will not appreciably reduce the TBTF subsidy that banks reap.

The right way to address this problem is to find ways to get banks to internalize the true costs.  This is best done by capital requirements that reflect the risks of the activities banks engage in, and the costs associated with bail outs.  Restrictions on permissible activities are a meat cleaver approach that will not mitigate the TBTF subsidy.

Kemp also goes on about the metals warehouse games.  As I’ve said repeatedly, both here and in media interviews, banks are not uniquely positioned to engage in such sorts of shenanigans.  If the conditions are right, whoever owns the warehouses will play the games. The best way to deal with this problem is ex post deterrence, either through private action (e.g., the numerous class action lawsuits against Goldman for its alleged warehouse manipulations) or government enforcement actions.

The role of banks in physical commodity markets will remain under scrutiny-and attack-for the foreseeable future. Many of these attacks are predicated on ignorance, not to say stupidity.  Kemp isn’t guilty of those things, but his analysis is nonetheless misguided.  Even when he identifies a real potential problem-the TBTF subsidy-eliminating banks from the physical commodity market is not the appropriate way to address it.

This illustrates a general point I’ve mentioned in many forums.  Attempting to address TBTF problems, and systemic risk problems, through structural interventions such as clearing mandates, SEF mandates, Glass-Steagall, or preventing banks from participating in commodity markets, is inefficient and likely ineffectual.  It is better to operate at the level of fundamental incentives, by getting banks and other financial intermediaries to internalize the costs and benefits of their activities. This is an easy principle to state in the abstract, though hard to implement in practice: just what is the right capital charge overall, and how should different bank activities contribute to this charge?  Not an easy question to answer.  Although imperfect, that’s still a better way of addressing these problems than mandating market structures.

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  1. I agree 100% with your statement “This is best done by capital requirements that reflect the risks of the activities banks engage in, and the costs associated with bail outs. Restrictions on permissible activities are a meat cleaver approach that will not mitigate the TBTF subsidy,” Prof.

    I view BHC commodities intermediation as equivalent to savings-and-credit intermediation. However, it cannot be regulated in the manner money and credit are regulated — it is fundamentally global, and far beyond the control or scope of the Fed, the Treasury, the CFTC, the OCC, and other regulatory agencies to comprehend or encompass. The only way to effectively deal with the mismatch between commodities-market risk and the inability to effectively encompass intermediation — which, in the event of the failure of one or more of these BHC commodities units, unambiguously means taxpayers are at risk of once again having to bail out the BHC parents — is to, in effect, separately capitalize the commodities units of the BHCs.

    Toward that end, the appropriate capital structure of the commodities divisions of these firms would be: 1) equity-only investment by the parent BHC in the commodities units of those BHCs; 2) standalone debt unsupported in any way, shape or form by the parent company, such that the commodities units, if they seek debt funding, must fund themselves based on their own balance sheets and income statements, without any regard to the parent’s financials, and without any direct or indirect credit provision from the parent; and, lastly, 3) zero BHC parent-company guarantees for trading of any sort (physical, derivatives, futures, etc.) by the commodities units. That would get us closer to internalizing the risks and rewards within these units, without recourse to the parent BHCs, and, thru them, Uncle Sugar’s very deep pockets (in the event another round of bailouts is sought by the BHC parents).

    The virtue of this approach can be seen on the risk and credit sides: If the commodities units engage in business in which the risk was not commensurate with the reward (owing to … oh, I don’t know, the presumption that anything they do cannot and will not be allowed to fail by Uncle Sugar), or they tried to lever themselves beyond what lenders deem prudent, they either have to reduce their exposure to risky endeavours (i.e., business and business practices not favored by creditors), so as to bring the risk-reward tradeoff within limits demanded by debt providers, or raise additional equity from the parent (or other interested equity investors).

    If the commodities units fail, then the equity is wiped out and the creditors are left to fight over the scraps. Uncle Sugar stays on the sidelines watching, but not participating. What could be simpler?

    Comment by markets.aurelius — September 26, 2013 @ 10:29 am

  2. I’m interested in John Kemp’s claim that

    “If banks were forced to withdraw from physical trading, or required to scale back, existing trading houses and energy firms would probably expand to fill the gap, and specialist brokerages and dealers might flourish again.”

    To assert this, you would surely need to know what their physical trading positions are; in sufficient detail to know also that others have the capital and the risk appetite to take them on, and would do so despite the reduction in hedging liquidity that would follow a bank exit from the space.

    These seem (to me) to be assumptions beyond what the available data supports.

    Comment by Green as Grass — September 27, 2013 @ 3:52 am

  3. @Green. Yes. An assertion/assumption. As a general matter, though, if all participants have upward sloping marginal costs, the elimination of some firms from the market will result in the expansion of those who remain, but (a) total output will fall, and (b) the price of the service will fall. In the event, the trading firms will profit, and consumers of the service will be hurt. It’s an empirical question as to how steep the supply curves are, and hence what the price-quantity effects will be, but it is flatly wrong to insinuate that the “gap” that results from the (forced) exit of the banks would be filled 100 percent by the expansion of existing firms, or the entry of new ones which were too inefficient to compete before.

    The ProfessorComment by The Professor — September 27, 2013 @ 8:10 am

  4. Kemp’s assertion as @green reported it is astounding – has the man never taken micro economics 101, or is he an idiot, or is he dishonest? Or some combination of the above?

    I like some of @Markets ideas – the problem is that the BHC’s may not guarantee credits, have equity investments, etc. but there might be the fear in the market that any BHC that has a “stand alone” trading arm is still on the hook. The example that comes to mind is what happened to the SIV’s – these had to be taken back on balance sheet even though the equity holders were often not the Banks themselves. Fear doesn’t need reality to spread.

    Comment by sotos — September 27, 2013 @ 1:05 pm

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