[Senate Hearing 113-67]
[From the U.S. Government Publishing Office]
S. Hrg. 113-67
EXAMINING FINANCIAL HOLDING COMPANIES: SHOULD BANKS CONTROL POWER
PLANTS, WAREHOUSES, AND OIL REFINERIES?
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HEARING
before the
SUBCOMMITTEE ON
FINANCIAL INSTITUTIONS AND CONSUMER PROTECTION
of the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED THIRTEENTH CONGRESS
FIRST SESSION
ON
EXAMINING PERMISSIBLE BANKING ACTIVITIES UNDER THE BANK HOLDING COMPANY
ACT (BHCA)
__________
JULY 23, 2013
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
Available at: http: //www.fdsys.gov /
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
TIM JOHNSON, South Dakota, Chairman
JACK REED, Rhode Island MIKE CRAPO, Idaho
CHARLES E. SCHUMER, New York RICHARD C. SHELBY, Alabama
ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee
SHERROD BROWN, Ohio DAVID VITTER, Louisiana
JON TESTER, Montana MIKE JOHANNS, Nebraska
MARK R. WARNER, Virginia PATRICK J. TOOMEY, Pennsylvania
JEFF MERKLEY, Oregon MARK KIRK, Illinois
KAY HAGAN, North Carolina JERRY MORAN, Kansas
JOE MANCHIN III, West Virginia TOM COBURN, Oklahoma
ELIZABETH WARREN, Massachusetts DEAN HELLER, Nevada
HEIDI HEITKAMP, North Dakota
Charles Yi, Staff Director
Gregg Richard, Republican Staff Director
Dawn Ratliff, Chief Clerk
Kelly Wismer, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
______
Subcommittee on Financial Institutions and Consumer Protection
SHERROD BROWN, Ohio, Chairman
PATRICK J. TOOMEY, Pennsylvania, Ranking Republican Member
JACK REED, Rhode Island RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York DAVID VITTER, Louisiana
ROBERT MENENDEZ, New Jersey MIKE JOHANNS, Nebraska
JON TESTER, Montana JERRY MORAN, Kansas
JEFF MERKLEY, Oregon DEAN HELLER, Nevada
KAY HAGAN, North Carolina BOB CORKER, Tennessee
ELIZABETH WARREN, Massachusetts
Graham Steele, Subcommittee Staff Director
Tonnie Wybensinger, Republican Subcommittee Staff Director
Kathryn Milani, Legislative Fellow
(ii)
C O N T E N T S
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TUESDAY, JULY 23, 2013
Page
Opening statement of Chairman Brown.............................. 1
WITNESSES
Saule T. Omarova, Associate Professor of Law, University of North
Carolina at Chapel Hill........................................ 3
Prepared statement........................................... 35
Response to written questions of:
Chairman Brown........................................... 81
Randall D. Guynn, Partner & Head of the Financial Institutions
Group, Davis Polk & Wardwell LLP............................... 5
Prepared statement........................................... 60
Response to written questions of:
Chairman Brown........................................... 82
Joshua Rosner, Managing Director, Graham Fisher & Co............. 7
Prepared statement........................................... 69
Response to written questions of:
Chairman Brown........................................... 88
Timothy Weiner, Global Risk Manager, Commodities and Metals,
MillerCoors LLC................................................ 9
Prepared statement........................................... 76
Response to written questions of:
Chairman Brown........................................... 90
Additional Material Supplied for the Record
ALCOA prepared statement......................................... 103
(iii)
EXAMINING FINANCIAL HOLDING COMPANIES: SHOULD BANKS CONTROL POWER
PLANTS, WAREHOUSES, AND OIL REFINERIES?
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TUESDAY, JULY 23, 2013
U.S. Senate,
Subcommittee on Financial Institutions
and Consumer Protection,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Subcommittee convened at 10:05 a.m. in room SD-538,
Dirksen Senate Office Building, Hon. Sherrod Brown, Chairman of
the Subcommittee, presiding.
OPENING STATEMENT OF CHAIRMAN SHERROD BROWN
Senator Brown. The Subcommittee will come to order.
Thank you to the four witnesses. Thank you for those of you
in attendance for being here and part of this interesting
hearing. I will begin. Senator Toomey will join us in a few
moments, and I understand a couple of other Members will likely
be here.
In 1913, former Supreme Court Associate Justice Louis
Brandeis voiced concerns about the growth of trusts in the
United States. He said:
Investment bankers became the directing power in railroads,
public service, and industrial companies through which our
great business operations are conducted. They became the
directing power also in banks and trust companies. Distinct
functions each essential to business and each exercised
originally by a distinct set of men became united in the
investment banker. It is to this union of business functions
that the existence of the money trust is mainly due.
Today, large, complex, opaque, diverse corporations, we
know, of course, are no longer called trusts. Instead, we have
financial holding companies, large conglomerates combining
banks and trading firms and energy suppliers and oil refiners
and warehouses and shipping firms and mining companies.
The question is, how did we get here? For years, our Nation
had separated banking from traditional commerce. But in 1999,
after years of eroding that protection, finally, Congress tore
down that wall. Beyond just combining commercial banking with
insurance and investment banking, banks were now allowed to
trade in commodities and to engage in a variety of nonfinancial
activities.
Four years later, the Federal Reserve enabled the first
financial holding company to trade in physical commodities. The
justification for allowing this activity is a familiar one.
Other companies were doing it. Banks were at a competitive
disadvantage.
Over the next 6 years, the rules became looser and looser.
Goldman Sachs, in its own words, now engages in the production,
storage, transportation, marketing, and trading of numerous
commodities, including crude oil products, natural gas,
electric power, agricultural products, metals, minerals,
including uranium, emission credits, coal, freight, liquefied
natural gas, and related products. This expansion of our
financial system into traditional areas of commerce has been
accompanied by a host of anti-competitive activities,
speculation in oil and gas markets, inflated prices for
aluminum and, we learned, potentially copper and other metals,
and energy manipulation.
It has also been accompanied by important and troubling
questions. Do the benefits of combining these activities
outweigh the harm to consumers and to manufacturers? Can
regulators or the public fully understand these large and
complex financial institutions and the risks to which these
firms are exposing themselves and, importantly, the rest of
society? Are the laws and regulations sufficiently stringent
and transparent, and are regulators enforcing them aggressively
enough? And what do we want our banks to do, to make small
business loans or refine and transport oil? To issue mortgages
or corner the metals market?
There has been little public awareness of or debate about
the massive expansion of our largest financial institutions
into new areas of the economy. That is in part because
regulators, our regulators, have been less than transparent
about basic facts, about their regulatory philosophy, about
their future plans in regards to these entities.
Most of the information that we have has been acquired by
combing through company statements in SEC filings, news
reports, and direct conversations with industry. It is also
because these institutions are so complex, so dense, so opaque
that they are impossible to fully understand. The six largest
U.S. bank holding companies have 14,420 subsidiaries, only 19
of which are traditional banks. Their physical commodities
activities are not comprehensively or understandably reported.
They are very deep within various subsidiaries, like their
fixed-income currency and commodities units, Asset Management
Divisions, and other business lines. Their specific activities
are not transparent. They are not subject to transparency in
any way. They are often buried in arcane regulatory filings.
Taxpayers have a right to know what is happening and to
have a say in our financial system because taxpayers, as we
know, are the ones who will be asked to rescue these megabanks
yet again, possibly as a result of activities that are
unrelated to banking.
I thank the witnesses for being here. I look forward to
their testimony, and I will introduce the four of them now for
your opening statements.
Saule Omarova is an Associate Professor of Law at the
University of North Carolina at Chapel Hill Law School. Prior
to joining the Law School, Professor Omarova practiced law in
the Financial Institutions Group of Davis Polk and Wardwell,
where she specialized in a wide variety of corporate
transactions and advisory work in the area of financial
regulation. In 2006 and 2007, she served at the U.S. Department
of Treasury as a Special Advisor for Regulatory Policy to the
Under Secretary for Domestic Finance.
Randall Guynn has served as partner and head of Davis
Polk's Financial Institution Group since 1993. Coincidentally,
or perhaps not so, he was Professor Omarova's supervisor while
she worked at the firm. I noticed the glancing look there when
I said Davis Polk. They will agree on everything today, I
understand.
[Laughter.]
Senator Brown. His practice focuses on providing bank
regulatory advice and advising on M&A and capital markets
transactions. He has advised all the United States' six largest
banks and many non-U.S. banks on Dodd-Frank and its regulatory
implementation.
Joshua Rosner is Managing Director at independent research
consultancy Graham Fisher and Company. He advises regulators
and institutional investors on housing and mortgage finance
issues. Mr. Rosner was among the first analysts to identify
operational and accounting problems at the Government-Sponsored
Enterprises and was one of the first to identify the peak in
the housing market and the weaknesses in the credit rating
agencies' rating of collateralized debt obligations. Mr. Rosner
co-authored Reckless Endangerment with New York Times columnist
Gretchen Morgenson, which traces the beginning of the housing
crisis.
Tim Weiner is the Global Risk Manager of Commodities and
Metals for MillerCoors. With 29 years of risk management,
commodity training, and fund management in many globally
exchanged, traded, and over-the-counter futures and options,
including interest rate, agricultural currency, metals, and
energy commodities for the last 7 years, he has managed
commodity price risk at MillerCoors for multiple commodities
with a primary focus on global aluminum.
So, we will start with Ms. Omarova. Please proceed. And
thank you all four for joining us, and please proceed.
STATEMENT OF SAULE T. OMAROVA, ASSOCIATE PROFESSOR OF LAW,
UNIVERSITY OF NORTH CAROLINA AT CHAPEL HILL
Ms. Omarova. Thank you for the opportunity to testify on
this important issue today. You have my written statement that
lays out the details of what I have to say, so let me focus on
a few key points.
I am an academic and my job is not to represent the
interests of any particular industry. My job is to ask
questions that need to be asked. One such question which I have
been researching for some time concerns the legal and policy
implications of what appears to be a significant expansion over
the past decade or so of large U.S. banking institutions into
physical commodity and energy markets.
These bank holding companies, or BHCs, own federally
insured banks, and as a result are subject to the Bank Holding
Company Act of 1956 that significantly limits their ability to
conduct nonfinancial commercial activities. Yet, these
companies through their nonbank subsidiaries currently own and
operate metals warehouses, oil pipelines and terminals,
tankers, electric power plants, and coal mines. This phenomenon
raises potentially significant regulatory and policy questions.
The foundational principle underlying U.S. bank regulation
is the principle of separation of banking from general
commerce. Since at least 1863, federally chartered banks have
been allowed to engage only in the business of banking and,
therefore, prohibited from trading physical commodities other
than gold and bullion.
In 1956, Congress extended the same principle to banks'
parent companies, BHCs, and generally limited their activities
to those closely related to banking. The Gramm-Leach-Bliley Act
of 1999, which partially repealed the Glass-Steagall Act, also
allowed certain qualified BHCs or financial holding companies
to expand their commercial activities, subject to certain
limits.
Since the early 2000s, several large firms have availed
themselves of these newly created statutory powers to grow
physical commodity operations. Now, depending on the nature and
magnitude of these operations, which we currently do not have
the means of tracking, this trend potentially undermines the
principle of separation of banking from commerce and implicates
specific policy concerns behind that principle.
Let me give you a few examples of such potential concerns,
including safety and soundness of financial institutions,
potential systemic risk, market integrity and consumer
protection, firm governability, regulatory capacity, and
concentration of financial and economic power.
Safety and soundness. Financial institutions may argue that
allowing them to trade crude oil will enhance their safety and
soundness by diversifying their sources of income. However, it
will also expand the sources of risk to these institutions.
What if the Deepwater Horizon disaster happened on an oil-rig-
owned and operated by JPMorgan? How would that affect Chase's
deposit base?
Systemic risk. In the same example, how would the news
about JPMorgan's oil spill affect the financial markets in
which JPMorgan is a major dealer and counterparty? Would that
also rattle, for example, Citigroup and Bank of America, who
have huge exposures to JPMorgan?
Market integrity and consumer protection. If the same
financial institution, for example, Goldman Sachs, is a major
dealer and trader in both oil derivatives and underlying
physical oil, the potential for market manipulation and
artificial inflation of consumer prices is obvious.
Leakage of public subsidy. The financial industry often
asserts that banks' entry into commercial sectors provides
public benefits by increasing competition and by enabling them
to provide better, more efficient services to their clients.
What these claims leave out, however, is the potential
competitive advantage that the Federal subsidy of banking
institutions gives them when they act in commodity markets. An
oil refinery may very well benefit from a low cost of its crude
inventory supplied entirely by Morgan Stanley. But is Morgan
Stanley able to offer the low price because its own cost of
funding is partly subsidized by the taxpayer?
Institutional governability. Allowing large financial
conglomerates to grow commodity merchant operations may make
their internal risk management much more challenging. These
institutions already are enormous and complex, and making them
even bigger and more complex may make the next ``London Whale''
episode much more likely to happen.
Regulatory capacity. Even more troubling is the fact that
bank regulators, including the Fed, may be incapable of
effectively monitoring and overseeing complex financial
industrial conglomerates. Bank regulation is simply not geared
toward controlling the risks of banking institutions acting
like Enron. Other regulators cannot fill that gap effectively,
as each one may be looking only at the slice of the
conglomerate's activities where the essence of the problem is
the whole.
Finally, political economy. It has been a venerable
American tradition to view large aggregations of economic and
financial power in the hands of a few money trusts with great
suspicion and fear of this power translating into political
influence. If the same institutions that control the flow of
credit throughout the economy also control the flow of raw
materials, these fears are greatly exacerbated.
In conclusion, let me emphasize that I am not arguing that
any of these policy concerns actually presents an imminent
danger and must be acted upon in a hurried manner. At this
point, we simply lack the necessary data on what exactly is
happening in this space and how risky it all may be. If
sunlight is the best disinfectant, however, it will do us good
to shine some intense light on BHCs' commodity activities.
Thank you.
Senator Brown. Thank you very much, Ms. Omarova.
Mr. Guynn.
STATEMENT OF RANDALL D. GUYNN, PARTNER AND HEAD OF THE
FINANCIAL INSTITUTIONS GROUP, DAVIS POLK & WARDWELL LLP
Mr. Guynn. Thank you, Chairman Brown, Ranking Member
Toomey, and Members of the Subcommittee.
The regulation of our financial system is a serious matter.
Having rules and regulations that ensure an appropriate level
of financial stability while allowing the financial system
enough flexibility to innovate, meet ever changing client
needs, and otherwise adjust to ever changing market conditions
is essential.
A longstanding principle of our banking laws is that
banking should generally be separate from commerce. Thus, our
banking laws generally do not allow the Wal-Marts of the world
to own a bank or vice-versa. But our banking laws have allowed
banks to buy and sell gold, silver, and other precious metal
commodities since at least 1863. They have also allowed them to
buy and sell a wide variety of derivative contracts, including
contracts for physical commodities, for many decades, as long
as these contracts have been traded on recognized exchanges or
have otherwise been sufficiently liquid to be appropriate
banking assets.
The connection between banking and commodities is not a new
development. It has very ancient roots. Physical commodities,
such as grain and salt, were among the first forms of money in
ancient Mesopotamia, Egypt, China, Japan, and even the colonies
that became the United States. These physical commodities have
the essential characteristics that we have come to associate
with money: Fungibility, divisibility, and relative liquidity.
Indeed, the modern history of banking began with grain
merchants in Lombardy. Many of the merchants of the 19th
century in the United States similarly started as dry goods and
commodity traders, including Lazard Brothers and Brown
Brothers. The private banking partnership of J.P. Morgan
engaged in a wide variety of activities, including investing in
physical commodities and related facilities. In short, U.S.
banks and other financial institutions have long been actively
involved in the physical commodities markets.
Congress understood this history when it enacted the Gramm-
Leach-Bliley Act in 1999 and expressly authorized financial
holding companies to engage in merchant banking and permanently
grandfathered the commodities activities of investment banks
that were not yet bank holding companies. Congress clearly
understood and expected the Federal Reserve to permit the new
Citigroup to retain its physical commodities affiliate, Phibro.
Indeed, the only issue in controversy was whether Congress
would allow the new Citigroup to rely on the commodities
grandfathering provision. Ultimately, Congress revised the
grandfathering provision to exclude the new Citigroup, but did
so fully understanding and expecting that Citi would be able to
obtain these powers through the new complementary powers
provision.
Thus, when Professor Omarova and Mr. Rosner describe the
physical commodities powers in modern banks and bank holding
companies as a radical departure from the traditional
separation of banking and commerce, or that the Federal Reserve
somehow went rogue to the surprise of Congress when it allowed
Citigroup to retain Phibro, they are engaging in revisionist
history. This was not radical. It was not a breach of the
traditional principles separating banking from commerce. And it
was not unexpected by Congress.
The problem with treating the general principle of
separating banking from commerce as a strict legal wall is that
reasonable people disagree over where the line between banking
and commerce should be drawn. Professor Omarova believes that
it should exclude physical commodities activities. But former
Congressman Jim Leach of Gramm-Leach-Bliley fame, one of the
most ardent and consistent champions of the separation of
banking from commerce, would disagree. As recently as 2008,
former Congressman Leach said that the merchant banking,
complementary powers, and commodities grandfathering provisions
of the Gramm-Leach-Bliley Act did not breach this principle.
In their written testimony, Professor Omarova and Mr.
Rosner identify a long list of potential--and I stress
``potential''--dangers of allowing financial holding companies
to continue to engage in physical commodities activities, but
they do not provide a shred of evidence to support the view
that these potential dangers are likely to be realized. In
contrast, both the Congress that enacted the Gramm-Leach-Bliley
Act and the Federal Reserve Board that granted the
complementary powers to Citigroup concluded that the public
benefits of allowing financial holding companies to engage in
physical commodities activities were likely to outweigh their
potential adverse effects. I refer the Subcommittee to my
written testimony outlining the numerous public benefits and
the safeguards that are designed to prevent any potential
adverse effects.
In conclusion, it is certainly appropriate for this
Committee to review whether our banking laws, including the
extensive amendments made by the Dodd-Frank Act, reflect an
appropriate balance between financial stability and operating
freedom. But in light of the history of the longstanding
connection between banking and commodities activities, the
extensive public benefits of allowing financial holding
companies to engage in these activities, and the relevant
safeguards, my view is that this Subcommittee should not seek
to repeal or curb these powers unless and until substantial
evidence is provided that these commodities powers cannot, in
fact, be exercised without creating a substantial risk to the
safety or soundness of depository institutions or the financial
system generally.
Thank you.
Senator Brown. Thank you, Mr. Guynn.
Mr. Rosner, please proceed. Thank you for joining us.
STATEMENT OF JOSHUA ROSNER, MANAGING DIRECTOR, GRAHAM FISHER &
CO.
Mr. Rosner. Thank you. Chairman Brown, Ranking Member
Toomey, Members of the Subcommittee, thank you for having me
here to testify this morning. I would hope that you would read
my written testimony.
My name is Josh Rosner, and a an independent bank analyst,
I saw the mortgage crisis firsthand. I warned it was coming,
but too few listened. It resulted in the loss of $7 trillion in
real estate wealth. The recession that followed still shackles
a generation of our fellow Americans, many of whom lost jobs,
lost homes, lost hope.
Mixing banking and commerce will not bring these trillions
back. It will not help the working class, the middle class, the
upper-middle class, or the investor class. In fact, it has
already cost them billions. It will not help anyone but those
bankers.
What I see now in the mixing of commerce and banking is the
dawn of a new Gilded Age, where the fruits of all are enjoyed
by a few, where competition in the real economy is stifled by
the advantages bestowed by a generous Federal Reserve, and
where we will forever be one small tragedy away from another
financial crisis that will dwarf 2008.
Since 2003, our Government and central bank have allowed
the unprecedented use of insured deposits for speculation and
the expansion of far-flung business interests. This is
partially the result of unilateral decisionmaking by
Congressionally empowered and unelected officials at the
Federal Reserve. Only Congress can prevent this unfortunate
consolidation of American business and act to prevent the
Federal Reserve from continuing its coddling of these biggest
banks. Only Congress can put the brakes on a handful of firms
that nearly ruined the American economy in 2008 because it
could not police itself and may well wreck the economy again.
Congress did not hold the line. Congress did not protect the
American people.
Regulators remain unprepared. Appreciate how difficult it
is to oversee a bank holding company with $2 trillion in assets
and businesses in 160 countries. Now add oil tankers, coal
mines, electrical generating plants, and zinc warehouses. As we
have seen, even top bank managers cannot keep track of
everything a big bank does. Before you know it, $6.2 billion is
gone and the reputational damage is irreparable.
We have been lucky so far, but a regime based on luck is
not sustainable. Now the banks, having received approval or
exemption for whatever they wish to do, seek to control
nonfinancial infrastructures all over the world. They have
already taken control of ports, airports, electric utilities,
water utilities, sewer utilities, wind power farms, parking
meters, solar power generation, parking garages, rail leasing,
charter schools, and more. These activities create significant
conflicts of interest, may be anti-competitive, and certainly
engender operational and reputational risks that can lead to
systemic failure. This is not hypothetical nor is it hyperbole.
We have seen it happen.
Mortgages were once the boring way banks made money. But
the conflicts of interest resulting from the combination of
commercial and investment banking laid bare what compliant
regulators had never dreamed would happen. The banks went too
far. As a result, bank counterparties began to question toxic
mortgage exposures of firms and their ability to cover losses
on those exposures. As questions of solvency arose, demands for
more collateral ensued and liquidity was withdrawn from those
firms, leading to failures contagion and the need for Federal
backstops.
Think of a scenario, not farfetched, of a disaster
befalling a bank-controlled pipeline or oil tanker. The
outcomes would be similar to the mortgage meltdown, when banks
funded by the Fed protected their reputations by bailing out
affiliated hedge funds and legally isolated investment
vehicles. The possibility that such events could threaten the
flow of money and bring the financial system to a standstill
again should not be tolerated. These risks should stay outside
the banking system, with its call on the Fed's window and the
FDIC's insurance guarantee.
Executives of dominant firms can convince captured
regulators that whatever they do is in the national interest.
This is not true. These executives are correctly motivated by
real obligations that do not allow them to sacrifice returns in
consideration of the common good, even if they would be so
personally inclined.
Congress has the power to rein in the Federal Reserve.
Congress has the power to mandate the biggest, most complex
banks' businesses get narrower and easier to resolve should
they collapse. Congress has the power to protect industry in
the biggest and potentially best economy in the world and to
stand up for ordinary Americans who pay more for aluminum and
gasoline simply because banks and investment banks take a cut.
Historically, Congress has acted when a few large firms
exploited their advantage and sought to control too much.
Congress must honor that history and curtail big banks'
activities in commercial business or else we are destined to
view 2008 as the first financial crisis and not the worst.
Thank you.
Senator Brown. Thank you, Mr. Rosner.
Mr. Weiner.
STATEMENT OF TIMOTHY WEINER, GLOBAL RISK MANAGER, COMMODITIES
AND METALS, MILLERCOORS LLC
Mr. Weiner. Good morning, Mr. Chairman and Members of the
Committee. My name is Tim Weiner and I am the Global Risk
Manager of Commodities and Metals for MillerCoors. Thank you
for letting me testify today. My written statement and my
comments are supported by a group of companies, including the
Coca-Cola Company, Novelis, Ball Corporation, Rexam, Dr. Pepper
Snapple, Yuengling, North American Breweries, Rogue Brewery,
and Reynolds Consumer Products, just to name a few.
Mr. Chairman, my statement is neither an indictment of the
free market principles nor the existing exchange traded futures
system here in the United States, which we use regularly to
hedge our commodity price risks and volatility. In fact, it is
our hope that the LME system could one day function in a manner
equally as transparent and efficient as the exchanges here in
the United States.
MillerCoors will produce this year in excess of 60 million
barrels of beer in the United States. Over 60 percent of our
beers are sold in aluminum cans, bottles, and kegs. Aluminum is
critical to our supply chain and our single largest commodity
risk.
In my written statement, I provided the Committee an in-
depth look at how the LME functions and how their system
negatively impacts our ability to manage and secure aluminum we
have purchased with associated costs we must pay under this
system. It has cost MillerCoors tens of millions of dollars in
excess premiums over the past several years, and billions to
the entire industry, with no end in sight.
Mr. Chairman and Members of the Committee, I am a beer guy
that simply buys critical materials for our business. I manage
a comprehensive portfolio of commodities for brewing,
packaging, and shipping of our fine beers, like corn, barley,
natural gas, and diesel fuel.
Mr. Chairman, let me give you a snapshot of how we buy
barley. Senator Tester, who serves on your Subcommittee, knows
we are one of the largest grain purchasers in the State of
Montana. We contract with our barley growers and we pay for our
harvested crop. We receive delivery of that crop. It is
immediate. It enters our grain elevators in Huntley and Power,
Montana. The same can be said for the delivery of corn from the
CME and natural gas from the NYMEX. But not so for aluminum
under the LME warehouse rules.
Mr. Chairman, in a nutshell, here is how the LME warehouse
system works. Banks and trading companies pay an incentive to
aluminum producers to attract and store the majority of global
aluminum production directly to their own warehouses. In the
United States, it is mainly drawn into warehouses located in
Michigan, but also other locations throughout the United
States. Just imagine a warehouse with a huge door marked ``in''
and a tiny door marked ``out.''
The banks pay an incentive because they receive rent each
day the aluminum stays in the warehouse. This makes it harder
and more expensive for MillerCoors and other aluminum consumers
to get the aluminum we need to make the fine products we sell
to keep our employees working.
So let us take the LME system and apply it to, let us say,
buying a case of beer in a store in Trenton, Ohio. I am one of
your constituents and I go into a store to buy a case of Miller
Lite--of Coors Lite. I pay in full. As I reach for my beer, the
cashier grabs the case and tells me I need to go around back
and pick it up from the warehouse. ``Not to worry,'' says the
cashier. ``Just present your receipt and you will get your beer
in a timely manner.'' So I go around back, present the receipt,
and the warehouse manager informs me that due to the warehouse
constraints, I will have to come back in 16 months to pick up
my beer. He then tells me that my beer will be kept safe in
storage, but that I will have to pay for rent each and every
day that my beer sits in his warehouse. Can you imagine the
revolt that would create with your constituents, not to mention
what that Congressional hearing would be like?
My point is how absurd it is to buy a commodity, in our
case aluminum, and then have to wait an average a year to 18
months to obtain our physical possession of the purchased metal
from the LME warehouses. The current LME warehouse system is
not functioning as other futures exchanges do.
Mr. Chairman, we have tried to resolve this problem
directly with the LME, and you will probably hear that some
minor changes have been made to their operations over the past
few years and that they are investigating additional minor
changes that, at the earliest, would not go into effect until
April of 2014. In our view, these changes do not go far enough,
fast enough, nor do they correct the underlying problem.
In my testimony, I recommend very specific changes to the
LME rules and we simply ask for the same regulatory and
legislative oversight of the LME that other U.S. futures
exchanges receive in order to level the playing field and
ensure a transparent, balanced, and functional market for both
buyers and sellers. This oversight will restore the free market
functioning of the LME, which will regain our confidence in the
institution and permit us to successfully brew, ship, and sell
our fine beers.
I thank the Committee for allowing me to appear to testify
here today and I am happy to answer any questions that you may
have. Thank you.
Senator Brown. Thank you, Mr. Weiner. I really appreciate
it.
I am going to turn it to Senator Toomey, who has to leave
early, but I want to ask one real quick question first. Mr.
Guynn, what was ``you are not fair or not correct'' about the
story that Mr. Weiner just told about the consumer in Trenton,
Ohio, walking in to buy a case of beer? What was either
misleading, incorrect, or not fair about his story as an
example of what has happened in aluminum?
Mr. Guynn. Just as a prelude, just so you know, I do not
represent either JPM or Goldman on the LME situation, so I have
no facts to add other than what is in the public record. But
what I understand is that the LME metals warehouses only hold
about 5 percent of the aluminum that is actually bought and
sold globally annually, that, in fact, 95 percent of the
aluminum is bought directly from the producers. So I cannot
quite understand where the market share issue is here.
Also, I think the LME warehouse owner is only a custodian,
so it is not as if they are the owner of the metals in the
warehouse.
Lastly, I think the CFTC has announced they are going to do
an investigation. So, to the extent there are issues with the
warehouse owners' violating any laws, contracts, or rules,
presumably, that will be dealt with in that investigation.
Senator Brown. OK. Thank you. I would only illuminate on
that by saying that while it is a small part of the whole
aluminum market, what the LME pricing structure is, as peculiar
as it is and circuitous as it is, that affects price for all
aluminum sold in the market, but we will get to more of those
questions in a moment.
We are setting the clock for 7 minutes for each Member and
we will do second or third round as long as Senator Merkley and
Senator Toomey, if he can come back and stay. So thank you.
Senator Toomey. Thank you very much, Mr. Chairman, and
thank you for your kind accommodation of my challenging
schedule this morning. I appreciate that very much.
I appreciate the testimony. Let me just say briefly, Mr.
Weiner, I read your testimony last night and it certainly does
seem rather odd that a large buyer of any commodity cannot
access that commodity in a timely fashion. That is--I just do
not know of any other precedent for that. It strikes me, as
your testimony suggests, that there are some problems with the
rules by which the warehouse operates. It strikes me that it
may be more specific to the rules than it is to whoever happens
to own the warehouse, but the rules by which they operate are
strange, it seems. I would like to learn more about this, but I
think it is a little bit tangential to some of the things I
would like to explore. So I would like to follow up with you on
another occasion on some of the particulars there.
I would like to address my first question to Mr. Guynn, and
I read your testimony, as well. Some of this gets a little bit
confusion. There has been discussion about whether the Fed
would revisit some rules in September. Could you just briefly
summarize the actual legal authority by which bank holding
companies engage in dealing in physical commodities as opposed
to a regulatory discretion. But what is the legal authority?
Mr. Guynn. It is actually important to distinguish between
different types of banking entities. Insured banks can buy and
sell precious metals commodities under the National Bank Act.
They can also trade in commodities contracts where the
underlying commodity is a variety of things, including the
energy and physical commodities we talked about here, as part
of their core banking powers. That is, again, an interpretation
of the National Bank Act.
Bank holding companies and the nonbank affiliates of banks,
are also able to do similar trading, again, limited to
contracts.
Then Gramm-Leach-Bliley added a provision that said that
financial holding companies--special bank holding companies
that meet certain capital and management requirements--would be
able to engage in expanded powers, including these
complementary powers. And it is pursuant to that provision that
the Federal Reserve authorized Citigroup and other financial
holding companies, starting in 2003, to trade in physical
commodities as a complement to their financial activities of
trading in the contracts.
And then there is a separate provision, there is a
grandfathering provision in Section 4 of the Bank Holding
Company Act that was actually designed to provide a two-way
street for investment banks and commercial banks so that if
Goldman Sachs and Morgan Stanley, for instance--who were not
bank holding companies in 1999--became bank holding companies
later on, their commodities activities would be grandfathered.
Senator Toomey. OK. Thank you.
Let me just ask you--this may be a judgment call, an
opinion call on your part, Mr. Guynn. Do you think part of the
motivation for banks to engage in this is that it is profitable
for banks?
Mr. Guynn. That certainly is part of the motivation,
certainly, because when things are profitable----
Senator Toomey. Right.
Mr. Guynn.----it helps their balance sheet.
Senator Toomey. So, this has been going on a long time,
that banks have engaged in various levels of physical commodity
dealing. Can you point to any time in which large financial
company trading in physical commodities created a systemic risk
for our financial system?
Mr. Guynn. I cannot think of a single example.
Senator Toomey. Let me ask you this. Well, that might be
because it is a profitable line of business, and, as such,
might actually diminish risk rather than enhance risk.
But let me ask you this. Could you give us an example of
how a large, sophisticated commodity trading operation--it
could be a bank holding company--provides a service that might
actually be valuable to consumers?
Mr. Guynn. Sure. So, a good friend of mine founded JetBlue.
JetBlue is a discount airline that obviously consumes a lot of
jet fuel. They need to be able to manage the price risk of that
jet fuel. As we know, jet fuel has been fairly volatile in
recent years. And so they can enter into long-term fixed price
contracts with Goldman Sachs, Morgan Stanley, JPMorgan, Citi,
others who have the power to enter into those sort of
contracts, in order to fix that price or manage their price
risk. And then the financial institutions can go long in the
physical commodity to hedge their risk in the contract, or go
short, depending on how they are otherwise positioned.
That reduces the cost for JetBlue and other airline
companies and, presumably, those reduced costs are passed on to
consumers in the form of lower traveling costs, or at least
avoid higher travel costs.
Senator Toomey. Or maybe greater job security on the part
of their employees?
And does it work in the opposite direction? In other words,
you just gave an example where a buyer of a commodity benefits
from the assurance of a known fixed price into the future. But
what if you are in--say you are a silver miner. You mine silver
and you sell it. You have got a lot of sunk costs, heavy
capital investment. It seems to me your biggest variable cost
is probably labor. If the price of silver collapses, you are
probably going to lay off a lot of workers. If you could sell
it at a known price in advance, would that give you some more
stability, some more security for your workforce, for your
business?
Mr. Guynn. Obviously, and that is why it is important to
have strong, deep, liquid markets if we can have them in those
sort of commodities, so that the silver miner or other miners
will be able to buy or sell their goods in large quantities,
very quickly, without causing price movements.
Senator Toomey. And this example that you gave with JetBlue
and that we discussed with, say, a silver miner, does that
actually happen? Are there consumers who do, in fact, engage in
these medium- and longer-term contracts for commodities?
Mr. Guynn. I think that is actually most of the business,
that, in fact, these financial institutions engage in.
Senator Toomey. OK. Thank you very much, and again, Mr.
Chairman, I really appreciate your cooperation.
Senator Brown. Sure. Thanks for joining us.
Mr. Weiner, I will start with a series of questions for
you, if I could. I want to be clear exactly how this works. Is
it correct, the warehouses pay premiums to aluminum producers
to store the metal in their warehouses and then that they also
charge purchases like yourselves and the companies you are
representing today, that you said, rents to store the aluminum
there after you have purchased it? Is that my understanding?
Mr. Weiner. Yes, that would be correct. They actually pay
an incentive to the producers to attract the metal to their
warehouses and then store that metal in that warehouse and they
do charge rent for the period of time that that metal stays in
that warehouse.
Senator Brown. And Goldman Sachs is entitled--you
mentioned, I am not sure you called it by name, but the
Michigan warehouses, many of them owned by Metro--Goldman Sachs
bought Metro. They are entitled to hold it for 10 years as a
merchant banking investment. Mr. Guynn explained sort of the
legal parts of this, and that term, merchant banking
investment, is what Goldman Sachs supposedly operates under,
although as Ms. Omarova pointed out, we do not have enough data
to know nearly all of what we need to know.
At current capacity, our estimates are that Goldman Sachs
could earn $26 billion in rental income over that period. My
question is, is it correct that four of the six largest LME,
London Metal Exchange, warehouses are owned by Goldman Sachs
and JPMorgan and the commodity trading firms Trafigura and
Glencore so that there is limited competition in the warehouse
business?
Mr. Weiner. Yes. There are limited owners of the
warehouses. I am not sure on the exact numbers. I can get that
back to you. But they are--the two that you mentioned are some
of the largest warehouse owners and it is limited to a small
number, group of people.
Senator Brown. Both the banks that own the warehouses and
the London Metal Exchange acknowledge that the aluminum held
for companies like yours, companies that actually make things
from aluminum, the manufacturers themselves, are given
secondary status. This means that aluminum bought by people who
buy aluminum as investments are given priority in the queue.
One, is that true? Second, what effects do those delays have
upon consumers and businesses like MillerCoors? What does it do
to the price of your, ultimately, of your product?
Mr. Weiner. I cannot speak to that particular point on the
banks, but I can say that as far as the effect to us as a
consumer of aluminum, it has a great effect, and also the
companies that I mentioned. The increased cost that we incur
takes away from innovation and new products that we can come up
with, other qualities that we may be able to offer to our
consumers, not only for us but for the companies that I
mentioned here on this list.
Senator Brown. Well, you said you cannot speak to the
question of whether they are given priority in the queue, the
people who buy aluminum as investments. But the fact is, you
cannot get the quantity of aluminum you want, apparently,
correct?
Mr. Weiner. If a buyer buys aluminum through the LME
system, buys aluminum, cancels, gets a warrant, and goes to the
warehouse to get his metal, if he gets his metal, for example,
use Detroit for an example if you are in the United States, it
can take up to 18 months to receive your----
Senator Brown. Which would lead me to think, and you do not
need to necessarily acknowledge this, but it would lead me to
think that you are not a very high priority compared to those--
because of, I mean, the New York Times said delays have
increased from 6 weeks not that long ago to 7 months in 2011 to
16 months today.
Mr. Weiner. Mm-hmm.
Senator Brown. That would imply you are not a very high
priority.
Mr. Weiner. You could take that implication.
Senator Brown. Now, Goldman Sachs and JPMorgan are
reportedly exploring selling the warehouses. The LME has
proposed new warehouse rules. Reuters is saying the CFTC could
investigate this issue. The Fed is reportedly reconsidering its
policies. Are those actions sufficient to address this problem?
Mr. Weiner. No. They are all wonderful ideas. They are all
proposals----
Senator Brown. It is necessary for intervention. You want
these things to happen, but you think they are not sufficient?
Mr. Weiner. Yes, we do. In fact, this is--we are going down
the right path. This is a great beginning, but these are not
sufficient to resolve the problem. We have heard about the
warehouses selling--or the banks selling the warehouses. We
have heard about all these other promises of new changes in the
rules. And they are all wonderful ideas. They are all in the
right direction. But they do not resolve the situation.
Senator Brown. What----
Mr. Weiner. It will take, as I mentioned in my testimony,
the new rules that they have proposed, even if they go into
effect, could not take effect any earlier than April of 2014,
if that.
Senator Brown. If they could take effect immediately, would
that solve your problem?
Mr. Weiner. It could. It depends upon which rule changes
they make. We gave a list of rule changes in my testimony. If
they were to take some of those rule changes, it might have a
much quicker effect as far as changing the current situation
and status and the functioning of the LME warehouses.
Senator Brown. As your company and others have talked to
Graham Steele and Katie Malone in my office and talked to us,
you have made clear that you have done a number of other
things. Could you describe your efforts to engage U.S. and LME?
I mean, I know there has been a problem. LME says it does not
have jurisdiction in Detroit and the United States says U.S.
regulators--I guess CFTC, right--says it does not have
jurisdiction with LME because the ``L'' stands for London. Talk
to me about your interaction, working with both U.S. and U.K.
regulators.
Mr. Weiner. We met with the LME and we made some very
serious proposals, the same proposal we listed in our written
statement, and they were shrugged off. We went to the FSA at
the time, which is now the FCA, that is the----
Senator Brown. That is the British regulators.
Mr. Weiner. It is the regulator over the LME. And we were
informed that the LME is a self-regulated entity and the FCA
now has oversight over that.
