Capital Surcharges On Bank Commodity Operations: Good In Theory, But Potentially Bad In Application

Includes: KBE
by: Craig Pirrong

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

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

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

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

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

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

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