Streetwise Professor

October 17, 2013

Capital Surcharges on Bank Commodity Operations: Good in Theory, But Potentially Bad in Application

Filed under: Commodities,Derivatives,Economics,Energy,Politics,Regulation — The Professor @ 7:52 pm

In some earlier posts discussing the role of banks in commodity markets, I suggested that the decision should not be a binary one: banks in, or banks out.  Instead, the preferable approach would be to levy capital charges on bank commodity operations that reflected the risks of these operations, thereby attempting to ensure that banks internalize the TBTF costs associated with them and scale their commodity businesses accordingly.

The WSJ reports that the Fed is leaning towards this approach:

Federal Reserve officials are considering imposing a new capital surcharge on Wall Street banks that own oil pipelines, metals warehouses and other lucrative physical-commodities assets, according to people familiar with the matter.

Such an approach could encourage banks to pare back their involvement in physical commodities, which has increasingly raised concerns among regulators and lawmakers.

While no decision has been made, imposing a surcharge would allow the Fed to sidestep a legal jam caused by existing laws that set Goldman Sachs Group Inc. and Morgan Stanley apart from peers and give the former investment banks broad leeway to own commodities.

The devil, of course, is in the details.  The question is whether the surcharge will be set in a way that accurately reflects the relevant risks, or whether instead it will be set at punitive levels to achieve via misdirection what the Fed is apparently reluctant to do in a straightforward fashion (due to fears of legal challenge): i.e., precluding banks from participating in physical commodity markets.

In other words, this proposal is fine in principal, but could be a disaster in practice.  If the Fed really wants to drive banks out of commodity markets, I would much prefer it do so forthrightly, rather than by hiding behind capital surcharges that it chooses to achieve that outcome.

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  1. So, Prof, how do you see these capital surcharges working? Would the banks have to maintain higher capital specifically against their commodity operations? How would that be calculated? Some sort of VaR calc that takes account of the non-linearity of commodity exposures (e.g., an oil spill and the attendant costs if the bank is found guilty of negligence?) Would they still get to borrow at the discount window if their commodity operations threw them into distress?

    What do the banks bring to the market that the big commodity trading houses don’t offer? The trading houses don’t have the benefit of discount-window borrowing when the sh*t hits the fan; they have to fund their operations on a stand-alone basis, absent any government support. What benefit do taxpayers derive from the implicit (some would argue explicit) guarantee of Uncle Sugar ready to step in and keep them whole should they go distressed because of bad management decisions or poor internal controls? Should the bank guarantees be extended to the commodity trading houses if it is argued that this government support for the banks is beneficial to the markets?

    Comment by markets.aurelius — October 17, 2013 @ 9:22 pm

  2. @markets. All good questions. Right now it’s an idea, with zero details.

    Here’s the thing. Like you suggest, it’s not price risk that’s the issue. That’s relatively easy to handle. It’s the operational/legal risks. For instance, a massive spill from a Heidmar vessel or a massive explosion at a TransMontaigne storage facility. How do you estimate the exposure to that (net of insurance cover)?

    I am generally in favor of free entry, and policies that ensure (at least roughly) that costs and benefits are internalized. TBTF undermines the latter principle. But as I said in my post on the Kemp article, banning banks from the business altogether is likely inefficient, and reduces competition. Better to choose capital requirements that price the risk.

    With respect to pricing operational risks related to oil transport, storage, etc., insurance companies do this all the time. There is data. That data can be used to set capital cushions so that the likelihood of a bailout in response to an operational disaster is small.

    Alternatively, require massive insurance cover that makes the likelihood of a hit to bank capital small. Then let the insurance companies price and bear the risk, thereby keeping our uncle out of it, and Uncle’s hands out of our pockets.

    The ProfessorComment by The Professor — October 17, 2013 @ 10:23 pm

  3. Alternatively, require massive insurance cover that makes the likelihood of a hit to bank capital small. Then let the insurance companies price and bear the risk, thereby keeping our uncle out of it, and Uncle’s hands out of our pockets.

    Probably ain’t going to happen, Perfesser, too simple. After 30 years dealing with these people in one form or another, they gravitate between being power mad and risk averse – having an insurance company in the mix would probably be added into their counterparty risk testing / calculations. I see an amazing expansion for regulatory fiddle faddle with many opportunities for posturing, self promotion and lucrative consulting jobs after their retirement.

    Comment by Sotos — October 18, 2013 @ 1:05 pm

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