Senator Brown. Well, who owns the LME?
Mr. Weiner. The Hong Kong Exchange now owns the LME.
Senator Brown. But they bought them from----
Mr. Weiner. They bought them from a large group of owners
in December of 2012, so about 6, 7 months ago.
Senator Brown. So they are a self-regulating exchange with
no real government with teeth oversight?
Mr. Weiner. That would be correct, yes.
Senator Brown. OK. So before--I am sorry to interrupt.
Before Hong Kong, this company in Hong Kong bought them, they
were almost a co-op of sorts? They were the aluminum producers,
sellers, brokers----
Mr. Weiner. Yes. I mean, the exchange was owned by banks,
by producers, by warehouse owners, by traders----
Senator Brown. And they were partly funded by the rents
charged in Detroit?
Mr. Weiner. Yes. Well, by rents charged all over the world.
Senator Brown. In Detroit and elsewhere. But----
Mr. Weiner. Yes. Right.
Senator Brown.----the money that Goldman was making in
Detroit, the bountiness--no, I will not judge this--the money
made in Detroit, the more that was, the more the LME got paid.
Mr. Weiner. No. Actually, the more that was, the more it
went to the warehousing company, Metro, that owns those
warehouses.
Senator Brown. But then LME got a percentage----
Mr. Weiner. The LME gets a small one or one-and-a-half
percent of all the metal----
Senator Brown. Continue on your efforts with U.S. and U.K.
regulators, if you would.
Mr. Weiner. Yes. So we then came back to the United States.
We went to the CFTC, who felt for us and understood our cause
but said that they really had no regulatory power over the LME
warehouses here in the United States or the LME, which is a
foreign exchange. We have gone to several other regulatory
agencies to see what they would do and now we are here today
and this is just the next step in hopefully resolving this
problem.
Senator Brown. One more question and then I will turn to
Senator Merkley. I want to read you the response of Goldman
Sachs to the complaints about the role of their warehouse in
aluminum prices. Roughly 95--and this echoes a little bit of
what Mr. Guynn said. Roughly 95 percent of metal sold every
year does not pass through the warehouse system and it all goes
straight from producers to consumers. Metro, Goldman's company,
does not own or control the metal in its warehouses. That is up
to its consumers and subject to LME rules. So the extent that
metal flows inside the warehouse system on and off warrant
there is a function of consumer demand. As you might expect,
the vast majority of the buildup in inventories at warehouses
is a result of the financial crisis and the subsequent lack of
demand.
Goldman continues, the warehouses absorbed excess
production, but the macro picture is one of soft demand and
excess supply, which is why aluminum prices have come down
substantially over past years, roughly 40 percent lower since
pre-crisis level, Goldman says, another factor the New York
Times failed to mention. As with other global commodity
markets, prices are only driven by supply and demand. There has
been significant over-capacity in the global aluminum market
for years now, thus the need for storage, thus the role the
warehouses have increasingly played.
Your response?
Mr. Weiner. I can respond to a couple things in there.
Number one, I can respond to the fact that the real crux of the
problem here in the LME is the fact that up through December of
this past year, the owners of the LME warehouse sat on all the
committees to make the rules for the warehouses that they own,
are really the backing or the real problem here, because you
have people setting up rules for themselves under a self-
regulated exchange. And this is what I talked about in my
testimony. I would like to get transparent and a functioning
LME market, just like we have here in the United States, and
that is really the problem that we have here today. It is not
that demand has dropped or supply has increased, because when
demand drops, prices usually--should go down and should
disincentivize producers from producing, and that has not
happened because there have been incentives to have the
producers continue producing in a significantly over-supplied
market.
Senator Brown. The incentives come from Metro, for
instance, paying a premium to bring the aluminum there.
Mr. Weiner. Yes. Otherwise, why would you produce aluminum
in an over-supplied market and deliver it into a warehouse?
Senator Brown. Any other comments on Goldman's statement?
Mr. Weiner. Well, the 9 and 95 percent. All of our
contracts, and all the contracts of the companies that I
mentioned here in my statement, all of our contracts are linked
to the price of the LME plus a premium that we pay, and the way
that we buy the metal through the LME, which we pay the LME
plus the premium or the time that it sits in a warehouse, or we
go to a warehouse outside of the LME, we still pay the same
price. It is kind of like if I went to you to sell you an apple
for $100 and someone came and they offered you something for
$50, you would go and buy it for $50, but you are not going to
offer it cheaper to somebody else. It is just not going to
happen.
Senator Brown. So you are saying that only--if you agree
that 5 percent of this aluminum is in the warehouse only, 5
percent----
Mr. Weiner. Using that as an example. I cannot----
Senator Brown. OK, but, I mean, that is what Goldman said,
5 percent. If that is, in fact, true----
Mr. Weiner. Yes.
Senator Brown.----the price charged in the warehouse for
that aluminum affects the other 95 percent of the market
because of LME, perhaps arcane, obscure, hard to understand,
but because of LME rules, correct?
Mr. Weiner. Absolutely correct.
Senator Brown. OK. All right.
Senator Merkley.
Senator Merkley. Thank you, Mr. Chair, and thank you all
for testifying.
I wanted to follow up, Mr. Weiner, on the point that if
demand is dropping, it would seem like it would take less time
to get your aluminum out of the warehouse because you have
fewer customers knocking on the door, if you will. Would that
not be the logical conclusion if demand was diminishing?
Mr. Weiner. Absolutely.
Senator Merkley. OK. This whole discussion is fascinating.
I think that the general picture is one in which you can make a
lot of money by manipulating a market. Now, if you can put a
thumb on the scale, you can do a number of things. You can make
bets on the future price. That is one way of making a lot of
money, if you can influence the supply and demand and make bets
on the supply and demand. In addition, you can charge customers
more for getting their product by charging rent, as you have
pointed out, on the warehouse.
So which is the bigger issue here? Is the bigger issue that
by controlling the warehouses, you can influence the prices and
thereby make a lot of money by adjusting the outcome for bets
you are making, or is the bigger issue the rent, the additional
rent being charged that seems so unjustified?
Mr. Weiner. It is a combination of both----
Senator Merkley. OK.
Mr. Weiner.----because--I am sorry. Go ahead.
Senator Merkley. I wanted to turn to Ms. Omarova.
Ms. Omarova. Yes.
Senator Merkley. Thank you for your testimony. I think what
is being presented here is a pattern. We have JPMorgan being
involved in the supply of electricity, and I believe you have
done work on Morgan Stanley's involvement in oil, petroleum
markets.
Ms. Omarova. Only research work, not the real involvement.
Senator Merkley. Research work. And then we have this case
of aluminum, and then we have a conversation about coming
ownership through electronic traded funds in copper. And so is
really what we see--is this a vast strategy employed by large
financial institutions that are theoretically banks that take
deposits and make loans, but really, they are giant firms
dedicating themselves to be able to make bets on prices and
then control behind the scenes, help control those prices?
Ms. Omarova. You are asking a very important question,
actually. Is there a vast pattern of these large financial
institutions turning into effectively trade and financial
super-intermediaries? I believe there is a reason to suspect
that there is, in fact, such a pattern emerging.
My point is that we really do need to get more specific
data, specific information, to assess the vastness of this
pattern, because this trend has enormous implications for the
rest of the economy and the rest of our country.
Now, in this connection, let me just make a clarifying
point further to Randy's testimony. It has been said here today
that what is happening in the physical commodities markets with
JPMorgan and Morgan Stanley and Goldman Sachs accumulating
these physical assets is, in effect, nothing new. It is just
sort of incremental continuation of what banks have been doing
since ancient Egypt. That is true and yet not exactly true. At
least, it is not helpful.
First of all, the relevant history here is not what
happened in ancient Egypt. The relevant history here is what
has been happening since 1956, when Congress made an explicit
decision that bank holding companies should not be engaged in
commodities or other commercial activities unless specifically
permitted. And although in 1999 Congress did, in fact, create
the merchant banking authority, the complementary authority,
and the grandfathering exception, there is no evidence that
Congress meant for these exceptions to swallow the rule.
Whether or not in reality the law has been effective in
preventing such swallowing of the rule by the exceptions is
precisely the issue at stake today. We need to figure that out.
I do not have substantial evidence of whether or not it
happened, but it is not my position to present such evidence.
Now, history has also--you know, history can prove too much
and too little, right. Just because some bank somewhere in the
past did something and that was OK does not mean necessarily
that it is OK today. For example, I am sure that some time,
some bank has financed slave trade, right? That does not mean
that JPMorgan today should be financing human trafficking based
on some historical tradition. So that is basically my point on
history.
With respect to the law, and especially the Gramm-Leach-
Bliley Act provisions, it is one thing to say that the law, as
written, technically allows for these types of investments to
be conducted as long as they comply with certain requirements.
My concern is how that law is implemented. Has it worked in
reality?
Let me give you a quick example. For example, merchant
banking authority, right, it was meant to allow banking
institutions to make purely financial private equity, very
passive, investments for financial appreciation, right. We
invest in the company, then we resell it and make money on it.
And there is an important requirement for such a merchant
banking investment, for example, that Goldman Sachs as the
financial holding company cannot participate in the routine
management of an oil company or Metro International, the
warehousing company it owns. And it all sounds really
important, right. No routine management. That means they
directly cannot participate in that business.
But in reality, what it means is that, for example, Goldman
Sachs' managing director cannot be the CEO of Metro, or that
Goldman Sachs cannot formally obligate Metro International to
check with Goldman Sachs every time they want to hire a
janitor, for example. But, Goldman Sachs has the full right
under the law, as written, to appoint all directors on the
board of directors of that company. They can engage in
extensive consultations with the managers of Metro
International with respect to the business.
And it is very hard to tell how much of informal influence
Goldman Sachs, for example, exerts over Metro International's
management decisions. They may not exert any influence. It may,
in fact, be a purely financial investment. But I wonder if the
Federal Reserve, for example, is actually doing its job, asking
those kinds of questions and looking in what is happening on
the ground instead of just referring us to the letter of the
law.
Senator Merkley. Thank you.
Mr. Rosner, to my broader question here, if I want to be in
the business of making a lot of profits on placing bets on the
price of commodities, owning a fair amount of the commodity
itself and owning the pipelines or the ships, in the case of
oil, or owning the warehouses, in the case of aluminum and
copper, do not those things give me significant ability to
manipulate the market?
Mr. Rosner. Well, of course they do. And, in fact, we
should be expanding this just beyond the warehouses. The
example was given about the delivery of metals by the miner.
Well, there is nothing that prevents through the Asset
Management Division one of these banks from becoming the
general partner, the control over a mine, OK, which creates
other problems.
Look at what we saw, as an example, in California, where
the government demanded that AES bring two power plants back
online to make up for lost capacity and we saw JPMorgan attempt
to block that. FERC ended up intervening and overruling them,
but there were attempts. One has to ask if they were driven by
profit motives on the desk, keeping prices up in the market for
their benefit, and, frankly, one has to ask and go further,
what would happen if, in fact, through the Asset Management
Division they had control of a generating facility on that
grid. Again, that would end up helping their pricing. So, I
think these are very real.
Now, add one more level, which I really think needs to be
stressed. If, in fact, we saw a catastrophic event at any of
these owned facilities, nonfinancial facilities, the impact,
reputationally and operationally, not only to the institution
but to the Federal Reserve, would be catastrophic.
Senator Merkley. Thank you very much. Thanks.
Senator Brown. Thank you, Senator Merkley.
Senator Warren, and we are setting the clock at 7 minutes.
Please proceed.
Senator Warren. Thank you, Mr. Chairman, and I apologize.
We are having simultaneous hearings and I was off at an NLRB
hearing. But I appreciate your having this hearing, Mr.
Chairman.
An interesting conversation about the history. The way I
sort of see this is that, you know, the turn of the 20th
century, the biggest banks, and JPMorgan was one of the prime
examples, played an active role in the management of many of
the Nation's key industrial companies. JPMorgan partners, for
example, sat routinely on the boards of railroad companies,
steel companies, other large corporations. Now, it began to
change leading up to the Great Depression as reformers like
Louis Brandeis warned again and again and again about the
dangers of both conflicts of interest and the concentration of
power and as they generated greater and greater public support
for the notion that these should be separated.
After the 1929 crash, the Glass-Steagall Act clamped down
on the banks' interconnectedness with industry by separating
boring banking, like checking and savings accounts, from the
high-risk gambling found on Wall Street.
So I am glad we are having this hearing today because our
banks and industrial have changed, but the dangers of
concentration and the principles at stake have not, and that is
why I share the concern of many of my colleagues about asset
managers at huge Wall Street banks exercising control over key
parts of America's infrastructure.
So I thought I would start my questions with you, Mr.
Rosner. If we ever experience again a crisis like the crisis in
2008, how do you think Wall Street control over electric plants
or seaports or airports could factor into the systemic risk
confronted by the Department of Treasury and the Fed and,
ultimately, the taxpayer?
Mr. Rosner. Right. As I said in my testimony, I think that
those are very real risks that need to be considered. The
situation is not terribly different than in 2008, where we
watched the industry go from originally making mortgage loans
to taking over through investment banking the entire mortgage
complex, from front, hiring third-party mortgage originators,
pooling and packaging securities, making money on the sale and
trading of those securities, proprietary trading on those
securities, owning the servicing and, in some cases, we watched
the servicing companies that they purchased run not by separate
divisions but actually be owned and operated by the trading
desk, creating significant opportunities for informational
advantage of the firm over its customers, and incentives that,
frankly, led to many of the outcomes that we have seen and
losses, OK.
The problem ends up being that with the backstop of the
Federal Reserve, with the backstop of insured deposit regimes
through the FDIC, there will always be an ultimate call on the
system. Now, one institution theoretically could be resolved
under Dodd-Frank. I do not believe that Title I, Title II
works. But even assuming that it could, the reality is, if we
had a catastrophic risk in one of these infrastructure
businesses, the counterparty exposure would lead to exactly the
same outcome, the calls for more collateral, the risk of
contagion, counterparties backing away, liquidity leaving the
system, and ultimately the Government being called in to
stabilize against the risk of contagion.
Senator Warren. Or to say this another way, the
interconnectedness----
Mr. Rosner. Absolutely.
Senator Warren.----increases the likelihood----
Mr. Rosner. Absolutely.
Senator Warren.----that these institutions----
Mr. Rosner. That is right.
Senator Warren.----remain too big to fail.
Mr. Rosner. That is right. And as I said before, you know,
one does have to question what would have happened if, in fact,
the Exxon Valdez was owned by one of these bank holding
companies.
Senator Warren. Yes. Good. Thank you.
I have another question for you. I do not think there is
any question that institutional investors, like pension funds,
hope that asset managers at a big bank will return solid
profits over time. But I also do not think that most retirees
realize that their pension or retirement savings are used to
pave the way for big banks to be able to control an electric
plant or an oil refinery. So, Mr. Rosner, what dangers do you
think result from big banks spending, as Brandeis put it, other
people's money to amass this kind of power and control?
Mr. Rosner. Well, I mean, I think we saw this with
JPMorgan's ownership and control of U.S. Steel, one-sixth of
the Nation's railroad, rail lines, General Electric and Edison,
and we saw some of the outcomes, the consolidation of the
power, the impact on pricing.
I think it is also, though, important to really think
about, and if you have any questions about the strategy here,
look at some of the footnotes in my written testimony. The
statements, the language used by these asset managers, these
bank-run asset managers in pitching to those firms include the
advantages of controlling monopolistic and quasi-monopolistic
assets as an inflation hedge because of the ability to
negotiate long-term leases with riders that allow pricing to
rise even when demand falls.
Senator Warren. So say this one again, Mr. Rosner. I mean,
I just want to make sure you put the right summary on this.
These people are out amassing this power. They are using the
money that people invest, for example, in their pension plans.
They are using it to amass this power and then they are
selling, in effect, themselves on the notion that if you will
invest with their company, they are going to have the benefits
of having created this powerful and interconnected sort of
corporate and banking conglomerate that will be able not only
to produce big returns because you have figured out the right
things to invest in, but produce big returns because they will
have, as you describe it, monopoly control----
Mr. Rosner. As they describe it.
Senator Warren. As you described their describing it----
Mr. Rosner. Correct.
Senator Warren.----because they will have monopoly control.
Mr. Rosner. That is correct.
Senator Warren. Thank you, Mr. Rosner. I think that is
clear.
Mr. Chairman, thank you.
Senator Brown. Thank you, Senator Warren.
I want to pursue, and I will start with you, Mr. Guynn,
more on the oil, gas, and energy markets that both my
colleagues touched on. Before Morgan Stanley converted in 2008,
largely to get access to the window, apparently, it was one of
the leading investment banks directly involved in the physical
commodities and energy sectors. That would lead you to think
they would be grandfathered.
They currently own TransMontaigne, a petroleum and chemical
transportation and storage company, and Heidmar, Inc., which
reportedly manages some 100 oil tankers, 80 of which might be
at sea on a given day. Bloomberg reported on Friday that a
spokesman for Morgan Stanley said the bank did not expect,
quote, ``to have to divest any of its activities after the
grace period ends in September.'' That was the grandfather
issue, I believe.
In a 2012 Reuters story, one expert said that owning
physical assets in trading financial markets, quote:
gives you the visibility of the market to make far more
successful proprietary trading decisions in both physical and
financial markets. It is trading with material nonpublic
information. The difference compared with equity markets is
that it is perfectly legal.
So, as they know the markets so much better because of
their control of some of these assets--it could be Metro, it
could be something else--they have an advantage, purportedly,
in the marketplace in terms of proprietary trading. There are
not conflicts of interest in the insider trading issues with
equity markets. The laws do not apparently apply the same way.
So my question, Mr. Guynn, are there concerns when a
financial company that is wagering on oil prices also controls
a fleet of over 100 tankers that it can hold back from
delivering to a port to influence prices? So you own 100
tankers for a period of time. You scale back the number of
those tankers delivering oil. And you are also in a position to
wager on oil prices. Is that a concern to you?
Mr. Guynn. So, I think all of these things--trading in
material nonpublic information, having and abusing market
power--are serious concerns. Obviously, if they had a large
enough market share to give them market power, and they abused
that power, they would presumably be violating the antitrust
laws. I am not sure that it is actually quite accurate to
describe the sharing of information between these two markets--
the cash and derivatives markets--as sharing material nonpublic
information. I think the better analogy is a bank buys the
bonds or trades in the bonds of a company. It also enters into
swaps with the company and uses the information from each
market in the other market. I think that is the better analogy.
In fact, actually having knowledge of both markets helps
price discovery and helps the prices in the derivatives markets
and the prices in the physical markets to converge, which is
actually a good thing. It helps the markets. It helps the
liquidity of the markets. It helps the miner in Senator
Toomey's example to be able to sell his product very quickly
with a known and expected price.
Senator Brown. But this situation, you do not think is a
particularly serious potential problem?
Mr. Guynn. The situation----
Senator Brown. With owning oil tankers and also wagering on
the price of oil.
Mr. Guynn. Well, I mean, if they own oil tankers and they
participate in the markets--the spot market and the futures
market for oil--and they had market power and they abuse it, I
suppose that could be a problem. Presumably, the antitrust
authorities would look at that, however. Unlike the 19th
century, we have the Sherman Act and the Clayton Act now and we
have the U.S. Department of Justice and the Federal Trade
Commission that survey that. We have bank regulators that look
at that. We also have securities and commodities regulators
that look at insider trading or misuse of information. If there
are any gaps in the regulations, I would have thought that it
would be a legitimate thing to fill any gaps and to make sure
that any sort of bad behavior of the sort you are suggesting as
potential did not occur.
Senator Brown. I would like to think that we have
regulators in the Justice Department that would be as
aggressive as you suggest they might.
Ms. Omarova, comment on Mr. Guynn's comments, please.
Ms. Omarova. Well, I think oil market and the way price is,
quote-unquote, discovered in oil markets is in itself a very
interesting and complicated question. The term ``price
discovery'' sounds very neutral, and it generally refers to
this very liquid, very public market, lots of buyers and
sellers come independently and somehow in that wonderful
process the fair price for particular goods is established.
But in these markets, for example, over-the-counter oil
derivatives markets, Goldman Sachs is not just doing price
discovery in that traditional sense. I suspect they are
actually able to form the price, to set the price, because they
are a major dealer in these markets.
Now, is that an issue, that not only can they set the price
or affect the price in these financial markets, but they can
also influence the price of the physical oil if they own the
fleet of tankers or contractually have access to the physical
barrels of oil? I think it is a far more important issue than
the traditional antitrust DOJ concerns with just the market
share calculated based on some definition of a market, for
example.
I am all for the DOJ to actually conduct a serious
antitrust investigation of these issues. But recently, there
have been attempts internationally to figure out, to
investigate how the global oil prices are actually discovered
or established and that investigation did not go anywhere
because the oil industry basically refused to cooperate, it is
my understanding. So if this is the market in which Morgan
Stanley and Goldman Sachs are playing, it makes me
uncomfortable as a banking law person.
Senator Brown. The response of the panel to my colleagues'
questions about a potential Exxon Valdez or BP oil spill, if
the banks had ownership in those companies, begs the question,
can bank examiners, already overworked, already underfunded,
sometimes too captured by the people whom they regulate--
perhaps leave that part of it out--but can these bank examiners
fully appreciate and understand the kind of environmental
potential impact on some of these commodities?
Ms. Omarova. Well, if there are actually bank examiners
that realistically can do that, then probably they should be
running the world, because it is extremely difficult to imagine
a human being--and I do not know what kind of professional
qualifications bank examiners must have to get the job, right.
I assume that even if they had a Ph.D. in economics or finance
or anything like that, they might still have a difficulty
figuring out exactly the dynamics of a market as globalized and
as complicated and as nontransparent as oil, for example.
Now, on top of that, if you move to electricity, that is a
whole different market with its own factors shaping the prices
and shaping the behavior of market actors, and so on and so
forth. There is no such thing as a single unified commodity
sector that one can study and understand and then say, well,
everything is under control.
The fact that there are many regulators looking at various
aspects of this sprawling enterprise that JPMorgan or Goldman
Sachs are becoming does not necessarily mean that, as a whole,
as a team, they are looking at the right things. That is the
most important issue. We need to be able to say that our
regulators are actually capable of overseeing and monitoring
these risks and I have serious doubts they can do it.
Senator Brown. Thank you.
I am sorry. Let me do one more question and then turn it
again to Senator Warren.
Morgan Stanley also markets energy and owns energy
generation facilities in the United States and Europe. JPMorgan
has similar authority. JPMorgan said that power has
monopolistic pricing power and demand that is relative
insensitive to price, which essentially is saying that you can
charge what you want for electricity and people will pay for
it.
I want to quote from Mr. Rosner's testimony. You said, FERC
took action against JPMorgan for its attempts at preventing the
implementation of State sequestered changes to Huntington
Beach, California, power plants owned by AES Corporation. The
State deemed the work necessary to replace lost power capacity
that resulted from the shutdown of a nuclear plant. JPMorgan
sought to prevent the changes and claimed its marketing
contract with AES gave them the right to veto the work.
While the bank's motives were not stated, it is reasonable
to consider that the firm sought to profit from the higher peak
energy prices that would have resulted from its actions to
prevent new capacity from coming online. Media reports are that
there is a $400 million settlement around that, a payment from
JPMorgan. It suggests heightened risks of conflicts of
interest, anti-competitive practices, market manipulation that
can arise when a company controls the supply of a commodity and
trades in financial markets for that commodity as a market
maker and as a principal.
Mr. Rosner, I mean, I quoted you, but expand on that, if
you would, or how concerned you are with this, and do
regulators have the ability or the authority to regulate these
sorts of arrangements?
Mr. Rosner. No. I mean, look, even the information
advantage that comes from their knowledge of what their intent
is has real impact in the marketplace and has real benefits
that it can provide in the marketplace.
To suggest that regulators have the ability to manage these
is to ignore all of the areas directly related to banking and
investment banking businesses that the regulators failed to
oversee or manage leading to the crisis. In fact, as I warned
in 2006, regulators did not even have access to underlying CDO
data, OK, collateralized debt obligation data, and, therefore,
could not really look at the underlying collateral or the risks
posed to the institutions by those exposures.
To expect the regulators to have working knowledge and to
expect the regulators to be able to understand the web of
relationships that exist here is not rational. And, in fact, if
we think about it more fully, just even looking at the various
businesses that come off of this--let us take that mortgage
period as an example. So the banks made loans to third-party
mortgage originators and they got paid for warehouse lines from
those. One distinct business opportunity. They took the
mortgages they received. They pooled them, they packaged them,
and they securitized them. They sold them to investors. Second
distinct line of business. Then they were able to trade them in
a secondary market on behalf of those customers. Third income
stream. They also were able to trade them on a prop basis.
Fourth income stream. They had servicing businesses that they
owned and were able to glean informational advantage both in
advance of their customers, it turns out, and also for the
income streams provided by that servicing.
The conflicts of putting together all of these business
lines, even within financial services, need to be managed. They
were not managed so well by the regulators. And to expect that
we can see the expansion into far more lines of business, far
more far-flung infrastructure assets, I think, is unrealistic
and, as I said, poses a very different level of catastrophic
risk. No one should suggest that private industry should be
prohibited from owning businesses. But when you have the
backstop, implied or explicit, of the Federal Government, it
changes the equation, and I would contend that these
institutions have become today's equivalent of the Government-
Sponsored entities that we saw fail in the mortgage crisis.
Senator Brown. Mr. Guynn, why is he wrong? You seemed--the
look on your face suggests you think he is.
Mr. Guynn. So, first of all, I think the riskiest thing
that financial holding companies do is actually lend money on a
long-term basis. That is actually the asset that tends to fall
in prices, it tends to result in runs. It actually is probably
the riskiest thing they do.
The bank regulators are not omniscient. They are human
beings. They make mistakes. They made lots of mistakes in the
financial crisis. So did lots of other people. And they are not
going--and my guess is it would be the unusual bank examiner
who understands the commodities markets or the oil markets or
oil tankers and so forth. But they do have tools that they have
used, can use and have used, to try to control this risk and
have safeguards.
So, for instance, in the complementary powers orders, they
only allow activities by bank holding companies. It is
important to know that the banks themselves cannot do it. We
often sort of mix those up. So the separately capitalized,
insulated nonbank affiliates can buy and sell physical
commodities, but it is limited to physical commodities where
there is a contract that is authorized for trading on an
exchange by the CFTC, which means that they are sufficiently
liquid, or if there is not a contract that is authorized, that
the Federal Reserve has specifically determined is sufficiently
fungible and liquid to be an appropriate banking asset. Then
they have volume limits.
They also have capital and liquidity requirements. There is
no question that the bank regulators are not going to be able
to calibrate the risk of these activities any more than they
have been able to calibrate the risks of lending. And so the
way they manage--the way they sort of put safeguards in place
to manage all of the risks of the financial services industry
is to have limits, capital requirements, liquidity
requirements, surveillance, examinations, and so forth.
Senator Brown. Thank you.
Ms. Omarova, do you want to just respond?
Ms. Omarova. Just a quick note on this, that I do agree
that lending in and of itself is an extremely risky activity
and I do not think anybody seriously is aiming at eliminating
risk entirely from the banking business. That is just
impossible.
However, it is important to understand that the entire
system of banking law and regulation is built on an assumption
that these are the kinds of risks banks generate for
themselves, it is built on an assumption of what that business
is about. And so, poorly or effectively, but that regulatory
scheme actually targets those risks.
Now, when that regulatory scheme has to deal with risks
that are completely outside of that type of business and,
therefore, were not even meant to be addressed, then this is an
issue of legal efficiency and regulatory efficiency.
Senator Brown. Thank you.
Mr. Rosner, last comment, then Senator Warren. Sorry.
Mr. Rosner. I just want to go back and point out that on
September 27, 2012, the CFTC issued an order against JPMorgan
for violations of 4(a)(b)(2) of the Commodities Exchange Act,
finding deficiencies in newly created automated position limit
monitoring system for the commodities business used by
commodities traders to track their current positions, in
particular, futures contracts. After learning of this
deficiency, JPMCB utilized a manual position limit monitoring
procedure pending correction of the automated monitoring
system. Despite adoption of this manual position limit
monitoring procedure, JPMCB violated its short side speculative
position limits on several occasions.
So, first of all, we find in that statement internal
control failures. The company themselves could not manage those
controls.
More importantly to this point, those were uncovered by the
CFTC. We are not talking about the bank examiners. We are not
talking about the Federal Reserve. We are talking about the
CFTC, OK. The primary regulator clearly does not have the
capacity to manage all of the risks. Otherwise, we would not
have seen one of these institutions spend 12 percent of net
income between 2009 and 2012 on settlements for various
operational failures across their business lines.
Senator Brown. Thank you.
Senator Warren.
Senator Warren. Thank you, Mr. Chairman.
Professor Omarova, you have written about how regulators
began chipping away at Glass-Steagall starting in the early
1980s and began breaking down the wall between commercial
banking and investment banking. So, I want to ask you the other
part of the question. What do you think is the impact of a
financial institution being able to take consumer deposits
while also being able to control, say, an electric plant or an
oil refinery through its Management Division? Professor
Omarova.
Ms. Omarova. That is a very important issue that needs
actually further significant research, and I am hoping that
this hearing will start the process of asking the questions of
the people who can provide us with information for us to be
able to arrive at the full conclusion on that.
But, as a preliminary matter, right, as a person sort of
applying common sense and some knowledge of what has been
happening in the past, I would say that there are some serious
concerns with that situation. We have talked today a lot about
potential, for example, for manipulating prices in either
market. Now, it may or may not hurt the individual consumers,
but that raises an issue of market integrity in the financial
markets, also in the underlying commodities markets, right. It
also interferes with the traditional supply and demand dynamics
that typically form prices in a variety of markets.
So, do we want that to happen? Of course not. Is it
happening? It is hard to tell. But might it happen? Of course,
it can happen, and that is the issue to be asked.
Then there is this whole another problem with the systemic
risk and what not. We have already talked about it.
But then, ultimately, if you think about it from the point
of view of a regular person, you know, if these trends were to
continue without any kind of principled limitation on what
should be allowed to banks, simply because they can afford to
do it maybe cheaper than others, then probably at some point in
the future, we will find ourselves in a situation where we--not
only do we buy our house with the money borrowed from a big
bank, not only that house was built maybe by a subsidiary of
that big bank, it is heated and electrified and provided with
water that is also distributed and perhaps produced by that
same bank, and who knows what else. In fact, you know--this is
hyperbolic hypothetical, of course, being a law professor, I
cannot resist that----
[Laughter.]
Ms. Omarova.----but one could envision JPMorgan's new
slogan as, ``Get Everything You Need From Your Friendly Local
Global Financial Conglomerate.''
And perhaps that is OK. Perhaps that is the kind of a
future for this country that we should be prepared to live
with, because JetBlue or an oil refinery in Pennsylvania
actually gets cheaper financing of its inventories, right. But
if that is the case, what I am asking for is a chance for a
public deliberation. We have to be able to make that decision.
Senator Warren. Mr. Rosner, did you want to weigh in on
that?
Mr. Rosner. Yes, only in the discussion of cheaper
financing, because I think it needs to be, again, stressed.
There is nothing wrong with vertical integration of industries.
There is nothing wrong with investors owning those assets,
investing in those assets, controlling those assets within the
confines of regulation.
When you have institutions that have access to the Fed
window, and that may well be the basis of their cheaper
financing, it is anti-competitive. It prevents Wall Street, and
I am talking about investors, I am talking about where price
discovery happens, where people buy and sell securities, trying
to bring price and value in line. You are distorting the
ability of markets to function, and I think that really needs
to be front in people's minds here.
This is not about liking or disliking Wall Street's
investments in infrastructure assets. That is a clear driver of
our economy. The question is tying those to competitive
advantage of the Federal funds.
Senator Warren. Well, it is both. It is competitive
advantage and it is risk----
Mr. Rosner. Right.
Senator Warren.----that we are talking about.
Mr. Rosner. No, that is right.
Senator Warren. So let me ask the question, then, from the
other direction, and that is that Senator McCain, Senator
Cantwell, Senator King, and I recently introduced a 21st
century Glass-Steagall Act. So, what impact do you think a new
Glass-Steagall Act would have on the developments you have seen
in the marketplace? Mr. Rosner.
Mr. Rosner. Well, so, first of all, I have not read the
text, so I cannot comment on the specifics.
Senator Warren. Fair enough, but I will tell you, it is
short.
Mr. Rosner. I do worry that, given the complexity of these
institutions, it may be difficult to achieve, and even if we
did have the Congressional intent to do so. We have got
institutions whose derivative books themselves are enormous.
And, frankly, there are real questions as to what they know of
their thresholds within those businesses. And so I think to
expect the quick dismantling of those would be difficult----
Senator Warren. Fair enough, although I will tell you, in
the bill, there is a 5-year period, because it acknowledges
exactly that point, that we have created a tangle and it takes
time to undo that. But at least in terms of the direction we
are trying to head, and that is to say that commercial banking,
boring banking, should be separated from these other functions.
Mr. Rosner. Well, we certainly have seen negative outcomes
from the broader economy and, frankly, for financial markets as
a result of the combination of those businesses. Now, we often
hear, well, our largest institutions will be less competitive
globally, to which I would usually respond, one, we have--first
of all, I would be very happy if this gentleman was able to
secure cheap funding because a German bank had a cheaper cost
of funds because it had a backstop of the German government. I
would actually find that to be OK, if we outsourced that risk,
prevent our largest institutions from underpricing risk to be
competitive, because in Europe, through actions----
Senator Warren. Let me just make sure I am following. You
would be glad to shift that risk----
Mr. Rosner. Absolutely.
Senator Warren.----over to the German taxpayers----
Mr. Rosner. That is right.
Senator Warren.----so long as the American taxpayers do not
take it on.
Mr. Rosner. Well, that is the point, right? So we have in
our country Dodd-Frank. The intent was to make sure that our
largest financial institutions are not sovereign obligations.
In Europe, they have accepted them as sovereign obligations.
And so that competitive issue really suggests that we are
willing to say, let business get funding from capital markets,
where, by the way, most of it comes from, or where foreign
banks are willing to underprice risk, because lending is very
risky, as we discussed, let them do so without creating the
race to zero, bringing our institutions down that road.
Senator Warren. OK. Or, to say it another way, but not the
American taxpayer.
Mr. Rosner. That is right.
Senator Warren. And, Professor Omarova, would you like to
weigh in on that?
Ms. Omarova. Well, personally, I think that the proposed
bill on the 21st century Glass-Steagall Act is a move
potentially in the right direction. What I want to emphasize,
though, is that just by separating boring banks from the rest
of the financial system, we may not completely, of course,
resolve the issue we are talking about today, because,
ultimately, this is about financial institutions that are also
dealers and traders in financial markets, capital markets, and
credit markets, being engaged on such a large scale in the
physical trading of commodities. That is the combination that
worries us here today, and that does not necessarily depend on
the actual charter.
So I would urge you, Senator Warren, and your colleagues to
perhaps, you know, think more in terms of perhaps expanding
the----
Senator Warren. I think it is fair to say that many of us
are very well aware of the need for multiple tools in the
toolbox and looking for more ways to move us in the right
direction, that Glass-Steagall is not designed to solve every
problem, but it helps move us in the right direction, helps
reduce risk, helps, at least to some extent, disentangle what
has become a mess that is both hard to regulate and is creating
additional risk on its own. So thank you very much.
Thank you, Mr. Chairman.
Senator Brown. Thank you, Senator Warren.
This is a picture of the ownership structure of an exchange
traded fund, a so-called ETF, established by JPMorgan to invest
in copper. In documents filed with the SEC, JPMorgan
acknowledges, as you can see from this chart, and I will quote:
The trust, the sponsor, the administrative agent, the warehouse
keeper, the JPMorgan Securities LLC, the initial authorized
participant are all affiliates of JPMorgan Chase. Although the
sponsor attempts to monitor these conflicts, it is extremely
difficult, if not impossible, for the sponsor to ensure that
conflicts of interest do not, in fact, result in adverse
consequences to the trust.
They note the sponsor has the authority to fire the
warehouse, their own Henry Bath subsidiary, but they have an
incentive not to exercise this authority even when it may be in
the best interest of shareholders to do so because of the
affiliation among the entities. I would also point out, Reuters
reported that JPMorgan added commodity chief Blythe Masters and
some other JPMorgan executives to Henry Bath's board.
Reading on, ``JPMorgan Chase Bank currently engages in and
in the future expects to engage in trading activities related
to copper.'' Much talk about aluminum and energy in this
discussion today, less so about copper, but my guess is, a year
from now, we might be talking a lot more about copper. And I
spoke to a labor official today who represents industrial
workers and he talked about how important copper is in so many
of the products that his workers and the companies they work
for make.
Futures contracts in copper and other copper-related
investments for its accounts or for the accounts of its
clients. Essentially, other parts of the bank may bet against
investors in the copper ETF. This structure is eerily
reminiscent of Mr. Rosner's comments about the subprime
collateralized debt obligation arrangements that we saw before
the financial crisis, and I have a series of questions for Mr.
Rosner.
We know, first of all, we know the three largest ETFs could
control up to 80 percent of the copper available in the market.
Mr. Weiner pointed out the problems they faced in aluminum.
This could be, perhaps, worse. So, questions, Mr. Rosner. Are
you troubled by the effects that this could have for end users
of copper? Should regulators share your concern? Should
consumers? Should investors? Are you troubled by the ETF
structure and the conflicts of interest involved?
Mr. Rosner. Well, of course. Look, in the industry, the
financial service industry, whether it is commercial banking or
investment banking, there will always be conflicts and those
conflicts must always be managed. And so if we had confidence
that the regulators could appropriately manage those conflicts
or that the companies themselves could appropriately manage
those conflicts, there would be no reason for us to be here
today.
I do not suggest that any of the activities that we are
talking about today are being run by people who are malicious,
malevolent, or have particular schemes to intentionally harm
the public. Functionally, though, we have businesses where
those conflicts of interest are driven by management who have
obligations to their investors. That is their primary
obligation. And so to make sure that the public is not harmed,
we need to make sure that those are fully private industries
without Government support, to Senator Warren's point.
We had Wall Street function, frankly, for generations,
effectively, both in doing lending functionally through
syndicates--financing, I should say, through syndicates--and
investment banking businesses. All of those activities are
fine. They just should not be tied to the Government support.
And so where they are, yes, all of these activities should
raise concern, should raise questions, and the conflicts of
interest become all the more meaningful specifically because
the U.S. taxpayer is functionally on the hook.
Senator Brown. Does anyone else wish to comment on that?
OK. Let me go to another line of questions on transparency.
