Hatchet job or bellwether, report probes Volcker rule’s energy costs

A Morgan Stanley-commissioned report released this week claims that a proposed federal ban on proprietary trading by banks will devastate energy derivatives hedging, lead to a hefty hike in natural gas, electricity and gasoline prices and cause East Coast refineries to shut down.

The report, however, is “a hatchet job” that makes “ridiculous” assumptions and assertions without proper analysis, according to John Parsons, the executive director of the Center for Energy and Environmental Policy Research at MIT.

In a withering takedown of the report released Wednesday by analysts at IHS, Parsons said the report assumes a conclusion that it cannot back up and ignores tax money used to subsidize risk taking by banks.

“So the IHS report assumes its conclusion,” Parsons wrote. “All of the ginormous economic costs that it tallies assume that because the banks don’t provide the service, the service is not provided. Not at all. Silly.”

The report claims that the proposed Volcker rule, which would prohibit banks that are backed by federal deposit insurance and that have Fed discount window borrowing privileges from proprietary trading and limit their investments in hedge funds, will constrain banks’ market-making activities. In turn, this will prevent banks from offering the energy industry commodities risk-management and intermediation services.

The report claims this will result in multiple consequences, including:

– A 2.1 Bcf/d drop in US natural gas production
– A 4 cent increase in gasoline prices
– A $5.3 billion annual increase in power costs
– A $34 billion drop in US GDP each year through 2016.

Parsons, of course, argues that none of these consequences, laid out in what he called “a long, bloated report,” may occur.

For one, just because some banks would be barred from proprietary trading, others would still be able to, and likely would, step in to this role. “Suppose a state were to ban grocery stores from selling alcohol,” Parsons wrote. “Does that mean alcohol would not be sold? Obviously not.”

Parsons also took issue with the report’s lack of consideration of taxpayer subsidies to banks. “If banks are better at providing the intermediation, then by all means, let’s do it through banks,” he wrote. “But that is not the reason this activity moved onto bank balance sheets. It happened because banks do not pay the full cost of the risks they fund–taxpayers do. Ignore the taxpayer subsidy, and, of course, it looks wise to allow the banks to keep doing the business. But accounting for the subsidy, it makes no sense.”

Parsons is quickly finding a place among the Volcker rule’s most vocal supporters, arguably more so than former Federal Reserve Chairman Paul Volcker himself, who has criticized the rule for being overly complex and muddled by banking lobbyists beyond the basic premise that he first proposed.

But, while he may have been the quickest to criticize IHS’ report, he’s certainly not alone. Commodity Futures Trading Commission member Bart Chilton on Friday dismissed the argument that prices would rise if banks could not engage in proprietary trading. “Markets seemed to do quite well before Glass-Steagall was repealed,” Chilton said, referring to the 1933 act that mandated the separation of commercial and investment banking. The Glass-Steagall Act was repealed in 1999.

In a blog post Thursday, Michael Levi, a senior fellow for energy and the environment at the Council on Foreign Relations, said that while the study looks at the costs of the Volcker, “it completely ignores any benefits.”

Levi compared study’s argument that the natural gas industry may be hurt by government limits on bank trading to a hypothetical argument in 2007 that banks should not be barred from trading in mortgage backed securities because of the central role they have in making markets in these instruments.

“Much of that argument about the costs of bank regulation would have been correct–yet no one, with the benefit of hindsight, would now say ‘the financial crisis was a price worth paying for keeping mortgages cheap,'” he said.

Banking regulators and the Securities and Exchange Commission released a proposed rule in October and the CFTC released its proposal in January. CFTC Chairman Gary Gensler said this week he would be willing to propose anew the Volcker rule, if the agency determines it would be needed.

Federal Reserve Chairman Ben Bernanke has said he expects regulators to miss a July deadline to impose the rule.


After this blog was posted energy economist Philip K. Verlenger wrote in to add his views:

“The United States has benefited greatly from the introduction of trading in futures.  In fact, the increase in natural gas supply is a direct result of the introduction of futures trading combined with the decision of large oil companies to desert the United States in the 80s.

 However, the Volker rule will not reverse this trend.

This study is the worst sort of pandering by a group of individuals who has contributed to or understands the workings of commodity markets.  It is my hypothesis that IHS-CERA was unable to find any reputable recognized independent expert on financial markets to join their effort because the experts recognized the totally biased point of view demanded by Morgan Stanley.  No doubt anyone asked remembered the movie Inside Job  and did not want to be involved with such an unbalanced report.  The new American Economic Association ethic rules would further discourage the participation of any truly independent scholar.

Tragically, it is what one expects from the organization.  Biased, unsubstantiated and incorrect analysis.”

Second Update:

Since this was posted the lead author of the IHS study has responded directly to the criticism from Parsons and Levi.

For a response to Parsons’ criticism go here.

For a take on Levi’s criticism go here.


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