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Are Banks About to Win on Commodities Trading After Their Success in Watering Down Basel III Capital Rules?

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You know it’s bad when Bloomberg’s editors attack the banks’ win against regulators, in this case, their success in watering down already-too-generous Basel III capital requirements. And they look primed to score a twofer on pending rulemaking on trading in physical commodities.

One of the hard-fought battles of Basel III was establishing limits on total leverage, as well as risk-weighted leverage. Basel II, which was implemented in Europe pre-crisis, called for risk-weighting of assets. You didn’t count every asset at its face or market value, add that up, and then use that to determine how much in equity a bank had to have as loss reserves; banks had to count only a percentage of the value of assets deemed to be less risky. For instance, the big reason Eurobanks wound up carrying huge holding of periphery country sovereign debt is that it carried a 0% risk weighting. We know how that movie turned out. And in general, that approach wasn’t terribly successful. As former central banker London Banker wrote:

I was looking at the preferred asset classes under the Basel Accords…and realised that every single asset class that is given less than a 100 percent credit risk weighting is now tainted by widespread default, scandals or bailouts.

The credit risk weightings mean that instead of reserving the standard 8 percent of capital in respect of a debt, the bank can cut that by the weighting applied to the asset class. Effectively, the reduction in credit risk weighting operates as a powerful subsidy to the borrowers and equally powerful incentive to over-leveraging the lenders.

The FDIC noticed that the banks that looked well capitalized under these sort of risk weightings (US regulators allowed similar principles to be applied pre-crisis) but had low capital if you used a simple equity versus total assets measure were the most likely to fail. So Sheila Bair, with the support of Dan Tarullo at the Fed, pushed hard and won what sounds like a skimpy requirement for equity to total assets: 3%. But even that meager requirement had the banks grumbling.

And recall that even Timothy Geithner had touted higher capital as the one-stop fix for other shortcomings in regulations. From the Wall Street Journal in 2010:

“The most simple way to frame it is: capital, capital, capital,” Treasury Secretary Timothy Geithner told Congress last year. “You want capital requirements designed so that, given how uncertain we are about the future of the world, [and] given how much ignorance we fundamentally have about some elements of risk, that there is a much greater cushion to absorb loss and to save us from the consequences of mistaken judgment.”

So fast forward and what happened? We turn the mike over to Bloomberg:

This week, the Basel Committee on Banking Supervision, an international group of regulators, announced a number of changes that will make the denominator in leverage ratios — total assets — less simple. Banks will be able to count as little as 10 percent of off-balance sheet commitments, such as letters of credit, as assets. Also, banks can net out cash they borrow and lend against securities in so-called repo agreements, as long as the deals are done with the same counterparty.

There’s a case of sorts for these relaxation… But there’s also a cost: Banks will have more opportunities to understate their assets.

What’s certain is that the changes represent an easing of requirements that were already too loose. The Basel rules require banks to have only $3 in capital for each $100 in assets by 2018 — meaning that a decline of just 3 percent in the value of a bank’s assets could render it insolvent…When capital is so thin, a little manipulation can mean the difference between stability and systemic crisis.

Experience and research strongly suggest that much higher leverage ratios — as high as $20 in capital per $100 in assets — would provide a net benefit by reducing the likelihood of economy-killing financial disasters. The dangers of an undercapitalized banking system have just been vividly demonstrated. Regulators recognized the problem, but they tightened capital-adequacy rules too little. They would do better to show more resolve.

The fact that Bloomberg’s editors are citing the 20% capital ratio, based on the work of Stanford professor Amat Admati, shows that more and more orthodox sources are recognizing the need for way more capital. Too bad the critical players take the banks’ pleadings seriously.

The banks look on their way to scoring another important win on a different front: trading in physical commodities. Most of the financial press is reporting that tougher rules might be in store, due in large measure to pressure by senators led by Sherrod Brown plus media stories of how banks are using their strategic position in storage and delivery to reap large profits at the expense of real-economy users. An important New York Times investigation charged that Goldman was using its large aluminum warehousing operation to inflate inventories, ultimately costing end users $5 billion. So in keeping with official messaging, Bloomberg tells us: Fed Weighs Further Restrictions on Banks’ Commodities Units.

An exclusive report by Shahien Nasiripour of Huffington Post gives a very different picture:

Big banks are poised to reap a significant victory in their fight to maintain lucrative businesses hoarding, selling and trading physical commodities as the Federal Reserve prepares to punt on the issue, people familiar with the matter said.

The Fed’s move to solicit public input on what it should do, rather than use its authority to regulate the activities of large financial institutions, is expected to be announced by Wednesday afternoon in advance of a Senate Banking Committee hearing on the issue. Some federal financial regulators said the move may be a way for the Federal Reserve’s Board of Governors in Washington to evade calls to curb banks’ risk-taking.

Translation: the Fed has the power, now, to tell the banks to cut it out and exit or curtail their participation in the trading of physical commodities (note that former investment banks that are now under the Fed’s purview have physical commodities trading grandfathered for a few years; Goldman cheekily expanded its activities by acquiring a major aluminum warehousing operation that was the focus of the New York Times expose. the Fed blandly permitted it rather than calling out the violation of the intent of the waiver).