Ms. Omarova, you, in your opening statement, you talked about
lacking the necessary data generally to address so many of
these issues. We have talked about the lack of transparency on
both the regulators and the institutions. We do not even know
what the regulators seem to be doing. There is no easy way for
Senator Merkley or Senator Warren or me or Senator Toomey, any
of us, to learn about practices that these banks are
undertaking or if the process, even the process, most
egregiously in my mind, by which the Federal Reserve reviews
and approves these activities, we do not even know if, in fact,
they have a deadline, when that deadline might be, although we
think we can calculate it, but the Fed will not acknowledge it,
that September deadline. It might apply to Goldman and Morgan
Stanley, but we do not know.
The Fed says that there is no deadline. Morgan Stanley's
public filings say it has 5 years from September of 2008. It is
not hard to add 5 years and come up with 2 months from now that
they have to comply with the Bank Holding Company Act. Other
companies say they expect the Federal Reserve to clarify the
scope of permissible grandfathered activities sometime this
fall.
Ms. Omarova, should Members of the Banking Committee,
should the public generally be forced to feel around in the
dark in order to figure this stuff out?
Ms. Omarova. Well, of course, we should not. Being in the
dark about this issue may in some ways make our lives easier,
right, because we do not--you know, what we do not know does
not hurt us, supposedly. But it still might hurt us and it is
better to be prepared for what is going on and weigh into that
conversation before it is too late.
Now, with respect to that September deadline, the banking
statutes, and the Bank Holding Company Act is no exception, are
frequently written in such an unclear manner that it is very
difficult to figure out what exactly is required and what
exactly is discretionary.
So while the text of the Gramm-Leach-Bliley Act that
created that grandfathering exemption for newly registered bank
holding companies after 1999 technically does not require the
Fed to approve the use of this particular exemption--on its
face, the statute does not do that. However, the same statute
also says that within 5 years at the maximum, right, these
institutions have to be, in effect, approved by the Fed as
being fully in compliance with the Bank Holding Company Act
prohibitions on their activities.
So as a practical matter, as a procedural matter, it is up
to the Fed at some point to weigh in on the question that after
you have become a bank holding company now and now are subject
to these limitations, what did you do with those assets that
you held prior to such conversion and at the time did not have
to comply with the limitations of the Bank Holding Company Act?
And that is the decision that is made by the Fed in negotiation
with these companies.
Now, what I would like to do, or what I would like you to
do, I suppose, is to ask the Fed these questions. Has the Fed
been looking into this issue, what kind of criteria the Fed is
using when it talks to these institutions, and how specifically
does the Fed arrive at its conclusions, for example, that a
particular type of an investment or activity is, in fact,
consistent with the public interest. And, again, this is a very
important inquiry.
Senator Brown. Well, and we have asked those questions. We
have not asked them in a public forum. They have been less than
forthcoming. We will do a hearing probably in September, and I
hope it is before the deadline, but we do not know when the
deadline is because they will not tell us when the deadline is,
if that sounds a bit circuitous. But we will continue this, and
it was not just Morgan Stanley and the Fed. It has also been
JPMorgan.
For instance, Reuters, in a different situation but still
leaving Fed involvement, is attempting to convert its ownership
of the Henry Bath warehouse into a merchant banking investment,
as you know, allowing them to hold it for 5 more years beyond
the 2015 cutoff. Goldman Sachs apparently--apparently--also
holds its Metro warehouse system under this provision. They
elect to do so using a Federal Reserve form that is not
necessarily available to the public.
So the Fed, again, has not been forthcoming in showing us
this form, discussing the deadline, allowing us a schedule on
how the form is filled out and when it is due. Surely, and I
will not even pose this question because the answer is so
obvious, that this information should be available to Members
of Congress, to the public, to all of us.
Senator Warren.
Senator Warren. Thank you.
So, Mr. Weiner, I read your testimony about what happened
in the market for aluminum as a result of the activities of the
large financial institutions. I thought it was pretty alarming,
and I just wanted to ask you, can you describe specifically how
you think the market developments here have affected consumers.
Mr. Weiner. We are the ultimate consumers here of aluminum.
It affects all of us. What it does is it takes away our
opportunity to give the consumers what they want. Our
consumers, in our particular case, 60 percent of our products
are packaged in aluminum. We would like to give them what they
ask for and they want aluminum. We give them the punch-top can.
We give them the aluminum pint. We give them all these
innovations, which creates jobs so we can buy new can lines to
promote and push our business forward. These are the things
that are held back from us that we cannot offer to the general
public.
Senator Warren. Thank you. That is very useful.
And, Professor Omarova, you wrote last year that big banks
began actively seeking expanded authority to conduct physical
commodities and energy trading activities in the early 2000s,
shortly after the fall of Enron, the pioneer in financializing
commodity and energy markets.
Now, you said in this paper that it is difficult to draw
causal connections here because of the timing, but you also
seem to have a hunch that this was not a coincidence. Would you
be willing to expand on that a little?
Ms. Omarova. Well, again, let me reiterate, I do not--I
have not done research to substantiate the link between the
fall of Enron and the rise of Morgan Stanley and Goldman Sachs
as this kind of integrated super-intermediary derivatives/
physical commodities traders. But, you know, there is at least
a plausible, a very plausible argument that Enron was the
pioneer in discovering a business model that brought together
the ability to move physical commodities, like oil, gas, and
other things, right, through a network, vast network of
commodity infrastructure throughout the entire Nation and a
major derivatives platform that is tied to the price of those
commodities that Enron was moving.
Now, it is important to understand that in that model, it
is not really even the key to own any particular producing
company in that chain or any particular distributor. Through
contractual networks, Enron was able, or at least it was
seeking the ability, to establish this kind of vast network of
kind of trade intermediation plus financial intermediation.
What happened to Enron, we all know. Now, once that model,
though, was discovered, that model was up for the taking, and I
think that the early 2000s is a particularly important
threshold because that was the beginning of the major,
unprecedented global commodities boom. And, again, it is hard
to draw any kind of causal connections. Was the boom at least
in part facilitated by the influx of the financial institutions
into the commodities market and financialization of commodities
markets? Perhaps, at least partly, the answer is yes.
Or was it the other way around? Was it that when Citigroup,
for example, and JPMorgan saw that physical commodities have
become the next hot asset class after the dot-com boom ended,
they have decided that they should use this sort of ability in
the statute to actually start getting into that physical
commodities game? I am sure, partly, at least, the answer is
yes.
Senator Warren. So, I do have to say here, whichever way
the causation era runs, the notion that two of our largest
financial institutions in this country are adopting a business
model that was pioneered by Enron suggests that this movie does
not end well and that we are now pulling more and more risk
into the system, and that what happened with Enron at least
should stand as a cautionary tale as we look forward to the
integration of these larger financial institutions and the
commodities market. So, thank you very much.
Mr. Rosner, did you want to comment on that?
Mr. Rosner. No.
Senator Warren. Good. Thank you very much. I appreciate it.
Mr. Chairman, thank you.
Senator Brown. Thanks, and I want to just close with a
couple of comments.
One, to be fair, I mentioned Morgan Stanley and JPMorgan
Chase in terms of the failure or the inadequacy of the Fed
response. I would add that Goldman's investment in Metro and
energy company Kinder Morgan are both merchant banking and
tended to be passive investments. Two managing directors of
Goldman Sachs serve on Kinder's board of directors, owning a 19
percent stake in the company. So that, I think--that is another
place where the Fed should look a little more carefully, we
think.
We primarily learned three things, I think, from this
hearing. We learned that this kind of ownership of a whole part
of the real economy can potentially be a risk for the banking
system.
We learned that the banks, when they own, they can get less
expensive financing because of their access to the window, can
get less expensive financing to capitalize their commodity
holdings.
And we learned that there is an advantage because of their
knowledge of the buying and selling and storing and
transporting of commodities. These banks get an advantage for
proprietary trading.
None of those seem to fit, in my mind, with the history of
financial regulation in this country, but they are two sides of
debate. Mr. Guynn argued that we should not be that troubled
that banks are recreating the old model of the original
JPMorgan. Mr. Rosner cited Mr. Morgan as a reason to be wary.
We should ask ourselves what it does to the rest of our
society, to our businesses, to our consumers, to our
manufacturers, to taxpayers, when wealth and resources are
diverted into finance that way.
The issue needs more explanation. The Federal Reserve and
the banks themselves are in the best position to provide it.
Stay tuned.
I so appreciate the four of you being here. I appreciate
Senator Warren's and Senator Toomey's and Senator Merkley's
questions. If the Members of the Subcommittee may have
questions of you, they will have a week to get them to you.
Please respond as quickly as you can.
Thank you all very much. The hearing is adjourned.
[Whereupon, at 11:53 a.m., the hearing was adjourned.]
[Prepared statements, responses to written questions, and
additional material supplied for the record follow:]
______
PREPARED STATEMENT OF SAULE T. OMAROVA
Associate Professor of Law
University of North Carolina at Chapel Hill
July 23, 2013
I am an Associate Professor of Law at the University of North
Carolina at Chapel Hill, where I teach subjects related to U.S. and
international banking law and financial sector regulation. Since
entering the legal academy in 2007, I have written articles examining
various aspects of U.S. financial sector regulation, with a special
focus on systemic risk containment and structural aspects of U.S. bank
regulation. For 6 years prior to becoming a law professor, I practiced
law in the Financial Institutions Group of Davis Polk & Wardwell and
served as a Special Advisor on Regulatory Policy to the U.S. Treasury's
Under Secretary for Domestic Finance.
For the past 14 months, I've been working on a research project
examining the involvement of large U.S. banking organizations in
physical commodities and energy markets. The working draft of my
article, entitled ``The Merchants of Wall Street: Banking, Commerce,
and Commodities'' is available on the Social Science Research Network,
at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2180647. This
written testimony represents an abbreviated version of that article.
For further details and full citations, please see the text of the
article.
I. The Legal Background: Separation of Banking from Commerce
One of the core principles underlying and shaping the elaborate
regime of U.S. bank regulation is the principle of separation of
banking and commerce. Pursuant to that principle, U.S. commercial banks
generally are not permitted to conduct any activities that do not fall
within the relatively narrow band of the statutory concept of ``the
business of banking.''\1\ In addition, under the Bank Holding Company
Act of 1956 (``BHCA''), all bank holding companies (``BHCs'')--i.e.,
companies that own or control U.S. banks--are generally restricted in
their ability to engage in any business activities other than banking
or managing banks, although they may conduct certain financial
activities ``closely related'' to banking through their nondepository
subsidiaries.\2\ The Gramm-Leach-Bliley Act of 1999 (``GLBA'') amended
the BHCA to allow certain BHCs qualifying for the status of ``financial
holding company'' (``FHC'') to conduct broader activities that are
``financial in nature,'' including securities dealing and insurance
underwriting.\3\ All BHCs (including their subset, FHCs) are subject to
extensive regulation and supervision by the Board of Governors of the
Federal Reserve System (the ``Board''), an agency in charge of
administering and implementing the BHCA.
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\1\ 12 U.S.C. Sec. 24 (Seventh).
\2\ 12 U.S.C. Sec. Sec. 1841-43.
\3\ 12 U.S.C. Sec. 1843(k)(1)(A).
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In effect, the entire system of U.S. bank and BHC regulation is
designed to keep institutions that are engaged in deposit-taking and
commercial lending activities from conducting, directly or through some
business combination, any significant nonfinancial activities, or from
holding significant interests in any general commercial enterprise. The
main arguments in favor of maintaining this legal wall between the
``business of banking'' and purely commercial business activities have
traditionally included the needs (1) to preserve the safety and
soundness of insured depository institutions, (2) to ensure a fair and
efficient flow of credit to productive economic enterprise (by, among
other things, preventing unfair competition and conflicts of interest),
and (3) to prevent excessive concentration of financial and economic
power in the financial sector. The BHCA, which was originally
envisioned as explicitly anti-monopoly legislation, embodies and seeks
to implement these policy objectives.
Of course, in practice, the relationship between banking and
commerce in the United States has never been simple, as the legal wall
separating them has never been completely impenetrable. Numerous
exemptions from the general statutory restrictions on affiliations,
such as the exemption for unitary thrift holding companies or companies
controlling certain State-chartered industrial banks, historically have
allowed a wide variety of commercial firms to own and operate deposit-
taking institutions. Banks and BHCs, in turn, have always been allowed
at least some degree of involvement in nonfinancial activities, subject
to various statutory and regulatory conditions and limitations. For
example, BHCs are generally permitted to invest in up to 5 percent of
any class of voting securities of any nonfinancial company--an
exception designed to allow banking organizations to take small,
noncontrolling stakes in commercial businesses as passive investors.\4\
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\4\ 12 U.S.C. Sec. 1843(c)(6),(7).
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In the last decade, however, there has been a qualitative change in
the practice of mixing banking and commerce, at least within the
structure of large, systemically important FHCs. Thus, large U.S.
FHCs--including Goldman Sachs, Morgan Stanley, and JPMorgan Chase & Co.
(``JPMC'')--have emerged as major merchants of physical commodities and
energy, notwithstanding the legal wall designed to keep them out of any
nonfinancial business. As explained in greater detail below, these
three FHCs currently own and operate what appear to be significant
businesses trading in crude oil, gas, refined petroleum products,
electric power, metals, and other physical commodities. In conducting
these activities, they function as traditional commodity merchants
rather than purely financial intermediaries. That's why it is important
to understand how the law has failed to prevent, and apparently has
enabled, this extensive entry of banking organizations into the sphere
of general commerce.
In an important sense, the story begins with passage of the GLBA in
1999. The GLBA is best known for partially repealing the Glass-Steagall
Act and thereby opening the door to a mixing of commercial with
investment banking. More significantly for present purposes, however,
the GLBA also opened the door to a greater mixing of banking with
commerce. Under the BHCA, as amended by the GLBA, there are currently
three main sources of legal authority for FHCs (but not all BHCs) to
conduct purely commercial activities, despite the general separation of
banking from commerce: (1) merchant banking authority; (2)
``complementary'' powers; and (3) ``grandfathered'' commodities
activities. In order to engage, directly or through any subsidiary, in
any nonfinancial, commercial activity--including producing, refining,
storing, transporting, or distributing any physical commodity--an FHC
has to ``fit'' that activity within the legal confines of at least one
of these three statutory exceptions created by the GLBA.
A. Merchant Banking Powers
The merchant banking authority permits an FHC to acquire or
control, directly or indirectly, up to 100 percent of any kind of
ownership interest--including equity or debt securities, partnership
interests, trust certificates, warrants, options, or any other
instruments evidencing ownership--in any entity that engages in purely
commercial, as opposed to financial, activities.\5\ By creating this
new investment authority, the GLBA sought to enable FHCs to conduct a
broad range of securities underwriting, investment banking, and
merchant banking activities, subject to statutory conditions and
limitations. At the height of the high-tech stock boom, the GLBA's
grant of merchant banking powers allowed FHCs to compete with
securities firms and venture-capital funds by investing in technology
startups.
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\5\ 12 U.S.C. Sec. 1843(k)(4)(H).
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The statute, however, does not define the term ``merchant
banking.'' In 2001, the Board and the Department of Treasury jointly
issued a final rule implementing Section 4(k)(4(H) of the BHCA (the
``Merchant Banking Rule'').\6\ The Merchant Banking Rule defines
``merchant banking'' activities and investments as those activities and
investments that are not otherwise authorized under Section 4 of the
BHCA.\7\ In effect, the merchant banking power serves as a catch-all
authority for FHCs to invest in commercial enterprises, as long as any
such investment meets the following key requirements:
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\6\ 12 C.F.R. Part 225, Subpart J.
\7\ The Merchant Banking Rule provides the following definition:
Section 4(k)(4)(H) of the Bank Holding Company Act (12 U.S.C.
1843(k)(4)(H)) and this subpart authorize a financial holding company,
directly or indirectly and as principal or on behalf of one or more
persons, to acquire or control any amount of shares, assets or
ownership interests of a company or other entity that is engaged in any
activity not otherwise authorized for the financial holding company
under section 4 of the Bank Holding Company Act. For purposes of this
subpart, shares, assets or ownership interests acquired or controlled
under section 4(k)(4)(H) and this subpart are referred to as ``merchant
banking investments.'' 12 C.F.R. Sec. 225.170.
(1) the investment is not made or held, directly or indirectly, by a
U.S. depository institution (such as a bank subsidiary of the
---------------------------------------------------------------------------
FHC);
(2) the investment is made ``as part of a bona fide underwriting or
merchant or investment banking activity,'' which includes
investments made for the purpose of appreciation and ultimate
resale;
(3) the FHC either (i) is or has a securities broker-dealer
affiliate, or (ii) has both (A) an insurance company affiliate
that is predominantly engaged in underwriting life, accident
and health, or property and casualty insurance (other than
credit-related insurance), or providing an issuing annuities
and (B) a registered investment adviser affiliate that provides
investment advice to an insurance company;
(4) the investment is held ``only for a period of time to enable the
sale or disposition thereof on a reasonable basis consistent
with the financial viability of the [FHC's] merchant banking
investment activities;'' and
(5) the FHC does not ``routinely manage or operate'' any portfolio
company in which it made the investment, except as may be
necessary in order to obtain a reasonable return on investment
upon resale or disposition.
At least in theory, the requirement that a permissible merchant
banking investment be made as part of a bona fide underwriting or
investment banking activity imposes an important functional limitation
on merchant banking activities. Even though an FHC is permitted to
acquire full ownership of a purely commercial firm, the principal
purpose of its investment must remain purely financial: making a profit
upon subsequent resale or disposition of its ownership stake. The Board
made clear that merchant banking authority was not designed to allow
FHCs to enter the nonfinancial business conducted by any portfolio
company. This explicitly stated statutory requirement ``preserves the
financial nature of merchant banking investment activities and helps
further the [ ] purpose of maintaining the separation of banking and
commerce.''\8\
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\8\ 66 Fed. Reg. 8466, 8469 (Jan. 31, 2001).
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Another important requirement that shapes the practical usefulness
of the merchant banking authority to FHCs investing in commercial
companies is the holding period for merchant banking investments, which
is generally limited to a maximum of 10 years. If the investment is
made through a qualifying private equity fund, the maximum holding
period is fifteen years. In certain exigent circumstances, the FHC may
petition the Board to allow it to hold the investment for some limited
time in excess of the applicable holding period. Explicit limits on the
duration of merchant banking investments underscore the principally
financial nature of this activity.
Finally, the prohibition on FHCs' involvement in the routine
management and operation of portfolio companies they own or control
under the merchant banking authority is designed to serve as an
additional safeguard against mixing banking and commerce. The Merchant
Banking Rule lists the indicia of impermissible routine management or
operation of a portfolio company, which include certain kinds of
management interlocking \9\ and contractual restrictions on the
portfolio company's ability to make routine business decisions, such as
hiring non-executive officers or employees or entering into
transactions in the ordinary course of business.\10\ Arrangements that
do not constitute routine management or operation of a portfolio
company include contractual agreements restricting the portfolio
company's ability to take actions not in the ordinary course of
business;\11\ providing financial, investment, and management
consulting advice to, and underwriting securities of, the portfolio
company;\12\ and meeting with the company's employees to monitor or
advise them in connection with the portfolio company's performance or
activities.\13\ Importantly, the Merchant Banking Rule specifically
allows an FHC to elect any or all of the directors of any portfolio
company, as long as the board of directors does not participate in the
routine management or operation of the portfolio company.\14\
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\9\ 12 C.F.R. Sec. 225.171(b)(1). An FHC is deemed to be engaged
in the routine management or operation of a portfolio company if (1)
any director, officer, or employee of the FHC or certain of its
subsidiaries (including depository institutions, securities broker-
dealers, and merchant banking subsidiaries) serves as, or has the
responsibilities of, an executive officer of a portfolio company; or
(2) any executive officer of the FHC or any of the same subsidiaries as
mentioned above serves as, or has the responsibilities of, an officer
or employee of the portfolio company. Id. An FHC is presumed to be
routinely managing or operating a portfolio company if (1) any
director, officer, or employee of the FHC serves as, or has the
responsibilities of, a non-executive officer or employee of a portfolio
company; or (2) any officer or an employee of the portfolio company is
supervised by any director, officer, or employee of the FHC (other than
in that person's capacity as a director of the portfolio company). 12
C.F.R. 225.171(b)(2). An FHC may rebut these presumptions by
providing the Board with sufficient information showing the absence of
routine management or operation. 12 C.F.R. Sec. 225.171(c).
\10\ 12 C.F.R. Sec. 225.171(b)(1).
\11\ 12 C.F.R. Sec. 225.171(d)(2).
\12\ 12 C.F.R. Sec. 225.171(d)(3)(i),(ii).
\13\ 12 C.F.R. Sec. 225.171(d)(3)(iii).
\14\ 12 C.F.R. Sec. 225.171(d)(1). The portfolio company must
employ officers and employees responsible for routinely managing and
operating its affairs. An FHC may engage, on a temporary basis, in the
routine management or operation of a portfolio company only if such
actions are necessary to save the economic value of the FHC's
investment and to obtain a reasonable return on such investment upon
its resale or disposition. 12 U.S.C. Sec. 1843(k)(4)(H)(iii); 12
C.F.R. Sec. 225.171(e).
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B. Activities ``Complementary'' to a Financial Activity
As discussed above, the main justification for allowing FHCs to own
or control commercial companies under the merchant banking authority is
the notion of merchant banking as a fundamentally financial activity.
However, the GLBA also contains a separate grant of authority for FHCs
to conduct activities that are clearly not financial in nature but are
determined by the Board to be ``complementary'' to a financial
activity. The statute requires that the Board also determine that any
such complementary activity ``not pose a substantial risk to the safety
or soundness of depository institutions or the financial system
generally.''\15\
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\15\ 12 U.S.C. Sec. 1843(k)(1).
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Procedurally, the Board makes these determinations on a case-by-
case basis. Any FHC seeking to acquire more than 5 percent of the
voting securities of any class of a company engaged in any commercial
activity that the FHC believes to be complementary to a financial
activity must apply for the Board's prior approval by filing a written
notice. In the notice, the FHC must specifically describe the proposed
commercial activity; identify the financial activity for which it would
be complementary and provide detailed information sufficient to support
a finding of ``complementarity;'' describe the scope and relative size
of the proposed activity (as measured by the expected percentages of
revenues and assets associated with the proposed activity); and discuss
the risks the proposed commercial activity ``may reasonably be
expected'' to pose to the safety and soundness of the FHC's deposit-
taking subsidiaries.\16\
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\16\ 12 C.F.R. Sec. 225.89(a).
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The notice must also describe the public benefits that engaging in
the proposed activity ``can be reasonably expected'' to produce. In
making its determination, the Board is required to make a specific
finding that the proposed activity would produce public benefits that
outweigh its potential adverse effects.\17\ The statutory list of such
public benefits includes ``greater convenience, increased competition,
or gains in efficiency.''\18\ The Board must balance these benefits
against such dangers as ``undue concentration of resources, decreased
or unfair competition, conflicts of interests, unsound banking
practices, or risk to the stability of the United States banking or
financial system.''\19\
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\17\ 12 C.F.R. Sec. 225.89(b)(3).
\18\ 12 U.S.C. Sec. 1843(j)(2)(A).
\19\ Id. This list essentially reiterates the policy concerns
underlying the principle of separation of banking from commerce.
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The legislative history of this provision shows that the industry
deliberately sought the inclusion of the ``complementary'' clause as an
open-ended source of legal authority for banking organizations to
engage in any commercial activities that may become feasible or
potentially profitable in the future. In congressional hearings,
financial services industry representatives stressed ``the importance
of having the flexibility to engage in nominally commercial activities,
particularly those related to technology and telecommunications, that
support and complement [their] core business.''\20\ This is how the
then Vice-Chairman of J.P. Morgan & Co. described the industry's vision
of ``complementary'' business activities:
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\20\ The Financial Services Act of 1998--H.R. 10: Hearing before
the S. Comm. on Banking, Housing, and Urban Affairs, 105th Cong. 172
(1998) (prepared statement of John G. Heimann, Chairman, Global
Financial Institutions, Merrill Lynch & Co., Inc., on behalf of the
Fin. Servs. Council).
The world of finance has changed. Information services and
technological delivery systems have become an integral part of
the financial services business. Financial firms use
overcapacity in their back office operations by offering
services to others such as telephone help lines or data
processing for commercial firms. These activities may not be
strictly `financial,' yet they utilize a financial firm's
resources and complement its financial capabilities in a manner
that is beneficial to the firm without adverse policy
---------------------------------------------------------------------------
implications.
Financial firms also engage in activities that arguably might
be considered nonfinancial, but which enhance their ability to
sell financial products. One example is American Express, which
publishes magazines of interest to cardholders--Food & Wine and
Travel & Leisure. Travel & Leisure magazine is complementary to
the travel business (an activity permitted within the
definition of financial in H.R. 10) in that it gives customers
travel ideas which the company hopes will lead to ticket
purchases and other travel arrangements through American
Express Travel Services. Similarly, Food & Wine promotes dining
out, as well as purchases of food and wine, all of which might
lead to greater use of the American Express Card. These
activities are complementary to financial business and thus
should be permissible for financial holding companies.\21\
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\21\ H.R. 10--The Financial Services Modernization Act of 1999:
Hearings Before the Comm. On Banking and Fin. Servs., 106th Cong. 294-
95 (1999) (prepared testimony of Michael E. Patterson, Vice Chairman,
J.P. Morgan & Co., Inc., on behalf of the Financial Servs. Council).
The industry's frequent references to Travel and Leisure and Food
and Wine magazines effectively framed the congressional debate on
``complementary'' activities as a debate about relatively low-risk,
low-profile activities, such as publishing and financial data
dissemination. In reality, however, the possibility of having a
flexible, undefined statutory category of permissible commercial
activities was especially attractive to financial institutions seeking
to take advantage of the dot-com boom and potentially expand into far
riskier Internet ventures.\22\ From the industry's perspective, an
intentionally open-ended ``complementary'' authority was the key to
such an expansion.
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\22\ As the CEO of Bank One Corp. put it, ``The area on the
commerce side that is most interesting to me is what is happening on
the Internet.'' H.R. 10--The Financial Services Modernization Act of
1999: Hearings Before the Comm. On Banking and Fin. Servs., 106th Cong.
18 (1999) (testimony of John B. McCoy, President and CEO, Bank One
Corporation).
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In April 1999, the Senate introduced its version of the reform bill
that for the first time included the ``complementary powers''
provision. In June 1999, the House bill was amended to incorporate a
similar authorization of ``complementary'' activities but only ``to the
extent that the amount of such complementary activities remains small
in relation to the authorized activities to which they are
complementary.''\23\ This express limitation disappeared from the final
version enacted into law as part of the GLBA, leaving the Board free to
set its own conditions for FHCs' complementary activities.
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\23\ H.R. 10, 106th Cong. Sec. 102 (as reported by H. Comm. on
Banking & Fin. Servs., June 15, 1999) (internal citations omitted). ).
An earlier House Committee Report included a similar provision. See
H.R. Rep. No. 106-74, pt. 1, at 5 (Mar. 23, 1999).
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The Board has described the intended scope and purpose of its own
authority to approve certain activities as complementary to an FHC's
financial activity in relatively cautious terms, as allowing individual
FHCs ``to engage, to a limited extent, in activities that appear to be
commercial if a meaningful connection exists between the proposed
commercial activity and the FHC's financial activities and the proposed
commercial activity would not pose undue risks to the safety and
soundness of the FHC's affiliated depository institutions or the
financial system.''\24\
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\24\ 68 Fed. Reg. 68,493 (Dec. 9, 2003) (emphasis added).
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Curiously, between 2000 and 2012, the Board used its authority
almost exclusively to approve physical commodity and energy trading
activities as complementary to FHCs' financial activity of trading in
commodity derivatives.\25\ It seems that, after the GLBA was enacted,
FHCs discovered that trading crude oil and wholesale electricity
``complemented'' their traditional financial activities much better
than publishing travel and culinary magazines. This phenomenon raises
critical questions about the scope and practical operation of the
undefined and intentionally broad statutory concept of
``complementarity.''
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\25\ As of mid-2012, the Board approved only one other type of
activity--certain disease management and mail-order pharmacy services--
as complementary to a financial activity of underwriting and selling
health insurance. Wellpoint, Inc., 93 Fed. Res. Bull. C133 (2007).
Wellpoint, which was not a BHC, submitted an application to the FDIC to
obtain deposit insurance for its new Utah-chartered industrial bank.
Although owning an industrial bank would not make Wellpoint a BHC
subject to the BHCA's activity restrictions, Wellpoint had to request
the Board's determination because, at the time, the FDIC-imposed
temporary moratorium on providing deposit insurance to new industrial
banks prohibited approval of any such applications unless the applicant
(Wellpoint, in this instance) engaged exclusively in FHC-permissible
activities. See Moratorium on Certain Industrial Bank Applications and
Notices, 72 Fed. Reg.5290 (Feb. 5, 2007).
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C. Grandfathered Commodities Activities
In addition to granting FHCs potentially broad and vaguely defined
merchant banking and ``complementary'' powers, the GLBA contains a
special grandfathering provision for commodities activities. Section
4(o) of the BHCA explicitly authorizes any company that becomes an FHC
after November 12, 1999, to continue conducting ``activities related to
the trading, sale, or investment in commodities and underlying physical
properties,''\26\ subject to the following conditions:
---------------------------------------------------------------------------
\26\ 12 U.S.C. Sec. 1843(o).
(1) the company ``lawfully was engaged, directly or indirectly, in
any of such activities as of September 30, 1997, in the United
---------------------------------------------------------------------------
States;''
(2) the aggregate consolidated assets of the company attributable to
commodities or commodity-related activities, not otherwise
permitted to be held by an FHC, do not exceed 5 percent of the
company's total consolidated assets (or such higher percentage
threshold as the Board may authorize); and
(3) the company does not permit cross-marketing of products and
services between any of its subsidiaries engaged in the
grandfathered commodities activities and any affiliated U.S.
depository institution.
The vague phrasing of this section seems to allow a qualifying new
FHC to conduct not only virtually any kind of commodity trading but
also any related commercial activities (for example, owning and
operating oil terminals and metals warehouses), if it engaged in any
commodities business--even if on a very limited basis and/or involving
different kinds of commodities--prior to the 1997 cutoff date.
Potentially, so broadly stated an exemption may open the door for large
financial institutions to conduct sizable commercial activities of a
kind typically not allowed for banking organizations.\27\
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\27\ The statutory 5 percent limit on the FHC's total consolidated
assets attributable to the grandfathered commodities activities is
designed to prevent a dramatic shift in the business profile of such an
FHC from financial to purely commercial commodities activities. In
absolute terms, however, even such a small fraction of total
consolidated assets of a large FHC may allow for a considerable
expansion of its commercial business of owning, producing,
transporting, processing, and trading physical commodities. Such an
expansion may very well implicate the fundamental policy concerns
underlying the principle of separation of banking and commerce.
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To date, the outer limits of the commodities grandfathering clause
have not been tested. It is difficult to assess, therefore, whether and
to what extent this seemingly inconspicuous provision may be used to
deal the final deathblow to the principle of separation of banking and
commerce. The legislative history of this special grandfathering
clause, however, provides valuable context in which to place analysis.
It is also highly instructive from the point of view of the political
economy of U.S. financial services regulation.
The grandfathering of pre-existing commodities trading activities
was originally proposed in 1995 by Congressman Jim Leach as part of a
broader set of provisions establishing a new charter for ``wholesale
financial institutions'' (``WFIs''), which could conduct a wide range
of banking activities but, importantly, could not take federally
insured retail deposits.\28\ Under the proposal, companies that owned
or controlled one or more WFIs (but not FDIC-insured banks)--Wholesale
Financial Holding Companies (``WFHCs'')--would be regulated and
supervised by the Board but less stringently than regular FHCs.\29\
These provisions of the House bill were designed specifically to create
a so-called ``two-way street'' for investment banks, to enable them to
acquire commercial banks and offer their institutional clients
wholesale banking services, without becoming subject to the full range
of activity restrictions under the BHCA.\30\ Because WFIs and their
parent-companies--dubbed ``woofies''--would not have access to Federal
deposit insurance and, therefore, were not likely to pose any
significant potential threat to the deposit insurance fund, the
proposal authorized them to engage in a broader set of nonfinancial
activities than regular FHCs backed by FDIC insurance. One of these
explicit tradeoffs involved the grandfathering of woofies' pre-existing
commodities trading and related activities.\31\
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\28\ Financial Services Competitiveness Act of 1995, 104 H.R. 1062
(Version 1), Sec. 109.
\29\ Id. In the 1995 versions of the House bill, these WFI holding
companies were referred to as ``Investment Bank Holding Companies.''
Compare 104 H.R. 1062 (Version 1), Sec. 109 with 105 H.R. 10 (version
3), Sec. 131.
\30\ This is how an American Bankers Association report described
the 1997 proposal:
To allow for two-way affiliations between banks and securities
firms, a new type of holding company would be permitted. This would be
the investment bank holding company. These companies would have still
wider powers than the new bank holding company format would bring, but
the separation between banking and commerce would still be retained.
These special holding companies could own wholesale financial
institutions (WFIs, also known as ``woofies'') which would be uninsured
but also not subject to standard bank holding company firewalls.
Steve Cocheo, Outlook Brightens for New Banking Laws, ABA BANKING
JOURNAL, Feb. 27, 1997, at 10.
\31\ Goldman lobbied for specific inclusion of the commodity
grandfathering clause in the ``woofie'' provisions of the House bill
because of its existing investment in J. Aron, a commodity trading
company. In fact, at the time, the commodity grandfathering provision
was ``widely viewed as the ``Goldman'' exception.'' Martin E. Lybecker,
Financial Holding Companies and New Financial Activities Provisions of
the Gramm-Leach-Bliley Act, in BACK TO THE FUNDAMENTALS: INSURANCE
REGULATION, BROKER-DEALER REGULATION, AND INVESTMENT ADVISER REGULATION
(ABA CENTER FOR CLE NAT'L INSTITUTE, NOV. 8-10, 2001), fn. 11.
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Curiously, both Goldman and J.P. Morgan were among the big banks
and securities firms that strongly pushed for the passage of the
``woofie'' charter. The proposal, however, became a subject of intense
political contention in Congress. In contrast to the House bill, the
Senate version of the reform legislation did not contain ``woofie''
provisions.\32\ In April 1999, however, Senator Phil Gramm introduced
an amendment that effectively replicated the commodity grandfathering
provision for ``woofies'' in the House bill--but without any reference
to ``woofies.''\33\ In the Conference, the entire subtitle of the House
bill dealing with ``woofies'' was dropped. The Senate's broader version
of the commodity grandfathering clause, however, remained in the text
of the GLBA and became the current Section 4(o) of the BHCA. Thus, an
initially limited concession to financial institutions that were
explicitly denied access to Federal deposit insurance became an open-
ended exemption available to all newly registered FHCs fully backed by
the Federal Government guarantees.
---------------------------------------------------------------------------
\32\ S. 900, 106th Cong. (as placed on the Senate calendar, Apr.
28, 1999).
\33\ S. Rep. 106-44 (Apr. 28, 1999), at 3.
---------------------------------------------------------------------------
To sum up, the GLBA created significant opportunities for U.S.
banking organizations to play a much more direct and active role in
purely commercial sectors of the economy. In the years following the
passage of the GLBA, large U.S. FHCs have used these statutory
provisions to enter and grow operations in physical commodity and
energy markets.
II. From the GLBA to the Global Financial Crisis: Physical Commodity
Trading as ``Complementary'' to FHCs' Financial Activities
Even before the enactment of the GLBA, U.S. commercial banks and
their affiliates had become actively involved in trading and dealing in
financial derivatives--publicly traded futures and various over-the-
counter contracts--linked to the prices of commodities. Since the mid-
1980s, the OCC has been aggressively interpreting the bank powers
clause of the National Bank Act to include derivatives trading and
dealing as part of the ``business of banking.''\34\ Similarly, under
the BHCA, trading in commodity derivatives is generally treated as a
financial activity that raises no controversial legal issues. Handling
physical commodities, however, was a much different matter. Even
physical settlement of permissible commodity derivatives--which
necessitated taking ownership, transporting, and storing actual crude
oil or iron ore--presented a problem in light of the general principle
of separating banking from commerce. FHCs seeking to engage in physical
trades had to find a specific legal authority to do so.
---------------------------------------------------------------------------
\34\ Saule T. Omarova, The Quiet Metamorphosis: How Derivatives
Changed the ``Business of Banking,'' 63 U. MIAMI L. REV. 1041 (2009).
---------------------------------------------------------------------------
In the early 2000s, global commodities markets began experiencing
an unprecedented price boom, which coincided with the increased push by
large U.S. financial institutions to establish large-scale physical
commodity trading operations. Between 2003 and 2008, several large U.S.
FHCs and foreign banks successfully obtained Board orders allowing them
to trade physical commodities as an activity ``complementary'' to the
financial activity of trading and dealing in commodity derivatives.
In 2003, Citigroup became the first to receive Board approval of
its physical commodities trading as a ``complementary'' activity.\35\
Under the Board's order, Citigroup was allowed to purchase and sell
oil, natural gas, agricultural products, and other nonfinancial
commodities in the spot market and to take and make physical delivery
of commodities to settle permissible commodity derivative transactions.
The Board based its determination on four main considerations. First,
the Board found that the proposed activities ``flowed'' from FHCs'
legitimate financial activities, essentially providing them with an
alternative method of fulfilling their obligations under otherwise
permissible derivatives transactions. Second, permitting these
activities would make FHCs more competitive vis-a-vis other financial
firms not subject to regulatory restrictions on physically settled
derivatives transactions. Third, the proposed activities would enable
FHCs to offer a full range of commodity-related services to their
clients in a more efficient manner. Finally, conducting physical
commodity activities would enhance FHCs' understanding of the commodity
derivatives market.
---------------------------------------------------------------------------
\35\ Citigroup, Order Approving Notice to Engage in Activities
Complementary to a Financial Activity, 89 Fed. Res. Bull. 508 (2003)
[Citigroup Order].
---------------------------------------------------------------------------
To minimize the safety and soundness risks that this type of
commercial activity may pose, the Board imposed a number of conditions
on Citigroup's commodity-trading business. First, the market value of
any commodities owned by Citigroup may not exceed 5 percent of its
consolidated Tier 1 capital.\36\ This market value limitation is
generally meant to ensure that physical commodity trading does not grow
too big, at least in relative terms. Second, Citigroup may take or make
delivery only of those commodities for which derivatives contracts have
been approved for trading on U.S. futures exchanges by the Commodity
Futures Trading Commission (``CFTC''), unless the Board specifically
allows otherwise. This requirement was designed to prevent Citigroup
from dealing in finished goods and other items, such as real estate,
which lack the fungibility and liquidity of exchange-traded
commodities. Third, the Board made clear that Citigroup must conduct
its physical commodity trading business in compliance with the
applicable securities, commodities, and energy laws.
---------------------------------------------------------------------------
\36\ In 2003, Citigroup reported its total consolidated Tier 1
capital of nearly $66.9 billion. See Citigroup Inc., Form 10-K, Annual
Report pursuant to Section 13 or 15(d) of the Securities Exchange Act
of 1934, for the fiscal year ending on December 31, 2003, at 56. This
puts the numerical limit for the market value of the physical
commodities held by Citigroup for 2003 at slightly above $3.1 billion.
