Banks play an important business role in the physical commodities sector by providing the much needed access to capital and related risk management, including through:

• extension of credit;
• project finance;
• market making and liquidity;
• risk management and hedging; and
• fostering competition.

These services are especially important to small and medium-sized companies that do not have the in-house cash flows, expertise or risk management capabilities of their larger competitors.

However, banks operate under a complex and more rigorous regulatory framework than companies that extract and refine natural resources and distribute energy. In the US, banks and financial holding companies (“FHCs”) are subject to oversight by: a) the Board of Governors of Federal Reserve System (the “Federal Reserve”); b) the Securities and Exchange Commission; c) the Commodities Futures Trading Commission; and d) most importantly, the “Court of Public Opinion”. The legal authority for banks and FHCs to engage in physical commodities activities that are “complementary to a financial activity” is derived from the Gramm-Leach-Bliley Act of 1999, which amended the U.S. Bank Holding Company Act of 1956 to expand the permissible business activities of FHCs.

Critics claim that physical commodities activities by FHCs pose a risk to the safety and soundness of depository institutions or the financial system generally. Recent catastrophic events have increased concerns on the ability of banks to shoulder the high costs and liabilities that result from major energy disasters such as Deepwater Horizon and the San Bruno, California pipeline explosion.

On January 14, 2014, the Federal Reserve issued an Advanced Notice of Public Rulemaking (“ANPR”) that it would review the “nature of risks that physical commodities activities could pose to the safety and soundness” of FHCs and to financial stability more broadly; the “potential conflicts of interest and other adverse effects of engagement” by FHCs in physical commodities activities and the “potential risks and benefits of imposing additional capital requirements or other restrictions on the commodity activities” of FHCs.

In response, the Federal Reserve received more than 17,000 letters on this proposal, some of which can be accessed at federalreserve.gov. While the Federal Reserve has still not decided what form of rulemaking action to take, based on its ANPR, it could impose additional restrictions including through:

• reductions in the maximum amount of assets or revenue for commodities activities; and
• increased capital or insurance requirements.

The Federal Reserve is however going ahead with other regulations that could drastically impact the role of banks and FHCs in the physical commodities sector. On September 3, the Federal Reserve announced that it has finalized its Liquidity Coverage Ratio rule, which creates a standardized minimum liquidity requirement for large and internationally active banking organizations. It has also announced a proposed rulemaking on margin requirements on non-cleared swaps.

As scrutiny over banks and FHCs increases throughout the globe, and the margin for profit becomes slimmer, the physical commodities market for banks is shrinking – reportedly to about US $ 4 billion from as high as US $12 billion at the end of the last decade.

Bank exits have dominated headlines in the last couple of years, with JP Morgan, Deutsche Bank, Barclays, Bank of America Merrill Lynch and Morgan Stanley either reducing or closing their European power and gas trading units.

Several problems arise as banks and FHCs are exiting the energy sector. A report by IHS Inc. commissioned by the Securities Industry and Financial Markets Association warns that curtailing banks’ involvement in commodity markets “would impair liquidity, increase risk for market participants, reduce energy investment, and make disruptions more likely”:

• banks would be faced with the dilemma to either exit the business of providing financial risk management services, or materially increase the cost of providing these services;
• the banks’ ability to provide this service requires physical participation in the marketplace day-to-day in order to provide the information necessary to make competitive price assessments;
• bank exits would lead to a decrease in number of entities willing to quote forward prices and hedge for producers and consumers; and
• with less liquidity and fewer participants, hedging costs will go up.

Most importantly, the question arises as to who will fill the gap that banks and FHCs are leaving behind as they exit the sector. The Financial Times and Wall Street Journal report that there will be an increasing role of utilities, investment funds, and gas and power trading companies in the energy sector. Along with utilities, commodity merchants such as Vitol, Glencore Xstrata and Mercuria are stepping up their activity.

Not all news for banks and FHC’s is gloomy, however, as BNP Paribas recently announced that it intends to rebuild its North American physical electricity trading practice. This could potentially signal that some needed liquidity could be coming back to that market.