By having the Fed rely on the public comments process, it enables the banks to throw their firepower at it, both directly and through all sorts of proxies (friendly think tanks, fake public interest groups). It’s the same sort of concerted effort that enabled banks to score their Basel III win; why shouldn’t the same route be even more successful with a bank-friendy Fed?

The Huffington Post article notes:

It’s likely to stoke criticism that the central bank, while taking some action to reduce the risks large lenders pose to the financial system, is shirking its responsibility to ensure financial stability.

“This is clearly an attempt to avoid dealing with the issues while pushing back against public pressure,” said Joshua Rosner, managing director at independent research firm Graham Fisher & Co….

JPMorgan Chase, Goldman Sachs and Morgan Stanley now are among the nation’s biggest suppliers of energy, according to industry rankings and federal data. Over the last several years, the three banks were among a group of select financial institutions to broaden their physical commodities activities as the sector promised substantial revenues that, coupled with the banks’ traditionally low cost of financing, guaranteed steady and at times enormous profits.

Yet again, it’s important for members of the public to demand that banks operate in the public interest, not for their own outsized enrichment. Being able to use their weight to move commodities markets is a clear-cut transfer from the productive economy to the Wall Street casino. The Fed’s complacency is proof yet again of whose interest it really cares about. Please call your Senators and tell them to come down hard on the central bank for its cravenness.

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27 comments

  1. fajensen

    One of the many problems politicians have with raising capital requirements for banks is that banks are effectively competing with governments in extracting taxes. Banks would immediately charge customers for the entire costs of raising reserve capita, adding opportunity costs and less lending also, so at least some multiple of that money effectively disappears from the economy instantly making the recession even worse than the politicians intend/plan it to be.

    The FED is the Bank of The Bankers – Of Course the FED will not regulate anything. It is indeed a question if the FED dares to regulate – or even do it’s job anymore. The total world market in unregulated derivatives is about 720 Trillion USD, 11 times world GDP. If the FED does *anything at all* it is likely that something unregulated blows up. If the unregulated derivatives market lose 2% in “value” (and it is easy to lose 2% in proper markets), that is 14 Trillion USD or just about the entire US GDP down the drain – which just might leave a mark in the accounts of the FED since they are (probably still) backstopping a good chunk of that “market”!

    1. F. Beard

      Banks would immediately charge customers for the entire costs of raising reserve capita, fajensen

      Why? How does a bank selling more common stock raise its operating costs? All it does is cut profits per share.

      1. fajensen

        Because fees are not there to cover operating costs. Generating and collecting fees is the main business of the banks these days, with Zero interests rates it is quite logical too.

        At least “here” in Scandinavia, banks are busy lowering operating costs and raising their fees at the same time. The “too-big/crooked-to-fail” ones owns interbank transfers, so it is not a question of customers going to another bank to escape.

        1. F. Beard

          When we’ll we ever be rid of banking? How much more abuse will people take before they set their minds to killing that invention from Hell?

  2. Yonatan

    These ‘banks’ are no longer banks. The privileges associated with being a bank should be revoked. The can then become just another Cargill, etc.

  3. ReaderOfTeaLeaves

    It’s things like this post that make me wonder how close we are to a moment when government needs public support, claiming to protect us all, and 95% of the population shrugs, yawns, and ignores the pleas. This is ludicrously self-defeating for government.

    FWIW, Josh Rosner’s analysis is always insightful. The dynamics he describes are yet one more example of failed, captured government. Ominous.

  4. Chauncey Gardiner

    Thank you for this post. It has become difficult to even respond objectively anymore to such blatant, in-your-face demonstrations of raw political power so that a few individuals can pursue speculative endeavors for short-term personal financial gain. As your article demonstrates, there is no effective counterbalance. I expect the implications of policies that enable a relative few individuals to continue their behavior of privatizing speculative gains while transferring and socializing losses without any meaningful personal risk or moderation will be born out in time.

    Who was MF Global? Who was Lehman?

  5. Shane

    Rise of the banks huh? Well I, for one, have long given up on the thought of banks operating at the best interest of the public. Business, controlling the market — these are all they ever care about, or so their recent moves suggest.

  6. Gibby the GFifth

    One of the few ways to cut out this nonsense is to eliminate the tax deductibility of interest, so that the borrower would face a much higher cost to borrow money. I assume that would cause a significant reduction in leverage at companies, and reduce the volume of lending by making companies use higher levels of equity. Presumably banks would respond by returning equity, but at least the commercial sector of the economy would be less highly leveraged.. Tougher for private equity but who cares about those guys anyway? The main difficulty would be ensuring that the tax deductibilty was eliminated across the world, later on we could address whatever schemes the banks would dream up to game the rules. I also have a major objection to Basel rules, which is that so far as I am aware, risk weights stay constant during a cycle regardless of price and risk changes. In 2003 it mazy have been fair to assume low risk weightings for mortgages, by 2007 that was clearly incorrect. So risk weightings need to be dynamic, and you can see how well the HKMA has managed this process by looking at their frequent adjustments to the minimum down payment required at different points in the HK house price cycle.