---------------------------------------------------------------------------
Finally, the Citigroup Order stated that the FHC was not authorized
to (i) own, operate, or invest in facilities for the extraction,
transportation, storage, or distribution of commodities; or (ii)
process, refine, or otherwise alter commodities. The expectation was
that Citigroup would use storage and transportation facilities owned
and operated by unrelated third parties. The purpose of this important
limitation is to minimize nonfinancial risks inherent in physical
commodity trading: storage risk, transportation risk, and potentially
serious environmental and legal risks associated with these activities.
The Board relied on specific representations from Citigroup to the
effect that it would exercise heightened care in avoiding these
nonfinancial risks. Thus, Citigroup represented that it would require
the owner of any vessel carrying oil on behalf of Citigroup to carry
the maximum insurance for oil pollution available from a protection and
indemnity club and to obtain a substantial amount of additional
pollution insurance. Similarly, it promised to require all third-party
storage facilities to carry a significant amount of oil pollution
insurance from a creditworthy insurance company. Citigroup would also
place age limitations on vessels and develop a comprehensive backup
plan in the event any owner of a vessel or storage facility fails to
respond adequately to an oil spill.
In subsequent years, the Board granted similar orders authorizing
physical commodity trading activities on the part of FHCs and foreign
banks treated as FHCs for purposes of the BHCA. These grants of
complementary powers allowed large non-U.S. banks--such as UBS,
Barclays, Deutsche Bank, and Societe Generale--to expand their
worldwide physical commodities businesses by adding U.S. operations,
albeit on a limited scale. In 2005, JPMC also obtained an order
permitting the FHC to engage in physical commodity trading activities
as complementary to its booming financial derivatives business.\37\ In
all of these cases, the Board imposed the same standard set of
conditions and limitations originally articulated in the Citigroup
Order.
---------------------------------------------------------------------------
\37\ JPMorgan Chase & Co., 92 Fed. Res. Bull. C57 (2006). Bank of
America and Wachovia received Board approvals to conduct physical
commodities trading in 2006-07.
---------------------------------------------------------------------------
In 2008, The Royal Bank of Scotland (``RBS''), then the U.K.'s
largest banking group, received the Board's order authorizing a wide
range of physical commodities and energy trading activities as
complementary to RBS's financial derivatives activities.\38\ RBS sought
these expanded powers in connection with its acquisition of a 51
percent equity stake in a joint venture with Sempra Energy, a U.S.
utility group. The joint venture, RBS Sempra Commodities (``RBS
Sempra''), was set up to conduct a worldwide business of trading in
various physical commodities--including oil, natural gas, coal, and
nonprecious metals--and be an active player in power markets in Europe
and North America.
---------------------------------------------------------------------------
\38\ The Royal Bank of Scotland Group plc, 94 Fed. Res. Bull. C60
(2008) [RBS Order].
---------------------------------------------------------------------------
In the RBS Order, the Board significantly relaxed the standard
limitations and expanded the scope of permissible trading in physical
commodities. Thus, the Board allowed RBS to take and make physical
deliveries of nickel, even though nickel futures were not approved for
trading on U.S. futures exchanges by the CFTC. The Board reasoned that
contracts for nickel were actively traded on the London Metals Exchange
(``LME''), a major non-U.S. exchange subject to regulation comparable
to the regulation of the U.S. futures exchanges. The Board also
authorized physical trading in a long list of physical commodities--
including natural gasoline, asphalt, kerosene, and other oil products
and petrochemicals--despite the fact that contracts for these
commodities have not been approved for trading on any major exchange.
In authorizing physical trading in these commodities, the Board relied
on the fact that these commodities were fungible and that contracts for
them were traded in sufficiently liquid over-the-counter markets
(through individual brokers and on alternative trading platforms).
The Board authorized RBS to hire third parties to refine, blend, or
otherwise alter the commodities. In effect, this removed the ambiguity
in previous orders by explicitly allowing RBS, for example, to sell
crude oil to an oil refinery and then buy back the refined oil product.
The Board determined that this activity essentially posed the same
risks as hiring a third party to operate a storage or transportation
facility, as permitted under previous orders. In addition, RBS made a
specific commitment that it would not have exclusive rights to use the
alteration facility.
The Board also permitted RBS to enter into long-term electricity
supply contracts with large industrial and commercial customers. The
Board noted that, while most commodities traded by FHCs were limited to
wholesale markets, electric power could much more easily reach small
retail customers. To ensure that RBS remained a wholesale electric
power intermediary dealing only with sophisticated customers, the RBS
Order specified the minimum consumption levels for customers to whom
RBS was allowed to sell electricity on a long-term basis.
Finally, in the RBS Order and in two separate orders issued to a
Belgian-Dutch bank, Fortis, the Board specifically approved so-called
energy management and energy tolling services these institutions sought
to perform in the United States.\39\ RBS and Fortis were authorized to
provide certain energy management services--consisting of transactional
and advisory services--to owners of power generation facilities under
Energy Management Agreements (``EMA''). FHC-permissible energy
management services generally entail acting as an intermediary for a
power plant owner to facilitate purchases of fuel and sales of power by
the plant, as well as advising the owner on risk-management strategies.
Thus, the energy manager--Fortis or RBS--would buy fuel for the plant
from third parties and sell it to the plant in a mirror transaction. It
would then purchase the power generated by the plant and resell it in
the market. In effect, the energy manager would provide credit and
liquidity support for the plant owner, including the posting of any
required collateral for transactions. In addition, the manager also
would assume responsibility for administrative tasks in connection
with, and the hedging of exposure under, fuel and power
transactions.\40\
---------------------------------------------------------------------------
\39\ Fortis S.A./N.V., 94 Fed. Res. Bull. C20 (2008) [Fortis
Order]; the RBS Order; Board Letter Regarding Fortis S.A/N.V. (May 21,
2008) [2008 Fortis Order].
\40\ The administrative tasks include, among other things,
arranging for third parties to provide fuel transportation or power
transmission services, coordinating fuel purchases and power sales,
negotiating and monitoring contracts with the plant owner's
counterparties.
---------------------------------------------------------------------------
These FHC-permissible energy management services, however, were
subject to several conditions designed to limit the safety and
soundness risks of such activities. Thus, the Board required that the
revenues attributable to the FHC's energy management services not
exceed 5 percent of its total consolidated operating revenues. The
Board also required that all EMAs, pursuant to which the FHC engages in
these activities, include certain mandatory provisions. For example,
the EMA must mandate that the plant owner approve all contracts for
purchases of fuel and sales of electricity, although the owner may be
allowed to grant a standing authorization to the manager to enter into
contracts that meet certain owner-specified criteria. The owner must
retain responsibility for the day-to-day maintenance and management of
the power generation facility, including hiring employees to operate
it. The owner must also retain the right to (i) market and sell power
directly to third parties, although the manager may have the right of
first refusal; and (ii) determine the facility's power output level at
any given time. In addition, the FHC is prohibited, directly or through
its subsidiaries, from guaranteeing the financial performance of the
power plant and from bearing any risk of loss if the plant is not
profitable.
Energy tolling is generally similar to energy management. Under
these arrangements, an FHC (the ``toller'') makes fixed periodic
(usually, monthly) ``capacity payments'' to the power plant owner, to
compensate the owner for its fixed costs, in exchange for the right to
all or part of the plant's power output. The plant owner retains
control over the day-to-day operation of the power plant. The toller
pays for the fuel needed to produce the power it directs the owner to
produce. The owner receives a marginal payment for each megawatt hour
produced by the plant, as compensation for its variable costs plus a
profit margin.
The Board approved energy tolling as a complementary activity
because it found it to be an ``outgrowth'' of the relevant FHC's
permissible commodity derivatives activities. The Board reasoned, in a
familiar fashion, that permitting energy tolling would provide the FHC
with valuable information on the energy markets, which would help it to
manage its own commodity risk, and allow the FHC to compete more
effectively with other financial firms not subject to the BHCA.
These competitors, of course, were Goldman and Morgan Stanley, at
the time independent investment banks. The recent financial crisis,
however, brought both of these firms under the direct jurisdiction of
the Board as new FHCs--and raised the potential salience of U.S.
banking institutions' commodity trading activities to a whole new
level.
III. The ``Game-Changing'' Impact of the Crisis: Morgan Stanley,
Goldman Sachs, and JPMC
One of the most profound and least appreciated consequences of the
recent financial crisis is the emergence of a powerful trio of large
FHCs with extensive physical commodities business operations: Morgan
Stanley, Goldman, and JPMC. Two extraordinary crisis-driven phenomena
led to this result: the emergency conversion of Morgan Stanley and
Goldman into BHCs and the once-in-a-lifetime acquisition by JPMC of the
commodity assets of two failing institutions, Bear Stearns and RBS.
On September 21, 2008, Morgan Stanley and Goldman received approval
to register as BHCs subject to the Board's regulation and supervision,
in a desperate effort to bolster investor confidence and avoid
potential creditor runs on their assets. In the midst of the unfolding
crisis, the Board approved these firms' applications to become BHCs
almost literally overnight, without putting them through its normal,
lengthy and detailed review process. It is highly unlikely that, at the
time of the conversion, the Board focused on these firms' extensive
physical commodities assets and activities--or gave full consideration
to the question of how to deal with such activities in the long run.
JPMC followed a different route to the top of the Wall Street
commodities game. In 2008, the firm acquired the physical commodity
trading assets of failing Bear Stearns. In 2009-2010, JPMC bought the
global commodities business of nationalized RBS. In a few short years,
the firm's aggressive growth strategy transformed it into one of the
three biggest U.S. banking organizations dominating global commodity
markets.\41\
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\41\ Morgan Stanley May Sell Part of Commods Unit: CNBC, REUTERS,
June 6, 2012, Among non-U.S. financial institutions, only UK's Barclays
and Germany's Deutsche Bank currently compete with Morgan Stanley,
Goldman and JPMC in global commodity markets.
---------------------------------------------------------------------------
Thus, in the wake of the financial crisis, the Board finds itself
facing a qualitatively different commodities business conducted by
three of the largest U.S. banking organizations. Under the BHCA, a
newly registered BHC has up to 5 years from the registration date
either to divest its impermissible nonbanking activities or to bring
such activities into compliance with BHCA requirements.\42\ The
statutory 5-year grace period for the nonconforming commodity
activities of Goldman and Morgan Stanley ends in the fall of 2013, at
which point the Board must make a potentially fateful decision whether
these firms will be able to continue--and further expand--their
commodity and energy merchant businesses. This decision requires a
thorough understanding of the nature and scope of these institutions'
actual involvement in physical commodities and energy markets.
---------------------------------------------------------------------------
\42\ 12 U.S.C. Sec. 1843(a)(2).
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A. The Informational Gap
Crucially, however, there is no meaningful public disclosure of
banking organizations' assets and activities related to physical
commodities and energy. Hence, it is important to preface discussion of
what is at stake in the Board's coming decision with a note on the
scarcity of information available to those who might wish to weigh in,
including Congress.
Three difficulties explain why the American public does not yet
have a full picture of what is happening in this space. The first
difficulty is that publicly traded financial institutions--including
all of the largest FHCs--typically report their assets, revenues,
profits, and other financial information for the entire business
segment, of which commodities trading is only a part. For instance,
Goldman includes commodities in its Fixed Income, Currencies and
Commodities division, which is included in the firm's Institutional
Client Services business segment.\43\ The same is true of Morgan
Stanley, which includes commodities operations in its Fixed Income and
Commodities division within the Institutional Securities business
segment.\44\ Neither firm provides full financial information
attributable specifically to its commodities divisions.
---------------------------------------------------------------------------
\43\ The Goldman Sachs Group, Inc., 2011 Form 10-K, at 1-4. The
firm's Institutional Client Services activities are organized by asset
class and include both ``cash'' and ``derivative'' instruments. Cash
instruments refer to trading in the assets underlying derivative
contracts, such as ``a stock, bond or a barrel of oil.'' Id. at 3. The
firm's annual report does not provide details on their physical
commodity operations and simply lists commodity products FICC trades:
``Oil and natural gas, base, precious and other metals, electricity,
coal, agricultural and other commodity products.'' The report states
that FICC generally facilitates client transactions and makes markets
in commodities. Id. at 115.
\44\ Morgan Stanley, 2011 Form 10-K, at 2-3. According to the
company's description of its activities, The Company invests and makes
markets in the spot, forward, physical derivatives and futures markets
in several commodities, including metals (base and precious),
agricultural products, crude oil, oil products, natural gas, electric
power, emission credits, coal, freight, liquefied natural gas and
related products and indices. The Company is a market-maker in
exchange-traded options and futures and OTC options and swaps on
commodities, and offers counterparties hedging programs relating to
production, consumption, reserve/inventory management and structured
transactions, including energy-contract securitizations and
monetization. The Company is an electricity power marketer in the
United States and owns electricity-generating facilities in the United
States and Europe.
---------------------------------------------------------------------------
The second difficulty is that, to the extent FHCs include in their
regulatory filings financial information specific to their commodities
operations, such information usually pertains to both commodity-linked
derivatives operations and trading in physical commodities. As a
result, most financial information reported under the ``commodities''
rubric relates to the derivatives business, leaving one to guess what
is going on in the firms' physical commodities businesses. Because of
this reporting pattern, industry analysts' estimates of the revenues or
profits generated by large FHCs' commodities trading desks often
include the estimated revenues and profits from purely financial
transactions in commodity derivatives. More broadly, this disclosure
format tends to de-emphasize--and thus make even less visible--the fact
that financial institutions often act not only as dealers in purely
financial risk but also as traditional commodity merchants.
Currently, large FHCs are required to report to the Board, on a
quarterly basis, only one financial metric directly related to their
physical commodities operations: the gross market value of physical
commodities in their trading inventory.\45\ These mandatorily reported
data provide a hint of the potential scale of these activities. For
instance, a look at this line item in JPMC's filings reveals a
significant growth in the market value of physical commodities the
company holds for trading purposes. Thus, as of March 31, 2009, JPMC
reported the gross fair value of physical commodities in its inventory
as a relatively modest $3.7 billion.\46\ By September 30, 2009, the
amount had doubled to $7.9 billion.\47\ By the end of 2009, the number
had further increased to slightly over $10 billion.\48\ At the end of
2010, the reported amount reached above $21 billion.\49\ As of December
31, 2011, JPMC reported the gross fair value of physical commodities in
its inventory at approximately $26 billion.\50\ As of March 31, 2012,
the gross fair value of physical commodities in JPMC's inventory had
slightly decreased to $17.2 billion.\51\ At the end of 2012, that
number was $16.2 billion.\52\
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\45\ See ``Consolidated Financial Statements for Bank Holding
Companies--FR Y-9C,'' Schedule HC-D (``Trading Assets and
Liabilities''), Item M.9.a.(2) (the ``Gross Fair Value of Physical
Commodities held in Inventory''). Form FR Y-9C is a quarterly report
filed with the Board by BHCs with total consolidated assets of $500
million or more. 12 U.S.C. Sec. 1844; 12 C.F.R. Sec. 225.5(b).
\46\ JPMC, FR Y-9C, March 31, 2009, Schedule HC-D, Item M.9.a.(2).
\47\ JPMC, FR Y-9C, September 30, 2009, Schedule HC-D, Item
M.9.a.(2).
\48\ JPMC, FR Y-9C, December 31, 2009, Schedule HC-D, Item
M.9.a.(2).
\49\ JPMC, FR Y-9C, December 31, 2010, Schedule HC-D, Item
M.9.a.(2).
\50\ JPMC, FR Y-9C, December 31, 2011, Schedule HC-D, Item
M.9.a.(2).
\51\ JPMC, FR Y-9C, March 31, 2012, Schedule HC-D, Item M.9.a.(2).
\52\ JPMC, FR Y-9C, December 31, 2012, Schedule HC-D, Item
M.9.a.(2).
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Morgan Stanley's regulatory filings show that, as of March 31,
2009, the gross fair value of physical commodities it held in inventory
was slightly below $2.5 billion.\53\ The reported value of this line
item in Morgan Stanley's reports rapidly increased to $10.3 billion as
of September 30, 2011,\54\ before going slightly down to approximately
$9.6 billion as of March 31, 2012.\55\ At the end of 2012, the gross
fair value of physical commodities in Morgan Stanley's inventory was
about $7.3 billion.\56\
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\53\ Morgan Stanley, FR Y-9C, March 31, 2009, Schedule HC-D, Item
M.9.a.(2).
\54\ Morgan Stanley, FR Y-9C, September 30, 2011, Schedule HC-D,
Item M.9.a.(2).
\55\ Morgan Stanley, FR Y-9C, March 31, 2012, Schedule HC-D, Item
M.9.a.(2).
\56\ Morgan Stanley, FR Y-9C, December 31, 2012, Schedule HC-D,
Item M.9.a.(2).
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Goldman's filings show more fluctuations in the gross fair value of
physical commodities in the firm's inventory during the same 3-year
period. Thus, as of March 31, 2009, Goldman reported $1.2 billion in
this line item.\57\ At the end of the next quarter, the number fell to
$682 million.\58\ It peaked at the end of 2010 at over $13 billion.\59\
As of March 31, 2012, Goldman reported the gross fair value of its
physical commodities inventory at $9.5 billion.\60\ At the end of 2012,
Goldman's number rose to $11.7 billion.\61\
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\57\ Goldman Sachs Group, FR Y-9C, March 31, 2009, Schedule HC-D,
Item M.9.a.(2).
\58\ Goldman Sachs Group, FR Y-9C, June 30, 2009, Schedule HC-D,
Item M.9.a.(2).
\59\ Goldman Sachs Group, FR Y-9C, December 31, 2010, Schedule HC-
D, Item M.9.a.(2).
\60\ Goldman Sachs Group, FR Y-9C, March 31, 2012, Schedule HC-D,
Item M.9.a.(2).
\61\ Goldman Sachs Group, FR Y-9C, December 31, 2012, Schedule HC-
D, Item M.9.a.(2).
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As issuers of publicly traded securities, FHCs include the same
data in their quarterly reports filed with the SEC. The gross market
value of FHCs' physical commodity trading inventory, however, measures
solely their current exposure to commodity price risk.\62\ It does not
provide a full picture of these organizations' actual involvement in
the business of producing, extracting, processing, transporting, or
storing physical commodities. To a great extent, this nearly exclusive
regulatory focus on commodity price risk reflects the underlying
assumption that U.S. banking organizations do not conduct any
commodity-related activities that could potentially pose any additional
risks to their safety and soundness or create systemic vulnerabilities.
If one assumes that banking organizations act only as arms' length
buyers and sellers of physical commodities, strictly for the purpose of
providing financial risk management services to their clients, then it
is logical to conclude that sudden price fluctuations in commodity
markets are the main source of potential risk from such activities. In
the absence of detailed information on U.S. banking organizations'
actual commodities assets and operations, however, this assumption
becomes dangerously unreliable.\63\
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\62\ Similarly, the VaR data included in FHCs' SEC filings provide
a measure of their exposure to commodity price risk.
\63\ There may be ways to collect some information on FHCs'
physical commodities activities from a wide variety of diverse sources,
including statistical records maintained by the Department of Energy
(``DOE''), FERC, or other nonfinancial regulators. However, theoretical
availability of these disparate data does not cure the fundamental
informational deficiency in this area. Even if it can be located, with
significant effort, such amalgamation of data is not likely to create a
complete and reliable picture of large FHCs' commodity operations and
assets.
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Gaps in the current system of public disclosure and regulatory
reporting explain the near-absence of reliable, detailed data on the
precise nature and full scope of U.S. banking organizations' physical
commodity operations. The traditional lack of transparency in global
commodity markets and the inherently secretive nature of the commodity
trading industry create a third source of difficulties for
understanding what exactly U.S. FHCs do, and how significant their role
is, in these markets. A handful of large, mostly Switzerland-based
commodities trading houses--including Glencore, Vitol, Trafigura,
Mercuria, and Gunvor--dominate the global trade in oil and gas,
petroleum products, coal, metals, and other products. Nearly all of
these publicity-shy commodities trading firms are privately owned. They
do not publicly report results of their financial operations and
generally refrain from disclosing information about the structure or
performance of their investments. Secrecy has always been an important
attribute of the traditional commodities trading business, in which
access to information is vital to commercial success and having
informational advantage often translates into windfall profits. Given
this lack of transparency and secretive nature of the commodities
trading business, it is nearly impossible for an industry outsider--and
even for most insiders--to gauge accurately the relative size and
importance of U.S. FHCs as traders and dealers in the global markets
for physical commodities.\64\
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\64\ This is especially true of oil and gas markets. Currently, the
markets for trading crude oil and oil products are dominated by three
groups of players: major oil companies (Royal Dutch Shell, Total, and
British Petroleum), independent commodity trading houses (Vitol,
Gunvor, Glencore, Trafigura, and Mercuria), and financial institutions
(Morgan Stanley, Goldman). See, LITASCO SA, International Oil Markets
Market and Oil Trading (Sept. 19, 2008), http://www.litasco.com/
_library/pdf/social_acts/international_oil_market_and_oil_trading.pdf.
Although these three types of oil traders have significantly different
business structures and profiles, they have been converging in some
important respects. Thus, the trading arms of oil majors and commodity
trading houses have been developing active financial derivatives
trading and dealing capabilities to supplement their traditional
operations in physical markets. Recent media reports indicate that
independent commodity trading companies have also been acquiring both
upstream (oil production) assets and downstream (refining and
processing) assets. Javier Blas, Trading houses: Veil slowly lifts on a
secretive profession, FIN. TIMES, May 23, 2011; Javier Blas,
Commodities traders face growing pains, FIN. TIMES, Apr. 26, 2012. It
is nearly impossible, however, to ascertain how big or important
financial institutions' physical oil and gas trading operations are
vis-a-vis the other two groups, in large part because that would
require access to potentially sensitive nonpublic information on the
oil companies' and trading houses' operations and activities. In an
informal interview with the author, a professional oil industry
consultant who wished to remain anonymous claimed that even a rough
estimate would require a lot of sophisticated and prohibitively
expensive investigative work not dissimilar to industrial espionage.
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With these information-related caveats in mind, it is nevertheless
possible to piece together enough data to get a sense of the potential
significance of Goldman's, Morgan Stanley's, and JPMC's physical
commodities businesses.
B. Morgan Stanley: Oil, Tankers, and Pipelines
During the years preceding the latest financial crisis, Morgan
Stanley built a significant business trading in oil, gas, electric
power, metals, and other commodity products. According to industry
estimates, Morgan Stanley's commodities unit generated $17 billion in
revenue over the past decade, trading both financial contracts and
physical commodities.\65\ Unlike Goldman, Morgan Stanley ``has remained
resolutely a merchant-trader, focusing on the business of storing or
transporting raw materials.''\66\ According to a 2008 research report,
traditional client ``flow'' business--market-making, selling indices to
investors, and commodity risk hedging--constituted only about 10-15
percent of the firm's commodities activities.\67\ About half of Morgan
Stanley's commodities business is reportedly in crude oil and oil
products, while about 40 percent is in power and gas.
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\65\ Morgan Stanley May Sell Part of Commods Unit: CNBC, REUTERS,
June 6, 2012.
\66\ Matthew Robinson & Scott DiSavino, Deal or no deal,Morgan
Stanley commodity trade shrinks, REUTERS, Jun. 7. 2012.
\67\ Id.
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Morgan Stanley has been using physical assets in trading energy and
commodities since the mid-1980s. In the early 1990s, Morgan Stanley's
oil trader, Olav Refvik, struck deals to buy and deliver oil and oil
products to large commercial users around the globe and earned the
nickname ``King of New York Harbor'' for accumulating a record number
of leases on storage tanks at the key import hub, which gave the firm a
great market advantage. During the same period, Morgan Stanley
constructed power plants in Georgia, Alabama and Nevada, which allowed
it to become a major electricity seller.
In the mid-2000s, Morgan Stanley began aggressively expanding its
energy infrastructure investments, especially in oil and gas
transportation and logistics. In 2006, Morgan Stanley acquired full
ownership of Heidmar Inc., a Connecticut-based global operator of
commercial oil tankers. Although Morgan Stanley sold 51 percent of
equity in 2008, it still retained a 49 percent stake. Heidmar operates
a fleet of more than 100 double-hull vessels and provides
transportation and logistics services to major oil companies around the
world.\68\
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\68\ http://www.heidmar.com/what-we-do/.
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In September 2006, Morgan Stanley acquired, in a leveraged buyout,
the full ownership of TransMontaigne Inc., a Denver-based oil-products
transportation and distribution company. TransMontaigne markets
``unbranded gasoline, diesel fuel, heating oil, marine fuels, jet
fuels, crude oil, residual fuel oils, asphalt, chemicals and
fertilizers.''\69\ The company is affiliated with a fuel terminal
facility operator, TransMontaigne Partners L.P., which operates oil
terminals in several U.S. States and Canada.\70\ In 2005, the last year
TransMontaigne was a publicly listed company, it reported revenues of
about $8.6 billion and assets of slightly less than $1.2 billion.\71\
Forbes estimated the company's 2011 revenues at $12 billion.\72\
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\69\ http://www.transmontaigne.com/about-tmg/.
\70\ http://www.transmontaigne.com/about-tmg/. TransMontaigne is
the general partner of TransMontaigne Partners L.P., a publicly traded
Delaware limited partnership.
\71\ CNN Money, Fortune 500 Rankings 2006, http://money.cnn.com/
magazines/fortune/fortune500/snapshots/1452.html.
\72\ http://www.forbes.com/lists/2011/21/private-companies-
11_TransMontaigne_7I0O.html. The estimate excludes the revenues
generated by the company's publicly traded subsidiaries.
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Both Heidmar and TransMontaigne are subsidiaries of Morgan Stanley
Capital Group Inc. (``MS Capital Group''), Morgan Stanley's commodities
and energy trading arm through which it holds equity stakes in multiple
commodity businesses. According to Morgan Stanley's own description of
its physical commodities business activities in its SEC filings:
In connection with the commodities activities in our
Institutional Securities business segment, we engage in the
production, storage, transportation, marketing and trading of
several commodities, including metals (base and precious),
agricultural products, crude oil, oil products, natural gas,
electric power, emission credits, coal, freight, liquefied
natural gas and related products and indices. In addition, we
are an electricity power marketer in the United States and own
electricity generating facilities in the United States and
Europe; we own TransMontaigne Inc. and its subsidiaries, a
group of companies operating in the refined petroleum products
marketing and distribution business; and we own a minority
interest in Heidmar Holdings LLC, which owns a group of
companies that provide international marine transportation and
U.S. marine logistics services.\73\
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\73\ Morgan Stanley, Form 10-K, Annual Report pursuant to Section
13 or 15(d) of the Securities Exchange Act of 1934, for the fiscal year
ending on December 31, 2011, at 27.
---------------------------------------------------------------------------
The SEC filings of TransMontaigne Partners, the only publicly traded
subsidiary of MS Capital Group and TransMontaigne, provide a
fascinatingly detailed picture of one significant facet of Morgan
Stanley's physical commodities business: ``oil terminaling and
transportation.''\74\ TransMontaigne Partners owns and operates a vast
infrastructure, including numerous crude oil and refined products
pipelines and terminals along the Gulf Coast, in the Midwest, in Texas,
along the Mississippi and Ohio Rivers, and in the Southeast. The
company receives refined oil products and liquefied natural gas from
customers via marine vessels, ground transportation, or pipelines;
stores customers' products in its tanks located at the terminals;
monitors the volume of stored products in its tanks; provides product
heating and mixing services; and transports the refined products out of
its terminals for further distribution.
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\74\ TransMontaigne Partners L.P., Form 10-K, Annual Report
pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934,
for the fiscal year ending on December 31, 2011.
---------------------------------------------------------------------------
In 2011, TransMontaigne Partners earned over $152 million in
revenues, of which almost $107 million came from its affiliates.\75\
The company's primary customers are its indirect parent-entities, MS
Capital Group and TransMontaigne. This is how the company described the
business activities of MS Capital Group:
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\75\ http://sec.gov/Archives/edgar/data/1319229/000104746912005319/
a2208753z10-ka.htm#aa3, at 73.
Morgan Stanley Capital Group is a leading global commodity
trader involved in proprietary and counterparty-driven trading
in numerous commodities markets including crude oil and refined
products, natural gas and natural gas liquids, coal, electric
power, base and precious metals and others. Morgan Stanley
Capital Group has been actively trading crude oil and refined
products for over 20 years and on a daily basis trades millions
of barrels of physical crude oil and refined products and
exchange-traded and over-the-counter crude oil and refined
product derivative instruments. Morgan Stanley Capital Group
also invests as principal in acquisitions that complement
Morgan Stanley's commodity trading activities. Morgan Stanley
Capital Group has substantial strategic long-term storage
capacity located on all three coasts of the United States, in
Northwest Europe and Asia.\76\
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\76\ Id.
TransMontaigne Partners' SEC filings offer a rare glimpse into
Morgan Stanley's sprawling network of assets and activities in the
energy sector. Ownership of critical infrastructure assets--including
terminals, pipelines, and marine vessels--greatly facilitates Morgan
Stanley's trading of energy and commodities, in both physical and
derivatives markets. At the same time, such a direct and active
involvement in the business of oil and gas processing, storage, and
transportation creates significant risks for Morgan Stanley. Global
energy prices are notoriously volatile and depend on a complex
interplay of various factors, including geopolitical ones. More
importantly, however, these activities expose the firm to potential
legal liability, financial loss, and reputational damage in the event
of industrial accidents, oil spills, explosions, terrorist acts, or
other catastrophic events that cause serious environmental harms.\77\
It is difficult to quantify the extent of this risk, especially in the
case of potential large-scale environmental disaster, but it is not
difficult to imagine that it may be potentially fatal even for a large
company with a formidable balance sheet. For a financial institution
whose main business depends greatly on its reputation and market
perceptions of the quality of its credit, even a remote risk of such an
event may be too much to live with.
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\77\ According to Morgan Stanley's own description of the risk
factors specific to its physical commodities business in its annual
report:
As a result of these activities, we are subject to extensive and
evolving energy, commodities, environmental, health and safety and
other governmental laws and regulations. In addition, liability may be
incurred without regard to fault under certain environmental laws and
regulations for the remediation of contaminated areas. Further, through
these activities we are exposed to regulatory, physical and certain
indirect risks associated with climate change. Our commodities business
also exposes us to the risk of unforeseen and catastrophic events,
including natural disasters, leaks, spills, explosions, release of
toxic substances, fires, accidents on land and at sea, wars, and
terrorist attacks that could result in personal injuries, loss of life,
property damage, and suspension of operations.
Morgan Stanley, Form 10-K, December 31, 2011, at 27.
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C. Goldman Sachs: Metals, Warehouses, and Other Things
Wall Street's biggest commodities dealer by revenues, Goldman is
``credited with attracting the investors to the asset class with the
creation of the Goldman Commodity Index in 1991.''\78\ According to
industry estimates, the firm's commodities business--including
derivatives and physical trading--generated annual revenues of $3-4
billion between 2006 and 2008.\79\
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\78\ Jack Farchy, Goldman and Clive Capital to launch commods
index, FIN. TIMES, June 12, 2011.
\79\ Javier Blas, Commodities Trading Loses its Goldman Queen, FIN.
TIMES, Jan. 12, 2012.
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Goldman's commodities trading business goes back at least to 1981,
when the firm bought its principal commodities trading subsidiary, J.
Aron & Co., which at the time specialized mostly in trading futures and
options on precious metals and coffee.\80\ In the 1980s-90s, Goldman
focused primarily on client-driven financial transactions in
commodities and built a dominant position in the energy futures and OTC
derivatives markets. In the first decade of this century, however,
Goldman has also been expanding into physical commodities, with
ventures into coal and shipping trading. For example, in early 2005,
the press reported that Goldman had bought 30 electricity-generating
plants.\81\ At least in part, this may have been a reference to
Goldman's 2003 acquisition of Cogentrix Energy LLC, a major power
producer based in Charlotte, North Carolina. At the time, Cogentrix
owned and operated 26 coal- and natural gas-fired power plants.\82\
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\80\ J. Aron & Co. Reduces Staff, N.Y. TIMES, Aug. 19, 1983.
\81\ Ann Davis, Morgan Stanley Trades Energy Old-Fashioned Way: In
Barrels, WALL ST. J., Mar. 2, 2005.
\82\ Ryan Dezember, Carlyle to Acquire Cogentrix from Goldman, WALL
ST. J., Sept. 7, 2012. According to media, ``Goldman sold off most of
those plants--and built and sold others--during the last decade as
Cogentrix transformed into more of a developer of power plants.'' Id.
In September 2012, Goldman reportedly agreed to sell Cogentrix to a
private equity firm, Carlyle Group L.P., on undisclosed terms.
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During the same period, Goldman reportedly made significant
acquisitions in the oil and gas sector, including a significant stake
in Kinder Morgan, Inc. (``KMI''), a major oil transportation and
terminaling company that controls approximately 37,000 miles of
pipelines and 180 terminals handling crude oil, natural gas, and
refined petroleum products.\83\ According to KMI's SEC filings, at the
end of 2011, Goldman owned (through several controlled funds) 19.1
percent of the company's common stock.\84\ In addition, the report
listed each of the two managing directors of Goldman who also served on
KMI's board of directors as holders of 19.1 percent of the company's
common stock.\85\ It appears that Goldman has similarly structured
private equity investments in other energy companies, including Cobalt
International Energy Inc. (``CIE''), a Houston-based deep-water oil
exploration and production company.\86\
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\83\ Kinder Morgan, Inc., 2011 Form 10-K, at 5. In investing in
KMI, Goldman teamed up with two private equity partners, The Carlyle
Group (``Carlyle'') and Riverstone Holdings LLC (``Riverstone''). Id.
\84\ Id., at 121-22.
\85\ It is difficult to ascertain whether and to what extent this
ownership structure and board membership give Goldman effective control
over KMI's management and operations. It appears that, for regulatory
purposes, Goldman treats its investment in KMI as a merchant banking
investment permissible to FHCs under the BHCA. In the context of
Goldman's overall commodities trading business, however, one may
legitimately question whether Goldman's stake in KMI is truly a
passive, purely financial investment made solely for the purpose of
reselling it at a profit.
\86\ According to the 2011 SEC filings, Goldman held a common
equity stake in CIE through several controlled funds, and two of its
managing directors in the merchant banking division served on CIE's
board. The firm originally invested in CIE in partnership with Carlyle
and Riverstone. Cobalt International Energy Inc., 2011 Form 10-K, at 5;
Cobalt International Energy Inc., Schedule 14A, Proxy Statement (filed
on Mar. 22, 2012), at 10-17.
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Even after becoming an FHC subject to the activities restrictions
of the BHCA and the consolidated supervision by the Board, Goldman
continued to acquire significant hard assets in the commodities sector.
For instance, in May 2012, the Financial Times reported that Goldman
made a $407 million deal with Brazil's Vale, to acquire full ownership
of Vale's Colombian coal assets, including the El Hatillo coal mine,
Cerro Largo coal deposit, and a coal port facility on Colombia's
Atlantic coast. The deal also included an 8.43 percent equity stake in
the railway connecting the mines to the port.\87\
---------------------------------------------------------------------------
\87\ Joe Leahy, Goldman in Deal to Buy Vale's Coal Assets, FIN.
TIMES, May 28, 2012.
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Goldman's subsidiary, GS Power Holdings LLC, holds another prized
asset in Goldman's commodities empire: Metro International Trade
Services LLC (``Metro''). Metro is a metals warehousing company that
owns and operates nineteen warehouses in the Detroit metropolitan area,
as well as warehousing facilities in Europe and Asia. By acquiring
Metro in February 2010, Goldman gained control of one of the largest
metals warehouses in the global network of storage facilities approved
by the LME. This acquisition strategically positioned the firm in the
middle of the global metals trading chain. Storing large quantities of
metal generates lucrative rental income for warehousing companies like
Metro. The warehousing business is particularly profitable during
economic downturns when slackening demand forces producers to hold more
of their commodity inventories in storage. Not surprisingly, Goldman
was not the only commodity trader that rushed to acquire large LME-
approved warehouses in the wake of the global financial crisis.\88\ The
recent entry of financial institutions effectively turned this
traditionally low-profile industry run by dispersed independent
operators into yet ``another arm of Wall Street.''\89\
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\88\ Glencore, bought metals warehousing assets of Italy based
Pacorini Group, while JPMC acquired the UK-based Henry Bath as part of
its purchase of RBS Sempra's assets. See Tatyana Shumski & Andrea
Hotter, Wall Street Gets Eyed in Metal Squeeze, WALL ST. J., June 17,
2011.
\89\ Id.
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This transformation has caused serious turbulence in the global
market for aluminum, the second most widely used metal in the world
after steel.\90\ Aluminum producers store their metal in LME-approved
warehouses and then sell their metal to industrial users. The buyers
claim their purchased quantities of aluminum from the warehouse, which
must deliver it to the specific buyer.\91\ Ownership of the key LME
warehouses by large commodity traders with integrated financial and
physical metals operations allows them to control the supply of
aluminum to commercial users and, as a result, to control prices.\92\
This led other market participants to worry about unfair advantage for
such firms, as they now can use their knowledge of how much metal is
stored, as well as their ability to control delivery of physical metal
to consumers, to determine their own trading strategies.
---------------------------------------------------------------------------
\90\ Jack Farchy, Banks force aluminium market shake-up, FIN.
TIMES, Sept. 12, 2012 (``The arrival of investment banks in the
aluminum market has triggered a shake-up in the $100bn industry that is
forcing producers from Alcoa to Rusal and consumers such as BMW and
Coca-Cola to change the way they do business. The increasingly dominant
role of banks including Goldman, JPMorgan and Deutsche Bank--as well as
traders such as Glencore--has prompted a surge to record levels in the
premium consumers pay for metal over the benchmark price set at the
London Metal Exchange.'').
\91\ The LME rules set the minimum delivery rates for its
warehouses. If the demand for delivery of aluminum out of a particular
warehouse significantly exceeds the rate at which the warehousing
company actually releases it, the resulting bottleneck prevents the
industrial users of aluminum from getting their purchased metal.
\92\ Financial institutions like Goldman Sachs can also use their
warehouses to store vast quantities of physical metals in so-called
``financing'' deals. This strategy allows financial institutions to
secure a guaranteed return. Removing a large portion of physical metal
from the market, however, creates artificial shortages of aluminum for
commercial purchase and inflates its market price.
