Back in July, we delved into a game that Goldman Sachs has been playing with aluminum markets: It warehouses metal and drives up the price, filtering down into the cost of your Coke. But that was just a small window into a lucrative side business that investment banks have taken up over the past few years, trading in all sorts commodities like oil, natural gas, and petrochemicals. Last fall, for example, JPMorgan got permission to trade shares in warehoused copper, which copper users worry will interfere with supply.

The Federal Reserve Board of Governors could stop the multibillion-dollar party as soon as early October, though, and banks are going to the mat to prevent that from happening.

The door between banking and physical commerce opened back in 2003, when the Securities and Exchange Commission granted Citigroup permission to buy commodities trader Phibro, determining that it was "complimentary" to the bank's financial activities. Not to be shut out, foreign banks like the Royal Bank of Scotland followed, as well as Goldman Sachs and JPMorgan (which gained assets such as power plants and warehouses through its purchase of Bear Stearns).

The Fed has been reviewing that state of affairs since last year. And the users of commodities -- such as beer distributor MillerCoors -- have been lining up against it, with the Senate Banking committee holding a finger-wagging hearing on this subject this summer. The case against bank ownership of physical infrastructure, as outlined by Graham Fisher and Co.'s Josh Rosner, goes like this:

  • Serving both investors and the suppliers and buyers of commodities creates conflicts of interest and sources of insider information that can be difficult for a bank holding company to navigate.
  • Banks are already huge enough, and granting them market power in different sectors will allow them to distort competition -- like what happened with Goldman Sachs' aluminum shuffle.
  • A catastrophic event in a physical industry, like an oil spill -- or a London Whale -- could ripple through a big banks' other lines of business in a way that could potentially destabilize parts of the economy they support.

In advance of the Fed's decision, the banks are fighting back. The Securities Industry and Financial Markets Association, which represents pretty much all of Wall Street, commissioned a paper from consultant IHS on how important banks are to the commodities sector. The report was overseen by energy scholar Daniel Yergin and prefaced with a note saying it represented only the opinions of the authors. But it does say exactly what the banks want the Fed, Congress and the public to hear:

Does this convince you that banks are super-essential? (IHS)
  • Industry participants that use commodities, like airlines and jet fuel or agribusinesses and fertilizer, need to hedge their risk against price volatility. Banks that own pieces of the delivery pipeline and are able to order up any given resource can help their clients avoid disruptive spikes.
  • Banks can bridge physical geographies, allowing them to efficiently allocate commodities. "For example, one bank has electricity transmission capabilities between the Midwest and Georgia, which it can use to 'wheel' or move power from an oversupplied and lower-priced area in the Midwest to an undersupplied, higher-priced location in Georgia," the report reads.
  • Being immersed in a physical market allows banks to bring buyers and sellers with different time horizons and incentives together with customized trades, rather than standard futures.
  • Banks are uniquely positioned to help finance infrastructure projects, like wind farms, when they're able to take "non-standard" collateral for loans.
  • Since banks are heavily regulated, their integration in these markets offers stability, accountability, and transparency. And it's better to have them serving in this role than some shady foreign entity.

Still, is bank participation in commodities markets necessary to achieve all these good things? The market did function before they got into the game, after all.

Saule Omarova, a professor at the University of North Carolina-Chapel Hill, has described in detail how the system has gotten out of whack. And the SIFMA/IHS paper didn't convince her otherwise.

"In the commodities market, it is probably true that you need something like that to do some things more efficiently," she said, noting that very large banks can provide cheaper credit to their best clients. "The thing about banks is that they are the only animals in the free market economy whose debts are explicitly guaranteed by the government. What they're telling us is, they decide to take that risk, and that means we decide to take that risk."

Who else would play the beneficial roles that banks say they do, without the downsides? The other option is giant commodities houses like Cargill and Glencore getting into the finance business, which they've been doing with about as much zeal. As the New America Foundation's Lina Khan has outlined, that's problematic too, because they're perhaps even less transparent than Goldman Sachs and the rest. (At the same time, when banks tried to disparage commodities houses, the report they commissioned to do so found they actually pose less systemic risk).

What should the Fed do? Are there options in between letting the status quo stand and making the banks go back to their pre-2003 existence? Simply regulating banks' physical businesses like their mortgage or consumer credit divisions wouldn't be easy.

"When we step outside the traditional banking area, even within finance, regulators struggle," Omarova says. "I don't think it's possible to regulate banks as commodities traders using the same regulatory structure that we have today."