Betting the Business

In a previous post, I criticized a report by the consulting firm IHS on the potential impact of the Volcker Rule on the US energy industry.  Kurt Barrow, Vice President of IHS Purvin & Gertz and co-author of that report, has sent me the following reply:

Thank you for your interest in our report.  We wanted to take an opportunity to clarify a few points about our work.

The first point in your Blog refers to “bans banks from proprietary trading” but should instead speak to “restrictions on market makers.”  We have no issue with bans on bank proprietary trading, and the banks have already exited, or are currently exiting this activity, due to the heightened capital adequacy requirements of Basel 2b and Basel 3, which make the ROE of proprietary trading quite poor.  Our study does not address “proprietary trading”, but just the opposite – “market making” is the role that the Volcker Rule Legislation had intended to preserve for the banks (but the Regulation appears less able to do so), due to its importance in serving the energy industry specifically, and for the safety and soundness of our financial markets, more broadly.  Marketing making is the function that creates, in aggregate, a willing counterparty for commercial companies (e.g. airlines, natural gas producers) to lock in commodity prices and hedge their financial risk.  Hedging is the opposite of speculation and is more akin to buying insurance.

Now, regarding non-bank institutions, such as hedge funds, providing market making for commodities risk management and intermediation services, let’s first keep in mind that the intent of the Legislation (“the very purpose of the Rule”) is to avoid creating any “void” in the provision of hedging and market making services in the first place – this is why there are exemptions for these services.  Unfortunately, in commodities markets, these are difficult activities to strictly define since principal trading is required for both proprietary trading and market making.  That we are even talking about a potential void to be filled is a warning sign that the proposed Regulation does not meet the intent of the original Legislation.  And why would our regulators want to push this activity, so vital to our economy and to our energy security, into distant and unregulated reaches of the world?

It was certainly was not obvious to us who the natural players, with the requisite capabilities, could be to adequately fill any void, at least for some period (our modeling period was five years).  This role requires an “A” credit rating or better, in order to be a viable counterparty that most corporations could even consider doing business with, and especially for long-dated contracts.  It also requires a client-facing business model with account executives out calling on American companies to identify their needs and develop client solutions.  It requires a willingness to provide financing, which is often an important component of many structured solutions.  And on occasion, this activity demands someone capable of straddling both the physical and financial markets, in order to efficiently provide an effective client solution.  Again, it was not obvious to us who was a good fit with the requisite positional assets and organizational capabilities for this role.

IHS did not ignore taxpayer subsidies to banks.  FDIC insured customer demand deposits (DDA) is indeed a relatively inexpensive form of funding, but this is not bank capital.  You can think of DDA as a COGS item on your Income Statement, but not something that goes on your Balance Sheet.  Bank capital is largely shareholder equity, though admittedly, banks are also allowed to hold a portion of capital in Tier 2 form, such as long-dated junior subordinated debentures or trust preferreds, which also command some credit from the ratings agencies.  Nor is the presence of DDA an important or even prevalent part of the business model for the principal market makers in commodities risk management and intermediation services (they secure their funding through the wholesale markets).  DDA is more the domain of money center banks, like the large regional and national retail franchises.  But credit risk is very much a part of the business model of market makers, and it is one that garners close scrutiny by the credit committee in extending financing and executing trades with all counterparties.  Now, our study does not address financial institution capital adequacy – this is well outside the scope of the report – but indeed, regardless of how the accounting falls, enhanced capital adequacy guidelines (i.e. Basel 3) goes a long way to improving the safety and soundness of our financial markets.