---------------------------------------------------------------------------
Goldman and its subsidiary Metro became the key figures in a recent
ugly battle over global aluminum prices. In mid-2011, Metro reportedly
stored nearly half of the global inventories of the industrial
aluminum.\93\ Months-long delivery delays at the firm's storage
facilities in Detroit caused much discontent among big commercial users
of aluminum, such as the soft-drink giant Coca-Cola and the aluminum
sheet-maker Novelis. In mid-2011, Coca-Cola filed a complaint with the
LME alleging that Goldman intentionally limited the releases of
aluminum from its Metro-operated warehouses in order to inflate the
price of aluminum. In addition to potentially enabling Goldman to sell
its own aluminum at artificially inflated prices, holding aluminum in
the warehouse generates additional fees for Metro, as the buyers have
to pay for each day their purchased metal stays in the warehouse.\94\
---------------------------------------------------------------------------
\93\ Pratima Desai, Clare Baldwin, Goldman's New Money Machine:
Warehouses,reuters.com, Jul. 29, 2011 (stating that, in the first 6
months of 2011, ``Metro warehouses in Detroit took in 364,175 tonnes of
aluminum and delivered out 171,350 tonnes,'' which ``represented 42
percent of inventory arrivals globally and 26 percent of the metal
delivered out.'').
\94\ Trefis Team, Metals Warehousing Pays Off for Goldman Sachs,
FORBES, July 8, 2011 (``Goldman charges 42 cents to store a metric ton
of aluminum in its facilities for a day, which translates into $150 in
annual revenues for every metric ton it stores. With millions of tons
in storage, the industry is expected to rake in $1 billion in storage
revenues each year. Goldman Sachs which is estimated to hold 900,000
tons in its facilities can make $138 million in revenues from its
storage business alone.'').
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In response to these complaints, the LME doubled the minimum
delivery rates for large warehouses, including Metro. Nevertheless,
warehousing bottlenecks and record-high aluminum premiums continued to
wreak havoc in global aluminum markets. By mid-2013, the reported
waiting time for aluminum in Detroit was longer than 460 days.\95\ In
July 2013, the LME's new leadership proposed another change to its
rules to require warehouses experiencing logjams to deliver out more
metal than they take in.\96\ The new rule, however, is expected to
become effective only starting in April 2014.
---------------------------------------------------------------------------
\95\ Laura Clarke & Matt Day, New Stab at Metals Gridlock, WALL ST.
J., July 2, 2013, C1.
\96\ Jack Farchy, LME takes aim at warehousing queues, FIN. TIMES,
July 1, 2013.
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D. JPMC: The New ``Whale?''
Unlike Morgan Stanley and Goldman, JPMC has always been a regulated
BHC subject to activity restrictions. As discussed above, in 2005, JPMC
received the Board's approval to trade physical commodities as an
activity ``complementary'' to its commodity derivatives business. Under
the terms of the Board's approval, however, JPMC did not have legal
authority to own, operate, or invest in any physical assets and
facilities for the extraction, transportation, processing, storage, or
distribution of commodities.
The financial crisis became the key turning point for JPMC, which
emerged from it significantly larger and even more systemically
important than before the crisis. In 2008, JPMC bought the key assets
of Bear Stearns, an independent investment bank on the verge of
failure. As part of the deal, JPMC acquired commodity trading assets
and operations, including a significant network of electric power
generating facilities owned by Arroyo Energy Investors L.P., a
commodities subsidiary of Bear Stearns.
After acquiring Bear's energy assets, JPMC's CEO Jamie Dimon and
the head of commodities operations Blythe Masters began aggressively
expanding the firm's physical commodities business. In 2008, the firm
started trading physical oil and looking at ``more ways to boost its
presence in energy markets.''\97\ In addition to hiring more people in
its commodities and energy trading and investment team, JPMC started
drawing plans for strategically expanding its metals and energy
operations in Asia.
---------------------------------------------------------------------------
\97\ Sambit Mohanty, JPMorgan to Start Physical Oil Trade; Eyes
$200 Oil, REUTERS, May 15, 2008.
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JPMC's once-in-a-lifetime chance to become a major player in
commodities came in late 2009, when the European Commission ordered
nationalized RBS to divest its riskier assets, including its 51 percent
stake in RBS Sempra, a large U.S. commodities and energy trading
company. In July 2010, JPMC bought RBS Sempra's global oil, global
metals and European power and gas businesses. In addition to bringing
in approximately $1.7 billion of net assets, the $1.6 billion
acquisition nearly doubled the number of clients of JPMC's commodities
business and enabled the firm ``to offer clients more products in more
regions of the world.''\98\
---------------------------------------------------------------------------
\98\ JPMorgan Chase & Co., 2011 Form 10-K, at 184.
---------------------------------------------------------------------------
In November 2010, JPMC also bought RBS Sempra's North American
power and gas business, which added further strength to the operations
the firm inherited from Bear Stearns. This purchase propelled JPMC into
the top tier of natural gas and power marketers in North America.\99\
Several months after closing the deal, the firm boasted having control
of ``a diverse network of physical assets, including 70 billion cubic
feet per day of storage capacity--an increase of almost 100 percent
since the purchase--and almost double the transport capacity it had had
previously.''\100\
---------------------------------------------------------------------------
\99\ Gregory Meyer, JPMorgan buys RBS Sempra Commodities' trading
book, FIN. TIMES, Oct. 7, 2010 (``In the second quarter [of 2010], RBS
Sempra ranked the fifth-largest North American gas marketer by volume,
after BP, Royal Dutch Shell, Conoco-Phillips and Macquarie, According
to Platt's. JPMorgan was 12th.'').
\100\ J.P.Morgan, Energy Risk Names J.P.Morgan ``Oil &Products
House of the Year'' (Jul. 1, 2011), available at http://
www.jpmorgan.com/cm/cs?pagename=JPM_redesign/JPM_Content_C/
Generic_Detail_Page_Template&cid=1309472621690&c=JPM_Content
_C.
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By late 2010, JPMC had emerged as a formidable contender for the
title of the dominant Wall Street energy and commodities trading house,
previously shared by Morgan Stanley and Goldman. JPMC's official Web
site describes the firm as one of the leading energy market-makers in
the world:
We are active in both the physical and financial markets
worldwide for crude oil and oil-refined products, coal, power
and gas, and have extensive capabilities in the voluntary and
mandatory emissions markets. [ . . . ]. Our geographically
diverse physical asset portfolio includes more than 40 North
American locations. In addition, we are one of the largest
natural gas traders in the U.K. and European markets, with
daily volumes of approximately 100 million therms.\101\
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\101\ http://www.jpmorgan.com/pages/jpmorgan/investbk/solutions/
commodities/energy.
In addition to oil, gas, and electric power assets, JPMC's crisis-
driven acquisitions allowed the firm to become a significant force in
global markets for metals. In late 2011, JPMC bought a stake in LME
from the bankrupt futures firm, MF Global, and became the exchange's
largest shareholder. As part of its Sempra deal, JPMC acquired control
of Henry Bath, a UK-based metals warehousing company that owns and
operates one of the largest LME-approved global metal storage networks.
---------------------------------------------------------------------------
According to the company's own description:
Today, Henry Bath, a subsidiary of JPMorgan, engages in the
storage and shipping of exchange traded metals and soft
commodities. It offers warehousing, shipping transportation and
customs clearance services. The company stores and issues
exchange traded warrants for commodities, including aluminum,
copper zinc, lead, nickel, tin, steel billets, cocoa, coffee
and plastics.\102\
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\102\ Mike Jackson, Henry Bath & Son: A Company and family History
(2010), available at http://www.henrybath.com/assets/_files/documents/
jun_11/HENRYBATH_1308588481_
Complete_Henry_Bath_History.pdf.
Media reports indicate that JPMC has been building up its metals
warehousing business in order to strengthen the competitive position of
Henry Bath vis-a-vis Glencore's Pacorini and Goldman's Metro. The
reports of JPMC moving large amounts of metal from other warehouses
into its own suggest that the firm may be rebuilding its stocks and
consolidating its warehousing business in key European locations. This
is likely to exacerbate the conflict within the aluminum industry over
the unprecedented degree of power that the largest warehousing
companies like Henry Bath and Metro exercise over global aluminum
prices.
JPMC may be in a particularly sensitive situation because of its
controversial move to market the first exchange-traded fund (``ETF'')
backed by physical copper.\103\ JPMC has been reportedly buying up
copper since 2010, in anticipation of its ETF launch.\104\ The firm's
ability to remove from the market and store in its own warehouses vast
quantities of this critically important metal potentially lends more
credibility to the fears of market cornering expressed by the opponents
of JPMC's ETF plan. It makes it difficult for JPMC to argue that
trading copper-backed ETF shares would not artificially inflate global
copper prices.
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\103\ Jack Farchy, Copper ETF would ``wreak havoc,'' FIN. TIMES,
May 23, 2012. The SEC approved JPMC's plan to market its copper-backed
ETF in December 2012. See http://www.sec.gov/rules/sro/nysearca/2012/
34-68440.pdf.
\104\ Louise Armitstead & Rowena Mason, JPMorgan as mystery trader
that bought 1-bn-worth of copper on LME, TELEGRAPH, Dec. 4,
2010. In April 2012, JPMC reportedly held 30-40 percent of total copper
positions on the LME. CESCO week: Glencore, JPMorgan hold dominant
copper position as back flares--sources, METALBULLETIN.COM, Apr. 18,
2012.
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JPMC's newly acquired physical commodity and energy assets and
operations, however, raise a more fundamental legal question as to
whether the firm has the statutory authority to own such assets and to
conduct such operations in the first place. The Board's original order
authorizing JPMC's physical commodity trading does not allow JPMC to
own or operate any assets involved in generating, storing,
transporting, or processing commodities. In fact, even energy tolling
and energy management were outside of the scope of that original
authorization. Presumably, as part of its Sempra acquisition, JPMC had
to obtain the Board's approval to continue the commodities activities
permissible under the RBS Order. Unfortunately, it is difficult to
locate any public records showing how and when the Board amended its
original authorization, to allow JPMC to conduct ``complementary''
commodities activities of RBS, including energy tolling and energy
management.
It appears that JPMC generally conducts its physical commodity
operations subject to Board-imposed limitations. According to the
firm's SEC filings, it entered into operating leases for ``premises and
equipment'' used for ``energy-related tolling service
agreements.''\105\ JPMC also enters into various forms of ``supply and
off-take'' contracts with producers and processors of commodities, such
as oil refineries. These contracts are functionally similar to energy
management arrangements JPMC and other FHCs have with electric power
plants under the ``complementary'' authority grants. Thus, in April
2012, business media reported that Delta Airlines was planning to
purchase Conoco's idle Trainer oil refinery, in order to lower its jet
fuel costs, and that JPMC agreed to finance the entire production
process through a supply and off-take agreement. Under the arrangement,
JPMC would purchase and pay for delivery of the crude for the
refinery's operation, sell the jet fuel to Delta at a wholesale price,
and then sell other refined products on the open market. In July 2012,
JPMC entered into a similar supply and off-take arrangement with the
largest oil refinery on the East Coast, owned and operated by Sunoco
and Carlyle. These transactions significantly reduce refineries'
working capital needs and offload the risk on JPMC, which has far
greater balance-sheet capacity.\106\ In effect, JPMC contractually
replicates owning oil refineries without violating the letter of the
law.
---------------------------------------------------------------------------
\105\ JPMC, 2011 10-K, Note 30, at 289. This probably reflects the
general practice among FHCs engaged in physical commodity trading under
the Board's ``complementary'' orders. To avoid legally owning or
operating any physical assets involved in the marketing chain, JPMC
probably enters into some form of a sale-and-lease-back contract,
whereby an unaffiliated third party is the legal owner of the physical
facilities and operates those facilities under a lease agreement with
JPMC.
\106\ According to Blythe Masters, the head of JPMC's commodities
unit, it is this ``risk and balance sheet capacity'' that puts big
banks in the unique position to do these supply and off-take deals.
Nonbank commodity trading houses typically use about 75-80 percent of
their credit lines, which leaves them little room for taking on new
deals, while maintaining a comfortable cushion against sudden price
rises. See Gregory Meyer, Wall Street banks step up oil trade role,
FIN. TIMES, July 15, 2012.
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Nevertheless, some of JPMC's recently acquired physical commodity
operations appear to exceed the boundaries of the Board's
``complementary'' power grants. In April 2012, JPMC sold its metals-
concentrate trading unit to Connecticut-based Freepoint. The sale was
reportedly part of the mandatory divestment by JPMC of RBS Sempra's
commercial assets and activities impermissible for FHCs under the
BHCA.\107\ The firm's ownership and operation of Henry Bath, however,
continue to present a potential problem in this regard.
---------------------------------------------------------------------------
\107\ Because metal concentrate futures were not traded on major
organized commodity exchanges, the Board excluded metal concentrates
from the scope of its original order approving RBS's ``complementary''
activities.
---------------------------------------------------------------------------
JPMC's speedy rise to the top of the Wall Street commodity-trading
circle has created new legal and reputational risks for the firm. In
the summer of 2012, the FERC launched an investigation into JPMC's
electric power trading practices. The agency began its probe in
response to complaints from electric power grid operators in California
and the Midwest in 2011, alleging that JPMC's power traders had
intentionally bid up wholesale electricity prices by more than $73
million. Artificial inflation of wholesale prices benefits power
generators (which is functionally JPMC's role) but translates into
higher power prices for households and other endusers. As recent FERC
enforcement actions demonstrate, the focus of today's fraud prevention
in power markets is on more subtle trading strategies that seek to
manipulate the price of physical power in order to increase the value
of the manipulator's financial bets. JPMC's role as the leading global
energy derivatives dealer potentially exacerbates concern over the
firm's traders engaging in this type of Enron-reminiscent market
manipulation.\108\
---------------------------------------------------------------------------
\108\ On September 20, 2012, the FERC initiated official proceeding
accusing J.P. Morgan Ventures Energy Corporation, JPMC's commodity
trading arm, in intentionally providing misleading information to the
regulator. FERC, News Release (Sept. 20, 2012), available at http://
www.ferc.gov/media/news-releases/2012/2012-3/09-20-12-E-24.asp.
---------------------------------------------------------------------------
Even in the absence of conclusive evidence of any wrongdoing on the
part of JPMC, however, the very fact of FERC's investigation--and
potentially severe regulatory sanctions--raises uncomfortable questions
about the potential impact of the firm's newly expanded energy
operations on its overall institutional culture and reputation. These
concerns become particularly acute in the context of the infamous
``London Whale'' scandal that exposed deep problems with JPMC's risk
management practices. Both cases demonstrate the inherent difficulty of
drawing regulatory distinctions among various transactions based on the
firm's intentions and proclaimed business purposes. Just like a
legitimate hedge can become a lucrative bet under favorable market
conditions, so can financing-and-risk-management arrangements with oil
refineries and power generators become a profitable proprietary
business of energy merchanting.
How the law should deal with this complex reality is one of the key
questions in today's financial services regulation reform.
IV. Potential Legal and Policy Implications of Allowing This Trend to
Continue
Even a cursory overview of publicly available information shows
that the current commodity operations of Morgan Stanley, Goldman, and
JPMC defy carefully drawn pre-crisis regulatory boundaries of FHC-
permissible physical commodities activities--and, if permitted to
continue, effectively nullify the principle of separating banking from
commerce. Broadly, there are two potential ways to resolve this
doctrinal tension: either FHCs' commercial activities must be
curtailed, or the law should be changed to reflect FHCs' newly
acceptable role as global commodity merchants.
Unfortunately, the BHCA does not provide a clear and effective
legal framework for making a fundamental policy decision on the
socially efficient degree of mixing banking and commercial commodities
activities. There are, however, important policy reasons to suggest
that such mixing, at least to the degree it is done today, may be
socially undesirable and inefficient. Some of these policy concerns
grow out of the traditional rationales for the separation of banking
and commerce, while others reflect broader regulatory principles and
normative commitments.
A. The Indeterminacy of the Current Statutory Framework
Under the BHCA, as amended by the GLBA, it is likely that all (or
nearly all) of the existing physical commodity assets and activities of
Goldman, Morgan Stanley, and JPMC can be permitted to continue as
compliant with the formal requirements of the statute. However, while
technically plausible, such an interpretation brings to the surface a
deep tension within the existing legal regime between the letter and
the spirit of the law.
The commodity grandfathering provision of Section 4(o) of the BHCA
potentially provides the greatest latitude for Morgan Stanley and
Goldman, as two FHCs qualifying for this exemption, to continue owning
and operating their extensive commodity assets ``and underlying
physical properties.'' On its face, Section 4(o) does not impose any
qualitative limits on grandfathered activities: the language of the
provision is broad and open to expansive interpretation. Yet, as
discussed above, the legislative history of this grandfathering
provision, originally conceived as a special concession to
``woofies''--financial institutions without access to FDIC-insured
retail deposit-taking--indicates that it was not conceived to operate
as a completely open-ended commodity-business license for banking
organizations. It is doubtful that, at the time the GLBA was passed,
Congress actually envisioned the current extent and depth of these
firms' physical commodities operations.
In the alternative, Morgan Stanley, Goldman, and JPMC can seek the
Board's approval of their existing commodities activities as
complementary to FHC-permissible financial activities, such as
commodity derivatives. As discussed above, the BHCA does not define
what ``complementary'' means and leaves it largely to the Board's
discretion to determine whether any particular activity fits that
description. An examination of published Board orders shows the
regulator's general reluctance to allow FHCs to incur nonfinancial
risks associated with owning and operating oil rigs, coal mines,
refineries, storage tanks, pipelines, and tankers. As is the case with
any agency policy, however, the Board's position may change in response
to various internal and external factors. Moreover, even if the Board
insists on its pre-crisis determination that ``complementary''
commodity trading activities exclude direct ownership and operation of
physical assets, the practical impact of that seemingly bright-line
border may be rather limited. FHCs can (and do) use various forms of
``sale and lease-back'' or ``supply and off-take'' arrangements to
replicate the effects of owning and operating individual key links in
the commodity supply chain.\109\
---------------------------------------------------------------------------
\109\ While these arrangements may potentially reduce direct risks
to individual FHCs' safety and soundness, their proliferation
implicates other policy concerns the Board must consider in granting
``complementary'' powers to FHCs: excessive concentration of market
power, conflicts of interest, and increased systemic risk.
---------------------------------------------------------------------------
Finally, FHCs can use merchant banking authority to keep, and even
expand, their current physical commodity assets. Merchant banking is a
potentially tempting choice, because it can be used without the Board's
pre-approval: the FHC can make the determination that it holds certain
investments under that statutory authority. As discussed above, FHC-
permissible merchant banking investments must meet certain statutory
requirements intended to prevent FHCs from actively running the
commercial businesses of their portfolio companies. The holding period
limitations and the prohibition on FHCs' involvement in ``routinely
managing'' portfolio companies' businesses seem tough in principle but
are not necessarily ``deal-killers.'' It is not difficult to structure
specific investments to meet the formal statutory criteria without
giving up real control. It is difficult to ascertain, however, whether
these investments are, in fact, truly passive private equity interests
acquired purely for the purposes of profitable resale. In practice,
FHCs can--and most likely do--exercise informal influence on portfolio
companies' business decisions, which may be just as effective as a
formal management role.
It may be tempting to assume that the post-crisis regulatory
reforms mandated by the Dodd-Frank Act--such as, e.g., the Volcker
Rule--impose (at least, prospectively) effective limits on FHCs'
commercial activities. Yet, there is little basis for any such
assumption at this point. Although the Dodd-Frank Act reiterated
Congress's general commitment to the principle of separation of banking
and commerce, the new law does not directly address the issue of the
proper scope of FHC-permissible nonfinancial activities. It is not
clear whether and how the regulatory implementation of the Act will
ultimately affect large FHC's physical commodities operations.
B. Potential Policy Concerns and Implications
Even though, as a technical matter of law, the U.S. FHCs' current
physical commodity-trading and related activities may be fully
permissible under the BHCA, there are several compelling policy reasons
to resolve the resulting doctrinal tension in favor of explicitly
curtailing such activities. In the absence of comprehensive and
detailed information on the precise nature and scale of individual
FHCs' physical commodity interests and activities, it is difficult to
arrive at a definitive conclusion in this regard. Nevertheless, the
potential gravity of these policy concerns demands their prompt and
thorough investigation.
1. Safety and Soundness; Systemic Risk
From the perspective of safety and soundness of individual banking
organizations, there is at least one straightforward, plausible
argument for allowing FHCs to conduct physical commodities trading as a
diversification strategy. Diversifying their business activities by
investing in oil pipelines and metals warehouses should make FHCs less
vulnerable to periodic crises in financial markets. Trading,
transporting, storing, and processing physical commodities are volatile
businesses, and that volatility is expected to continue for the
foreseeable future. It is a reliably profitable business, as global
commodity prices have been rising since the early 2000s and, despite
sudden ups and downs, are generally expected to continue rising in
response to increasing global demand. Intermediating physical
commodities trading is the surest way to profit from these trends.
As professional intermediaries, financial institutions appear to be
perfectly positioned to assume that lucrative role. Large FHCs have
huge balance sheets, access to cheaper financing, superior access to
information and in-house research capacity, and sophisticated financial
derivatives trading capabilities. To the extent that utilizing these
unique advantages allows FHCs to be more efficient, low-cost suppliers
of physical commodities and related logistics services, allowing them
to perform that function should produce economic benefits for the FHCs
and their customers.\110\
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\110\ By assuming this role of a ``super-intermediary,'' financial
institutions effectively--and far more successfully--adopted the
business model pioneered by Enron. See William W. Bratton & Adam
Levitin, A Transactional Genealogy of Scandal: From Michael Milken to
Enron to Goldman Sachs (Aug. 13, 2012), available at http://
papers.ssrn.com/sol3/papers.cfm?abstract_
id=2126778.
---------------------------------------------------------------------------
This traditional economic efficiency-based argument, however,
misses or ignores a crucial fact--namely, that running a physical
commodities business also diversifies the sources and spectrum of risk
to which FHCs become exposed as a result. Let us imagine, for example,
that an accident or explosion on board an oil tanker owned and operated
by one of Morgan Stanley's subsidiaries causes a large oil spill in an
environmentally fragile area of the ocean. As the shocking news of the
disaster spreads, it may lead Morgan Stanley's counterparties in the
financial markets to worry about the firm's financial strength and
creditworthiness. Because the full extent of Morgan Stanley's clean-up
costs and legal liabilities would be difficult to estimate upfront, it
would be reasonable for the firm's counterparties to seek to reduce
their financial exposure to it. In effect, it could trigger a run on
the firm's assets and bring Morgan Stanley to the verge of liquidity
crisis or collapse.
But there is more. What would make this hypothetical oil spill
particularly salient is a shocking revelation that the ultimate owner
of the disaster-causing oil tanker was not Exxon-Mobil or Chevron but
Morgan Stanley, a major U.S. banking organization not commonly
associated with the oil business. That revelation, in and of itself,
could create a far broader controversy that would inevitably invite
additional public scrutiny of the commodity dealings of Goldman, JPMC,
and other Wall Street firms. Thus, in effect, an industrial accident
could potentially cause a major systemic disturbance in the financial
markets. These hidden contagion channels make our current notion of
interconnectedness in financial markets seem rather quaint by
comparison. FHCs' expansion into the oil, gas, and other physical
commodity businesses introduces a whole new level of interconnections
and vulnerabilities into the already fragile financial system.
The basic economic efficiency-based argument may also be
overstating the claim that forcing U.S. FHCs out of the physical
commodity and energy business would leave consumers' needs in those
markets unmet. Traditional commodity trading companies will almost
certainly step in to fill any such gap. These nonbank commodity traders
may not be able to offer the same ``fully integrated risk management''
services to industrial clients by assuming nearly all financial risk
(and logistical headaches) inherent in such clients' commodity-driven
businesses. That possibility lends some support to the argument for
letting banks act as super-intermediaries, or commodity traders plus.
At the same time, however, it begs the real question as to why
banks are able to out-compete other commodity traders in this realm, or
where that all-important plus comes from. Huge balance sheets, high
credit ratings, and access to plentiful and relatively cheap
financing--these factors enable large banking organizations to absorb
their clients' commodity-related risks at a lower cost than anyone else
could. These unique advantages ultimately stem from the fact that, by
taking deposits and serving as the main channel for the flow of
payments and credit throughout the economy, banks perform a ``special''
public service and, therefore, enjoy a special public subsidy through
access to Federal deposit insurance, special liquidity facilities, and
other forms of implicit Government guarantees. In this context, the
discussion should focus not on a factual question whether banks are in
the best position to offer these services more efficiently but on a
normative question: should banks be offering them at all?
If banks' superior ability to provide commodity-related services is
rooted in the Federal subsidy, the answer to that question is not as
simple as the efficiency argument assumes.\111\ If taxpayers are the
party ultimately conferring this precious economic benefit on banks,
taxpayers also have the right to stop banks from abusing that benefit
by engaging in risky commercial activities unrelated to their
``special'' functions. The choice of moving into the physical
commodities business does not belong solely to bank executives--the
choice ultimately belongs to the taxpaying, bank-subsidizing public. If
JPMC's management wants to be free to make profits by drilling for and
shipping crude oil, it should be able to do so without the estimated
$14 billion in annual Federal subsidy it receives as a ``special''
banking institution.\112\
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\111\ In June 2012, when Moody's downgraded JPMC's credit rating by
three levels, the rating agency was quoted as saying that:
JPMC benefited from the assumption that there's a ``very high
likelihood'' the U.S. Government would back the bank's bondholders and
creditors if it defaulted on debt. Without the implied Federal backing,
JPMorgan's long-term deposit rating would have been three levels lower
and its senior debt would have dropped two more steps.
Dawn Kopecki, JPMorgan Trading Loss Drove Three-Level Standalone
Cut, BLOOMBERG.COM, June 21, 2012.
\112\ See Editorial, Dear Mr. Dimon, Is Your Bank Getting Corporate
Welfare? BLOOMBERG.COM, June 18, 2012. Section 23A of the Federal
Reserve Act, which imposes quantitative and qualitative limitations on
transactions between federally insured depository institutions and
their affiliates, should theoretically prevent the leakage of this
public subsidy from banks to their commodity-trading nonbank
affiliates. 12 U.S.C. Sec. 371c. As the recent crisis demonstrated,
however, the practical effectiveness of this statutory firewall is
subject to considerable doubt. See Saule T. Omarova, From Gramm-Leach-
Bliley to Dodd-Frank: the Unfulfilled Promise of Section 23A of the
Federal Reserve Act, 89N.C.L. Rev.1683 (2011).
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2. Conflicts of Interest, Market Manipulation, and Consumer
Protection
Banks' extensive involvement in physical commodity activities also
raises significant concerns with respect to potential conflicts of
interest and market integrity. One of the key policy reasons for
separating banking from commerce is the fear of banks unfairly
restricting their commercial-market competitors' access to credit, the
lifeblood of the economy. Without reliable empirical data, it is
difficult to assess the extent to which this obvious form of conflict
of interest currently presents a problem in the commodities sector.
Yet, there is a heightened danger that banks may use their financial
market power to gain an unfair advantage in commodities markets, and
vice versa.
Goldman's role in the ongoing aluminum warehousing crisis provides
an instructive example. As discussed above, Coca-Cola complained that
Goldman intentionally created a bottleneck at its Metro warehouses in
order to drive up market prices for aluminum and sell their own metal
stock at the inflated price. It is curious, however, that more
industrial endusers did not publicly complain, a lot sooner and louder,
about this potential conflict-of-interest situation. It is very likely
that commercial companies deliberately avoided an open confrontation
with Goldman because it was a Wall Street powerhouse with which they
had--or hoped to establish--important credit and financial-advisory
relationships. If they were facing Metro as an independent warehousing
operator, they might have felt less pressure to keep quiet--and to
continue paying high aluminum premia. This form of subtle counterparty
coercion may be difficult to detect and police but it raises a
legitimate question for further inquiry.
Moreover, metal warehousing operations are only one element in a
large financial conglomerate's complex business strategy involving
trading in metals and related financial contracts. Goldman is one of
the largest traders of derivatives in the metals markets. Unlike an
independent warehouse operator, Goldman can potentially use its storage
capabilities not only to generate rental income but also to move
commodity prices in a way that would benefit its derivatives positions.
This directly implicates serious issues of market integrity. As one of
the world's biggest dealers in commodity derivatives, Goldman can
devise and execute highly sophisticated trading strategies across
multiple markets. The ability to influence prices of physical assets
underlying derivatives, in effect, completes the circle. It makes
Goldman's derivatives profits not so much a function of its traders'
superior skills or executives' talents, but primarily a function of the
firm's structural market power.
It should be noted here that one of the fundamental drivers of the
value of any derivative is the degree of volatility of the value of the
underlying asset. If the value of the underlying asset is predictably
stable, neither hedgers nor speculators would have any reason to enter
into derivative contracts tied to that value. Conversely, the higher
the volatility, the higher the demand for derivatives instruments
allowing transfer of the underlying risk. This basic fact reveals the
fundamental incentive for a derivatives dealer with sufficient market
power in the underlying physical commodity markets to maintain price
volatility in such markets, regardless of the fundamentals of supply
and demand, as the necessary condition of continuing viability and
profitability of its commodity derivatives business.
Market manipulation in commodities markets has long been a hot
button issue. In contrast to securities market, commodities markets are
particularly vulnerable to so-called market power-based manipulation
that may not involve fraud or deceptive conduct.\113\ A large trader
can significantly move prices of futures and underlying physical
commodities not only by ``cornering'' the market in a particular
product but also by placing very large sell/buy orders in excess of
available liquidity. This salience of market power in commodities
market manipulation underscores the potential dangers of allowing large
financial institutions to dominate both commodity derivatives markets
and the related cash commodity markets.
---------------------------------------------------------------------------
\113\ Craig Pirrong, Energy Market Manipulation: Definition,
Diagnosis, and Deterrence, 31 ENERGY L.J. 1, 2 (2010).
---------------------------------------------------------------------------
Finally, artificially high premia for industrial aluminum translate
into higher consumer prices for a wide range of products, from soft
drinks to automobiles. Similarly, if JPMC's commodity traders did, in
fact, inflate wholesale power prices in California, their manipulative
conduct accounts for retail consumers' higher electricity bills.
Generally, commodity price inflation is a major component of consumer
price inflation. To the extent that banks' direct involvement in
physical commodity markets distorts traditional supply and-demand
dynamics and contributes to commodity price volatility, it becomes an
important matter of consumer protection.
An unsustainable rise in consumer prices, driven by the rising
prices of basic commodities, has significant macroeconomic
consequences. The recent spikes in nationwide gasoline and heating oil
prices illustrate these systemic effects. Despite the general
prevalence of traditional supply and-demand theories, there is also a
legitimate argument that a significant factor explaining these prices
is purely financial speculation in oil.\114\ Large financial
intermediaries enable and amplify such speculation by creating,
marketing, and dealing in commodity-linked financial products.
Indirectly, these intermediaries' physical commodities operations
contribute to speculative bubbles in key commodities, which ultimately
increase the cost of living for the ordinary Americans. Because rises
in the costs of basic goods tend to disproportionally affect the poor,
this artificially created price volatility can widen socioeconomic
disparities that have tangible and potentially grave consequences for
social cohesion and civil unity. From this perspective, large FHCs'
physical commodities businesses raise potential concerns not only as a
matter of consumer protection but also as a matter of macroprudential
regulation and even political stability.
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\114\ See, e.g., Robert Lenzner, Speculation in Crude Oil Adds
$23.39 To The Price Per Barrel, FORBES, Feb 27, 2012; Joseph P. Kennedy
II, The High Cost of Gambling on Oil, N.Y. TIMES, Apr. 10, 2012.
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3. Concentration of Economic and Political Power
Concerns with potential conflicts of interest, market manipulation,
and consumer protection are closely connected to the broader policy
concern with excessive concentration of economic power. That concern
looms especially large in the context of FHCs' physical commodity
trading.
It is difficult to overestimate the importance of this issue for
the long-term health and vitality of the U.S. economy and of American
democracy. Writing almost a century ago, Justice Brandeis famously
warned against the dangers of combination--or ``concentration intensive
and comprehensive''--that gave financial institutions direct control
over industrial enterprises.\115\ Brandeis saw the ``subtle and often
long-concealed concentration of distinct functions, which are
beneficial when separately administered, and dangerous only when
combined in the same persons'' as a great threat to economic and
political liberties.\116\
---------------------------------------------------------------------------
\115\ Louis D. Brandeis, OTHER PEOPLE'S MONEY: AND HOW THE BANKERS
USE IT (1933), at 3.
\116\ Id. at 4.
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The global financial crisis of 2008-2009 demonstrated the
continuing salience of Brandeis's concerns. The taxpayer-funded bailout
of large financial conglomerates whose risky activities had contributed
to--and, indeed, largely created--the crisis reignited the century-old
debate on the role of ``financial oligarchy'' in American
politics.\117\ Not surprisingly, one of the central themes in post-
crisis regulatory reform is the prevention of future bailouts of ``too
big to fail'' financial institutions. The ongoing transformation of
large U.S. financial institutions into leading global merchants of
physical commodities and energy, however, significantly complicates the
reformers' task. By giving banks that are already ``too big to fail''
an additional source of leverage over the economy--and, consequently,
the polity--it elevates the dangers inherent in cross-sector
concentration of economic power to a qualitatively new level. When
large financial conglomerates that control access to money and credit
also control access to such universal production inputs as raw
materials and energy, their already outsized influence on the entire
economic--and, by extension, political--system may reach alarming
proportions.
---------------------------------------------------------------------------
\117\ See, e.g., Simon Johnson & James Kwak, THIRTEEN BANKERS
(2010); Matt Taibbi, Why Isn't Wall Street In Jail? ROLLING STONE, Feb.
16, 2011.
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For these reasons, in rethinking the foundational principle of
separating banking and commerce, especially in the context of energy
and commodity activities, it is critically important to remember
Brandeis's warnings. Reassessing and reasserting the original antitrust
spirit of U.S. bank holding company regulation may be the necessary
first step in the right direction.
4. Institutional Governability and Regulatory Capacity
An examination of FHCs' physical commodity activities also
highlights potential problems such activities pose from the perspective
of regulatory design, regulatory process, and firm governability.
Understanding what exactly large U.S. FHCs own and do in global
commodity markets is the critical first step toward developing an
informed regulatory approach to this issue. Under the current
regulatory disclosure system, there is no reliable way to gather and
evaluate this information. Existing public disclosure is woefully
inadequate to understand and evaluate the nature and scope of U.S.
banking organizations' physical commodities trading assets and
activities. It may not be feasible or desirable to mandate detailed
disclosure of every commercial activity of a large FHC, but when it
comes to energy and other key commodities, what is hidden from the
public view may be highly consequential.\118\ It is imperative,
therefore, to mandate full public disclosure of financial institutions'
direct and indirect activities and investments in physical commodities
and energy.
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\118\ The Dodd-Frank Act requires SIFIs to submit to federal
regulators enterprise-wide recovery and resolution plans, or ``living
wills,'' to help their orderly resolutions in the event of failure.
Dodd-Frank Act 165(d). Goldman, Morgan Stanley, JPMC, and other large
FHCs have already submitted their living wills to the Board in July
2012. These documents should provide an exhaustive description of each
institution's corporate structure and core business activities. They
could give regulators the necessary information on these firms'
physical commodity assets and operations. It is not clear, however,
whether this is actually the case, as the bulk of the information in
these resolution plans is confidential. None of the publicly available
portions of the living wills filed to date contain any relevant
information on this issue. See, http://www.federalreserve.gov/
bankinforeg/resolution-plans.htm.
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Simply mandating more disclosure, however, will not be enough. The
recent crisis has demonstrated the limits of disclosure as a regulatory
tool, especially in the context of complex markets, institutions, and
instruments. Complexity is one of the fundamental drivers of systemic
risk, and managing complexity is one of the key challenges in today's
financial services sector. Large U.S. financial conglomerates are
already complex, in terms of their corporate structure, risk
management, and the breadth and depth of financial services and
products they offer. Allowing these firms to run extensive commercial
operations that require specialized technical and managerial expertise
adds to their internal complexity. Firm-wide coordination and
monitoring of operations, finances, risks, and legal and regulatory
compliance become all the more difficult in that context. This is
particularly true of capital-intensive, operationally complex, and
potentially high-risk physical commodity activities. An effective
integration of these operations may be further complicated by potential
shifts in corporate culture. Thus, the traditionally aggressive risk-
taking culture of commodity traders (think Enron) may push the already
questionable ethics of bankers beyond the limits of prudency and
legality. All of these factors present serious challenges for large
financial firms' internal governance and governability.
More importantly, mixing banking with physical commodity trading
creates potentially insurmountable challenges from the perspective of
regulatory efficiency and capacity. Direct linkages, through the common
key dealer-banks, between the vitally important and volatile financial
market with the vitally important and volatile commodity and energy
market may amplify the inherent fragility of both markets, as well as
the entire economy. Who can effectively regulate and supervise this new
super-market? And how should it be done?
The U.S. system of financial services regulation is already highly
fragmented and ill-suited to detecting and reducing systemic risk
across different financial markets and products. The expansion of FHCs'
activities into yet more new areas subject to extensive regulation
under very different regulatory schemes--environmental regulation,
workplace safety regulation, utility regulation--lays the foundation
for jurisdictional conflicts on an unprecedented scale. In addition to
the several Federal bank regulators, the SEC and CFTC, banking
organizations become subject to regulation by the DOE, the FERC, the
Environmental Protection Agency, the Federal Trade Commission, and
possibly other Federal and State agencies. Yet, none of these many
overseers are likely to see the whole picture, leaving potentially
dangerous gaps in the regulation and supervision of these systemically
important super-intermediaries. An additional complicating factor is
the high strategic and geopolitical significance of energy trading. The
flow of oil and gas in global markets is as much a matter of foreign
policy and national security as it is a matter of business.
Accordingly, the State Department could also be expected to insist on a
say in the affairs of large U.S. FHCs that import and export oil, gas,
and other strategically important commodities.
In terms of substantive regulatory oversight, the situation is
equally discouraging. In addition to being the umbrella regulator for
BHCs, the Board is now primarily responsible for prudential regulation
and supervision of all SIFIs. As discussed above, physical commodities
activities expose financial institutions to qualitatively different,
and potentially catastrophic, risks. In addition, commodities
operations create potential new channels of contagion and systemic risk
transmission. Yet the Board is not equipped to regulate and supervise
companies that own and operate extensive commodity trading assets: oil
pipelines, marine vessels, or metal warehouses.
It is not enough to pay lip service to these concerns by simply
requiring FHCs to conduct their commercial activities in compliance
with the applicable securities, commodities, energy, and other laws and
regulations. Those regulatory schemes are not designed with SIFIs in
mind and, therefore, do not address the unique risks--enterprise-wide
and systemic--posed by their activities. Realistically, however, the
Board has little choice but rely on FHCs' promises to comply with such
parallel regulatory regimes. Without the necessary expertise and a
clear legal mandate, neither the Board nor any other financial
regulator can be expected to exercise meaningful oversight of large
financial institutions' commodity businesses and the risks they
generate. This natural limit on regulatory capacity is an important
reason for serious reconsideration of FHCs' role in physical
commodities markets.
