Large financial institutions are struggling to grow revenue, due largely to the difficult interest rate environment and slowing mortgage activity, and it's about to get worse.
The Fed may soon attempt to restrict lucrative commodity trading activities. Worried that the careless trading of physical commodities like crude oil, electricity, and copper could both imperil the stability of the financial system and punch a hole in an institution's balance sheet, the Fed recently published its concerns and are indicated further action is on the horizon.
The impact of the regulatory threats
While any potential regulation that attempts to restrict commodity trading could take years to enact, many banks are already shedding their commodity businesses. In March, JPMorgan Chase (NYSE:JPM) sold its raw materials trading unit to Mercuria Energy Group, while Morgan Stanley (NYSE:MS) has made plans to sell its oil business. Barclays is exiting its commodities business altogether with the exception of certain precious metals and U.S. gas holdings.
These pre-emptive actions, combined with lower trading volumes due to the recent stability in the commodity markets, have driven commodity trading revenue down at the ten largest banks from $14 billion in 2008 to $4.5 billion in 2013.
However, commodity trading is notoriously volatile. Additionally, the impacts that the recent conflict in Ukraine and slowdown of the Chinese economy could have on prices, still have banks interested in the business despite the threat of Fed regulation.
Goldman is standing its ground
Contrary to its largest competitors, Goldman Sachs (NYSE:GS) has thus far elected to keep its commodity trading desk open for business. This is undoubtedly due, in part, to a grandfather provision included in a 1999 banking law that limits the Fed's ability to restrict the activities of Goldman and rival Morgan Stanley.
Goldman's resistance to give up its commodity business is also based on its legacy, as the bank entered the business in 1981, at least a decade ahead of most of its competitors. Moreover, Goldman's current President, CEO, and CFO all began their respective careers trading commodities.
Perhaps most important of all, Goldman appears to be more dependent on commodity trading to drive revenue than its competitors. While it does not disclose the exact revenue figure tied to its commodity business, Goldman generated approximately $2 billion, or roughly 21% of net revenue, from its fixed income, currency, and commodity trading activities in the first quarter of 2014. This compares to 10% and 8% of JPMorgan and Bank of America's first quarter net revenue, respectively.
Gearing up for a fight
Goldman Sachs has also made it clear that it does not intend to accept any new Fed regulation without a fight. Goldman, along with six major financial industry groups and four leading US law firms, recently drafted a 54 page memo arguing that existing statutes, case law, and risk management practices protect regulated banks from any catastrophic fallouts that may result from the trading of physical commodities.
Goldman Sachs, as well as other commodity trading banks, have also received support from big corporations like UPS, Boeing, and Alon USA Energy, who have appealed to the Fed on their behalf. According to these companies, banks like Goldman Sachs provide liquidity to the commodities markets while keeping hedging costs low.
Ironically, these companies also believe that Goldman and the regulated banks pose less of a credit and counterparty risk than unregulated commodity trading houses.
What does this mean for investors?
For investors, the impacts of Goldman's looming stand-off with the Fed are two-fold.
On a short-term basis, with the exit of many of its major competitors from the business, Goldman has seemingly captured a sizable piece of the commodity trading market. While this fact alone may mean little given the relative stability of the commodities markets in 2013 and early 2014, future volatility, whether due to bad weather, international conflicts, or any number of variables, may prove to be a windfall for Goldman Sachs and its investors.
On a longer horizon, investors should tread more carefully. The Fed seems determined, backed by vocal supporters including senior Senators and members of the Commodity Futures Trading Commission, to close down physical commodity trading at regulated financial institutions. Any progress toward this end will surely spook investors, and prevent Goldman investors from capitalizing on trading gains.
Additionally, as Goldman and many of its competitors have learned, it is never to an institution and its investors' interest to be the center of the Fed's attention. In addition to negative publicity and the tarnishing of its brand, costly sacrifices to be sure, Goldman Sachs could also find itself facing steep legal fees and fines for non-compliance. Investors need to monitor the regulatory landscape continuously if they want to take a long-term position in Goldman.
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Erik Knight has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Goldman Sachs. The Motley Fool owns shares of Bank of America and JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.