Now Wall Street banks yearn to be oil barons

Top US lenders may take up ownership of struggling US shale companies. But at what cost?

A clutch of major US lenders are redefining the term “fossil fuel bank”. Not only are JP Morgan, Bank of America, Citi and Wells Fargo the top providers of funds to the fossil fuel industry, Reuters reports that they could soon set up their own oil and gas companies to manage the assets of borrowers that welch on their loans.

US shale firms were in the hole for billions of dollars before the Saudi-Russia spat pummelled crude prices. If they can’t repay, their bank creditors have the right to seize their assets — including hydrocarbon reserves — as collateral. That’s how secured lending works.

From a contract law perspective, the banks’ actions make sense. But from just about every other angle they seem misguided at best and downright irresponsible at worst.

First, banks aren’t set up to directly manage oil companies. Second, they’re not allowed to. Third, they’re taking ownership of assets loaded with extraordinary risks — not the least being that they may become “stranded” as energy demand falls: in the first instance because of the coronavirus crisis and in the second as the world transitions to a low-carbon economy.

Throw out the rulebook

Financial holding companies (FHCs) are prohibited by the Federal Reserve from “owning, operating or investing in facilities that extract, transport, store, or alter commodities”, barring a handful of cases covered by grandfather clauses. This is in adherence to the long-standing principle that banking and commercial activities should be kept separate.

However, FHCs are allowed to engage in “complementary” activities, such as physical commodities trading, subject to restrictions. For example, the Fed limits the value of assets that an FHC can commit to such activities to 5% of their Tier 1 capital.

The Fed also permits FHCs to hold stakes in nonfinancial companies, like oil firms, under “merchant banking” authority. But such investments can only be held long enough to arrange a sale “on a reasonable basis consistent with the financial viability of the activities”, and a bank cannot “routinely manage or operate” its portfolio companies.

These regulatory hurdles suggest there’s no way the four banks mentioned by Retuers could become de facto oil kingpins overnight. But, as the story explains, they could be granted temporary waivers to hold the shale assets for a short time. It’d be up to the Fed to grant any such relief.

The banks may like their chances. Earlier this month, the Fed temporarily relaxed a key capital requirement of top lenders — the supplementary leverage ratio — a rule that may have interfered with the smooth running of the US Treasury market. In March, the Commodities Futures Trading Commission (CFTC) offered no-action relief to a bank, later identified as Capital One, from swaps regulations they would have had to comply with because of the size of their commodity derivatives exposures.

Why? In the midst of the coronavirus crisis, government agencies are obsessed with keeping the financial system from imploding. Tearing down barriers that frustrate banks from putting capital and liquidity to work sustaining the broader economy has been their method of choice thus far. It’s possible the plight of the US shale industry could be seen as a similar threat to the smooth operation of markets, giving the Fed the necessary space to take action.

On the other hand, the Fed answers to Congress. Allowing big banks to dodge rules and expose themselves to heightened risks at a time of profound economic turmoil would open the agency to political attack. Climate change activists have already unleashed an opening salvo.

Twitter avatar for @moira_kbMoira Birss @moira_kb
Letting some of the biggest Wall St backers of #ClimateChange own oil & gas companies? Climate activists agree: it’s a terrible idea!…

Zachary Warmbrodt @Zachary

The Fed may need to decide soon whether the biggest banks can expand their holdings of physical commodities — in this case oil and gas.

A costly gambit

Put the politics and regulations to one side, though, and the big banks’ bet on oil firms is still freighted with risk.

Owning and operating companies focused on physical resources would make them liable in the event of environmental catastrophe, like an oil spill. The costs of cleaning up after such a disaster could also shake public faith in the parent bank, to the point where it could struggle to fund itself in the wholesale markets.

Then there are the conflict of interest concerns. Banks that deal in commodity derivatives and own the underlying commodities themselves may be able to manipulate markets in their favour. For example, information gleaned from producing and trading crude could allow them to “front run” energy contracts struck with clients and undercut derivatives dealers that do not also own oil companies.