V. Conclusion
This testimony has described the legal, regulatory, and policy
aspects of an ongoing transformation of large U.S. FHCs into global
merchants of physical commodities and energy. In the absence of
detailed and reliable information, it is difficult to draw definitive
conclusions as to the social efficiency and desirability of allowing
this transformation to continue. What we can already ascertain about
U.S. financial institutions' physical commodity assets and activities,
however, raises potentially serious public policy concerns that must be
addressed through fully informed public deliberation. Even if big U.S.
FHCs were, in fact, to scale down their physical commodity operations
either in response to current regulatory developments or as a temporary
market adjustment, it would not obviate the need for such deliberation.
Addressing these policy concerns in a timely, open, and publicly minded
manner remains a task of the utmost importance, both as an economic
matter and as a matter of democratic governance.
______
PREPARED STATEMENT OF RANDALL D. GUYNN
Partner and Head of the Financial Institutions Group
Davis Polk & Wardwell LLP
July 23, 2013
Introduction
Chairman Brown, Ranking Member Toomey, Members of the Subcommittee:
My name is Randall Guynn, and I am a partner and head of the Financial
Institutions Group of Davis Polk & Wardwell LLP.\1\ Thank you for your
invitation to testify at this important hearing.
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\1\ My practice focuses on providing bank regulatory advice and
advising on M&A and capital markets transactions when the target or
issuer is a banking organization or other financial institution. My
clients include many of the largest U.S. and non-U.S. banks, a number
of regional, mid-size and community banks, and certain financial
industry trade associations.
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My testimony will describe the laws and regulations that currently
permit insured banks, bank holding companies, financial holding
companies and their nonbank affiliates to engage as principal in
futures, forwards and other commodities contracts and in owning or
controlling physical or intangible commodities or related facilities,
including electric power plants, commodities warehouses and oil
refineries. These financial institutions are permitted to engage in
commodities activities to meet the needs of customers, increase
customer choice, increase competition, act as more effective
intermediaries between producers and endusers, provide increased
liquidity to the markets and lower prices to consumers, and increase
the diversification of the revenue streams and exposures of these
financial institutions. All things being equal, increased
diversification of activities reduces risk, preserves capital and
should help an institution improve its financial condition over time.
As you will see, insured banks are the most limited in what they
are permitted to do, are not permitted to take delivery of physical
commodities and generally are not permitted to control related
facilities such as power plants, commodities warehouses or oil
refineries. Only separately incorporated, capitalized and insulated
nonbank affiliates are permitted to exercise broader powers, and even
they are subject to significant limits in doing so. These nonbank
affiliates are granted broader powers because they are not eligible for
Federal deposit insurance and do not have access to the Federal
Reserve's discount window.\2\ In addition, other Federal laws,
including Sections 23A and 23B of the Federal Reserve Act,\3\ prevent
insured banks from passing on the funding advantages of deposit
insurance or giving their nonbank affiliates access to the discount
window. These other laws also insulate insured banks against the risks
of a nonbank affiliate's commodities and other nonbanking activities.
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\2\ Deposit insurance and access to the Federal Reserve's discount
window are often referred to as the Federal safety net.
\3\ 12 U.S.C. 371c.
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Even the powers of these nonbank affiliates, however, are subject
to significant limits. Bank holding companies that do not qualify as
financial holding companies, and their nonbank affiliates, are subject
to the most severe limits. Subject to certain very narrow exceptions,
they are not permitted to buy, sell or make or take delivery of
physical or intangible commodities or control related facilities.
Moreover, even financial holding companies and their nonbank
affiliates must generally show that physical commodities activities are
complementary to permissible financial activities, such as entering
into futures, forwards or other commodities contracts, before being
permitted to engage in such physical commodities activities. They must
also show that their exercise of these powers does not pose a
substantial risk to the safety or soundness of depository institutions
or the financial system generally. They are prohibited from trading in
physical commodities unless a derivative contract has been authorized
for trading on a futures exchange by the Commodity Futures Trading
Commission or they otherwise demonstrate that the particular commodity
is sufficiently fungible and liquid. They are generally prohibited from
owning or controlling the day-today operations of processing, storage,
transportation or other physical or intangible commodities facilities,
including electric power plants, commodities warehouses and oil
refineries. They may, however, temporarily own or control companies
that operate such facilities pursuant to the merchant banking power,
the temporary exception for acquiring companies substantially engaged
in financial activities or the exception for acquisitions in
satisfaction of a debt previously contracted in good faith. Finally,
their physical commodities activities are subject to a variety of
conditions and limitations. These include appropriate risk management
requirements, oversight by the Federal Reserve and other regulators,
and volume limitations.
Financial holding companies whose commodities activities are
grandfathered under Section 4(o) of the Bank Holding Company Act are
generally permitted to engage in trading, sale or investment in
physical commodities activities and related facilities, but only
subject to certain conditions and limitations. These conditions and
limitations include appropriate risk management requirements, oversight
by the Federal Reserve and other regulators, and volume limitations.
All of these financial holding companies and their bank and nonbank
affiliates are subject to generally applicable laws and regulations
that govern these activities. For example, they must conduct their
commodities activities in compliance with all applicable antitrust,
securities, futures and energy laws. These include the orders, rules
and regulations of the Government agencies, exchanges and self-
regulatory organizations responsible for implementing and enforcing
those laws, including the U.S. Department of Justice, the Federal Trade
Commission, the Securities and Exchange Commission, the Commodity
Futures Trading Commission, the Federal Energy Regulatory Commission,
the National Futures Association, the CME Group, Intercontinental
Exchange and the London Metal Exchange.
My testimony will also describe the extent to which banks, bank
holding companies, their nonbank affiliates and other nonbank financial
institutions were permitted to act as principal--and were major
players--in the commodities markets before the Gramm Leach Bliley Act
of 1999, the Glass-Steagall Act of 1933 or even the National Bank Act
of 1863. In fact, there has been a close relationship between banking
and commodities since ancient times as well as in this country for most
of the past 200 years shows that both the grandfathering provision in
Section 4(o) of the Bank Holding Company Act and the complementary
powers orders that permit certain nongrandfathered financial holding
companies to engage in trading physical and energy commodities were
only incremental expansions of traditional banking powers, not the sort
of radical departure some of argued.
I will then discuss whether commodities activities, as currently
permitted by the law, are inconsistent with the principle of keeping
banking and commerce separate. Finally, I will address whether insured
banks or their nonbanking affiliates, including financial holding
companies, should be prohibited from engaging in commodities activities
or at least from controlling related facilities.
II. Current State of the Law
The National Bank Act expressly permits national banks to engage in
the ``business of banking,'' as well as all activities that are
``incidental'' to that business.\4\ Although the National Bank Act does
not define the business of banking, it provides a list of activities
that are included within that term, including ``buying and selling
exchange, coin, and bullion''\5\--that is, trading in precious metals
and other commodities that function as money or monetary substitutes.
In NationsBank v. VALIC, the Supreme Court held that the business of
banking is not limited to the list of activities in the National Bank
Act:
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\4\ 12 U.S.C. 24 (Seventh).
\5\ Id.
We expressly hold that the `business of banking' is not limited
to the enumerated powers in 24 Seventh and that the
Comptroller therefore has discretion to authorize activities
beyond those specifically enumerated. The exercise of the
Comptroller's discretion, however, must be kept within
reasonable bounds. Ventures distant from dealing in financial
investment instruments--for example, operating a general travel
agency--may exceed those bounds.''\6\
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\6\ 513 U.S. 251, 258-259 note 2 (1995).
In a series of orders and interpretive letters issued over time,
the Office of the Comptroller of the Currency (``OCC'') has defined the
range of activities that fall within the business of banking or that
are incidental to it. Among the activities that the OCC has defined as
bank-permissible are acting as principal or agent in connection with a
wide range of derivative contracts, including commodities contracts, as
long as certain risk management and other conditions are satisfied.\7\
National banks are generally not permitted to take delivery of any
underlying physical or intangible commodities and generally are not
permitted to control related facilities such as power plants,
commodities warehouses or oil refineries. They may, however, acquire
temporary ownership or control of companies that operate such
facilities in satisfaction of a debt previously contracted in good
faith for a maximum of 10 years.\8\
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\7\ See Comptroller of the Currency, Administrator of National
Banks, Activities Permissible for a National Bank, Cumulative, at 57-64
(2011 Annual Edition, Apr. 2012).
\8\ See 12 U.S.C. 24 (Seventh) (incidental powers clause); OCC
Interpretive Letter No. 643, reprinted in Fed. Banking L. Rep. (CCH)
para. 83,551 (July 1, 1992); OCC Interpretive Letter No. 511, reprinted
in [1990-1991 Transfer Binder] Fed. Banking L. Rep. (CCH) para. 83,213
(June 20, 1990); OCC Interpretive Letter No. 1007 (September 7, 2004);
See also Activities Permissible for a National Bank, supra note 7, at
86.
---------------------------------------------------------------------------
Section 4(c)(8) of the Bank Holding Company Act of 1956 (``BHC
Act'') similarly authorizes bank holding companies and their nonbank
affiliates to engage in activities that are determined by the Board of
Governors of the Federal Reserve System (``Federal Reserve Board'' or
``Board'') ``to be so closely related to banking as to be a proper
incident thereto.''\9\ In a series of orders eventually codified in
Section 225.28(b)(8) of the Board's Regulation Y, the Federal Reserve
Board has determined that engaging as principal in a wide range of
derivative contracts, including commodities contracts, is ``closely
related to banking'' as long as certain risk-management and other
conditions are satisfied.\10\ Subject to certain very narrow
exceptions, Regulation Y does not permit bank holding companies or
their nonbank affiliates to take or make delivery of physical or
intangible commodities as a closely related-to-banking activity.\11\
Nor are bank holding companies permitted to acquire control of related
facilities, except temporarily in satisfaction of a debt previously
contracted in good faith for a maximum of 10 years.\12\
---------------------------------------------------------------------------
\9\ 12 U.S.C. 1843(c)(8).
\10\ 12 C.F.R. 225.28(b)(8). See also Randall D. Guynn, Luigi L.
De Ghenghi & Margaret E. Tahyar, Foreign Banks as U.S. Financial
Holding Companies, in REGULATION OF FOREIGN BANKS & AFFILIATES IN THE
UNITED STATES, 10:4[9][a] (6th ed. 2012); Melanie L. Fein, FEDERAL
BANK HOLDING COMPANY LAW 18.07 (3rd ed. 2011).
\11\ See 12 C.F.R. 225.28(b)(8).
\12\ 12 U.S.C. 1843(c)(2); C.F.R. 225.22(d)(1).
---------------------------------------------------------------------------
Section 4(k)(1) of the BHC Act, which was added in 1999 by the
Gramm Leach Bliley Act (``GLB Act''), expressly permits bank holding
companies that qualify as financial holding companies, as well as their
nonbank affiliates, to engage in activities that are ``financial in
nature,'' ``incidental'' to a financial activity or ``complementary''
to a financial activity if certain conditions are satisfied.\13\ Among
the conditions that apply to engaging in a complementary activity is
that such activity can be and is conducted in a manner that does not
pose a substantial risk to the safety or soundness of depository
institutions or the financial system generally.\14\
---------------------------------------------------------------------------
\13\ 12 U.S.C. 1843(k)(1).
\14\ Id. 1843(k)(1)(B).
---------------------------------------------------------------------------
Section 4(k)(4)(F) expressly defines financial activities for this
purpose as including all of the closely related-to-banking activities
in Section 225.28 of Regulation Y, including the commodities activities
described above.\15\ Thus, Section 4(k)(4)(F) codified the Federal
Reserve Board's regulation as a matter of binding statutory law.
---------------------------------------------------------------------------
\15\ Id. 1843(k)(4)(F).
---------------------------------------------------------------------------
In a series of orders issued to specific institutions after passage
of the GLB Act, the Federal Reserve Board determined that purchasing or
selling a wide range of physical or intangible commodities, including
oil, natural gas, electric power, emissions allowances, agricultural
products, metals and certain other nonfinancial commodities in the spot
markets or to take or make delivery of such physical or intangible
commodities pursuant to commodities contracts, is ``complementary'' to
the financial activity of acting as principal with respect to commodity
contracts, subject to certain conditions.\16\ Among the conditions
applicable to this authority is that the commodities activities be
limited to commodities that are sufficiently fungible and liquid.\17\
To ensure that they are, the Board has generally required financial
holding companies requesting these expanded powers to limit their
physical commodities activities to commodities for which a derivative
contract has been authorized for trading on a futures exchange by the
CFTC or which the Board has specifically determined to be sufficiently
fungible and liquid.\18\
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\16\ See, e.g., Citigroup, 89 Fed. Res. Bull. 508 (2003); JPMorgan
Chase & Co., 92 Fed. Res. Bull. C57 (2006); Royal Bank of Scotland
Group, 94 Fed. Res. Bul. C60 (2008). See also Guynn, De Ghenghi &
Tahyar, supra note 10, 10:4[9][a].
\17\ See, e.g., Royal Bank of Scotland Group, supra note 16.
\18\ See, e.g., id.
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Complementary authority does not provide a basis for financial
holding companies to own or control the day-to-day operations of
processing, storage, transportation or other physical or intangible
commodities facilities, including electric power plants, commodities
warehouses and oil refineries. They may, however, temporarily own or
control companies that operate such facilities pursuant to the merchant
banking power, the temporary exception for acquiring companies engaged
in nonfinancial activities, or in satisfaction of a debt previously
contracted in good faith, which are discussed more fully below.
In approving the applications of certain financial holding
companies to engage in physical commodities activities, the Board also
determined that the activities would satisfy the requirement that they
be conducted in a manner that does not pose a substantial risk to the
safety or soundness of depository institutions or the financial system
generally if they were conducted subject to certain conditions. These
conditions include appropriate risk management requirements, oversight
by the Federal Reserve and other regulators, and a volume limit on the
extent to which balance sheet resources may be dedicated to these
activities.\19\
---------------------------------------------------------------------------
\19\ See, e.g., Citigroup, supra note 16; JPMorgan Chase & Co.,
supra note 16; Royal Bank of Scotland Group, supra note 16.
---------------------------------------------------------------------------
Finally, the Board found that permitting physical commodities
activities would likely produce public benefits in the form of
increasing customer choice, competition and market efficiency.\20\
These activities almost certainly also produce public benefits in the
form of providing increased liquidity to the markets and lower prices
to consumers, and increasing the diversification of the revenue streams
and exposures of these financial institutions. All things being equal,
increased diversification of activities reduces risk, preserves capital
and should help an institution improve its financial condition over
time. Another important benefit of allowing financial holding companies
to own inventory in physical commodities is that this permits them to
finance the inventory for customers, such as airlines and refiners.
---------------------------------------------------------------------------
\20\ See, e.g., id.
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The merchant banking power is contained in Section 4(k)(4)(H) of
the BHC Act.\21\ It permits all financial holding companies and their
nonbank affiliates to make temporary investments in any company that is
engaged in nonfinancial activities or mixed financial and nonfinancial
activities, subject to certain conditions.\22\ Such nonbanking
activities would include investing in physical commodities or related
facilities. The most important conditions on the merchant banking power
are that such investments in nonfinancial companies must be made as
part of a bona fide underwriting or merchant or investment banking
purpose and generally must be divested within 10 years, and the
financial holding company must not be involved in the routine
management of the portfolio company, except temporarily if necessary to
preserve the value of the investment.\23\
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\21\ 12 U.S.C. 1843(k)(4)(H).
\22\ See id.
\23\ See 12 U.S.C. 1843(k)(4)(H); 12 C.F.R. 225.171, 225.172.
---------------------------------------------------------------------------
Financial holding companies are also permitted, under a separate
authority, to acquire temporary control of any company that is engaged
in both financial and nonfinancial activities, provided that the
company is ``substantially engaged'' in financial activities and the
company conforms, terminates or divests any nonfinancial activities
within 2 years.\24\ A company is deemed to be ``substantially engaged''
in financial activities if at least 85 percent of its revenues and 85
percent of its assets are attributable to financial activities.\25\
Like other bank holding companies, financial holding companies and
their nonbank affiliates are also permitted to acquire temporary
control of a company that controls physical commodities or related
facilities in satisfaction of a debt previously contracted in good
faith for a maximum of 10 years.\26\
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\24\ 12 C.F.R. 225.85(a)(3).
\25\ Id. 225.85(a)(3)(ii).
\26\ 12 C.F.R. 225.22(d)(1).
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Finally, Section 4(o) of the BHC Act, which was also added in 1999
by the GLB Act, contains a permanent grandfathering provision for
institutions that were engaged in any commodities activities as of
September 30, 1997, were not bank holding companies when the GLB Act
was signed into law, but subsequently become bank and financial holding
companies.\27\ Section 4(o) expressly permits any qualifying financial
holding company to ``continue to engage in, or directly or indirectly
own or control shares of a company engaged in, activities related to
the trading, sale, or investment in commodities and underlying physical
properties,''\28\ provided that not more than 5 percent of the
qualifying company's consolidated assets are attributable to such
commodities or underlying physical properties.\29\ Unlike other
grandfathering provisions such as Section 4(n) of the BHC Act,\30\
Section 4(o) does not have a time limit. Thus, it is a permanent
exemption from the general requirement for a new bank holding company
to conform its activities to the restrictions on nonbanking activities
otherwise contained in Section 4 of the BHC Act within 5 years of
becoming a bank holding company.\31\
---------------------------------------------------------------------------
\27\ 12 U.S.C. 1843(o).
\28\ Id. (emphasis added).
\29\ Id.
\30\ Id. 1843(n).
\31\ See id. 1843(a)(2) (providing a transition period of 2-5
years for new bank holding companies to conform their activities to the
nonbanking activities restrictions in the BHC Act).
---------------------------------------------------------------------------
Section 4(o) was one of several provisions in the GLB Act that were
designed to ensure that the GLB Act would be a ``two-way street'' for
commercial banks and investment banks, making it just as easy for an
investment bank with a major commodities business to affiliate with an
insured bank as it is for an insured bank to affiliate with a
securities underwriting and dealing firm.\32\ The legislative history
stated that the activities described in Section 4(o) should be
construed broadly and to include at a minimum the ownership and
operation of properties and facilities required to extract, process,
store and transport commodities.\33\ It also explained that the purpose
of Section 4(o) was to ensure that:
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\32\ See, e.g., Cong. Rec. H3141 (daily ed. May 13, 1998)
(statement of Rep. Dingell) (``H.R. 10 . . . does nothing to hurt the
banks. It expands the range of allowable banking activities . . . It
creates, insofar as humanly possible, a fair two-way street for all
players.'').
\33\ See, e.g., H.R. Rep. No. 104-127, pt. 1, at 97 (May 18, 1995)
(``The Committee intends that activities relating to the trading, sale
or investment in commodities and underlying physical properties shall
be construed broadly and shall include owning and operating properties
and facilities required to extract, process, store and transport
commodities.'') (Emphasis added.)
a securities firm currently engaged in a broad range of
commodities activities as part of its traditional investment
banking activities, is not required to divest certain aspects
of its business in order to participate in the new authorities
granted under the [GLB Act].''\34\
---------------------------------------------------------------------------
\34\ Amendment No. 9 by Senator Gramm (Mar. 4, 1999), available at
http://banking.senate.gov/docs/reports/fsmod99/gramm9.htm.
All of these financial holding companies and their bank and nonbank
affiliates are subject to generally applicable laws and regulations
that govern these activities. For example, they must conduct their
commodities activities in compliance with all applicable antitrust,
securities, futures and energy laws. These include the orders, rules
and regulations of the Government agencies, exchanges and self-
regulatory organizations responsible for implementing and enforcing
those laws, including the U.S. Department of Justice, the Federal Trade
Commission, the Securities and Exchange Commission, the Commodity
Futures Trading Commission, the Federal Energy Regulatory Commission,
the National Futures Association, the CME Group, Intercontinental
Exchange and the London Metal Exchange.
III. Commodities Activities Before the GLB Act
Two of the most vocal critics of allowing financial holding
companies and their bank and nonbank affiliates to continue to buy and
sell physical and energy commodities are Professor Saule Omarova of the
University of North Carolina Law School and Mr. Joshua Rosner, managing
director of Graham Fisher & Co. In a widely circulated draft article,
Professor Omarova has asserted that U.S. financial holding companies
somehow waged a ``quiet transformation'' to become ``global merchants
of physical commodities'' during that period.\35\ To Professor Omarova,
this mixing of banking and commodities activities is a radical
departure from the past and not an incremental expansion of traditional
banking and nonbanking powers. She characterizes it as a serious breach
of the ``legal wall designed to keep them out of any nonfinancial
business''\36\ and ``effectively nullifies the foundational principle
of separation of banking from commerce.''\37\ She argues that these
physical and energy commodities activities ``threaten to undermine the
fundamental policy objectives . . . [of] ensuring the safety and
soundness of the U.S. banking system, maintaining a fair and efficient
flow of credit in the economy, protecting market integrity, and
preventing excessive concentration of economic power.''\38\ According
to Professor Omarova, unless these activities are prohibited or
severely curbed, financial holding companies will be exposed to a
variety of new and excessive risks, engage in anticompetitive behavior
and even threaten ``American democracy.''\39\ She sums up the
implication of her argument as follows: ``If there are good reasons to
believe that extreme power breeds extreme abuses, the ongoing expansion
of large FHCs into physical commodities and energy business warrants
serious concern.''\40\
---------------------------------------------------------------------------
\35\ See, e.g., Saule T. Omarova, The Merchants of Wall Street:
Banking, Commerce, and Commodities, at 4 (draft of Nov. 24, 2012),
available at http://papers.ssrn.com/sol3/
papers.cfm?abstract_id=2180647.
\36\ Id.
\37\ Id.
\38\ Id.
\39\ Id. at 5.
\40\ Id.
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Mr. Rosner has expressed similar views. As reported in the
Huffington Post, Mr. Rosner has stated that ``[i]f banks own storage,
distribution, transmission or generating assets, they have the ability
to manipulate prices for the benefit of their own balance sheet, to the
disadvantage of the public interest, which is why they were prohibited
from such activities after the Great Depression to the passage of
Gramm-Leach-Bliley in 1999.''\41\ Professor Omarova and Mr. Rosner also
reportedly told the Huffington Post that traders at banks that own
physical commodities business have a natural incentive to use inside
knowledge gleaned from their co-workers to reap profits from trades of
derivatives tied to the underlying commodities.\42\
---------------------------------------------------------------------------
\41\ Shahien Nasiripourshahien & Zach Carterzach, Beer Brewers
Blast Wall Street Banks over Aluminum Business Amid Congressional
Scrutiny, HUFFINGTON POST (July 16, 2013).
\42\ Id.
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Not only does Professor Omarova's law review article reflect a deep
distrust of the motives and behavior of financial holding companies and
their employees, but she has also reportedly been severely critical
about the Federal Reserve Board's lack of transparency about the
commodities activities of these firms. According to the Huffington
Post, Professor Omarova has said that ``[t]he Fed has absolutely not
been transparent'' and that ``[t]he Fed is like the Kremlin: They do
their magic and then tell people like me to go away.''\43\
---------------------------------------------------------------------------
\43\ Id.
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Before addressing whether today's commodities activities are
inconsistent with the principle of keeping banking separate from
commerce and whether there is sufficient evidence to justify
prohibiting or severely curbing these powers, let me first straighten
out a few historical facts about the relationship between banking and
physical commodities activities. First, there has been a close
relationship between banking and physical commodities since the dawn of
history. The essence of banking is the creation of money through the
maturity transformation process. By funding themselves with demand or
other short-term deposits or other liabilities (including the issuance
of paper currency) and then making medium- to long-term loans,
commercial banks participate in the money and credit creation
processes.
Physical commodities such as grain, salt, shells and pieces of wood
were among the first forms of money in ancient Mesopotamia, Egypt,
China, Korea, Japan, North America, Ethiopia, and Oceana, and some of
these commodities continued to be used as money until quite recently in
certain places.\44\ While not as durable as gold or silver, or as
reliable and easy to move as coins, paper or electronic money issued by
commercial banks, these physical commodities nevertheless had the
essential characteristics that made them an efficient medium of
exchange and store of value (i.e., money)--fungibility, divisibility
and relative liquidity. These ancient forms of money made trading much
more efficient than in a barter economy where nonfungible and
nondivisible goods and services are exchanged.
---------------------------------------------------------------------------
\44\ See, e.g., Catherin Eagleton & Jonathan Williams, MONEY: A
HISTORY at 18, 22, 135, 155-156, 196-197, 200 (The British Museum Press
2006) (grain used as money in ancient Mesopotamia and Egypt, as well as
China, Korea and Japan; salt used as money in Ethiopia and China;
shells and pieces of wood used in China, North America and Oceana).
According to Milton Friedman, cigarettes were used as money in Germany
after World War II. Milton Friedman, MONEY MISCHIEF at 14 (1992).
---------------------------------------------------------------------------
Second, the modern history of banking (and money) began with grain
merchants in Lombardy creating markets in grain and other commodities,
financing crops, holding gold (another commodity) of others for
settlement of their grain transactions and trading in gold while it was
on deposit.\45\
---------------------------------------------------------------------------
\45\ See, e.g., Charles P. Kindleberger, A FINANCIAL HISTORY OF
WESTERN EUROPE (1984).
---------------------------------------------------------------------------
Third, U.S. banks and other financial institutions were major
players in the commodities markets during the 19th century. National
banks were expressly permitted to trade in gold, silver and other
precious metals commodities. Many of the major U.S. merchant banks of
the 19th century started as dry goods and commodity traders, which
expanded into banking in somewhat similar ways and for somewhat similar
reasons as their Lombard predecessors from centuries earlier.\46\ These
commodity traders turned bankers include Lazard Brothers and Brown
Brothers.\47\ The private banking partnership of J. Pierpont Morgan,
Sr. engaged in wholesale or merchant banking, which included the buying
and selling of physical commodities and related facilities. To take
just one famous example, a trust controlled by J.P. Morgan purchased
Andrew Carnegie's steel company in 1901 and combined it with other
steel companies to form U.S. Steel.\48\ Pig iron and steel were the
most important commodities of the day, just as important then as energy
is today.\49\ In short, U.S. banks and other financial institutions
were actively involved in the commodities markets before the Glass-
Steagall Act of 1933 or even the National Bank Act of 1863.
---------------------------------------------------------------------------
\46\ See, e.g., Vincent P. Carosso, INVESTMENT BANKING IN AMERICA:
A HISTORY (1970); BRAY HAMMOND, BANKS AND POLITICS IN AMERICA: FROM THE
REVOLUTION TO THE CIVIL WAR (1957).
\47\ See id.
\48\ See Ron Chernow, THE HOUSE OF MORGAN: AN AMERICAN BANKING
DYNASTY AND THE RISE OF MODERN FINANCE 82-24 (1990).
\49\ See, e.g., Milton Friedman and Anna Jacobson Schwartz, A
MONETARY HISTORY OF THE UNITED STATES, 1867-1960 (1963) (using
statistics of pig iron to estimate the growth or contraction of the
economy during the Great Depression).
---------------------------------------------------------------------------
Fourth, the Glass-Steagall Act did not prohibit or otherwise limit
banks from engaging in commodities activities or affiliating with
commodities firms. It only prohibited banks from dealing in securities
or having affiliates that were principally engaged in underwriting or
dealing of corporate debt and equity securities.\50\
---------------------------------------------------------------------------
\50\ See Banking Act of 1933, 16, 20.
---------------------------------------------------------------------------
Fifth, while the BHC Act limited the authority of bank holding
companies and their nonbank affiliates to engage in commodities
activities or to own or control commodities firms, U.S. banks, bank
holding companies and investment banks were not entirely locked out of
the physical or energy commodities markets before the GLB Act in 1999.
The National Bank Act continued to permit national banks to buy and
sell gold, silver and other precious metals. More importantly, Goldman
Sachs, Morgan Stanley and various other investment banks emerged as
major players in the physical commodities in the 1980s,\51\ nearly 20
years before passage of the GLB Act and nearly 30 years before Goldman
Sachs and Morgan Stanley became bank holding companies.
---------------------------------------------------------------------------
\51\ For example, Goldman Sachs acquired commodities trading firm
J. Aron & Co. in 1981, and that same year, the commodities trading firm
Phibro Corporation acquired Salomon Brothers to form Phibro-Salomon
Inc. In 1984, Morgan Stanley formed the Natural Gas Clearinghouse with
law firm Akin Gump and Transco Energy, and in 1985, Morgan Stanley
expanded commodities coverage from metals options to oil markets.
Changing Landscape: Energyrisk.com, July 2009 (at 26). Prior to the
financial institutions' arrival, the commodities markets were best
described, according to Henrik Wareborn, head of commodities trading at
Natixis, as a shadowy place dominated by physical merchants and
cartels, which was opened up and transformed thanks to the entry of
European banks and U.S. investment banks. Insight: Banks struggle to
adapt or survive in commodities: Reuters, November 5, 2012.
---------------------------------------------------------------------------
Since then, financial institutions have assumed key roles in
satisfying customer needs, offering services that enable more cost-
effective commodity price hedging and secured financing for a broad
range of participants in the commodities sector. In fact, reducing
financial institution participation in the commodities sector would
likely reduce liquidity on exchanges and in over-the-counter markets,
and even the availability of some commodities hedging, financing and
other intermediation services. A retrenchment could lead to increased
prices and greater price volatility, among other consequences.\52\
---------------------------------------------------------------------------
\52\ Comments on Volcker Rule Regulations Regarding Energy
Commodities, submitted by IHS Inc., February 2012, at 7-9.
---------------------------------------------------------------------------
Moreover, these investment banks had a strong track record of
conducting these commodities activities in an efficient, profitable,
fair, responsible, and safe and sound manner, without any material
violations of applicable laws or regulations or losses as a result of
natural catastrophes. I am not aware of any evidence that their
activities undermined the safety or soundness of the U.S. financial
system, resulted in an unfair or inefficient flow of credit, involved
any material anticompetitive behavior or insider trading, or otherwise
resulted in other harmful effects on the financial system or the wider
economy, much less threatened the end of American democracy.
Indeed, their significant involvement and strong risk-management
record in conducting commodities activities was almost certainly one of
the reasons why Section 4(o) was considered to be such an acceptable
and important way to ensure that the GLB Act would provide a ``two-
way'' street of opportunities to investment banks as well as commercial
banks. It also was almost certainly one of the reasons why the Federal
Reserve Board determined that physical and energy commodities could be
traded by nongrandfathered financial holding companies as a complement
to their existing financial activities, that such activities would
produce public benefits that outweighed their potential adverse effects
and that they could otherwise be conducted in a manner that would not
pose a substantial risk to the safety or soundness of depository
institutions or the financial system generally.\53\
---------------------------------------------------------------------------
\53\ See, e.g., Citigroup, supra note 16, JPMorgan Chase & Co.,
supra note 16; Royal Bank of Scotland, supra note 16.
---------------------------------------------------------------------------
In short, the close relationship between banking and commodities
activities since ancient times as well as in this country for most of
the past 200 years shows that both Section 4(o) of the BHC Act and the
complementary powers orders that permit certain nongrandfathered
financial holding companies to engage in trading physical and energy
commodities were only incremental expansions of traditional banking
powers rather than a radical departure as Professor Omarova has argued.
While electricity and oil are modern commodities, they are not
fundamentally different from the traditional bank-eligible commodities
such as gold and silver in the sense that they are fungible, divisible
and relatively liquid.
IV. The Principle of Keeping Banking and Commerce Separate
The principle of keeping banking separate from commerce can be a
useful way to simplify the otherwise complex U.S. banking laws.
Certainly, the basic structure of the National Bank Act and the BHC Act
reflects this general principle. But this general principle is not a
binding legal rule and does not create an impermeable wall, and
reasonable people can disagree as to where the line is and should be
drawn.
For example, Professor Omarova argues that the current commodities
powers of the grandfathered and nongrandfathered financial holding
companies are radically inconsistent with this principle.\54\ Yet
former Representative James Leach, who has long been one of the most
vociferous and consistent champions of the separation between banking
and commerce,\55\ does not believe that the merchant banking power or
the physical commodities power under either the complementary power
orders or Section 4(o) of the BHC Act are inconsistent with this
principle.\56\ Thus, he defended the general principle in words that
are strikingly similar to those used by Professor Omarova in her
forthcoming article:
---------------------------------------------------------------------------
\54\ See Omarova, supra note 35, at 4.
\55\ See, e.g., James A. Leach, The Mixing of Banking and Commerce,
in Proceedings of the 43rd Annual Conference on Banking Structure and
Competition, Federal Reserve Bank of Chicago (May 2007).
\56\ See, e.g., James Leach, Regulatory Reform: Did Gramm-Leach-
Bliley contribute to the crisis?, Northwestern Financial Review
(Oct.15, 2008).
[T]here are few broad principles that could hurriedly be
legislated, which could in shorter order change the fabric of
American democracy as well as the economy, than adoption of a
new radical approach to this issue [i.e., mixing commerce and
banking].\57\
---------------------------------------------------------------------------
\57\ See supra note 55.
---------------------------------------------------------------------------
Yet, he said this about its application to the GLB Act:
Fortunately, despite the active advocacy of many in Congress
and early on support of the Treasury and partial support in the
Fed (both later reconsidered), the commerce and banking breach
did not occur.\58\
---------------------------------------------------------------------------
\58\ See supra note 56.
I agree with former Congressman Leach that the merchant banking
power and the physical commodities powers under either the
complementary powers orders or Section 4(o) of the BHC Act are fully
consistent with the historic principle of keeping banking separate from
commerce. The merchant banking power permits nonbank affiliates of
insured banks to engage in the traditional financial activity of
providing capital to small and medium-sized companies, without becoming
involved in the routine day-to-day management of these companies and
with a clear fixed time horizon. The physical commodities power is only
an incremental expansion of the physical commodities powers that banks
or their nonbank affiliates have exercised in this country for more
than 200 years. If the authority to buy and sell electricity or oil is
relatively new, it is probably because they are relatively modern
commodities. In addition, it was only relatively recently that that
futures contracts in these commodities have been authorized for trading
on a futures exchange by the CFTC or otherwise become sufficiently
fungible and liquid. Once they satisfied these criteria, however, it
was natural that the Federal Reserve would permit trading in them as a
complement to the financial activity of trading in their related
derivative contracts.
V. Should Existing Commodities Powers be Repealed or Scaled Back?
Professor Omarova has argued that the existing commodities powers
of financial holding companies should be repealed or severely scaled
back to be consistent with her concept of the ``foundational
principle'' of the separation of banking from commerce. She has said
that ``[t]here is a particular urgency to focusing'' on whether
financial holding companies should be allowed to continue engaging in
physical and energy commodities activities since Goldman Sachs and
Morgan Stanley are ``approaching the end of their 5-year grace period
during which they must either divest their impermissible commercial
businesses or find legal authority under the [BHC Act] for keeping
them. In the fall of 2013, the Board will have to determine whether
these firms may continue their existing commodities operations and, if
so, under what conditions.''\59\
---------------------------------------------------------------------------
\59\ See Omarova, supra note 35, at 7.
---------------------------------------------------------------------------
Before addressing this argument on the merits, let me explain why
there is no urgency at all to this issue, at least not for the reason
Professor Omarova gives. Goldman Sachs and Morgan Stanley are indeed
approaching the end of the 5-year transition period for conforming
their activities to the activities restrictions in the BHC Act. But
that deadline is irrelevant to the grandfathered commodities activities
of Goldman Sachs and Morgan Stanley because the grandfathering
provisions of Section 4(o) of the BHC Act have no time limit and do not
provide the Federal Reserve Board with the discretion to limit their
effect.
Professor Omarova's argument that the existing commodities powers
of the financial holding companies should be repealed or scaled back is
based on seven basic predictions:
Otherwise, financial holding companies will continue to
face a variety of new and excessive risks that will threaten
the safety and soundness of the U.S. financial system.
The fair and efficient flow of credit in the economy will
be threatened.
Market integrity will be at risk.
Financial holding companies have or will continue to gain
and may abuse market power.
Traders at financial holding companies will use inside
information to engage in illegal insider trading.
American democracy will be at risk.
The Congress that included Section 4(o) in the GLB Act clearly had
a different view of the benefits and risks of commodities activities
than Professor Omarova. That Congress said that the grandfathered
activities ``shall'' be broadly construed,\60\ and that the purpose of
the permanent grandfathering provision was to allow qualifying
financial holding companies to continue engaging in commodities
activities as long as certain conditions were satisfied.\61\ The
Federal Reserve that issued the complementary powers orders also had a
very different view of the benefits and risks of permitting financial
holding companies and their nonbank affiliates to buy and sell physical
and energy commodities. The Federal Reserve Board, applying the
standard in the BHC Act, found that the public benefits from those
activities in terms of increased customer choice and increased
competition outweighed their risks, provided they were conducted in
accordance with certain limitations and conditions discussed in Section
II of this testimony.
---------------------------------------------------------------------------
\60\ See supra note 33.
\61\ See supra note 34.
---------------------------------------------------------------------------
This Subcommittee should not take action to repeal or curb the
existing commodities powers of financial holding companies, including
any temporary or permanent authority to own companies that control
electric power plants, commodities warehouses or oil refineries, unless
and until critics provide substantial evidence that such powers cannot
be exercised without creating a substantial risk to the safety or
soundness of depository institutions or the financial system generally.
It should not be enough for critics to merely provide speculative
assertions of potential adverse consequences. Nor should this
Subcommittee take action to repeal or cut back on those powers solely
because certain financial institutions or their employees may from time
to time violate any generally applicable laws or regulations that
govern commodities activities, such as applicable antitrust,
securities, futures or energy laws. There is currently no reason to
believe that such laws and regulations, and the vigilant actions of the
Government agencies, exchanges and self-regulatory organizations
responsible for implementing and enforcing those laws, would not be
sufficient to deter or remedy any such compliance issues. Nor is there
reason to believe that such issues would never occur if these types of
assets were owned only by entities not subject to comprehensive Federal
regulation, as all bank holding companies are.
VI. Conclusion
In conclusion, insured banks, bank holding companies, financial
holding companies and their nonbank affiliates are currently permitted
to engage as principal in futures, forwards and other commodities
contracts and, in some cases, owning or controlling physical or
intangible commodities or related facilities, including electric power
plants, commodities warehouses and oil refineries, subject to certain
conditions. Both Congress and the Federal Reserve have previously found
that the public benefits of these activities outweigh their potential
adverse effects. This Subcommittee should not take action to repeal or
curb those powers unless and until critics provide substantial evidence
that such powers cannot be exercised without creating a substantial
risk to the safety or soundness of depository institutions or the
financial system generally.
______
PREPARED STATEMENT OF JOSHUA ROSNER
Managing Director, Graham Fisher & Co.
July 23, 2013
Banking and Commerce:
Chairman Brown, Ranking Member Toomey, and Members of the
Subcommittee, thank you for inviting me to testify today on this
important subject.
We stand on the other side of the largest financial crisis since
the Great Depression, a crisis that occurred less than a decade after
the repeal and erosion of long standing separations of commercial and
investment banking and of banking and nonfinancial business.
