Banks – the regulations that govern them – and what happens when they are not governed.

In addition to my Facebook posting previously on the issues that have been faced in the aluminum markets, banks are generally now increasingly involved in a number of markets from energy to aluminum.

I was reading an excellent article in Bloomberg which very neatly explained the connections. Banks are now subsidized by the government. The Federal Deposit Insurance Corporation and the Federal Reserve (both backed by the taxpayers) provide a subsidy to banks – allowing them to draw on reserves during times of market instability.

 

This means that the banks which are too big to fail (and can cause catastrophic consequences should they go under) are effectively allowed to borrow at low or cheap rates.

 

What this means is that banks who can borrow at a lower rate than most other corporations, start investing in markets such as energy or the metal markets such as the aluminum markets, create stockpiles and cut supply which in turn creates a higher price from which they benefit from when they then sell the commodities in the open market.

In the event they bet wrongly, and the prices of the commodities they are stockpiling drop and lead to financial distress at the banks, then the government (and taxpayers) are obliged to provide emerging funding reserves to tide them through.

This creates similar risk-incentive situations which caused the 2008 financial crisis in the first place.

It will be also useful to learn about some of the existing regulations which are in place or which have been lifted but which may need to be considered to prevent the type of problems we had/have now.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Link: in full here) –

This is an act that has polarised America with one faction arguing that the Act does little to prevent another financial crisis or stop risky behaviour that will lead to another bailout whilst another faction argued that it was too restrictive and draconian.

The volcker Rule – Within this Act, under the section of “Improvement to Regulation” is the Volcker Rule – which essentially restricts US banks from making a number of speculative investments that do not benefit their customers and only seeks to boost the banks and bonus payouts of senior management at the banks.

With the aim of reducing the amount of speculative investments on large firms’ balance sheets, it limits banking entities to owning no more in a hedge fund or private equity fund than 3% of the total ownership interest.The total of all of the banking entity’s interests in hedge funds or private equity funds cannot exceed 3% of the Tier 1 capital of the banking entity. Furthermore no bank that has a direct or indirect relationship with a hedge fund or private equity fund, “may enter into a transaction with the fund, or with any other hedge fund or private equity fund that is controlled by such fund” without disclosing the full extent of the relationship to the regulating entity, and assuring that there are no conflict of interest

 

Glass-Steagall Act (Link to Act here)

This was an Act that was around from the time of the Great Depression in the 1930s until the Clinton Administration repealed it at the turn of the century.

Established as a part of President Franklin D. Roosevelt’s New Deal following the Great Depression, the Glass-Steagall Act actually refers to a handful of provisions sponsored by Sen. Carter Glass and Rep. Henry B. Steagall, which were a part of the larger Banking Act of 1933.

These provisions accomplished a number of things, but most notably prohibited commercial banks from participating in investment banking; this includes activities such as underwriting securities (except for certain treasuries), providing services by brokers or dealers in transactions in the secondary market, as well as facilitating mergers, acquisitions and other forms of restructuring. Investment banks were likewise prohibited from accepting deposits.

The ending of Glass-Steagall removed the distinction between investment banks and commercial banks, leading to a scenario where banks started making risky investments with government-guaranteed deposits.

However, in the last few months, a bipartisan group of senators put forward a proposal for new Glass-Steagall legislation that would restore a strict separation between commercial banks and speculative trading. It is argued that this will inhibit the excessively risky behaviours demonstrated by a number of banks and help prevent the next financial catastrophe.