These are all risks the Fed itself outlined in a 2016 proposed rule to further tighten restrictions on banks’ commodities activities — one that never got turned into binding regulation.

However, what should deter the banks from wanting to own oil companies more than anything is the apocalyptic market environment. Oil prices collapsed last month to an 18-year low and West Texas Intermediate crude, the US benchmark, is down 60% year-to-date.

In ordinary times, oil prices are highly volatile. Today, they are berserk. Even a deal reached on April 12 to curb global supply has done little to improve matters, as the coronavirus crisis is expected to lower oil consumption by around 30 million barrels this month alone.

The banks would therefore be taking the keys to oil fields that are losing money hand over fist. To keep them in business, they would need an infusion of equity. This at a time when banks are being urged to retain as much as possible in order to absorb losses and underpin emergency loans to Main Street.

It’s hard to see an upside. Equity ploughed into shaky oil companies would be at high risk of loss, angering shareholders and regulators alike. Perhaps, as Reuters reports, the banks plan to hold the assets just for a short while, until oil markets stabilise — if and when that happens. The bet is they will be paid more to offload the collateral in a calmer future than in the stormy present. But in the meantime, they are opening themselves up to vast environmental, legal, reputational, political and market risks.

The “brown” tax

Still, the banks clearly believe this is their best move right now. What could have dissuaded them? Tougher regulatory capital requirements. The higher the equity “charge” assigned an asset, the higher the returns need to be to make ownership worth it. Make them high enough for an asset, and a bank won’t want it at all.

The Fed floated higher capital requirements for commodities activities in the never-to-be-finalised 2016 proposed rule. Here, it argued that the residual bank-owned commodities businesses held under the watchdog’s grandfathering authority should be subject to a 1,250% risk weight — meaning an FHC would have to effectively hold one dollar of capital in reserve for every dollar the business was worth.

The same punitive charge would also have applied to commodities companies held as “merchant banking” investments, and a 300% charge to pure physical commodities trading activities.

At the time, the Fed estimated these changes would have boosted banks’ capital requirements by an aggregate $4.1 billion. The agency even wrote: “If FHCs consider their physical commodity trading on a standalone basis, the proposed increases in capital requirements could make this activity significantly less attractive based on its return on capital, and could result in decreased activity.”

What’s interesting is how these old capital proposals accord with current efforts by sustainable finance advocates to implement a “brown penalising factor” (BPF) to banks’ fossil fuel assets.

Put simply, the factor would alter the risk-weights applied to carbon-intensive assets, increasing the capital required to be held against them.

Right now, the European Commission is consulting on whether a “brown” taxonomy of activities with negative climate impacts — like oil drilling — should be created, which could theoretically be used as a basis for a BPF.

In the US, Graham Steele, director of the Corporations and Society Initiative at Stanford Business School, says the Fed has the authority to “increase risks weights on the basis of climate risk to reflect the potential for capital intensive losses”.

In effect, the Fed’s physical commodities capital charge would have acted as a targeted BPF — though motivated out of concern for banks’ exposures to environment-related litigation rather than their climate risk.

Regardless, the proposal never became a final rule. Comments were accepted until February 2017 and then … silence. The Fed may have dropped it out of a belief that banks had already evacuated the commodities business:

Today, this looks short-sighted. A higher capital bar may have discouraged banks from becoming so interwoven with the shale industry in the first place, as they would have known that taking ownership of the loan collateral on a borrower’s default would have sapped their equity.

Or perhaps not. Maybe a high capital charge would simply have incentivised fossil fuel banks to squeeze as much from their shale clients as possible, and on taking possession of their collateral, ruthlessly strip out the valuable assets and flip the carcasses as soon as possible, impeding an orderly wind-down of drilling operations. Maybe the banks would have found ways to shift oil assets off-balance sheet, evading the capital charges full stop.

Either way, a punitive capital requirement would certainly have made it harder for banks to dive headfirst into the oil business and also tougher for the Fed to offer generous regulatory roll backs. As it stands, under existing rules lenders may have enough wriggle room to get their way, and regulators too little.

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