The Fed board voted to publish its concerns and potential remedies
following months of growing public and political pressure to check
banks' decade-long expansion into the commodities supply chain. The
Fed also questioned the initial rationale for allowing them to trade
and invest in risky raw materials and lease oil tanks or own power
The Fed "expect(s) to engage in additional rulemaking in this area,"
according to prepared remarks of Michael Gibson, the Fed's director
of bank supervision and regulation, to a U.S. Senate banking
committee hearing on Wednesday.
The new rules could include a cap on total assets or revenues from
such trading, increased capital or insurance, or prohibitions on
holding certain types of commodities "that pose undue risk."
Facing a clearly uneasy regulator, some banks including JPMorgan
Chase & Co are already quitting the business, a once-lucrative
trading niche that has reaped billions of dollars of revenue for
Wall Street over the years but is now facing diminished margins and
stiffer capital rules.
But others, such as Goldman Sachs Group Inc, have stood firm,
defending an operation they say benefits customers. Due to a
grandfather provision in a 1999 banking law, the Fed has less leeway
to restrict the activities of former investment banks Goldman and
Morgan Stanley, Gibson said.
In a 19-page document that included two dozen questions, the Fed
offered a host of reasons for imposing new restrictions in the
interests of limiting potential conflicts of interest and protecting
the safety and soundness of the banking system. It invoked disasters
including BP's oil spill in the Gulf of Mexico in 2010 and the
derailment and explosion of an oil train in Canada last year.
"The recent catastrophes accent that the costs of preventing
accidents are high and the costs and liability related to physical
commodity activities can be difficult to limit and higher than
expected," the Fed said in its notice.
The "advance notice of proposed rulemaking," which is an optional
initial step in the sometimes years-long process of making new
regulations, seeks comments until March 15.
CONFLICTS, RISKS AND CAPITAL
It is the Fed's first detailed public comment since it shocked the
banking industry last July by announcing a "review" of its 2003
authorization that first allowed commercial banks such as Citigroup
to handle physical commodities.
U.S. Senator Sherrod Brown of Ohio, who led the first hearing last
summer, said the measure was "overdue and insufficient", warning
that consumers and end-users risked paying higher commodity prices
until new curbs are imposed.
But others saw it as a likely prelude to tough action that would
curtail so-called "too big to fail" banks amid a wider political
move to restore the historical division between commercial banking
and riskier business. Eliminating that divide 15 years ago helped
open the door to commodities trading.
"That was the Greenspan era, and it was anything goes as far as
activities. Now, we realize that we made a lot of mistakes during
the Greenspan era," said Cornelius Hurley, banking law professor at
Boston University and former assistant general counsel to the Fed
Board of Governors.
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Beyond the financial risks, the Fed is also seeking comment on
potential conflicts of interest for banks, and the risks and
benefits of additional capital requirements or other restrictions — measures that have been hinted at in the past.
The Fed said that new limits on the three ways in which banks may
deal in physical commodities were up for debate: the authority to
trade raw materials as "complementary" to derivatives; the
investment in commodity-related business as arm's-length merchant
banking deals; and the "grandfather" clause that has allowed Morgan
Stanley and Goldman Sachs much wider latitude to invest in assets
than their peers.
The Fed also questioned several previously cited justifications for
allowing banks to trade in physical commodities such as crude oil
cargoes and pipeline natural gas — markets in which some banks such
as Goldman Sachs and Bank of America's Merrill Lynch are still
It said, for instance, that although most banks are not allowed to
actually own infrastructure assets, those that lease storage tanks
or own physical commodities held by third parties may nonetheless
face a "sudden and severe" loss of public confidence if they are
involved in a catastrophe.
They also said that several banks' recent moves to sell all or parts
of their physical trading operations "may suggest that the
relationship between commodities derivatives and physical
commodities markets...may not be as close as previously claimed or
While scoping out possible measures to tighten up commodity trading
and merchant investment, the Fed offered little insight into how it
might level the playing field by narrowing the grandfather exemption
that Goldman and Morgan enjoy.
"Our ability to address the broad scope of activities specifically
permitted by statute under the grandfather provision...is more
limited," Gibson will tell lawmakers.
Legal experts say the provision — which has long been a bone of
contention with other banks who had never been allowed to invest in
oil tanks and power plants — was widely written. It may require
Congressional action to crack down — a seemingly unlikely outcome
given the political divisions in Washington.
One legal expert at a private commodity trading firm said the tone
of the Fed's notice and mention of catastrophic risks made it almost
certain that some form of regulatory action would follow.
"Given some of the things they've said, it would almost make them
look bad if they ultimately decided not to do anything," said the
expert, who asked not to be identified because they were not
authorized to speak to the media.
(Additional reporting Karey Van Hall and
Patrick Rucker; editing by Leslie Adler and Grant McCool)
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