European banks have grown wary of financing commodity traders, raising borrowing costs and endangering smaller firms in the market for raw materials.

ABN Amro Bank NV is pulling out of trade and commodity finance altogether. ING Groep NV will likely enforce stricter monitoring and control over commodity deals it finances to reduce risks, said a person familiar with the matter. BNP Paribas SA, formerly a powerhouse in commodity-trade finance, is scaling back, a person familiar with the company said.

Banks are responding to the rout in oil prices, a spate of alleged frauds, a drift into riskier forms of lending and investor pressure over climate change. Their retreat is likely to concentrate the business of transporting oil, metal and grain in the hands of large traders that still have access to cheap funding.

Smaller traders, in contrast, are finding it increasingly difficult to borrow from banks, prompting some of them to seek out new sources of financing. That could come from their larger rivals or from trade-finance funds. Some will be pushed out of business altogether, according to industry executives, bankers and lawyers.

“The biggest impact will be on smaller players,” said Jarek Kozlowski, chief financial officer at power-and-gas trader TrailStone Group. “They will have difficulty finding funding.”

Banks fund traders through traditional forms of trade finance such as letters of credit—a payment guarantee to suppliers—as well as revolving-credit and borrowing-base facilities. In doing so, they grease the supply chains that ship oil, metal and grain from producers to consumers. Trading houses rely on borrowed money because the cargoes they handle can be worth tens of millions of dollars. Higher funding costs pose a danger because they run on thin margins.

Commodity trading is already dominated by a clutch of global players, including European traders Vitol Group, Trafigura Group Pte. Ltd. and Mercuria Energy Group Ltd., and U.S. agricultural giants Archer Daniels Midland Co., Bunge Ltd. and Cargill Inc. Banks will keep competing to lend to large traders, preventing a large rise in their borrowing costs, said Philip Prowse, a partner who specializes in commodities trade finance at law firm HFW in London.

“The big traders are very resilient and will always be well-supplied by the big banks,” said Mr. Prowse. “There will be very little left for the traders beneath that very large size.”

A drop in competition could help boost margins at the largest traders by enabling them to charge more from oil refiners, copper smelters and other customers while paying less for commodities, said Craig Pirrong, a finance professor at the University of Houston. Doing so could raise prices for end consumers and put more pressure on commodity producers, such as miners and energy companies.

Smaller traders are more exposed. Banks have become more cautious about lending to them since a series of blowups earlier this year, said Marie-Christine Olive, Citigroup’s head of natural resources for Europe, the Middle East and Africa.

“There’s a flight to quality,” said Ms. Olive. “How many [commodity traders] will be left?”

Singapore energy trader Hin Leong Trading Pte. Ltd. was placed under judicial management in April, owing $3.5 billion, mostly to banks. Founder Lim Oon Kuin was charged with abetment of forgery in August.

Other traders to hit financial trouble include GP Global Group, a trading, refining and logistics company in the United Arab Emirates. In July, GP said it would restructure after finding itself “unable to get full support from a few financial institutions” despite constantly seeking credit lines to fund its trading activity. An external restructuring officer at FTI Consulting is hopeful that an agreement with creditors will be reached, a GP spokesperson said.

Several of this year’s implosions—including those of Hontop Energy (Singapore) Pte. Ltd. and ZenRock Commodities Trading Pte. Ltd.—have taken place in Singapore. That has raised concern about the city-state’s oversight of trading firms.

Regulations designed to make the financial system safer after the 2007-2009 crisis have made low-risk, high-volume trade finance less attractive, according to John MacNamara, chief executive of consulting firm Carshalton Commodities Ltd. This prompted banks to take greater risks by lending on an unsecured basis, skimping on due diligence, and insuring a smaller portion of their loans.

“Banks have rather dropped their trousers to get new business in terms of trade finance,” Mr. MacNamara said. “The unintended consequence of Basel III was we took more risks.”

The threat of sanctions has also prompted banks to retreat, said Mr. Prowse. BNP Paribas shrank its business after pleading guilty to crimes of violating U.S. sanctions in 2014.

Commodity-trade finance isn’t the money spinner it once was. Revenue has slid over the past five years, and the coronavirus pandemic dealt another blow. Turnover from commodity-trade finance dropped to $1.7 billion in the first half of 2020, down almost a third from the same period last year, according to Coalition, which tracks data on banks.

Then there is pressure from investors on European banks to reduce the amount they lend to carbon-intensive industries, a particular issue for companies that earn most of their money from coal. Natixis SA, for example, in May said it would withdraw from the thermal-coal sector in members of the European Union and Organization for Economic Cooperation and Development by 2030.

Société Générale SA remains committed to the business of financing natural resources, but it is consolidating in Asia to serve key clients from Hong Kong, said a person familiar with the matter. The move was earlier reported by Bloomberg News.

ING is likely to raise borrowing costs and reconsider lending in the absence of collateral, the person familiar with its planning said. A spokesman said the Dutch lender currently has no plans to exit from the business.

WSJ, Editor: Joe Wallace, September 6, 2020, Photo by Sharon McCutcheon on Unsplash