Streetwise Professor

July 26, 2013

Banking on Complementarity: More on Financial Firms Getting Physical

Filed under: Commodities,Derivatives,Economics,Energy,Politics,Regulation — The Professor @ 11:09 am

In its 2003 Physical Commodities Trading Order, the Fed permitted bank holding companies (not the depository institutions under the BHC umbrella) to purchase and sell physical commodities because they are “meaningfully connected to a financial activity such that it complements the financial activity.”

I mentioned one example of this the other day in the “Get Physical” post (and don’t worry: I won’t post any Madonna videos!), but want to go  into more detail.  The example is offtake agreements (and relatedly, tolling deals).  In these arrangements, a bank (or other counterparty) agrees to supply inputs (e.g., crude to a refinery, gas to a power plant) and receives delivery of outputs (e.g., gasoline and heating oil, electricity).

Refineries, power plants, and the like typically need to pay for the inputs they process before they receive payment for their outputs.  This creates a need for working capital to finance the timing gap between cash outflows and inflows.

Providing funding for working capital is clearly a traditional banking activity.  One way to do this is for the bank to provide a loan or credit facility, and leave the refiner or power plant to acquire inputs and market outputs, and bear and perhaps manage the price and operational risks associated with those activities.

This exposes the bank providing the funds to risk: adverse movements in prices could put the refiner or generator into financial distress, and perhaps cause a default.  The bank could require the borrower to hedge, but there is a moral hazard: if it doesn’t, or doesn’t do it effectively, the lender bears risk.  The bank can monitor, but this is costly, and often imperfect.

The moral hazard problem can be eliminated by passing the risk on to the lender.  An uptake agreement or tolling deal does this.  These types of deal implicitly provide funding to bride the outflow-inflow gap, and pass the price risks back to the lender.  The lender can manage these risks, and the agency cost in this arrangement is lower: there’s no moral hazard, and no need to monitor.  Thus, bundling price risk management and funding can reduce the cost of funding working capital needs.  This is presumably more valuable for lower credit quality refiners and generators.

There are other potential benefits.  The lender may have a comparative advantage in managing risk due to specialization and expertise in this function: banks and commodity trading firms have a comparative advantage in risk management.  Moreover, they may able to be able to manage risk more cheaply because they run large books: there are economies of scope in risk management.  For instance, a lender doing an uptake deal with a refinery is short crude and long products, but it might have a long crude position based on a trade it executed with producer, and might have a short products position as the result of a swap with an airline or heating oil dealer.  These natural hedges reduce the amount of trading necessary to manage the risks.

Moreover, trading firms specialize in marketing and logistics, and there are scale economies and scope economies in these activities.  It may be cheaper for a big trading shop to provide marketing and logistical services, thereby eliminating the need for the refiner or the power plant to pay the overhead associated with such activities.

Thus, there are strong complementarities that make it beneficial to bundle financing, logistical, and marketing activities for some firms that process commodities.  Who should provide these bundles?  Banks have comparative advantages in funding and risk management, and can develop and staff physical trading operations.  Commodity trading firms are typically more expensive suppliers of financing, but they have strong competencies in marketing and logistics.  So both banks and commodity traders are reasonable suppliers of the bundled services, and thus reasonable counterparties in offtake and tolling deals.

What would be the effect of banning some market participants, like banks, from these activities?  Econ 101 gives the answer.  If these entities currently supply the bundled service-as is the case today-elminating them from the market will shift up the supply curve for this service, and in equilibrium it will be more costly.  Meaning that refiners and power plants will incur higher costs that will be passed upstream (lower prices for inputs) and downstream (higher prices for outputs).  To the extent that restricting participation gives (or enhances) the market power of those who remain in the market, these effects will be exacerbated.

What if some market participants-such as banks-get a subsidy of some sort that allows them to offer these services below cost? That is a source of inefficiency, to be sure: too much of the service is provided in equilibrium, and the beneficiaries of the subsidy have an excessively large market share.  But it does not follow that banning the subsidized from the market is the right policy response.  It’s usually better to eliminate the subsidy, especially in the case of something like a too big to fail subsidy, which has pervasive and perverse effects in all the markets in which the subsidized banks operate.

Evaluating the regulation of bank participation in any market, including the commodity markets, should proceed along similar lines.  The concept of complementarity is the right way to consider these issues, and that principle can be analyzed in particular instances using basic economic analysis.  The survival principle also suggests that if a firm gets market share in a particular business, it is because it is providing that service at lower cost, or delivering higher quality.  If the lower cost is an artifact of some sort of subsidy, eliminate the subsidy, especially when it is a pervasive on that cuts across myriad lines of business.  Populist venting about banks, especially venting based on some cramped understanding of what banking is and predicated on some belief that the involvement of financial institutions in commodity markets is somehow unnatural, is counterproductive.  It is also likely really a mask for some political economy agenda, an effort to benefit one group of firms by handicapping-or eliminating-others.

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  1. Trading in physical commodities was dominated by large private firms (Cargill,Koch, Glencore) and the largest risk-taking banks, Morgan Stanley & J. Aron. They unlocked the value in the physical assets, by unbundling the financial optionality in assets, and arbing the physical and financial markets. As the financial markets deepened over last 20 years, more players got involved and tremendous value was created through better logistics and optimization- probably trillions of value. This is how market capitalism should work…

    But then FrankenDodd came along, and now the commodities trading world is in retro-grade. Back to the dark ages of non-optimal, and high-cost delivery of commodities. Banks are exiting, liquidity is drying up. Nobody is willing to sell a derivative to a municipal without fear of GiGi doing a holdup.

    The market cannot easily go overseas to avoid GiGi, because it is physical business. And small firms with perhaps the appetite to take the regulatory and legal risk, do not have the economic scale or capital cushion to absorb the commodity risk. The commodities market is screwed.

    Bleak days ahead. We will all be paying higher prices for energy, metals and ag products.

    Ironically, the commodities markets in Europe are still moving towards improved efficiencies and not in retro-grade. Large state-owned incumbents are being forced to open-up their local rent-capturing markets to other state-owned competitors, thanks to EU integration. These state-owned entities have the financial scale, political acumen and sufficient profit-seeking motive to keep the needle moving forward. Albeit slowly.

    Comment by scott — July 29, 2013 @ 11:30 am

  2. @scott. In my industry talks when Frankendodd was being debated and after it was passed, I said that commodities markets were singled out, and the worst hit. The implementation has made it only worse, and the recent regulatory crusades, and the political fury directed at bank trading, are driving out the banks.

    The effect will be to widen margins between sales and purchase prices. Not that anyone will profit much from this; the wider margins are necessary because costs are going up. Consumers will pay more, and producers will receive less. Those to blame will escape accountability. Indeed, they will preen and brag at how they’ve driven those evil financiers from the Temple of Commodities.

    Inframarginal incumbents-the Glencores, Vitols, Mercurias, Trafiguras, Kochs, ABCDs, most notably-will profit. The new entrants will break even. Everyone else will pay. The net effect will be a decline in wealth.

    The ProfessorComment by The Professor — July 30, 2013 @ 12:41 pm

  3. If commodities were not singled out under DF, they are at least neglected and overrun by the lobby efforts of the banks to protect their larger franchises in loans and fixed income. It costs a bank far more in capital to own a barrel of oil than it does to own a Greek bond, causing further departures from commodities by financial firms. I am certain Barclays (12b GBP hole) is jettisoning whatever remnants of commodities trading and assets it still has on its books. Perhaps gold will move from “commodity” rubric to “currency” to hold onto that lucrative business.

    Comment by scott — July 30, 2013 @ 11:49 pm

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