06/01/2009 05:12 am ET | Updated May 25, 2011

Banks, the Oil Market, and the Next Financial Meltdown

Yesterday the Wall Street Journal reported that Citigroup Inc. is seeking the Treasury's approval to pay special bonuses to key employees. According to the Journal, the focus of the request is the highly profitable Phibro trading division whose energy trading unit is at the point of losing key employees because of federal pay restrictions. Citigroup, aside from receiving $45 billion in TARP funds, is now 30% owned by the government.

With the current focus on whether to pay bonuses or not, a much larger and more ominous issue is being overlooked. It highlights the massive distortions in our financial system and the grave potential to repeating the massive risk and leverage blunders taken on by the behemoths of the banking world that has come frighteningly close to destroying the financial system.

Once upon a time banks played a significant role in aiding the flow of trade both domestically and internationally. A bank would open letters of credit permitting trade to flow between buyers and sellers in different parts of the world. They would finance the inventory or storage of goods and commodities, thereby assisting the smooth functioning of markets. They would provide loans for the expansion of production capacity. In other words, they would function as banks did once upon a time.

But now, be it Citigroup or Morgan Stanley and myriad others such stolid unglamorous, sedate contributions to the world's economy have become too mundane. No, better they risk their depositors' monies and their capital (30% government-owned in the case of Citi as noted above), their TARP infusions ($10 billion for Morgan Stanley), by having opened oil trading casinos, forgoing their traditional function as lenders and facilitators of trade. 'Shazam,' they have transformed themselves into oil traders, or simply put, principals, taking title to the physical product by taking delivery, and storing it (according to Bloomberg, "Morgan Stanley Hires Super Tanker to Store Oil," January 19, 2009 -- Morgan chartered the supertanker "Argenta" to store 2 million/bbls at anchor at sea), and thereby foisting on their fiduciary depositor base and shareholders the enormous risks attendant to trading oil -- not simply oil futures on the exchanges, but an important part of the billions of barrels of crude oil being shipped all over the world.

The risks are enormous and the rewards can be as well, as they have been for the last few years. But the same could have been said, if anyone had been paying attention to the risk side, to the reckless compounding of credit instruments, the morphing of home finance loans into bank bonds, and the plunge into and packaging of CDSwaps. Banks had ceased to function basically as banks but had become traders and gamblers using Other People's Money, which provided enormous individual payouts while the going was good.

Where we probably do not need any more CDS instruments for which there is no insurable interest at hand, thereby becoming a pure speculative product, we probably do need oil traders for the smooth functioning of markets. But traders who trade at their own risk and capital. Leaving it to the banks portends another financial disaster by tying their viability to the highly volatile world of commodity trading, most especially crude oil.

It is long past time that the bankers got back to banking the old fashioned way. We would all be the better for it, and it is time our government did the needful to assure that bankers kept to their knitting.