Here's Proof a New Glass-Steagall Act Could Rein in the Big Banks

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The Too-Big-to-Fail banks have a notorious track record of avoiding, evading or eliminating nearly all of Washington's attempts to bring them to heel.

So skeptics can be forgiven for thinking that the recently proposed new Glass-Steagall Act won't change anything on Wall Street.

As the moniker "Too-Big-to Fail" implies, such banks are not easy to push around.

"No bank will ever get out of a profitable line of business, unless they're forced to, or there's a huge loss that threatens the perception of the banks' risk management, or some scandal forces a mea culpa and an exit," said Money Morning Capital Wave Strategist Shah Gilani, who as a former hedge fund trader understands how Wall Street thinks.

Yet the Too-Big-to-Fail banks have recently pulled back in one area - physical commodities trading - as a result of regulatory pressure from several directions.

That's good news for proponents of the 21st Century Glass-Steagall Act, introduced on July 11 by Sens. Elizabeth Warren, D-MA, John McCain, R-AZ, Maria Cantwell, D-WA, and Angus King, I-ME.

But the story of the Big Banks reversing course on the physical commodities trading also proves that it takes a lot of effort, and sustained effort at that, to curb such risky behavior.

Why Physical Commodities Trading at the Banks is Allowed

Banks only started to trade physical commodities - oil, metals, agriculture - following the 1999 Gramm-Leach-Bliley Act, which repealed key provisions of the original Glass-Steagall Act of 1933, and a 2003 letter from the U.S. Federal Reserve that allowed Citigroup to keep its just-acquired Phibro unit, which traded in the physical energy markets.

The original Glass-Steagall and Federal Reserve rules had prohibited banks from engaging in "non-financial activities" such as physical commodities trading.

When Citigroup got the green light on Phibro, it opened the door for banks not just to trade commodities on paper as they had done for years (via derivatives), but to own the underlying physical commodities and to own the infrastructure used in storing and transporting those commodities.

"Congress, regulators, and the public need to understand what has happened in the 14 years since the financial floodgates were opened, and reconsider what we want banks to do," said Sen. Sherrod Brown, D-OH.

What happened was that the greedy Too-Big-to-Fail banks pushed the limits of what they could do as physical commodity traders, and got into trouble because of it.

Some of the worst abuses took place in the energy markets, which has resulted in a wave of massive fines against several Big Banks from the Federal Energy Regulatory Commission (FERC).

Two weeks ago FERC fined Barclays Plc (NYSE ADR: BCS) $453 million for manipulating physical energy markets in the Western U.S. from 2006 to 2008 to benefit the bank's bets on swaps, derivatives used to either hedge risks or for speculation.

And just last week, JPMorgan Chase (NYSE: JPM) agreed to pay a $410 million FERC fine for manipulating power in California and the Midwest - the second-largest penalty in FERC history.

Other banks took liberties in the metals markets, particularly aluminum.

Major buyers of aluminum, such as soda companies, beer companies, and automakers have accused the commodities operations of Goldman Sachs Group (NYSE: GS) and other Big Banks of shuffling aluminum between warehouses it owns, greatly lengthening delivery times while the banks collect daily rent on the metal that belongs to the outside companies.

What's more, Goldman's ability to slow down delivery of aluminum has affected spot prices -which conveniently also help the bank's aluminum derivatives trading desk make more money.

"It's all about gaming the system," Gilani said. "Trading for profit includes transportation and storage management. Prices are reflective of transportation and storage costs; they impact trading. Understanding how to manipulate prices by manipulating transportation and storage is just part of the trading game."

He continued: "All commodities trading operations have experts in transportation and storage: Where is the commodity now, and how long will it take to get to market? Now, if we can just slow the ships down and constrain deliveries the spot price will rise....oh, good thing we got long before the price spike. Boy, we're good traders! See how simple and profitable this game is?"

But the guys getting hosed are starting to fight back.

The Wall Street Journal reported Monday that the London Metal Exchange and Goldman Sachs have been named as co-defendants in a U.S. lawsuit over aluminum storage practices. The lead plaintiff is Superior Extrusion of Michigan, which is an aluminum extrusion company.

According to a statement by Hong Kong Exchanges & Clearing, Ltd., the parent of LME, the class-action lawsuit alleges "anti-competitive and monopolistic" behavior in the warehousing market "in connection with aluminum prices."

Why the New Glass-Steagall Act Could Work

Lately, the Too-Big-to-Fail banks have begun to sour on their physical commodities trading operations, thanks to harsher treatment by regulators.

The FERC fines for transgressions in the electricity markets and the recent Senate hearing on the aluminum issue haven't been the only government action against the Big Banks' commodities shenanigans.

The Department of Justice and the Commodity Futures Trading Commission are also taking a hard look at the metals warehousing situation.

Also, stricter Basel 2.5 capital requirements have made capital-intensive businesses like commodities less appealing for the Big Banks.

And regulatory crackdowns on proprietary trading at the Big Banks have played a major part in cutting the revenue they earn from commodities in half.

Now the Federal Reserve is considering a reversal on its 2003 decision that helped create this whole mess in the first place.

"The Federal Reserve regularly monitors the commodity activities of supervised firms and is reviewing the 2003 determination that certain commodity activities are complementary to financial activities and thus permissible for bank holding companies," the Federal Reserve told Reuters.

Too-Big-to-Fail Banks Start Bailing Out

The restrictions on proprietary trading eating into profits from the trading of physical commodities and increasing heat from regulatory agencies have made these activities more trouble than they're worth for the Big Banks.

Morgan Stanley (NYSE: MS) has had a "For Sale" sign on its commodities division since last year.

Regulatory pressure also played a part in the decision last year of TransMontaigne, Morgan Stanley's oil transport and logistics subsidiary, to cut its stake in a $430 million oil storage tank project. And over the past two years, TransMontaigne has sold off half its stake in the Battlefield Oil Specialty Terminal project, specifically citing "the uncertain regulatory environment" as the reason.

Reuters reported last year that Goldman is looking at spinning off its commodities operations, though the bank denies it.

But the most remarkable evidence that tougher regulations can get Big Banks to cry "Uncle" was JPMorgan's announcement last week that it wanted out of the physical commodities trading business.

The bank said it had "concluded an internal review and is pursuing strategic alternatives for its physical commodities business, including its remaining holdings of commodities assets and its physical trading operations."

If a bank as mighty as JPMorgan can be hounded by determined regulators out of the business of trading physical commodities, then a new Glass-Steagall Act should be able to reconstruct the barriers between banking and investment banking activities that kept the nation's financial system stable for decades.

Banks have no business being in the physical commodities business other than for manipulating prices for their traders. Under a new Glass-Steagall Act, banks wouldn't be permitted to do that.

Money Morning is encouraging readers to support the new 21st Century Glass-Steagall Act to put a lid on Too-Big-to-Fail Banks once and for all. Here are more details on the new Glass-Steagall Act.

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