Commodities

Megabanks and commodities don't mix

July 31, 2013: 11:52 AM ET

Opening up commodities markets to megabanks has failed. It's time to break up the banks' business lines.

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J.P. Morgan's head of global commodities Blythe Masters

FORTUNE -- The Federal Reserve has blood on its hands from the most recent financial crisis. In the 1990s, Alan Greenspan and Fed researchers helped promote the explosive use of securitizations and credit derivatives as risk management tools for financial firms. A May 1996 speech exemplifies Greenspan's failure to grasp not only how these approaches would influence bankers' behaviors but also what the economics and risks would be, calling securitization "a paradigm of the evolving risk management techniques in financial markets."

It now feels like déjà vu all over again. Greenspan and Ben Bernanke's 2003 experiment into expanding megabanks' operations in commodities markets has failed, amid allegations of manipulation of the oil, electricity, silver, gold, copper, and aluminum markets. And it's probably worth considering that some of the same masters of the universe who pushed derivatives -- including J.P. Morgan's (JPM) Blythe Masters – have been part of the battle to see just how far we'll let the too big to jail banks control the prices of commodities we depend on. As Masters said in a CNBC interview, the "influence [of commodities] on growth, on economies, on disposable income is something we all individually feel every day. And of course corporations and governments feel it too."

It's a good thing Senator Sherrod Brown organized a hearing last week and the Fed and CFTC are looking into the bank and commodities issues. Before Bernanke leaves his role as chairman of the Federal Reserve (and hopefully, his best replacement Janet Yellen ascends at the Fed), I hope he'll reverse his 2003 vote of confidence.

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Dealing with bankers' commodities activities drains time and energy away from economic repair. And it distracts banks from making money and growing the economy the old-fashioned way, by making long-term loans they can understand and nurture.

To be sure, we've seen this movie before: What is new, sexy, and shallow is often preferred to the daily grind. At the end of the 1990s, I remember  watching a sea of young "quant" guys (and yes, it was almost all male) at a risk conference at the top of New York City's World Trade Center, riveted as they soaked up the investment banking salesmanship on display. They were mesmerized by the idea of putting their businesses on steroids (or cocaine, depending on what analogy suits you) by indulging in the new risk toys for sale. But actually improving their banks' operations and oversight (the topic of my speech)? Not so sexy.

For those selling risky instruments, it was like feeding candy to a baby. These quants weren't sophisticated enough to evaluate what the investment bankers were selling. (Some investment bankers did not understand it either.) And a decade later – well, we all know how that worked out.

Now, the same banks that pushed derivatives have had a decade run at the physical commodities markets and have not demonstrated the stewardship required to deserve the franchise. On July 16, the Federal Energy Regulatory Commission (FERC) ordered Barclays (BCS) to pay $453 million based on allegations that they manipulated the power market in the western U.S.  Earlier this week, FERC settled with J.P. Morgan for $410 million related to "allegations of market manipulation stemming from the company's bidding activities in electricity markets in California and the Midwest from September 2010 through November 2012." J.P. Morgan Ventures Energy Corporation "admits the facts set forth in the agreement, but neither admits nor denies the violations," according to the FERC news release. California representative Henry Waxman issued a statement calling J.P. Morgan's behavior "brazen, Enron-style market manipulation" which "cost California ratepayers" millions.

Commodities should be off limits to megabanks. The banks don't have a great track record of putting their customers' and society's needs before their own.

Nor have the megabanks been transparent or forthcoming about their activities. Last year, FERC voted to suspend J.P. Morgan's "electric market-based rate authority" because "the company made factual misrepresentations and omitted material information," according to a FERC statement. On Friday, J.P. Morgan issued a statement that it was considering "strategic alternatives for its physical commodities business." But like any statement of this kind, this could be a bluff, like when HP announced that it was considering a PC spinoff or when audit firms announced that they were exiting the consulting business. In other words, the truth can only be determined several years out. J.P. Morgan did not respond to calls for comment for this article.

Last week, Goldman Sachs (GS) issued a statement in response to concerns about its involvement with the warehousing of aluminum stating that "it is the owners of the metal who direct warehouse operators to dispose of stored metal or transport metal from LME-approved [London Metals Exchange] warehouses to warehouses outside the LME system to meet their own needs or objectives." Those owners, however, are often Goldman or commodities traders.

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And non-bank corporate peer pressure is not going to change megabank behavior. "Brewers and beer importers have been paying tens of millions of dollars in higher prices," the Beer Institute wrote me in an email, advocating changes at the London Metal Exchange. But the brewery industry has been a beacon in speaking out, while members of the auto, soft drink, and insurance industries have kept mum.

The decisions by banking regulators to allow bank mergers through the 1980s and beyond has created the behemoths we have today. These banks have become so complex they can't even manage themselves. And as J.P. Morgan showed last year, supposed hedges in the banking world can quickly morph into London Whales.

Rather than limit banks' geographic reach as we did 50 years ago, we need common sense ways to break up banks' business lines. By limiting the scope of a financial institution, we can enhance transparency and enable investors, regulators, depositors, and other stakeholders to judge their health and fraud risks. Why not break out commodities now?

Eleanor Bloxham is CEO of The Value Alliance and Corporate Governance Alliance (http://thevaluealliance.com), a board education and advisory firm.

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