Since 2003, our Government and central bank have allowed an
unprecedented mixing of banking and commerce. So far, that grand
experiment has gone better for the banks than it has for consumers.
Electricity users appear to pay more because of Wall Street
involvement, aluminum for airplanes and soda cans costs more, and some
say gasoline at the pump costs more--without any measurable benefit to
anyone but the banks. This is partially the result of unilateral
decisionmaking by the Federal Reserve, which Congress empowers to use
its judgment to grant exemptions to a half-century-old law. Our largest
bank holding companies now seek further control over other nonfinancial
infrastructure assets through the long-term leasing and control over
America's patrimony, in return for short-term influxes of cash. We're
on the threshold of a new Gilded Age, where the fruits of all are
enjoyed by a few.
Only Congress can prevent this unfortunate consolidation of
American business. The Federal Reserve Board should not allow banks to
be in businesses that don't directly support the resilience of the
payments system or the stability of FDIC insured deposits. ``Left
unchecked, the trend toward the combining of banking and business could
lead to the formation of a relatively small number of power centers
dominating the American economy. This must not be permitted to happen;
it would be bad for banking, bad for business, and bad for borrowers
and consumers.''\1\
---------------------------------------------------------------------------
\1\ (DOC 02-1-71) The 1970 Amendments to the Bank Holding Company
Act: Opportunities to Diversify By ALFRED HAYES President, Federal
Reserve Bank of New York, speech before the New York Scale Bankers
Association in New York City on January 25. 1971, MONTHLY REVIEW.
FEBRUARY 1971 available at: http://www.newyorkfed.org/research/
monthly_review/1971_pdf/02_1_71.pdf.
---------------------------------------------------------------------------
President Richard M. Nixon said that in 1969. At the time, a
generation had enjoyed relative tranquility in the banking system. That
was because in 1935, Congress recognized risks associated with the
combination of commercial banking and investment banking. And in 1956,
recognizing failures to protect the public interest from the
competitive and systemic risks arising from bank's control of
nonfinancial businesses, Congress then passed legislation to prevent
bank holding companies from exercising such control. Nixon's remarks
came as Congress debated closing a loophole in the 1956 Act, and in
1970, Congress did just that.
The line did not hold.
In 1987, as rumors began to circulate that the White House was
considering supporting the creation of ``financial leviathans'' or
``Super banks'',\2\ Federal Reserve Chairman Volcker echoed Nixon's
warning of two decades earlier: ``Widespread affiliations of commercial
firms and banks [carry] the ultimate risk of concentrating banking
resources into a very few hands, with decisions affecting these
resources influenced by the commercial ownership links, resulting in
inevitable conflicts of interest and impairment of impartial lending
judgment.''
---------------------------------------------------------------------------
\2\ ``BUSINESS FORUM: DOES THE U.S. NEED SUPERBANKS? Why Bigger
Isn't Better in Banking'', Thomas Olson, The New York Times, June
28,1987 available at: http://www.nytimes.com/1987/06/28/business/
business-forum-does-the-us-need-superbanks-why-bigger-isn-t-better-in-
banking.html.
---------------------------------------------------------------------------
At the time, large U.S. banks claimed prohibitions against the
combination of commercial and investment banks and commercial banks and
nonfinancial businesses were putting the United States' economy at a
competitive disadvantage to the Japanese banks--then the largest and
most concentrated in the world and also at disadvantage to the German
banks which had no such structural restrictions. Volcker's response was
clear: ``I have not heard any concern over the years that American
banks are not active competitors internationally. They have been at the
cutting edge of international banking competition and we have very
active international competitors among the American banks''. But the
United States' ``money center'' banks were not ready to give up.
On April 7, 1998, in defiance of Glass-Steagall, Citibank announced
a merger with Travelers Group, creating the world's largest financial
services company.\3\ In 1999, with the passage of Gramm-Leach-Bliley,
banks were given the ability to combine commercial and investment
banking and, as a result, were able to expand more deeply into
nonfinancial businesses. At the November 12, 1999 signing ceremony,
President Clinton offered the promise that ``this historic legislation
will modernize our financial services laws, stimulating greater
innovation and competition in the financial services industry'' and
``Removal of barriers to competition will enhance the stability of our
financial services system''.\4\
---------------------------------------------------------------------------
\3\ ``Citicorp and Travelers Plan to Merge in Record $70 Billion
Deal: A New No. 1: Financial Giants Unite'', The New York Times,
Mitchell Martin, April 7, 1998, available at: http://www.nytimes.com/
1998/04/07/news/07iht-citi.t.html.
\4\ http://www.presidency.ucsb.edu/ws/
index.php?pid=56922#axzz1aV0pqgub.
---------------------------------------------------------------------------
Unfortunately, less than a decade after those words were uttered,
our financial services industry was more concentrated, more cartel-like
and less stable. The result was the biggest financial calamity since
the Great Depression. While the actions of many parties, from
policymakers and banks, investors and consumers all led us to crisis
the fact remains that structured products innovated and sold as a
result of the combination of commercial and investment banking,
devastated Main Street USA and ravaged consumers and businesses alike.
Banks, which had previously been prevented from investment banking
activities, had stimulated demand for faulty mortgage products. When
the house of cards collapsed, the Federal Reserve and FDIC were called
on to support activities that are clearly outside of their legal
purpose.
In 2003, with the stroke of a pen, the Federal Reserve razed the
walls between deposits and commerce with its approval of Citi's
ownership of Phibro, a nonfinancial business. It did so again, in 2005,
when it approved JPM's entry into the physical commodities business.
This kind of unilateral extra-legal decisionmaking by an entity not
directly accountable to voters or Congress or even the executive branch
has proven perilous to the public and anti-democratic. Lawmakers ought
to remove the Federal Reserve's right to rewrite securities laws.
Today, regulators remain unprepared for the future demands that
will be put on them and have failed to even manage those early forays
that are primary to the discussion today. With ``systemically important
financial institutions''(SIFIs) involvement in global and regulated
nonfinancial assets there are now too many regulators across too many
jurisdictions for the public to hope for any regulatory effectiveness.
While the Federal Reserve remains the primary regulator of our
federally chartered bank holding companies, today these banks operate
businesses overseen by the Federal Energy Regulatory Commission, State
utility regulators, the Commodity Futures Trading Commission, the
Securities and Exchange Commission, commodity exchanges and their
international counterparts.
In 2005, the Federal Reserve decided that JPMorgan's ownership of
commodities would be ancillary to their financial business. They
determined that: ``Based on JPM Chase's policies and procedures for
monitoring and controlling the risks of Commodity Trading Activities,
the Board concludes that consummation of the proposal does not pose a
substantial risk to the safety or soundness of depository institutions
or the financial system generally and can reasonably be expected to
produce benefits to the public that outweigh any potential adverse
effects.
In issuing their approval, they took pains to make it clear that:
``To minimize the exposure of JPM Chase to additional risks, including
storage risk, transportation risk, and legal and environmental risks,
JPM Chase would not be authorized (i) to own, operate, or invest in
facilities for the extraction, transportation, storage, or distribution
of commodities; or (ii) to process, refine, or otherwise alter
commodities.''
Yet that is precisely what JPM proceeded to do.
In 2008, RBS sought Federal Reserve Board approval proposed to
enter into physical commodity trading including in certain commodities
not approved by the CFTC for trading on a futures exchange, long-term
energy supply contracts, energy tolling and energy management services.
The Federal Reserve ruled \5\ that each of these activities would be
ancillary to their financial services businesses assuming certain
safety and oversight regimes, including the ability to ensure proper
position limits, were in place.\6\
---------------------------------------------------------------------------
\5\ Federal Reserve Bulletin, Volume 94, First Quarter 2008, ``The
Royal Bank of Scotland Group plc Edinburgh, Scotland, ``Order Approving
Notice to Engage in Activities Complementary to a Financial Activity'',
available at: http://www.federalreserve.gov/pubs/bulletin/2008/legal/
q108/order7.htm.
\6\ Note: UNITED STATES OF AMERICA Before the COMMODITY FUTURES
TRADING COMMISSION, CFTC Docket No. 12-37, ``ORDER INSTITUTING
PROCEEDINGS PURSUANT TO.'' Last modified 2012, available at: http://
www.cftc.gov/ucm/groups/public/@lrenforcementactions/documents/
legalpleading/enfJPMorganorder092712.pdf (On September 27, 2012, the
CFTC issued an Order against JPMorgan for violations of Section
4a(b)(2) of the Commodity Exchange Act: ``deficiency in its newly
created automated position limit monitoring system for the commodity
business . . . used by commodity traders to track their current
positions in particular futures contracts . . . after learning of this
deficiency, JPMCB utilized a manual position limit monitoring procedure
pending correction of the automated monitoring system. Despite adoption
of this manual position limit monitoring procedure, JPMCB violated its
short-side speculative position limit on several occasions.'').
---------------------------------------------------------------------------
Between 2008 and 2010, through its purchase of Bear Stearns and
parts of RBS Sempra, JPMorgan acquired a number of power plants,
electricity tolling agreements, and the metals concentrates and
warehouses of Henry Bath.
By 2011, warnings were being sounded before the United Kingdom's
House of Commons: ``I believe there is a lot we can do just by
enforcing correct commercial law. For example, on the London Metal
Exchange there are four very large companies that own the very
warehouses that people deliver metal into. J.P. Morgan[2] is one of
them. They own a company called Henry Bath. They are, therefore, a
ring-dealing member of the exchange and they also own the warehouse.
That is restrictive. They were also reported, at one point, to have had
50 percent of the stock of the metal on the London Metal Exchange. That
is manipulative. These are things that we can do something about here.
That would mean the copper price probably would not be $10,000 a tonne,
which is higher than for some forms of titanium. That price is not down
to the fact that the metal is not being mined, it is because of such
actions.''\7\
---------------------------------------------------------------------------
\7\ House of Commons of the United Kingdom, Select Committee on
Science and Technology, ``Strategically important metals--Science and
Technology Committee'', ``Examination of Witnesses (Question Numbers
70-107)'', February 16, 2011, available at: http://
www.publications.parliament.uk/pa/cm201012/cmselect/cmsctech/726/
11021602.htm.
---------------------------------------------------------------------------
Limits on Nonfinancial Assets:
Among the key legal requirements that the Federal Reserve must
address when considering Gramm-Leach-Bliley Act's allowance of
`nonfinancial activities' is: ``the attributed aggregate consolidated
assets of the company held by the holding company pursuant to this
subsection, and not otherwise permitted to be held by a financial
holding company, are equal to not more than 5 percent of the total
consolidated assets of the bank holding company, except that the Board
may increase that percentage by such amounts and under such
circumstances as the Board considers appropriate, consistent with the
purposes of this Act''.\8\
---------------------------------------------------------------------------
\8\ GRAMM-LEACH-BLILEY ACT, PUBLIC LAW 106-102--NOV. 12, 1999,
available at: http://www.gpo.gov/fdsys/pkg/PLAW-106publ102/pdf/PLAW-
106publ102.pdf.
---------------------------------------------------------------------------
When Banks are as large as they are able to lever as much as they
do, perhaps we should consider whether 5 percent is still an
appropriate threshold. When one company can have its hands on 50
percent of all metals on LME and still be less than 5 percent of total
assets, the question becomes one of competition rather than arbitrary
thresholds.
Moreover, given the various forms of ``control'', one should ask
how much can that threshold can be gamed and what the banks are
counting as being in their control? As we have now seen, the banks may
abide by the letter of the regulation but not its spirit, finding
various loopholes to exploit as they conduct their business.
Such is the approach of Goldman when it states that their warehouse
unit, Metro, never owns the metal in its sheds, rather it merely stores
it. After all, it is prohibited from owning metal it stores. Similarly,
JPMorgan's ``tolling agreements'' with electricity generators are a
means for them to buy and sell power without having to own it. Five-
percent appears to be an arbitrary number and easily manipulated as a
liar loan.
Even if the Federal Reserve was serious about its efforts to limit
nonfinancial activities, the task may be too large because of all of
the legal loopholes available to banks, witnessed by the proliferation
of shell companies, differing ownership structures and subsidiaries.
According to research from the Federal Reserve Bank of New York, the
four biggest bank holding companies had, combined, about 3,000
subsidiaries in 1990. By 2011, the top four had more than 11,000.\9\
---------------------------------------------------------------------------
\9\ ``Fed Reviews Rule on Big Banks' Commodity Trades After
Complaints'', Bloomberg, Bob Ivry, July 20, 2013 available at: http://
www.bloomberg.com/news/2013-07-20/fed-reviews-rule-on-big-banks-
commodity-trades-after-complaints.html.
---------------------------------------------------------------------------
The Risks are Real:
As we have witnessed during and since the financial crisis, when
business-line profitability declines or regulatory or reputational
risks rise banks tend to exit markets.
In the world of narrow banking this behavior would pose little risk
to our system of financial intermediation. Unfortunately, in the
various businesses within investment banking, and in critical
nonfinancial businesses, withdrawals of liquidity that are manageable
during normal periods create dislocations during crisis. Contagion and
the failure of firms within an industry are acceptable realities within
a competitive economy. However, we must guard against the risk that
such dislocations lead to contagion within our banking sector, where
the explicit guarantees of depositors and direct access to the Federal
Reserve's discount window engender systemic risks to the public.
Conflict between the private motives of managements, with their
primary obligation to shareholders, and the public interest are not
rare. They exist and are the fundamental reason for regulation within
industries. Where these conflicts lead to abuses that circumvent
regulation they often can lead to failure, as was the case with Enron.
Unfortunately, where Enron could be shut down easily, the reality is
that our systemically important financial institutions are more
complex. Unlike a bank, Enron did not have ability to drive capital
away from competitors and this reduces the development of natural
competitors and possible successor firms. Enron did not have the
explicit guarantee that backs the deposits of our banks or the implied
guarantees still conferred by the market, even in the wake of the Dodd-
Frank Act. While banks have four types of risk, only the failure of
reputational risk management drives necessary collapse. Enron's
reputational risk posed no systemic risk.
While operational, liquidity and credit risks can cause the
downfall of a firm the value of the core assets can typically be
transferred, even at a loss, to other industry participants.
Unfortunately, reputational risk within a systemically important
financial institution can result in requirements that the firm backstop
assets, even those that were legally isolated. In 2008 Citi was
obligated to guarantee and then repurchase $17.4 billion of structured
investment vehicles (SIVs).\10\ As a result, the failure of the Federal
Government to backstop a firm's reputation against such losses during a
time of crisis could exacerbate panics and lead to contagion and the
creation of larger systemic problems.
---------------------------------------------------------------------------
\10\ ``Citi Finalizes SIV Wind-down by Agreeing to Purchase All
Remaining Assets'', Citigroup, Press Release, November 19, 2008,
available at: http://www.citigroup.com/citi/press/2008/081119a.htm.
---------------------------------------------------------------------------
While there is no suggestion that the current reputational problems
in banks' nonfinancial businesses are of a scale that could create a
systemic crisis, the possibility of such failures occurring in the
future must still be considered by prudential regulators and
policymakers.
This past weekend the New York Times demonstrated how Goldman Sachs
became a key middleman in the aluminum industry, possibly adding cost
to consumers without any real benefit . The warehouse business
worked\11\ fine without them; now, with their presence in the market,
it can be argued that it is neither better nor more efficient, only
more expensive.
---------------------------------------------------------------------------
\11\ ``A Shuffle of Aluminum, but to Banks, Pure Gold'', The New
York Times, David Kocieniewski, July 20, 2013, available at: https://
www.nytimes.com/2013/07/21/business/a-shuffle-of-aluminum-but-to-banks-
pure-gold.html?ref=todayspaper&_r=0.
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Similarly, in January 2013, the FERC took action against the
JPMorgan for its attempts at preventing the implementation of State-
requested changes to two Huntington Beach, California, power plants
owned by AES Corporation.\12\ The State deemed the work necessary in
order to replace lost power capacity that resulted from the shutdown of
the San Onofre nuclear plant.\13\ JPM sought to prevent the changes and
claimed its marketing contract with AES gave them the right to veto the
work. While the bank's motives were not stated it is reasonable to
consider that the firm sought to profit from the higher peak energy
prices that would have resulted from its actions to prevent new
capacity from coming on line. While the Federal Reserve, as the primary
regulator of the holding company, had authorities over the bank's
activities it appears not to have asserted any authority.
---------------------------------------------------------------------------
\12\ ``JPMorgan Unit Can't Block Calif. Power Project, FERC Says'',
Law 360, Daniel Wilson, January 07, 2013, available at: http://
www.law360.com/articles/405284/JPMorgan-unit-can-t-block-calif-power-
project-ferc-says.
\13\ ``Feds rule JPMorgan can't block California power plant
changes.'' The Sacramento Bee, Mary Lynne Vellinga, January 5, 2013,
available at: http://www.sacbee.com/2013/01/05/5093370/feds-rule-
JPMorgan-cant-block.html#mi_rss=Capitol%20and%20California.
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The Goal is Control Rather than Consolidating Ownership:
Today, there are few financial assets classes left to support
growth of the size necessary to generate returns proportional to our
largest banks' needs. Seeking new returns, our largest and most
systemically interconnected banking firms, under the guise of
infrastructure development, are turning their focus to an expansion of
their control of nonfinancial assets. Bank ownership and control of
physical commodities and the warehouses that store those commodities is
the subject that brings us here today, but they are only a small part
of the larger systemic risks being created by those excursions across
the commercial divide.
Our largest bank holding companies now seek to ``control'' other
nonfinancial infrastructure assets and will again wrap their intentions
in the flag of this great Nation--arguing that ``public private
partnerships'' are the key to redevelopment of our infrastructure. This
is the same strategy employed, through the largest public-private
partnership in our history, the National Partners in Homeownership,
which was supposed to be the key to a stable future for homeowners.\14\
---------------------------------------------------------------------------
\14\ Rosner, Joshua, Housing in the New Millennium: A Home Without
Equity is Just a Rental with Debt, June 29, 2001, p.5. Available at
SSRN: http://ssrn.com/abstract=1162456 or http://dx.doi.org/10.2139/
ssrn.1162456 (See: ``In an effort to restore the promises of the
``American dream'', the Clinton Administration embarked on a major
initiative to increase homeownership. In 1993, the Census Bureau
recommended ways to do so. Lowering down payment requirements and
increasing available down payment subsidies were suggested. In early
1994, HUD Secretary Henry Cisneros met with leaders of major national
organizations from the housing industry. By early fall, the Clinton
Administration, along with over 50 public and private organizations
agreed on `working groups', a basic framework and the core objectives
of what they named the ``National Homeownership Strategy''. The
creators of the strategy of the National Partners in Homeownership
(`NPH') include, among others: HUD, Federal Deposit Insurance Company,
Fannie Mae, Freddie Mac, the Mortgage Bankers Association, the American
Institute of Architects, America's Community Bankers, the U.S. Dept. of
Treasury and the National Association of Realtors. Their primary goal
was ``reaching all-time high national homeownership levels by the end
of the century''. This was to be achieved by ``making homeownership
more affordable, expanding creative financing, simplifying the home
buying process, reducing transaction costs, changing conventional
methods of design and building less expensive houses, among other
means''.4 It was almost unprecedented for regulators to partner this
closely with those that they have been charged to regulate.'')
---------------------------------------------------------------------------
The benefits and risks of public investment in essential
infrastructure, as well as the privatization of nonessential and
nonutility infrastructure, can be debated. The control of assets in
which the public has funded and invested, often for generations, by our
largest financial firms should give elected officials and regulators
pause.
Today, the Asset Management units of several of these firms are
seeking ``controlling interests'' nonfinancial assets without ownership
\15\ of those assets.
---------------------------------------------------------------------------
\15\ Citi Capital Advisors, Overview, last accessed July 22, 2013,
available at: https://www.citicapitaladvisors.com/ciiOverview.do (See:
``Citi Infrastructure Investors (CII) manages Citi Infrastructure
Partners (CIP), a multi-billion infrastructure fund that has
controlling interests in mature transportation and utility
infrastructure assets. CIP's portfolio includes: Kelda, owner of
Yorkshire Water, a regulated UK water and sewer company; Itinere
Infraestructuras S.A., a Spanish toll road concessionaire; DP World
Australia, a container terminal business in Australia; and Vantage
Airport Group, an airport investment and management company with
airports in Canada and the UK.'')
---------------------------------------------------------------------------
To effect these goals the firms are pitching pension and other
investors on investments in the leasing, operation and control of
infrastructure assets. To date, these firms have attained ``controlling
interests''\16\ and have ``active control strategies''\17\--in the
United States and abroad. They currently control ports, airports,
electric utilities, water utilities, sewer utilities, wind power farms,
parking meters, solar power generation, parking garages, rail leasing,
charter schools and other assets.
---------------------------------------------------------------------------
\16\ See, as example, https://www.citicapitaladvisors.com/
ciiOverview.do and https://www.JPMorgan.com/cm/
ContentServer?pagename=Chase/Href&urlname=JPMorgan/am/ia/
investment_strategies/investmentsGroupLHK and http://
www.morganstanley.com/infrastructure/portfolio.html and http://
www.goldmansachs.com/what-we-do/investing-and-lending/direct-private-
investing/equity-folder/gs-infrastructure-partners.html.
\17\ JPMorgan IIF Acquisitions LLC Maher Terminals, LLC, Letter to:
Mr. Ryan Pedraza Program Manager, Virginia Office of Transportation
Public-Private Partnerships, last accessed July 22, 2013, available at:
http://www.vappta.org/resources/RREEF%20and%20
JPMorgan_Detailed%20Proposal.pdf.
---------------------------------------------------------------------------
According to the firms' own marketing materials, these assets are
attractive, because of the ``monopolistic'' and ``quasi-monopolistic''
nature of the assets. They can ``support more debt/leverage without
incurring more risk than real estate'' and have ``attractive inflation
protection characteristics''.\18\ Though the firms have control over
these assets and are responsible for the management and operations of
the assets, investors in the funds in fact, own the assets. Through
their control, these firms can target majority and control positions to
enable the implementation of their business plans and other strategic
initiatives via a disciplined ``active asset management approach.''\19\
---------------------------------------------------------------------------
\18\ CIPFA Scotland Asset Management Workshop, ``Investing in
Infrastructure'', JPMorgan, Larry Kohn, Managing Director, March 1,
2007, last accessed July 22, 2013, available at: http://
www.slideshare.net/Jacknickelson/cipfa-scotland-asset-management-
workshop-investing-in.
\19\ JPMorgan IIF Acquisitions LLC Maher Terminals, LLC, Letter
to: Mr. Ryan Pedraza Program Manager, Virginia Office of Transportation
Public-Private Partnerships, last accessed July 22, 2013, available at:
http://www.vappta.org/resources/RREEF%20and%20JPMorgan_
Detailed%20Proposal.pdf.
---------------------------------------------------------------------------
There are Substantial Public Policy Issues to be Considered:
Besides the reputational risks of the projects failing,\20\ leaving
investors with losses and municipalities with long-term leases and the
possibility of limited refinancing opportunities, there are other risks
to the bank operators that should be of concern.
---------------------------------------------------------------------------
\20\ PPP Failures, Scribd, last accessed July 22, 2013, available
at: http://www.scribd.com/doc/155206053/PPP-Failures.
---------------------------------------------------------------------------
Conflicts of Interest
While, as example, JPMorgan claims to be ``a long-term
infrastructure owner who understands its responsibilities to all
stakeholders''\21\ the reality is, that as a fiduciary, there are
internal conflicts in these transactions. The firms have a fiduciary
obligation that may be unmanageable to pension and other investors--as
they did during the expansion of the Residential Mortgage Backed
Securities (RMBS) and Collateralized Debt Obligation (CDO) markets.
Even if these investments are legally isolated, as we witnessed with
Citi's SIVs, the firm may be pressed or required to reconsolidate.
Moreover, contractual obligations to the lessor, operating and
contracted partners (that may also be investment-banking clients \22\)
and obligations to customers of the operating entity all pose risks
that become difficult for a bank holding company to manage.
---------------------------------------------------------------------------
\21\ JPMorgan IIF Acquisitions LLC Maher Terminals, LLC, Letter to:
Mr. Ryan Pedraza Program Manager, Virginia Office of Transportation
Public-Private Partnerships, last accessed July 22, 2013, available at:
http://www.vappta.org/resources/RREEF%20and%20
JPMorgan_Detailed%20Proposal.pdf.
\22\ FDIC Banking Review, ``The Future of Banking in America The
Mixing of Banking and Commerce'', Current Policy Issues, Christine E.
Blair, last updated February 11, 2005, last accessed July 22, 2013,
available at: http://www.fdic.gov/bank/analytical/banking/2005jan/
article3.html#30 (See: ``Several banks have recently faced losses from
lines of credit that were extended to corporate customers in return for
receiving that corporation's underwriting business. In this sense,
legal tying or cross-selling can lead to losses that could threaten the
bank's safety and soundness.'')
---------------------------------------------------------------------------
Furthermore, in a concentrated financial industry, the presence of
a bank affiliate as an operator of nonfinancial businesses poses
significant risks to competition. These risks include:
Informational advantage that can result from ineffective
controls and therefore allow a firm's trading desk to gain
market information about underlying financial contracts or
securities that can be used to benefit the firm or its
customers or disadvantage customers and competitors.
The risk that a firm that controls an electric utility and
also, through a separate affiliate, has tolling agreements, can
manipulate the availability of energy for advantage.
The risk that a bank may choose to deny lending or
underwriting to a competitor of their commercial affiliate.
The risk that a bank may choose to lend, at preferential
rates, to a commercial affiliate.
The risk that a bank may, legally or illegally, tie loans
to the purchase of a commercial affiliate's products.
Concentration of Economic Power Within Banking
When Glass-Steagall was enacted, recent history served as a
reminder of the risks that existed with the combination of banking and
commerce and with the concentration of power within a small number of
financial companies. The need to protect against these dual risks
remains as much of an imperative today as it did then.
Only a generation before the Great Depression, J.P. Morgan began to
amass his power over both banking and, with the powers of the purse,
commerce. The over-indebted railroad industry, plagued by falling rates
provided Morgan with an opportunity and by 1900 he had consolidated the
industry and controlled one-sixth of the Nation's rail network.
Soon, he turned his attention to the control of the electricity and
steel industries. ``As a result of this extreme consolidation, most of
which occurred under Morgan's watch, businesses depended on Wall Street
and Morgan's money. Because most had no choice but to give up
managerial control, it was the bankers who approved mergers, handled
legal matters, underwrote securities, appointed managers and framed
policies. Even more importantly, the bankers set initial stock values
for companies and marketed them on an international level. Therefore,
if a company did not get Morgan's approval, it did not make it to
market; it was doomed.''\23\
---------------------------------------------------------------------------
\23\ J.P. Morgan: a Biography, Liz Bowen, Fordham University, last
accessed July 22, 2013, available at: http://www.fordham.edu/academics/
colleges_graduate_s/undergrad
uate_college/fordham_college_at_l/special_programs/honors_program/
hudsonfulton_cele
bra/homepage/biographies/jp_morgan_32212.asp.
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In the aftermath of the crisis, with our largest financial
institutions having become ever larger and more concentrated, there is
an opportunity for those firms designated as SIFIs to use their market
power to subvert and distort competition and development in the real
economy. Moreover, if they are allowed to control vast networks of
nonfinancial assets, either as principal or agent, they will have the
power to pick winners and losers in the commercial world, not based on
the productivity or competitive advantages of those firm's operations
but as a result of their own profit motives.
As Cam Fine of the ICBA warned in 2007: ``Over time, the
individual, the small business owner, small towns, and rural
countryside will suffer economically. More power will devolve to fewer
and fewer hands, and economic diversity will whither, and with it,
choices. While population centers may flourish, the decline of rural
and small town America will accelerate . . . The less advantaged of our
society will become even more disadvantaged.''\24\
---------------------------------------------------------------------------
\24\ Chicago Fed Letter, ``The Mixing of Banking and Commerce: A
conference summary'', Nisreen H. Darwish, Douglas D. Evanoff, Essays on
Issues, The Federal Reserve Bank of Chicago, Number 244a, November
2007, last accessed July 22, 2013, available at: http://
qa.chicagofed.org/digital_assets/publications/chicago_fed_letter/2007/
cflnovember2007_
244a.pdf.
---------------------------------------------------------------------------
Others have argued that the strong regulatory oversight by U.S.
regulators and the clear separation of banking and affiliates
ameliorate these risks but their arguments were largely disproved
during the crisis as bank holding companies demonstrated that their
first the impulse was to use bank resources in support of failing
commercial affiliates, potentially jeopardizing the bank's safety and
soundness. Such an effort was followed by a focused effort to move
affiliate obligations into the banks to be supported by the FDIC and
the Federal Reserve.
Catastrophic Risk
By allowing bank holding companies to ``control'' these assets and
accept the operating risks of those assets, regulators are supporting
the accumulation of potentially catastrophic and systemic risks
associated with the underlying operations . Imagine if a systemically
important financial institution \25\ was in the business of
transporting oil and was unfortunate enough to own the Exxon Valdez?
The systemic implications to the financial system and un-priced risks
to counterparties could result in the risk of a series of systemically
significant failures.
---------------------------------------------------------------------------
\25\ CIPFA Scotland Asset Management Workshop, ``Investing in
Infrastructure'', JPMorgan, Larry Kohn, Managing Director, March 1,
2007, last accessed July 22, 2013, available at: http://
www.slideshare.net/Jacknickelson/cipfa-scotland-asset-management-
workshop-investing-in p.4 (See: Debt represents 84 percent of Skyway's
$1.83 billion concession price. Under a concession structure, the
private sector concessionaire captures projected revenue growth in
exchange for assuming operating risk).
---------------------------------------------------------------------------
Conclusion
While our banks claim they provide efficiencies and that they must
be able to compete with the largest global banks it must be pointed out
that many of these efficiencies were merely an arbitrage with the
benefits accruing to executives and losses apportioned to investors and
the public.
European governments have, through actions and deeds in Greece,
Ireland, Cyprus, Italy and elsewhere, explicitly accepted their banks
as sovereign obligations. In the United States both parties have stated
their intent, whether or not we have yet become successful in our
efforts, that never again will our banks receive any implied or
explicit Government support for activities outside of the narrow
banking function of deposit insurance.
With that goal clearly stated we must recognize the most troubling
issue here before us today is that dominance of global banks in our
country has set us down a slippery slope where those firms can justify,
and convince captured regulators, that whatever they do is in the
national interest. And in a way, they are right about that because,
should they fail, the entire country will pay the price for it. Make no
mistake about that--there is no other way to deal with such a calamity.
The growth of big banks is a case of too much of a good thing
metastasizing into a bad thing. What started out with a limited safety
net designed to protect the payments system and to provide a safe place
for small, unsophisticated depositors to place their savings has
morphed into an anticompetitive system where Government-subsidized
banks can use unfair advantage to enter and dominate any market or
business, financial or nonfinancial, that they choose. This is
inconsistent with those concepts of competition and creative
destruction that have done so well for our country.
Let me make it clear, the people running these banks are smart,
smarter than many of us. The problem isn't that they are dumb,
malevolent, unpatriotic or dishonest. The real problem has three
components:
First, they are human, which means they are fallible and
they will fail, repeatedly, just like the rest of us;
Second, they are motivated by corporate values, which don't
allow them to sacrifice or compromise to protect public
interests, even if they would personally be inclined to;
Third, they are huge and of such size because they enjoy
public safety net benefits that foster unlimited growth, which
includes the sort of inappropriate growth in nonbanking
businesses discussed here today.
There is much for people across the political spectrum to dislike
about this. SIFI activity in the energy markets and other commercial
markets paints a clear picture of what we should not allow banks to do.
Government-subsidized businesses should be boring, low profit, and
limited by original purpose.
Reflecting on the Federal Reserve Board's 2005 letter allowing
JPMorgan to hold physical commodities while prohibiting them from
storing those commodities should lead legislators to reconsider the
authorities they have vested in the Fed regarding these activities. One
has to look with concern at the poor job of the Fed in policing the
limitations of their order allowing banks to enter commodity
businesses. Still, let us move past that and on to the real issue. The
Federal Reserve Board should not be allowing banks to be in businesses
that don't directly support the resilience of the payments system or
the stability of FDIC insured deposits.
There is a lot of undoing to be done in banking. The public good
and the benefits to Main Street and free enterprise, rather than
enrichment of SIFI executives, must be our primary focus.
______
PREPARED STATEMENT OF TIMOTHY WEINER
Global Risk Manager, Commodities and Metals
MillerCoors LLC
July 23, 2013
Good morning Mr. Chairman and Members of the Committee. My name is
Tim Weiner. I am the Global Risk Manager of Commodities and Metals for
MillerCoors, a U.S. brewing company headquartered in Chicago, IL.
MillerCoors employs 8,800 people here in the United States, working
in eight breweries in Irwindale, CA, Trenton, OH, Eden, NC, Fort Worth,
TX, Albany, GA, Elkton, VA, Golden, CO, and Milwaukee, WI. We also
operate the Leinenkugel's craft brewery in Chippewa Falls, WI, and the
Blue Moon Brewing Company in Denver, CO. We sell our products in all 50
States and we contract brew for export through associates. MillerCoors
insists on building its brands the right way: through brewing quality,
responsible marketing, sales, environmental and community impact.
This year, MillerCoors will brew and ship in excess of 60 million
barrels of beer within the United States. Our company will package
about 60 percent of that beer in aluminum cans and aluminum bottles.
That's the equivalent of about 4,000 747 jumbo jets worth of aluminum
each year. Beer in aluminum containers has a long history within our
company. In fact, Bill Coors invented the seamless two-piece aluminum
container in 1958 and started the first aluminum can recycling program
55 years ago.
To make our cans, we need aluminum--a lot of aluminum. In the
extensive portfolio of commodities that we manage, aluminum is our
single largest price risk. That risk, and the importance of aluminum to
our business, is why I am here today. As a representative of
MillerCoors, I will share with you my company's concerns about the
warehousing practices conducted by members of the London Metal Exchange
(LME). I will explain how the LME's rules allow those unfair practices
to impact U.S. manufacturing. I will explain why U.S. legislators and
regulators, including the Federal Reserve, should strengthen their
oversight of bank holding company activities, which are creating an
economic anomaly in the aluminum and other base metal markets.
Mr. Chairman, my statement is neither an indictment of free market
principles nor the existing exchange traded futures system here in the
United States, which we use regularly to hedge our commodity price
risks and volatility. In fact, our hope is the LME system could one day
function as transparently and efficiently as the exchanges here in the
United States.
Before I begin, my concerns are not unique to MillerCoors or even
the beer industry. MillerCoors is just one of a number of companies
that purchase aluminum for the production of a number of everyday
products used by Americans, from beer and soda cans to automobiles and
airplanes. MillerCoors is joined in airing its concerns about the LME
by a range of companies from a variety of business sectors, including
The Coca-Cola Company, Novelis, Ball Corp., Rexam, Dr. Pepper Snapple
Group, D.G. Yuengling Brewing Company, North America Breweries, Rogue
Brewery and Reynolds Consumer Products to name just a few.
The risk management team at MillerCoors also manages the risk for
the other commodities we use to brew beer and the energy to power our
eight breweries. Those include barley, corn, natural gas, electricity
to fuel our breweries and diesel fuel for our trucking operations. We
spend billions of dollars annually on these commodities, and must
manage the risk of price fluctuations to be an efficient brewer. In
order to properly manage this risk, we created strict governance in the
form of a commodity risk policy that clearly forbids speculation in our
hedging program, as we are not a trading operation.
Historically, consumers and suppliers purchased aluminum directly
from aluminum producers. The LME was always a market of last resort--
where aluminum producers would go to sell their stock in times of
oversupply and where aluminum users would go to buy metal in times of
extreme shortage. This is a key function of all exchanges. However, Mr.
Chairman, over the past few years, the market for aluminum and other
base metals has drastically changed. My company and other manufacturers
can no longer plan to buy the aluminum we need directly from aluminum
producers.
I am not an expert in the Bank Holding Company Act, but I
understand under that statute, the Federal Reserve has the authority to
decide whether commercial and physical commodity activities like the
LME warehouses are appropriate lines of businesses. Under this Federal
Reserve exemption, U.S. bank holding companies have effective control
of the LME, and they have created a bottleneck which limits the supply
of aluminum. Aluminum prices in general and for can sheet in particular
have remained inflated relative to the massive oversupply and record
production. What's supposed to happen under these economic conditions?
When supplies rise while demand is flat to down, prices should fall.
Instead, what's happening is that the aluminum we are purchasing is
being held up in warehouses controlled and owned by U.S. bank holding
companies, who are members of the LME, and set the rules for their own
warehouses. These bank holding companies are slowing the load-out of
physical aluminum from these warehouses to ensure that they receive
increased rent for an extended period time. Aluminum users like
MillerCoors are being forced to wait in some cases over 18 months to
take physical delivery due to the LME warehouse practices or pay the
high physical premium to get aluminum today. This does not happen with
any of the other commodities we purchase. When we buy barley we receive
prompt delivery, the same with corn, natural gas and other commodities.
It is only with aluminum purchased through the LME that our property is
held for an extraordinary period of time, with the penalty of paying
additional rent and premiums to the warehouse owners, until we get
access to the metal we have purchased.
What's most concerning is that all the key elements of the LME
(ownership/warehousing/policy control) for aluminum and other base
metals worldwide, are controlled by the same entities--bank holding
companies.
The practical effect of these LME warehouse rules is to essentially
create a funnel, with a wide end at entry and a very narrow end exiting
out. At the wide end, there is a massive supply of metal going into
these warehouses, at the rate of tens of thousands of metric tons per
day. At the narrow end, the LME warehouses, such as those in Detroit,
use minimum load-out rates as maximums, releasing no more than 3,000
MT/day. Just imagine a warehouse with a big garage door marked ``in''
and the small front door of your house marked ``out.'' A lot more metal
goes into the warehouse than comes out. U.S. manufacturers want to take
possession of their metal, but cannot because the LME rules allow the
warehouses to collect rent for every day, month and year that the
aluminum sits in these LME warehouses. The current system does not
work. It has cost MillerCoors tens of millions of dollars in excess
premiums over the last several years with no end in sight. My company
and others estimate that last year alone, the LME warehouse rules have
imposed an additional $3 billion expense on companies that purchase
aluminum.
As I stated earlier, my job is to reduce commercial risk associated
with our business. We are challenged in managing our aluminum costs due
to these LME warehouse practices. Aluminum prices have become inflated
and this flows directly through to the price of can sheet. Let me
restate one very important point. Although the LME has ordered strict
minimum release requirements for warehouses controlled by LME members,
those minimums are being treated as maximums and continue to restrict
the flow of metal out to the market. No matter what the markets demand,
the approved LME warehouses only release the minimum required amount of
metal each day, which is public record. This only increases the length
of the queues waiting for delivery. The warehouses are not responding
to ordinary supply/demand market conditions in part because of two
things.
