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Implications of trading losses by Sumitomo Corporation
Before the Committee on Banking and Financial Services, U.S. House of
September 18, 1996
Thank you for the opportunity to discuss the recent trading losses by Sumitomo Corporation
and their implications for U.S. banks and markets. These losses, which relate to copper
trading, may be as large as $1.8 billion and once again highlight the importance of sound
internal controls by all parties with significant trading activities. At this time the losses
appear to be limited to the Sumitomo trading company, which has been meeting all of its
obligations to U.S. banks arising from its transactions in the copper market.
In my remarks today, I would like to address the general nature of U.S. bank involvement in
trading and financing physical commodity transactions, the Federal Reserve's actions in the
immediate aftermath of the announcement of Sumitomo's losses, and the lessons we believe
should be drawn from this and similar episodes. In doing so, I would emphasize at the outset
that, as a nonfinancial company, the Sumitomo Corporation is not regulated by the Federal
Reserve or by any other banking supervisory or regulatory agency in this country or abroad.
Consequently, the Federal Reserve's involvement has related principally to reviewing the
exposure and role of U.S. banks that lent funds to Sumitomo or that dealt with the company
in its copper-related business and to assisting the Commodity Futures Trading Commission in
its evaluation of Sumitomo's U.S. activities.
Commodities Trading and Financing Activities of U.S. Banks
U.S. banks have long been involved in financing commodity activities through their
agriculture lending programs directed at the production and sale of agricultural products,
both domestically and abroad. Indeed, more than one-quarter of all U.S. banks have farm
loans in excess of 25 percent of their total loans. Such lending, however, has become less
important to our banking system, as the relative importance of primary agricultural products
in real gross domestic product has declined. At mid-year 1996, farm lending accounted for
roughly 2.7 percent of total lending by U.S. commercial banks, compared with 5.2 percent in
1970. U.S. banks have also, of course, been active in financing the production, distribution,
and sale of many other physical commodities ranging from metals to oil.
Beyond that traditional financing, banks--and, more importantly in this country, nonbank
financial institutions--have also participated in agricultural and other commodity markets
through their trading of commodity derivatives both on and off organized exchanges. Unlike
the banks' more traditional functions, their trading of commodity derivatives has increased in
recent years, largely for the same reasons trading activities, in general, have grown:
expanded international trade, increased demand for hedging instruments and improved
methods for managing and controlling risks, advances in computerization and
communications technology, and other factors.
Nevertheless, commodities trading at U.S. banks remains a very small component of their
overall activities. Ownership of actual, physical commodities--an activity underlying much

of the copper trading of Sumitomo--is generally limited for U.S. banks to gold, silver, and
other precious metals. Even their trading of physical commodities contracts on organized
exchanges or through privately negotiated transactions is small, accounting for less than 1.0
percent of all their derivatives positions. These contracts, in turn, are about evenly divided
between (1) gold and other precious metals and (2) all other commodities.
As you may know, the Sumitomo Corporation has been a major participant in the trading of
copper derivatives for many years, largely through the activities of its chief copper trader,
Yasuo Hamanaka. Consequently, following indications of problems in the company's copper
trading operations copper prices fell sharply. Copper markets appear to have stabilized, and
the Federal Reserve is not aware of any material spill-over effects to other markets.
Federal Reserve Actions Following Sumitomo's Announcement
Immediately following Sumitomo's announced loss, the Federal Reserve took steps to
determine the size and nature of U.S. bank exposures to the trading company and to the
copper market. Several banks had trading or financing transactions with Sumitomo relating
to its copper trading and were owed payments by Sumitomo in connection with those
transactions. Shortly after the announcement, the banks contacted Sumitomo to review and
confirm all outstanding transactions relating to copper, and Sumitomo has been meeting all
of its obligations as they come due. At this time, any losses appear to be limited to the
Sumitomo trading company, itself, but it should be noted the company, regulators, and others
are reviewing the events leading to the June announcement.
The Federal Reserve also sought to coordinate its review of U.S. banks' copper-related
activities with the CFTC, which was reviewing Sumitomo's conduct. To this end, shortly
after the announcement of Sumitomo's loss, senior staff of the Federal Reserve and the
CFTC began meeting together to share information pertinent to their respective enquiries.
This effort is still on-going.
Importance of Sound Management Controls
This event highlights, yet again, the importance of a sound management process for
controlling risks in both banking and nonbanking organizations. As we have seen time and
again in recent years, individual traders today have the capacity to inflict tremendous losses
on their institutions when they are allowed to operate in an environment lacking adequate
operating procedures and controls. On the other hand, these incidents also illustrate the
resilience of even specialized commodities markets and the ability of world markets to
absorb dramatic shocks.
It is instructional that the well publicized losses at Barings, Daiwa, Sumitomo, and others
have all derived from violations of fundamental, managerial principles of control, such as
those dealing with the recording of all positions and the adequate separation of duties.
Managements must build and maintain adequate systems for controlling risks, whether they
operate bank or nonbank institutions.
Losses such as Sumitomo's raise the issue of more extensive regulation. Regulation,
however, simply cannot substitute for sound management. Earlier episodes clearly
demonstrate that the very same problems can occur in regulated as well as unregulated firms
and with exchange traded contracts as well as with privately negotiated contracts. Thus, a
more appropriate response--indeed, for nonfinancial companies the only practical
response--is to continue to promote policies that foster greater market discipline.

Encouraging greater disclosure of risk levels is an effort that moves in that direction.
Disclosures such as an organization's calculated "value-at-risk" have the potential to provide
investors and other market participants with greater information regarding the organization's
willingness to take risks and are currently being discussed. Official and market pressures to
produce such statistics hopefully will continue to strengthen the internal auditing and
information systems of many firms. By themselves, though, such quantitative disclosures will
not suffice if large exposures are mismeasured or overlooked. Shareholders, boards of
directors, and senior managers must absorb the lesson that strong management and control
procedures are essential.
In the case of insured commercial banks, the Federal Reserve and the other U.S. federal
banking agencies have stressed the need for adequate management processes in dealing with
market conditions today and have announced new supervisory procedures to reinforce the
point. Through the Bank for International Settlements and other international organizations,
both the banking and securities regulatory communities have taken similar steps abroad.
These regulatory efforts, combined with the lessons imposed by the markets, should begin to
drive home to market practitioners the importance of sound operating procedures and
Although managing and controlling risks in a large organization today can be a complicated,
challenging, and expensive task, the costs of not adequately controlling risks can be much
greater. One must conclude from recent events that some institutions have yet to recognize
that fact and take adequate preventive measures. While financial risk-taking is essential to
our economy, risks should be taken in an informed and intelligent manner, and then only
when adequately supported with owners' funds.
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1996 Testimony
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