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On commodity trading, banks should mind their own (risky) business

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The big banks are pushing hard to bring rival commodity trading firms into a regulatory net, but it isn't all working to their advantage. Instead of trying to capture other people's businesses, they should look to their own.

Earlier this month, the Financial Stability Board, the body set up by the G20 to coordinate regulation of global finance, asked its national members whether commodity trading firms should be brought into the fold for their "shadow banking" activities. Financial regulators are scrutinising the big commodity trading houses, such as Cargill, Vitol and Trafigura, over concern that their vast scale and their use of financial derivatives might pose a risk to the financial system.

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The big banks have been forced to scale back their commodity trading businesses as they struggle under the burden of new solvency rules and trading limits imposed by the Dodd Frank legislation in the U.S. . Anxious to prevent trading houses from capturing more of the market, the banks have been lobbying to level the playing field and rein in commodity traders. But the question is whether commodity trading on a large scale does create systemic risk. A lobby organisation representing the big banks, the Global Financial Markets Association (GFMA) hired an academic to answer the question. His answer appears to have been negative – according to the Financial Times, the author, Craig Pirrong, concluded that the nature of commodity trading and the capital structure of the trading firms makes them substantially more robust than the big banks.

The GFMA has decided not to publish the report, but it confirmed that it did not find evidence of systemic risk. This is not surprising given the huge difference between the highly leveraged balance sheet of a bank compared with a commodity trader. Moreover, traders don't take deposits from the public, and the current trend among trading houses is to build up fixed assets – commodity traders are investing in oil production, mining and food processing. Traders are going upstream to expand their businesses, making investments in minerals and metals that are natural hedges and that are likely to reduce rather than increase trading risk. The banking collapse of 2008 occurred amid a massive increase in leverage; banks had expanded horizontally, capturing more risk assets.

The question banks should ask is why they want to take positions in physical commodity markets rather than just provide trade finance. It is not clear that investors in bank shares want their capital to be put at the disposal of bankers for them to make bets on wheat and oil prices, especially when those bets are without risk to the bankers' own pockets. This is a distraction from their core business of lending, which itself is coming under pressure from rivals. Peer-to-peer lenders, once regarded as eccentric and marginal, are beginning to take small chunks out of the conventional lending market. In Britain, these intermediaries – which simply match borrowers with a crowd of individual lenders via the internet – are about to reach a volume of £500-million ($775-million) in loans. Google has just bought a stake in a lending club. Bankers should be very afraid.

Carl Mortished is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here for more of his Insights.

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