1. The fact that the bank holding companies that are members of the
LME also comprise the LME Warehouse Rules and Regulations
committee and also own a number of LME-certified warehouses.
This structure is unprecedented in other global futures
exchanges. Specifically, the largest LME principal through
December 2012 was Goldman Sachs, which through its ownership of
Metro International Trade Services owns one of the largest
warehouse complexes in the LME system. They control 29 of the
37 warehouse locations at the LME approved warehouse site in
Detroit. This site houses approximately one quarter of the
aluminum stored in LME facilities globally and over 70 percent
of the available aluminum in North America. Henry Bath (100
percent owned by JPMorgan), Glencore and other trading
companies also own LME warehouses.
2. There is no clear ``regulator'' or oversight of the London Metal
Exchange warehouses, the LME itself is a self-regulated entity.
In addition to direct talks with the LME, both formal and
informal, we have urged regulators in the United States, the
United Kingdom and the European Union to give thoughtful
consideration to the effect of LME business practices on the
industries that rely on a supply of aluminum priced by
reasonable market conditions. Specifically, we have asked the
UK Financial Services Authority (recently reorganized as the
Financial Control Authority) and the CFTC to regulate the LME
system as it pertains to the commodity metals market. Both
agencies have indicated they are uncertain whether they have
the regulatory authority necessary.
On the commercial side, my company and other aluminum users have
attempted over the last year to resolve our concerns directly with the
LME. We offered up sensible and reasonable recommendations to expedite
and improve the current LME business practices and mitigate their
adverse impact on aluminum purchasers. We specifically asked the LME to
amend their rules to allow:
A daily rental to be charged for a limited period following
cancellation of a warrant (i.e., 30-45 days).
A daily load out rate for each warehouse shed at each
official site, rather than by company at an official site.
A daily load-out rate by warehouse shed that would clear
the queue within a reasonable period.
A review and adjustment of load-out rates more frequently
so that bottlenecks do not persist.
The LME dismissed our proposals. The changes they have made and
recently proposed to increase the daily load-out rates are minimal and
would seem to make no real impact, but we look forward to submitting
comments on their proposed rule changes.
In closing, in the view of MillerCoors and other companies in
similar situations, the LME's current practices must be changed. We
simply ask for the same regulatory and legislative oversight of the LME
that other U.S. futures exchanges receive in order to level the playing
field and ensure a transparent balanced functional market for buyers
and sellers. This oversight will restore the free market functioning of
the LME, which will regain our confidence in the institution and permit
us to successfully brew, ship and sell our fine beers.
On behalf of MillerCoors and any other companies adversely impacted
by the practices of the LME, I thank the Committee for allowing me to
appear and testify today. I am happy to answer any questions that you
have.
RESPONSE TO WRITTEN QUESTIONS OF CHAIRMAN BROWN FROM SAULE T.
OMAROVA
Q.1.a.-b. The ``grandfathering'' provision in the Bank Holding
Company Act was clearly included in the Gramm-Leach-Bliley Act
by interested parties who foresaw that investment banks would
someday want access to the Federal Reserve's discount window
and other facilities. Regulators point out that it is a
statutory exemption, and argue that they cannot prevent
eligible institutions from engaging in many nonfinancial
activities. The language is arguably ambiguous and open to a
narrow interpretation by the Federal Reserve, if it wanted to
do so.
a. LShould the Federal Reserve take a tougher line by
narrowing the scope of nonfinancial activities that
financial holding companies can engage in--both under
section 4(k) and 4(o)?
b. LAs a policy matter, what value does the 4(o) provision
add to enable regulatory safety, soundness and
capacity?
A.1.a.-b. Did not respond by publication deadline.
Q.2. The Federal Reserve has other tools to address
nonfinancial activities that it finds disconcerting or
impermissible. For example, Section 5 of the Bank Holding
Company Act authorizes the Fed to force a bank holding company
to divest a nonbank subsidiary that ``constitutes a serious
risk to the financial safety, soundness or stability'' of any
bank subsidiary.
LShould the Federal Reserve use this section 5
authority to force financial holding companies to
divest themselves of subsidiaries that expose it to
risks--for example, an oil spill or an oil tank
explosion--that are not the typical purview of banking
regulators?
A.2. Did not respond by publication deadline.
Q.3.a.-c. The Federal Reserve order approving Goldman Sachs'
formation into a bank holding company states `` . . . Goldman
expects promptly to file an election to become a financial
holding company pursuant to sections 4(k) and (l) of the BHC
Act and section 225.82 of the Board's Regulation Y. Section 4
of the BHC Act by its terms provides any company that becomes a
bank holding company 2 years to conform its nonbanking
investments and activities to the requirements of section 4 of
the BHC Act, with the possibility of three 1-year extensions.
Goldman must conform to the BHC Act any impermissible
nonfinancial activities it may conduct within the time
requirements of the Act.''
a. LTo the best of your knowledge, has the Federal Reserve
Board developed a list or given any written guidance of
what constitutes as ``impermissible nonfinancial
activities'' at any point during the 2-year conformance
period?
b. LHas the Federal Reserve Board determined any of the
assets held by the two former investment banks, Goldman
Sachs and Morgan Stanley, as ``an impermissible
nonbanking activity'' after they were made into
federally insured FHCs in 2008?
c. LIn essence, is it fair to say the Board legally
transformed the two largest investment banks into
financial holding companies in 2008, and then allowed
them to continue to operate as investment banks by
enabling them to hold and acquire traditionally
impermissible nonbanking commercial and physical
commodities assets?
A.3.a.-c. Did not respond by publication deadline.
Q.4.a.-b. You have stated, `` . . . it is virtually impossible
to glean even a broad overall picture of Goldman Sachs, Morgan
Stanley and JPMorgan's physical commodities and energy
activities from their public filings with the Securities and
Exchange Commission and Federal bank regulators . . . [this]
added complexity makes the financial system less stable and
more difficult to supervise.''
a. LPlease further describe the potential regulatory capacity
challenges since you have stated regulators may be
incapable of effectively monitoring and overseeing
large financial conglomerates.
b. LPlease describe the operational and supervisory risks at
the institutional level that may arise given the
increased complexity from traditionally nonbank,
physical commodity and energy holding.
A.4.a.-b. Did not respond by publication deadline.
------
RESPONSE TO WRITTEN QUESTIONS OF CHAIRMAN BROWN FROM RANDALL D.
GUYNN
Q.1. You state in your written testimony that `` . . .
financial institutions are permitted to engage in commodities
activities to meet the needs of customers, increase customer
competition, act as more effective intermediaries between
producers and endusers, provide increased liquidity to the
markets and lower prices to consumers, and increase the
diversification of the revenue streams and exposures of the
financial institutions.''
What evidence exists to prove that this statement holds
true in reality?
A.1. Since these questions and answers are for the record, let
me first note some slight but material errors in the question
regarding the actual words I used in my written testimony, as
well as provide some context for the passage.
The actual statement in my written testimony read as
follows:
These financial institutions are permitted to engage in
commodities activities to meet the needs of customers, increase
customer choice, increase competition, act as more effective
intermediaries between producers and end users, provide
increased liquidity to the markets and lower prices to
consumers, and increase the diversification of the revenue
streams and exposures of these financial institutions.
As made clear by the totality of my written statement and
the context of this passage, this passage was describing the
findings made by the Office of the Comptroller of the Currency
(the ``OCC'') in its various orders determining that national
banks are permitted to buy and sell futures, forwards and other
commodities contracts as a component or incident of the
business of banking, subject to certain risk-mitigating
limitations and conditions. It was also describing the findings
by the Board of Governors of the Federal Reserve (the ``Federal
Reserve Board'') in its various orders as to why certain
financial holding companies and their nonbank affiliates (but
not their insured bank affiliates) are permitted to make or
take delivery of, or otherwise own or control, certain physical
or intangible commodities, and to have certain relationships
with commodities storage, generation, refining, transportation
or other related facilities, subject to certain risk-mitigating
limitations and conditions, as a complement to the financial
activity of buying and selling commodities contracts. Among the
risk-mitigating conditions imposed by the Federal Reserve Board
in its complementary powers orders is that the power to make or
take delivery, or otherwise own or control, physical
commodities is limited to commodities that are sufficiently
fungible and liquid.
See, e.g., Randall D. Guynn, Luigi L. DeGhenghi & Margaret
E. Tahyar, Foreign Banks as U.S. Financial Holding Companies,
in REGULATION OF FOREIGN BANKS & AFFILIATES IN THE UNITED
STATES 11:2[3], 11:4[9], pp. 957-960, 1025-1029 (Randall D.
Guynn, Editor, 7th edition 2013); Gibson Dunn, Federal Reserve
to Re-evaluate the Permissibility of Physical Commodities
Trading: The Rationale Historically and Today (July 22, 2013).
As made clear later in my written testimony, these findings
are the considered findings of the OCC and the Federal Reserve
Board, and were balanced against their findings about the
potential adverse effects of these activities and the ability
of various risk-mitigating limitations and conditions to
address those potential adverse effects. I do not know whether
the OCC or the Federal Reserve Board conducted any empirical
studies to test whether these findings held true in reality or
whether the applicants for the particular orders provided any
empirical evidence to support these findings in their
application materials.
Most of these findings are obviously true, however, based
on widely accepted, fundamental principles of basic economics.
As a result, most people would find it unnecessary and even a
waste of public and private resources to conduct or require
costly empirical studies to support them.
Let me give a few examples. One set of findings is that
allowing insured banks or their nonbank affiliates to enter
into commodities contracts with customers, including allowing
certain nonbank affiliates to make or take physical delivery or
otherwise own or control physical commodities that are
sufficiently fungible and liquid, will ``meet the needs of
customers, increase customer choice, increase competition, . .
. provide increased liquidity to the markets and lower prices
to consumers.'' These findings are obviously true under
virtually all likely circumstances.
For example, if a customer like JetBlue has the option to
hedge its exposure to the volatility of jet fuel prices or
finance its inventory of jet fuel by entering into contracts
with insured banks or their nonbank affiliates, its needs will
be met better and it will have more choice in counterparties
and financial products than if banks and their nonbank
affiliates are not permitted to enter or are forced to exit the
commodities markets. Similarly, absent anti-competitive
behavior that is adequately prohibited by our antitrust laws,
the commodities markets will be more competitive, not less
competitive, if banks and their nonbank affiliates are allowed
to enter and remain in the commodities markets, and are not
forced to exit them, compared to a world in which competitors
in commodities markets are protected by regulatory barriers to
entry that keep banks or their nonbank affiliates out of that
market or regulatory mandates that force them to exit. See,
e.g., Gregory Meyer, A ban on banks holding physical
commodities could backfire, FINANCIAL TIMES (July 26, 2013).
Indeed, the very heart of our antitrust (pro-competition) laws
is to break down barriers to entry or mandates to exit, prevent
excessive concentrations of market share and otherwise foster
free and robust competition from the greatest number of
competitors. See, e.g., Robert H. Bork, THE ANTITRUST PARADOX
(1978).
A consequence of making commodities markets more
competitive is that the prices to consumers (meaning endusers)
will be lower than if the markets were less competitive as a
result of regulatory barriers to entry or mandates to exit. It
is well established that prices will be lower in a more
competitive market compared to those in a less competitive
market. See, e.g., James R. Kearl, ECONOMICS AND PUBLIC POLICY:
AN ANALYTICAL APPROACH, p. 225 (6th ed. 2011). Thus, one
consequence of forcing banks and their nonbank affiliates to
exit any of these markets will be to reduce the number of
competitors and possibly competition in general, which would
almost certainly result in higher commodities prices for end
users than in a world in which banks and their nonbank
affiliates are allowed to compete freely with everyone else. I
am confident that empirical evidence exists to support the
finding that prices are lower in competitive markets than in
noncompetitive markets, but it seems unnecessary to require or
spend any significant time searching for empirical evidence to
support the basic proposition that prices are generally lower
in competitive than in uncompetitive markets.
Another consequence of making commodities markets more
competitive is that they will be more liquid and efficient. A
more liquid commodities market means that the spread between
bid and ask prices of a particular commodity will be lower, and
that larger quantities of the commodity can be bought or sold
without affecting the then current market price of the
commodity. Markets are generally considered to be more
efficient the more liquid they are. Indeed, in the most
idealized and efficient market model--the perfectly competitive
market model--perfect liquidity is simply assumed when the
market is in long-term equilibrium--there is no spread between
bid and ask prices and individuals can buy and sell virtually
any quantity without moving market prices. All individual
consumers and producers are assumed to be price takers in such
an idealized market. See, e.g., James R. Kearl, ECONOMICS AND
PUBLIC POLICY: AN ANALYTICAL APPROACH, p. 157 (6th ed. 2011).
Perhaps the actual market that is closest to the perfectly
competitive model is the market for U.S. Treasury securities,
which is considered to be among the most liquid and efficient
markets in the world.
Although the finding about increased liquidity almost
certainly flows from the finding about increased competition in
the commodities markets, it is my understanding that reliable
empirical studies have been conducted to support the finding
that allowing insured banks and their nonbank affiliates to
participate in certain commodities markets will ``provide
increased liquidity to the markets.'' For example, IHS Inc.
included such empirical data with respect to the liquidity of
the markets for energy commodities in its comments on the
proposed regulations implementing the Volcker Rule. See IHS
Inc., Comments on Volcker Rule Regulations Regarding Energy
Commodities (Feb. 2012), available at http://
www.Federalreserve.gov/SECRS/2012/March/20120321/R-1432/R-
1432_021412_105313_542080912901_1.pdf.
It is also a truism that allowing banks and their nonbank
affiliates to compete in the commodities markets will
``increase the diversification of the revenue streams and
exposures of financial institutions,'' compared to the level of
diversification of their revenue streams and exposures based on
their other activities alone. Adding a revenue stream from and
exposures to a new activity that is different from their
existing activities necessarily increases the diversification
of their revenue streams and exposures.
Finally, allowing certain nonbank affiliates (but not
insured banks) to make or take physical delivery or otherwise
own or control physical commodities will allow financial
holding companies to ``act as more effective intermediaries
between producers and endusers.'' While the validity of this
finding may not be as self-evident as some of the other
findings without empirical proof, I understand that allowing
nonbank affiliates to make or take physical delivery, or
otherwise own or control physical commodities, in addition to
trading in commodities derivative contracts, helps to improve
the efficiency of both the derivatives markets and the cash
markets, fostering a greater convergence between the prices in
both markets. Like the convergence between bid and ask prices
in any market, a convergence between prices in the derivatives
and cash markets for a particular commodity generally makes
both markets more efficient and beneficial for both producers
such as small jet fuel refineries and end users such as JetBlue
in my example above. Thus, allowing certain nonbank affiliates
to make or take physical delivery or otherwise own or control
physical commodities, in addition to buying and selling
commodity derivative contracts, helps them to be more effective
intermediaries between producers and endusers. If the
Subcommittee desires more empirical evidence to support this
finding about improved intermediation, it may be worthwhile to
ask the Federal Reserve Board, the General Accounting Office or
a financial industry trade organization to undertake an
empirical study of the evidence supporting this finding.
Rather than focus on whether sufficient empirical evidence
exists to support the considered findings of the OCC and the
Federal Reserve Board, the Subcommittee might consider asking
whether there is any empirical evidence to support any of the
potential adverse effects that were alleged by some of the
other witnesses at the hearing and whether a world in which
banks and their nonbank affiliates are forced to exit the
commodities markets is better than a world in which they are
permitted to compete, subject to appropriate risk-mitigating
limitations and conditions. See, e.g., Gregory Meyer, A ban on
banks holding physical commodities could backfire, FINANCIAL
TIMES (July 26, 2013).
For example, one of the witnesses criticized the U.S.
financial holding companies (``FHCs'') engaged in commodities
activities for their alleged lack of transparency in disclosing
material information about their commodities activities. Set
aside the fact that she was not alleging that the disclosure
was insufficient to satisfy the FHCs' disclosure obligations to
investors as publicly traded companies under the U.S.
securities laws or that her main frustration seemed to be that
the disclosure was not sufficient to satisfy her curiosity as
an academic about their activities. Rather than offer a
surgical solution to this alleged problem, she offered a
blunderbuss approach: just force them to exit the commodities
markets altogether. But this blunderbuss approach would
actually decrease rather than increase the transparency of the
commodities markets if she is right about the players who
otherwise dominate the global commodities markets. Why? Because
she also said that the world's commodities markets, including
the U.S. markets, are otherwise dominated by ultra-secretive,
privately held foreign commodities firms that are even less
transparent about their commodities activities than the
publicly traded and highly regulated U.S. FHCs that were the
main targets of her criticism. Here is what she said in her
written testimony about those otherwise allegedly dominant
players:
A handful of large, mostly Switzerland-based commodities
trading houses--including Glencore, Vitol, Trafigura, Mercuria,
and Gunvor--dominate the global trade in oil and gas, petroleum
products, coal, metals, and other products. Nearly all of these
publicity-shy commodities trading firms are privately owned.
They do not publicly report results of their financial
operations and generally refrain from disclosing information
about the structure or performance of their investments.
Secrecy has always been an important attribute of the
traditional commodities trading business, in which access to
information is vital to commercial success and having
informational advantage often translates into windfall profits.
Written Testimony of Saule T. Omarova, Associate Professor
of Law, University of North Carolina at Chapel Hill, Before the
Senate Committee on Banking, Housing, and Urban Affairs,
Subcommittee on Financial Institutions and Consumer Protection,
p. 12 (July 23, 2013).
If this assertion is true that the world's commodities
markets are otherwise dominated by these ultra-secretive,
privately held commodities firms--and I am not sure it is--then
there is no more sure-fire way to eliminate whatever
transparency exists, and also decrease competition, reduce
liquidity and increase prices in these markets, than by forcing
the publicly traded and highly regulated U.S. FHCs to sell
their commodities businesses, since these ultra-secretive,
privately held foreign players may be the most likely buyers.
Q.2.a. You further state that `` . . . all things being equal,
increased diversification of activities reduces risk, preserves
capital and should help an institution improve its financial
condition over time.'' [Emphasis added]
Are there cases in which a financial holding companies
physical commodity and energy assets could present a risk to
the institutions safety and soundness?
A.2.a. As noted in my written testimony, the Federal Reserve
Board issued a series of complementary powers orders allowing
certain financial holding companies to make or take physical
delivery of, and otherwise control, certain physical or
intangible commodities, subject to certain risk-mitigating
limitations and conditions including a requirement that the
commodities involved are sufficiently fungible and liquid.
While these complementary powers orders allowed them to enter
into certain relationships with commodities storage,
generation, refining, transportation or other related
facilities, they did not permit these FHCs to own or otherwise
control these facilities as a complement to their financial
activities. All FHCs including these FHCs, however, are
generally permitted by Section 4(k)(4)(H) of the Bank Holding
Company Act of 1956 (the ``BHC Act'') to make temporary
``merchant banking'' investments in companies that own or
control such facilities, provided they comply with the
conditions and limitations applicable to such investments.
These conditions and limitations generally include a 10-year
maximum holding period and a prohibition on engaging in the
routine management of these companies, subject to certain
narrow exceptions. See Sections 225.171 and 225.172 of the
Federal Reserve Board's Regulation Y, 12 C.F.R. 225.172,
225.172. FHCs are also permitted to make temporary investments
in companies that own or control such facilities, provided the
companies are ``substantially engaged'' in activities that are
financial in nature or incidental to a financial activity. See
Section 225.85(a)(3) of the Federal Reserve Board's Regulation
Y, 12 C.F.R. 225.85(a)(3).
Congress also permanently grandfathered the commodities
activities of certain companies that became financial holding
companies after 1999, such as Goldman Sachs and Morgan Stanley.
That grandfathering provision is contained in Section 4(o) of
the BHC Act. The grandfathering provision applies to both
owning and controlling physical and intangible commodities, as
well as any commodities storage, generation, refining,
transportation or other related facilities, subject to certain
risk-mitigating limitations and conditions.
See, e.g., Randall D. Guynn, Luigi L. DeGhenghi & Margaret
E. Tahyar, Foreign Banks as U.S. Financial Holding Companies,
in REGULATION OF FOREIGN BANKS & AFFILIATES IN THE UNITED
STATES 11:2[3], 11:4[9], pp. 957-960, 1025-1029 (Randall D.
Guynn, Editor, 7th edition 2013); Gibson Dunn, Federal Reserve
to Re-evaluate the Permissibility of Physical Commodities
Trading: The Rationale Historically and Today (July 22, 2013).
If an FHC fails to comply with the risk-mitigating
limitations and conditions contained in its complementary
powers order or Section 4(o) of the BHC Act, or otherwise fails
to have an effective risk-management program with respect to
its commodities activities, it is possible that its positions
in physical commodity or energy assets could present a risk to
its safety and soundness. I am not aware of any empirical
evidence, however, that shows that the risks of holding
physical commodity or energy assets is inherently greater than
holding unsecured commercial loans or engaging in a variety of
other traditional banking or other financial activities.
Indeed, holding long-term loans (or more recently the sovereign
debt of certain nations) has been the source of more losses and
more bank failures over the centuries than virtually any other
asset or activity.
Moreover, as noted in my written testimony and in my answer
to Question 1 above, allowing banks and their nonbank
affiliates to engage in commodities activities, in addition to
all their other permissible activities, will increase the
diversification of their revenue streams and their exposures to
risk. It has long been well-established that, all things being
equal, increased diversification of investments or activities
reduces risk. See, e.g., Harry M. Markowitz, PORTFOLIO
SELECTION: EFFICIENT DIVERSIFICATION OF INVESTMENTS (Wiley
1959); Paul Samuelson, General Proof that Diversification Pays,
JOURNAL OF FINANCE AND QUANTITATIVE ANALYSIS (Mar. 1967). Such
a reduction in risk should result in lower net losses, as the
losses from one activity are offset by gains in another
activity. See Markowitz and Samuelson. This, in turn, should
help diversified institutions to protect and even improve their
financial condition over time.
Q.2.b. Do you have any concerns about the Federal Reserve's
regulatory capacity, i.e., that bank examiners may be incapable
of effectively monitor these financial conglomerates?
A.2.b. Obviously, it is important for the Federal Reserve Board
to have the capacity to effectively monitor and supervise FHCs
engaged in a diversified range of activities. But the diversity
of those activities is as much a risk-reducing benefit for the
reasons stated in my answers to Question 2.a. above as the
complexity of these institutions may be a challenge to
effective supervision. It may be more useful to ask the Federal
Reserve Board to do a self-assessment of its own capacity to
monitor and supervise diversified financial institutions. That
is likely to be far more useful than any observation I could
make.
Q.2.c. If so, what are your concerns? If you do not have any
concerns, please explain why.
A.2.c. Please see my response to Question 2.b. above.
------
RESPONSE TO WRITTEN QUESTIONS OF CHAIRMAN BROWN FROM JOSHUA
ROSNER
Q.1.a.-b. The ``grandfathering'' provision in the Bank Holding
Company Act was clearly included in the Gramm-Leach-Bliley Act
by interested parties who foresaw that investment banks would
someday want access to the Federal Reserve's discount window
and other facilities. Regulators point out that it is a
statutory exemption, and argue that they cannot prevent
eligible institutions from engaging in many nonfinancial
activities. The language is arguably ambiguous and open to a
narrow interpretation by the Federal Reserve, if it wanted to
do so.
a. LShould the Federal Reserve take a tougher line by
narrowing the scope of nonfinancial activities that
financial holding companies can engage in--both under
section 4(k) and 4(o)?
b. LAs a policy matter, what value does the 4(o) provision
add to enable regulatory safety, soundness and
capacity?
A.1.a.-b. Did not respond by publication deadline.
Q.2. The Federal Reserve has other tools to address
nonfinancial activities that it finds disconcerting or
impermissible. For example, Section 5 of the Bank Holding
Company Act authorizes the Fed to force a bank holding company
to divest a nonbank subsidiary that ``constitutes a serious
risk to the financial safety, soundness or stability'' of any
bank subsidiary.
LShould the Federal Reserve use this section 5
authority to force financial holding companies to
divest themselves of subsidiaries that expose it to
risks--for example, an oil spill or an oil tank
explosion--that are not the typical purview of banking
regulators?
A.2. Did not respond by publication deadline.
Q.3.a.-c. The Federal Reserve order approving Goldman Sachs'
formation into a bank holding company states `` . . . Goldman
expects promptly to file an election to become a financial
holding company pursuant to sections 4(k) and (l) of the BHC
Act and section 225.82 of the Board's Regulation Y. Section 4
of the BHC Act by its terms provides any company that becomes a
bank holding company 2 years to conform its nonbanking
investments and activities to the requirements of section 4 of
the BHC Act, with the possibility of three 1-year extensions.
Goldman must conform to the BHC Act any impermissible
nonfinancial activities it may conduct within the time
requirements of the Act.''
a. LTo the best of your knowledge, has the Federal Reserve
Board developed a list or given any written guidance of
what constitutes as ``impermissible nonfinancial
activities'' at any point during the 2-year conformance
period?
b. LHas the Federal Reserve Board determined any of the
assets held by the two former investment banks, Goldman
Sachs and Morgan Stanley, as ``an impermissible
nonbanking activity'' after they were made into
federally insured FHCs in 2008?
c. LIn essence, is it fair to say the Board legally
transformed the two largest investment banks into
financial holding companies in 2008, and then allowed
them to continue to operate as investment banks by
enabling them to hold and acquire traditionally
impermissible nonbanking commercial and physical
commodities assets?
A.3.a.-c. Did not respond by publication deadline.
Q.4.a.-b. In your testimony you note, `` . . . reflecting on
the Federal Reserve Board's 2005 letter allowing JPMorgan to
hold physical commodities while prohibiting them from storing
those commodities should lead legislators to reconsider the
authorities they have vested in the Fed regarding these
activities. One has to look with concern at the poor job of the
Fed in policing the limitations of their order allowing banks
to enter commodity businesses.''
a. LWhat types of considerations should legislators consider?
b. LDo you believe the Federal Reserve Board has the
appropriate legislative tools to regulate financial
holding companies and determine certain commodity and
energy assets are impressible?
A.4.a.-b. Did not respond by publication deadline.
------
RESPONSE TO WRITTEN QUESTIONS OF CHAIRMAN BROWN FROM TIMOTHY
WEINER
Q.1.a.-d. For the record, please provide the following
information:
a. LAverage LME traded price for aluminum for the following
years: 2009, 2010, 2011, 2012, and 2013;
b. LAverage monthly rental-fee-for metal storage in LME
warehouse for the following years: 2009, 2010, 2011,
2012, and 2013;
c. LAverage total costs for aluminum expenses for the
following years: 2009, 2010, 2011, 2012, and 2013; and
d. LNumber of months to receive the physical delivery of
aluminum from the LME warehouses for the following
years: 2009, 2010, 2011, 2012, and 2013.
Average LME traded price for aluminum from 2009-2013
A.1.a. Table 1 below shows the London Metals Exchange (LME)
price, Midwest Premium (MWP) and all-in Midwest Transaction
Price (MWTP=LME+MWP) for 2009-2013. While the underlying LME
price has changed very little over this period, the MWP has
more than doubled. We trace this increase to the purchase of
key LME warehouses by large financial institutions and LME
rules that allow warehouses to restrict outflow from warehouses
thus allowing them to increase the queues and hold rent-earning
metal longer. As the queues extend, the rent charges increase,
which means the warehouses can fund larger payments to
producers as incentives to direct metal into LME warehouses and
way from the spot market. Aluminum users must pay the MWP on
top of the LME price to obtain metal directly from a producer.
This practice adversely affects the available direct supply of
metal.
TABLE 1: London Metals Exchange (LME) price, Midwest Premium (MWP) and all-in Midwest Transaction Price
(MWTP=LME+MWP) for 2009-2013.
----------------------------------------------------------------------------------------------------------------
Annual Averages 2009 2010 2011 2012 2013
----------------------------------------------------------------------------------------------------------------
LME ($/MT) $1,665 $2,173 $2,398 $2,019 $1,858
MWP ($/MT) $105 $138 $169 $218 $258
MWTP ($/MT) $1,769 $2,311 $2,567 $2,238 $2,116
----------------------------------------------------------------------------------------------------------------
Source: LME, Platts
Average monthly rental-fee-for metal storage in LME warehouse from
2009-2013
A.1.b. Table 2 below shows the daily rents due on metal stored
in LME warehouses. These rents inflate the cost of aluminum as
end users choosing to purchase through the LME systems must
wait a long time to receive metal, and end users who cannot
afford to wait in an LME warehouse queue must pay increased
costs to obtain a direct supply of metal outside the LME. The
inflated rents allow the warehouses to reap a significant
profit on warehouse operations despite incentives paid to
producers to drive metal into those warehouses and royalty
payments made to the LME. The inflated rents increased with the
acquisition of LME warehouse ownership by large financial
institutions. Again, however, aluminum users must match these
inflated prices to get more timely physical delivery of metal.
TABLE 2: LME WAREHOUSE RENTS FOR PRIMARY ALUMINUM
(rates in USD per mton per day*)
------------------------------------------------------------------------
DETROIT (METRO VLISSINGEN (PACORINI
INTERNATIONAL) METALS)
------------------------------------------------------------------------
2009 $0.38 $0.38
2010 $0.40 $0.40
2011 $0.41 $0.45
2012 $0.45 $0.45
2013 $0.48 $0.48
------------------------------------------------------------------------
Source: HARBOR Aluminum
*Applicable from April 1st of specified year, to March 31st of
following year.
Average total costs for aluminum expenses from 2009-2013
A.1.c. We will assume that the question is asking the all-in
cost for aluminum. Aluminum users consider the average total
cost of aluminum to be the all-in Midwest Transaction Price,
which is the London Metals Exchange (LME) price plus the
Midwest Premium (MWP), because that is the price aluminum users
actually have to pay to obtain metal. Aluminum supply contracts
reference the LME price, and whether they buy through the LME
or directly, aluminum users must pay that price plus the MWP to
obtain aluminum. In other words, to obtain any supply, aluminum
users must pay rent to an LME warehouse or match the incentives
offered to producers by LME warehouse owners. Payment of
incentives to producers makes sense in times of undersupply,
but the United States has been in a period of serious over-
supply of aluminum for the entire period. Table 1 above shows
the all-in Midwest Transaction Price (MWTP=LME+MWP) for each
year from 2009-2013.
Number of months to receive the physical delivery of aluminum from the
LME warehouses from 2009-2013
A.1.d. One of the reasons the LME system is not a good option
for aluminum users is that it takes an exceptionally long time
to get physical delivery of metal. Curiously, while demand for
metal is low and inventories in LME warehouses are at an all-
time high, Table 3 below shows that delays in physical delivery
(queues) of metals from two key LME warehouses (Detroit and
Vlissingen) continued to increase between 2009-2013. There is a
correlation between the timing of the delays and the
acquisition of LME warehouse ownership by large financial
institutions. These delays affect pricing for all purchasers
whether they buy metal through the LME or acquire metal
directly by paying the Midwest Premium shown in Table 1.
TABLE 3: MAXIMUM LOAD-OUT QUEUES FROM KEY LME WAREHOUSING LOCATIONS
(calculated at end of period; calendar days)
------------------------------------------------------------------------
DETROIT VLISSINGEN
------------------------------------------------------------------------
2009 44 3
2010 71 1
2011 117 280
2012 490 420
H1 2013 539 564
------------------------------------------------------------------------
Source: HARBOR Aluminum
Q.2. In your written testimony, you stated you met with the
LME, U.S., UK and EU financial and banking regulators. You
indicated both the U.S. and UK regulatory agencies, the
Commodity Futures Trading Commission (CFTC) and Financial
Conduct Authority (FCA), ``indicated they are uncertain whether
they have the regulatory authority necessary.'' For the record,
please provide the following details:
a. LThe dates of each meeting with the LME, CFTC and FCA; and
b. LA description of each meeting's outcomes, including any
justifications or explanations for the state of the
issue.
A.2. Meeting with LME: There was a single October 2012 meeting
with LME CEO Martin Abbott and his deputy Diarmuid O'Hegarty.
Charles Li, CEO, Hong Kong Exchange (HKE) also participated.
The meeting occurred prior to completion of a planned
acquisition of the LME by the HKE. The LME representatives
indicated they did not intend to adjust current LME practices
or make institutional changes. The key takeaways from the
meeting were:
1. LThe LME representatives do not believe the current system
harms metal users because it is possible to acquire
metal. You have to be willing to wait in a long queue
and pay rent or pay a premium to avoid the queue, but
it is not impossible to obtain metal, therefore the
system does not harm metal users.
2. LMetal users could experience supply shortages and
increased costs if they tried to change the warehouse
rules.
3. LThe warehouses claim that while they have no trouble
loading metal into their facilities, they apparently
lack the infrastructure and driver work rules necessary
to load out metal in a timely manner.
4. LDespite establishing the rules for warehouses and
receiving a royalty, the LME claims that it has no
authority over the private warehouse owners.
5. LThe LME representatives see no conflicts of interest in
terms of who runs the Exchange, who owns the
warehouses, and how the warehouses operate.
Meetings with FCA: There was an October 2012 meeting with
representatives of the UK Financial Services Administration
(FSA), which is now the Financial Controls Authority (FCA),
regarding regulatory oversight activities focused on LME
warehouses. The FCA responded that it did not know whether it
had authority over the physical delivery of metal or the LME
warehouse system. More recently, in July 2013, different FCA
representatives said that they expect to find opportunities to
accelerate regulatory oversight activities focused on LME
warehouse changes. These FCA representatives were aware of the
scope of recent regulatory/legislative activities undertaken by
the U.S. Government to investigate the matter and possibly
clarify regulatory jurisdiction.
Meetings with CFTC: There have been several meetings with
CFTC Commissioners and their staffs and representatives of the
CFTC Office of International Affairs, Enforcement Division and
Surveillance Branch, among others, since last year. In December
2012, we understood that the Enforcement Division would look
into the issue of the agency's jurisdictional authority. In
March 2013, we learned that CFTC was not certain as to its
authority over the physical delivery of metal or the warehouse
system of the LME. In June 2013, we learned that there was
strong interest in oversight and enforcement activities. From
published news reports, we understand that the CFTC has opened
an investigation.
Q.3. In your written testimony, you offer recommendations to
improve the LME's business practices and expedite the delivery
of LME warehoused aluminum. These recommendations specifically
requested that the LME amend their rules to allow:
i. LA daily rental to be charged for a limited period
following cancellation of a warrant (i.e., 30-45 days).
ii. LDaily load out rate for each warehouse shed at each
official site, rather than by company at an official
site.
iii. LA daily load-out rate by warehouse shed that would
clear the queue within a reasonable period.
iv. LA review and adjustment of load-out rates more
frequently so that bottlenecks do not persist.
Please describe the LME 's reaction to your proposal and
any explanations the LME provided for ``dismissing'' your
efforts.
A.3. The LME's response was polite, but clearly communicated
that what we were asking was, in their view, not achievable. We
were very clear that similar to other exchanges, we wanted the
LME to be a transparent, open and free centralized place for
price discovery where buyers and sellers can come together for
this price discovery and timely delivery of goods purchased.
Q.4. The LME issued a proposal to decrease existing queues and
prevent new queues from forming on July 1, 2013. The proposal
targets warehouses with queues of more than 100 calendar days,
and would require warehouses to deliver out at least 1,500 tons
per day more than the amount it loads in.
LWhile this proposal is still under consultation,
please explain why this proposal would ``make no real
impact'' as you stated in your testimony?
LWhat consultative input have you provided the LME?
A.4. As you state, this is only a proposal and there is no
guarantee that the LME will make any changes. The proposed
changes, even if adopted, would not go into effect, at the
earliest, until April of 2014 with the market not feeling the
effects until well into 2015 at the earliest. The likelihood of
the warehouse rents increasing is very likely. The proposal
does not address this situation. The warehouses could increase
rents to compensate for revenues lost if the queues are no
longer exaggerated. They could simply charge a higher rent for
a shorter period. Moreover, while the proposal might cause
warehouse owners to cease paying incentives to producers and
traders to bring metal into LME warehouses, they could keep
current queues in place for years by loading out minimums at
the new 1,500MT/day rate, which is half the current rate.
As the LME load out minimums have become the maximums, so
too would the 100-day minimum queues for all warehouses. We
ask, why any queues at all? Why would the LME want to delay
delivery into the hands of owners of property purchased through
their exchange? The rules of other exchanges require reasonable
delivery times, and the LME could do the same.
There is nothing addressing the conflicts of interest of
being a shareholder/member/rulemaker and warehouse owner.
Attached are comments recently sent to the LME regarding
the proposed warehouse rule changes.
Q.5. In your testimony you stated `` . . . several banks and a
few trading companies have cornered the market on aluminum and
other base metal trading . . . These banks are using a Federal
Reserve exemption currently allowed under the Bank Holding
Company Act . . . [and] through their effective control of the
LME, they have created an artificial bottleneck or shortage of
aluminum.'' Furthermore, ``they are distorting access to
aluminum and through their warehousing practices are
artificially impacting the price of aluminum and driving
premiums to historic highs.'' Recent media reports suggest that
Goldman Sachs has explored selling its metals warehousing
business, Metro International Inc. Goldman Sachs has also said
that it will make physical aluminum available for immediate
delivery. Does this outcome solve the artificial shortages in
the aluminum market?
A.5. No, this outcome will not solve the artificial shortages
in the aluminum market. LME warehouse rules have to change
before that can happen. Take, for example, Metro, the warehouse
system in Detroit, owned 100 percent by Goldman Sachs. The
Metro warehouse system has 29 separate warehouse sheds, and 27
of these sheds hold well over 1 million metric tons of
aluminum, close to 25 percent of all the aluminum in the LME
warehouse system and over 70 percent of all the available
aluminum in North America. Goldman may want to sell the
business, but a sale by itself of a business hold over 70
percent of all the available aluminum in North America, does
nothing to address the underlying issues giving rise to that
stockpile and will not alleviate the artificial shortage. Once
you look at it closely, Goldman's offer to deliver metal in the
queue to consumers as a priority over others in the queue is
also meaningless. Goldman knows that no actual consumers have
metal in any Goldman queue, because no actual consumers can
afford to tie up their money for the 18 months it takes to get
metal out of the Goldman queue under ordinary circumstances.
The interesting question to ask is why Goldman extended this
offer only to consumers they knew were not in the queue? They
did not offer to load out aluminum to anyone waiting in the
queue. Is Goldman just going to require everyone else to wait
18 months and charge them rent the whole time? Goldman made a
very specific public offer to release specific metal to
specific people knowing that the offer was no offer at all, and
to avoid the real question--why does 70 percent of all the
available aluminum in North America sit in an 18-month queue
under Goldman's control.
Q.6. What concerns, if any, do you have with Goldman Sachs
plans to exit the aluminum warehousing market?
A.6. The problems could remain if the LME warehouse rules and
the practices of those warehouses remain unchanged. Logical
warehouse rule changes as we have suggested, in line with other
exchanges, are essential prior to any sale of the warehouses by
any U.S. financial institution.
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