The FSB is contemplating designating commodity trading firms like Cargill and Glencore (OTCPK:GLCNF) as systemically important. No, not that FSB: The Financial Stability Board, a group of global regulators established in the wake of the financial crisis.
The reason for this is, apparently, that these firms are engaged in shadow banking. The linked Reuters story mentions two types of activity.
First, commodity trading firms extend trade credit and working capital to their customers. Second, some use securitization to raise funding.
The FSB is rightly concerned about shadow banking, but the kinds of activities that commodity trading firms engage in is quite different from some of the activities implicated in the crisis.
Some forms of securitization contributed significantly to the crisis. Most of the most dangerous forms involved significant maturity transformation, and direct ties to big banks. Structured Investment Vehicles (SIVs) that funded portfolios of mortgage securities with short-maturity corporate paper, that were backed by liquidity puts provided by sponsoring banks are the prime example of this. When investors began to doubt the value of the underlying assets, there were runs on the SIVs: they could not rollover their paper, and sponsoring banks ended up taking the now toxic assets back onto their balance sheets. This was a big problem because the banks were highly leveraged; their main business is to provide credit; and they are essential components of the payment system.
The securitizations that commodity trading firms have engaged in, like the Trafigura program mentioned in the Reuters piece, are (a) far more limited, and (b) very different. In particular, these structures do not involve the kind of maturity mismatch that was the Achilles heel of the SIVs. Indeed, if anything, to the extent there is maturity transformation it is the opposite of the type that proved problematic in the crisis. The underlying assets are very short dated (such as receivables) and/or very liquid (like inventories of aluminum in LME warehouses). The assets typically have shorter maturities than the liabilities issued to fund them. Indeed, one of the challenges of these structures is to replenish the assets as they mature. Traditional SIVs had to rollover their liabilities: commodity trade securitizations have to replenish their assets. The former is far more problematic than the latter because the run risk is far greater.
Moreover, historically the default rates on the trade receivables that are securitized are very, very small. The extent data are for all trade receivables, not just commodity trade receivables, but the credit losses are trivial.
I also find little reason to be unduly concerned over the the granting of trade credit and extension of working capital funding through prepayments and other arrangements. Consider prepays, where a trading firm may provide funding to a refiner, say. The commodity trader may fund the input (crude oil), and in exchange receive refined products. The refined product is essentially collateral for the financing provided to buy the input. Moreover, the value of this collateral can be hedged in most cases, limiting the credit exposure of the commodity firm extending the credit. This is often quite different than extending credit to fund illiquid, hard to value, long maturity assets that cannot be hedged.
The commodity trading firm has a comparative advantage in marketing the output. Moreover, due to its knowledge of the industry and the particular firms involved, it likely has information that makes it the most efficient creditor. It knows more about the market and the particular borrowers than most banks.
The foregoing suggests that the credit risk and maturity transformation risk involved in commodity trading firm shadow banking activities is far less than that involved in the kinds of shadow banking that proved highly problematic during the crisis. But credit losses are conceivable. What would happen if commodity trading firms suffered big credit losses?
It’s hard to see how this could seriously threaten the stability of the financial system or the global economy. Commodity trading firms aren’t that big: if Glencore is too big to fail, so is Kraft (NASDAQ:KRFT), or a similarly sized company. Their assets are dwarfed by those of the big SIFI banks: they are about as big as many middling banks you’ve probably never heard of. Moreover, the commodity trading firms are far less leveraged than big banks. Furthermore, their capital structures are far less fragile, because they involve little maturity transformation: their short term liabilities are largely matched against short term assets, such as hedged commodity inventories. The firms provide financial intermediation, but unlike banks, that’s not their primary function, so they are not as vital to the credit supply process as banks. They are not essential elements in the payments infrastructure.
Commodity firms provide valuable logistical services, but the assets, human and physical, that they utilize are readily redeployed. If one company goes bust, its assets can be redeployed so that the trade in commodities can continue.
Some of the shadow banking activities that commodity firms engage in actually take risk out of the banking system. A major reason for the development of securitization in commodity markets was that big banks-especially French banks facing difficulties in securing dollar funding-cut their funding to commodity firms. So the firms turned to securitization and thereby transferred the risk to the capital markets. And unlike the case with SIVs sponsored by banks, there isn’t a backdoor by which this risk can make its way back to bank balance sheets.
I would also note that commodity trading firms do not benefit from deposit insurance, and so don’t pose the same moral hazard concerns as banks that do.
So I find few parallels between the kinds of shadow banking that proved so dangerous during the crisis, and the kinds of shadow banking that commodity firms engage in.
Commodity firms are first and foremost logistics specialists that engage in financing transactions to facilitate that business. A couple of other historical experiences suggest that such logistical intermediaries are not systemically important.
In 2002, the entire merchant energy sector in the U.S. imploded. These firms-companies like Enron, Dynegy, Mirant, and Williams-were primarily logistical intermediaries that provided financing and risk management services to their clients, just as global commodity trading firms do. Not just one of these firms imploded. The whole industry did: the stock prices of the firms in this business fell by about 90 percent between April and July of 2002. But gas and power continued to flow. The impact on the U.S. economy was barely measurable.
Furthermore, the experience of the Fukishima earthquake and tsunami suggests that even if the failure of one or more major commodity firms did disrupt commodity logistics for a time, the implications of this for the global economy would likely be small. The earthquake and tsunami created huge disruptions in supply chains, especially in automobiles and electronics. Trade was severely disrupted. But the impact on the global economy was almost immeasurably small. Studies undertaken by several governments found that the Japanese disaster shaved a tenth of a point or two off global GDP growth. The financial aftershocks were minimal, even in Japan. If the world economy can survive such a literal seismic shock that seriously disrupted supply chains in high valued manufacturing, it can almost certainly survive the failure of a big commodity trader. Or two. Or three. Especially since the Fukishima disaster destroyed or disrupted physical assets in a way that the financial distress of a commodity firm with redeployable assets would not.
I’d be more persuaded by the FSB’s concerns if it would provide a description of the mechanism by which commodity trading firms can be the source of financial contagion, or the channel through which contagion can be communicated from the financial sector to the real economy. As those who have read my writings on clearing can attest, I can have a pretty vivid imagination about how contagion can propagate, and despite giving this considerable thought, I haven’t found a plausible mechanism.
In some sense, it seems that the FSB is like Mark Twain’s cat that wouldn’t sit on a hot stove after it had been burned, but it wouldn’t sit on a cold one either. Once burned by shadow banking of one kind (the kind tightly tied into the banking system), it seems afraid of any kind of shadow banking.
And I have a pretty good idea who is stoking those fears. I know, as the result of personal experience, that major banks involved in commodity markets are chafing under the restrictions imposed on them, and resent the fact that commodity firms that are their competitors in certain activities are not subject to the same restrictions. I know they have been importuning the FSB to identify commodity trading firms as systemically important, and to impose bank-like disclosure and capital requirements on them. All the better to hamstring the competition.
How I know this, I can’t say. But I’m just sayin’. You can take it to the bank, as it were.
Too big to fail is a self-fulfilling phenomenon, in large part. It would be far less of a problem if governments could credibly commit not to bail out certain firms. It becomes much harder to make such credible commitments when those firms are identified as systemically important. Therefore, regulators should be very reluctant to confer the “systemically important” label. Very reluctant. Objectively, there are few reasons to consider big commodity trading firms-even the biggest ones-systemically important. All the more reason to eschew conferring that designation on them.
In other words, sitting on a cold stove isn’t dangerous. The FSB should be smarter than the cat in Puddin’ Head Wilson.