Why Are Banks Selling Aluminium Anyway?
Comment of the Day

July 30 2013

Commentary by David Fuller

Why Are Banks Selling Aluminium Anyway?

Here is the opening from an informative editorial by Bloomberg
The largest U.S. banks are accused of causing problems in markets ranging from energy to aluminum. Regardless of whether they're guilty of market-rigging, as critics say, the charges raise another question: Why are the banks active in these businesses in the first place?

Part of the answer is a point we've stressed before: They're among the country's most subsidized enterprises. The Federal Deposit Insurance Corp. and the Federal Reserve, both backed by taxpayers, provide an explicit subsidy by ensuring that banks can borrow money in times of market turmoil. Banks that are big and connected enough to bring down the economy enjoy an added implicit subsidy: Creditors will lend to them at low rates on the assumption that the government won't let them fail.

The subsidies arose because banks perform a special public service. The lending they do and the payments they process are crucial to the functioning of the economy. Problem is, access to cheap, subsidized financing gives banks a big advantage if they move into markets beyond their core business. That's great for the banks, but it distorts the competitive landscape.

Consider the recent mini-scandal in the aluminum market. Taxpayer subsidies gave the banks an edge in holding the metal. Subsidized financing -- made particularly cheap by the Fed's efforts to stimulate the economy with near-zero interest rates -- encouraged banks and their clients to build bigger stockpiles than they otherwise would have, tying up supplies. If the bets were to go wrong and lead to distress at a big bank, the Fed would have to provide emergency financing for an activity that taxpayers never intended to support.

Commodities are just one area in which the largest U.S. banks have sought to expand at taxpayer expense. Aside from trading and issuing securities and derivatives, they have gotten into water utilities, electricity generation, natural-gas distribution and even the operation ofChicago's parking meters. The full extent of the sprawl is hard to assess due to a lack of public disclosure.

There's no good economic reason for banks to be in such businesses. All they bring to the table is their privileged access to cheap financing. The solution is twofold: Reduce the subsidies and confine them as much as possible to the lending and payments businesses that legitimately require taxpayer backing.

In principle, much can be achieved within the framework of existing legislation. Regulators can reduce the implicit subsidy by requiring banks to fund themselves with more loss-absorbing equity, thus making them less likely to require government bailouts. The so-called Volcker rule, mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, can limit banks' ability to use the remaining explicit subsidies for speculative trading. The Fed also has great leeway in deciding what activities it considers complementary to, or naturally flowing from, the core business of banking.

David Fuller's view In the realm of unintended consequences, there are considerable risks if behemoth banks are speculating in commodity futures, including inviting institutional clients to participate in tracker funds. This can quickly destabilise the thinly traded commodity futures markets, as we last saw with serious consequences in 2008. I have long maintained that the surge in commodity prices, not least crude oil, was a bigger factor in the severe recession which followed than most people realised.

Here is one short paragraph from a longer discussion of this problem from my lead article comments on Tuesday 8th July 2008:

"Thereafter it should be a matter of common sense. After all, if energy and food prices continued to spiral higher with the help of tracker funds over the next few months, the gains in those investments would soon be more than offset by the deflationary impact of a severe global recession on most of one's non commodity assets. In other words, it would be a Pyrrhic victory."

A week later I was queried on this point in an interesting email which remains relevant to today's discussion: "On investments in commodity futures".

Today, we are much closer to legislation which would restrict banks from speculating / investing in commodity markets, as you will see near the end of today's leader article posted above.

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