  7. F. Beard

    The issue which has swept down the centuries and which will have to be fought sooner or later is the people versus the banks. Lord Acton

    This could be the generation that wins that fight. If not, it has no excuse.

      1. Sammy Maudlin

        Okay, I’m freaked out. What are the odds that, out of the whole wide interwebs, you would cite an article from 2001 that I just discovered and pointed someone else to today. Cosmic. Maybe Mr. Beard has an answer for that.

      2. Chauncey Gardiner

        Thank you for posting that link, Skippy. I have only just begun reading it, but it appears to provide some excellent background on the theory tree upon which many of the ornaments are hung.

      3. F. Beard

        BTW What causes wages to rise and what causes them to fall? skippy

        Probably labor unions and the lack of labor unions respectively.

        Is it better with earned credits (money) skippy

        If you mean fiat then yes since there is no need for the supply of fiat in the economy to ever shrink since the monetary sovereign should NEVER run a budget surplus and the central bank should not exist.

        1. Skippy

          “Probably labor unions and the lack of labor unions respectively.” – beardo

          Why is it O’Tay in your reality for people to form corporations et al and project that bargaining power and not wage earners.

          Skippy… do I smell a wee bit of volunteerism in the air?

          1. F. Beard

            I’m not against labor unions nor any other voluntary non-criminal association. And if it were up to me, workers could strike indefinitely because the entire population would have a generous guaranteed income.

            And if companies don’t like strikes then let them give the workers a stake (common stock) in the company like I’ve been saying all along.

            1. skippy

              I was being nice beardo due the lack of knowledge in your answer wrt what causes wages to rise and what causes them to fall, especially since our host and others have unpacked that quite clear over the years.

              Have you ever read Econned or stuff like the Powell memo, Carter doctrine, how industry started the conservative think tank projects like NBER et al or do you just use your sociopolitical document, in an act of faith, and just run around looking for anything to confirm that bias – project it as a narrative to the next reality with out critical thinking – believing it will come true.

              If you read the link I gave it might enlighten you a bit, especially since after all the gains in increased productivity have only gone upward since the 70s.

              Skippy… Hint it has nothing to do with unions.

              1. F. Beard

                … especially since after all the gains in increased productivity have only gone upward since the 70s. skippy

                To the common stock holders which the workers might easily be without the government-backed/enforced counterfeiting cartel, the banking system.

                Instead, the workers’ jobs have been automated and outsourced away with their own stolen purchasing power. Labor cartels were an effective counter to the credit cartel until that happened and still are when jobs cannot be outsourced or automated away (yet).

                or do you just use your sociopolitical document, in an act of faith, skippy

                So my faith caused the Bible to have the paradox that profits are good but profit-taking isn’t, leading me to the insight that common stock is a Biblically acceptable means to consolidate capital for economies of scale?

                1. skippy

                  Using real time and near real time data is more conclusive wrt workable out comes.

                  skippy… your data is century’s old, the updates since then are orders magnitude cubed above it. If your data can’t even get Human Nature right what bloody good is it. Insert Quote about repetitive failures and dogmatic responses.

                  1. F. Beard

                    Now you’re re-submerging into the fog of incomprehensibility.

                    Hint: Aim for maximum clarity always or “Aim small, miss small” as Mel Gibson’s character said in “The Patriot.”

                    1. skippy

                      Ok let make it simple, the opinions of the past have little workability in the now. It might as be as if were talking about two completely different planets all together.

                      skippy… the “Human Nature” bit is spot on IMO i.e. free will and such.

    1. Chauncey Gardiner

      F. Beard,

      Thank you for mentioning that quote. I recalled that Jesse, at Jesse’s Cafe Americain – who Yves links to in her blog roll – has also posted it from time to time. Jesse has a quote up today by Aung San Suu Kyi, as well as posting a song by Sam Cooke.

      1. F. Beard

        Jesse be a gold-bug, no? Then he has the future pleasure of learning that without government privilege gold will be a failure in a true free market of private money creation.

  8. Sammy Maudlin

    “Being able to use their weight to move commodities markets is a clear-cut transfer from the productive economy to the Wall Street casino. ”

    The arrogance of these banks. Thinking they can get the federal government to turn a blind eye, or even assist them, in creating market conditions that ensure profits for themselves while causing economic damage to other businesses and the American populace in general.

    I mean, who do they think they are? The health insurance industry?

  9. Fiver

    In what other essential activities might banks legally take a position between suppliers and consumers? Bandwidth? Water? Patents? Pimping? Weapons? NSA?

    Every day, effecting multiple outrages against all reason or decency, these global cysts that are choking our collective blood supply have grown huge, ponderous, scaly, grizzled and putrid. All they can do is buy votes and grow their tendrils. They are as useless as an extra arse and at some point they are coming off for good.

    You’d think they were deliberately setting up all the tiles for another domigeddon.

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