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Fed Weighs Further Restrictions on Banks’ Commodities Units

Bloomberg, Jan 15, 2014

The Federal Reserve is weighing further restrictions on banks’ trading and warehousing of physical commodities as Congress scrutinizes potential conflicts of interest and manipulation in those markets.

The Fed today sought comment on 24 questions, including some on the risks posed by bank ownership and trading of commodities such as oil, gas and aluminum by deposit-taking banks and the possible benefits of imposing additional capital standards.

“There has been a substantial increase since 2008 in the amount and types of commodities activities conducted by the firms we supervise,” Michael Gibson, the Fed’s director of bank supervision, said in testimony prepared for a Senate subcommittee hearing tomorrow. “Moreover, recent catastrophic events involving physical commodities have increased concerns regarding the ability of companies to mitigate potentially extraordinary tail and other risks.”

The Fed said it is considering whether additional restrictions are needed to ensure physical commodities activities by banks are conducted in a safe and sound manner. The central bank said it will consider whether further rules are needed after the public comment period ends on March 15.

In its notice, the Fed cited a list of recent accidents and natural disasters, including the 2010 Deepwater Horizon drilling rig explosion that cost BP Plc more than $42 billion through the end of 2012, as examples of catastrophic events posing risk to exposed institutions.

Goldman Sachs

The Fed’s action could increase pressure on Goldman Sachs Group Inc. (GS) and Morgan Stanley (MS) to sell commodities businesses. Although the Fed generally forbids bank holding companies to own or trade physical commodities, the two Wall Street firms were permitted to retain units after they converted into banks during the 2008 financial crisis.

Commodity trading revenue at the 10 largest global investment banks fell 18 percent in the first nine months of 2013 to $4 billion, industry analytics firm Coalition Ltd. said in a report this month.

Senators Sherrod Brown of Ohio and Carl Levin of Michigan, both Democrats, have raised concerns that financial companies’ involvement in physical commodity markets could lead to abuses that harm consumers. A Senate Banking subcommittee led by Brown has scheduled its second hearing on the issue for tomorrow.

“This decision, while a step forward, is still overdue and insufficient,” Brown said today in a statement on the Fed’s announcement. “Each day that we wait to rein in these activities means that end users and consumers will pay higher commodity and energy prices, and taxpayers will continue to be exposed to excessive risks at Too Big to Fail banks.”

Beer Distributors

Brown held his first hearing on banks’ ownership of physical commodities in July after beer distributors complained that companies such as Goldman Sachs were manipulating aluminum prices. The Commodity Futures Trading Commission issued subpoenas to Goldman Sachs, JPMorgan and other operators of metal warehouses after brewer MillerCoors LLC and others complained of long waits for materials.

JPMorgan Chase & Co. (JPM) agreed to pay $410 million in July to settle Federal Energy Regulatory Commission allegations that the bank manipulated power markets in California and the Midwest from 2010 to 2012.

Gibson, along with officials from the CFTC and FERC, will testify on the issue at tomorrow’s Senate hearing. Gibson said in testimony that the Fed could take additional restrictions including reductions in the maximum amount of assets or revenue for such activities, increased capital or insurance requirements, and prohibitions on holding specific types of physical commodities.

‘Placating Legislators’

“I suspect, with over a decade to address complementary activities and merchant banking, and five years to address grandfathering, this will continue to be a slow process,” Joshua Rosner, managing director at Graham Fisher & Co., said in an e-mail after the Fed’s announcement. “This release is more focused on placating legislators than affirmatively restricting activities of the bank holding companies.”

The Fed requested comment on whether physical commodities businesses pose catastrophic or safety and soundness risks. The central bank also asked whether additional capital, liquidity, reporting or disclosure requirements would be necessary.

Soliciting comment doesn’t bind the Fed to issuing a rule at a later date. The central bank has issued such preliminary notices before, including for a credit-ratings rule in 2010 and capital rules in 2003. After gathering outside views, the Fed could then propose a rule and open that for comments before issuing a final version.

‘Clear Sailing’

“The open-ended tone of this release, combined with the lack of specifics on any possible capital charges, means it’s clear sailing for current physical-commodity operations,” said Karen Shaw Petrou, managing partner at Federal Financial Analytics, a Washington regulatory research firm. “New entrants –- if any -– are on hold, but the lack of specifics combined with the amount of time it will take the Fed to finalize anything it might ultimately choose to do means that this business is as is for now at Morgan Stanley, Goldman Sachs and other big bank holding companies.

Federal law restricts banks from owning non-financial businesses unless they get special exemptions. Goldman Sachs and Morgan Stanley, the biggest U.S. securities firms until they became bank holding companies during the 2008 credit crisis, had grandfather exemptions for commodities operations under a 1999 law.

2003 Decision

In a 2003 decision, the Fed let Citigroup Inc. (C) continue making transactions in physical commodities after finding them complementary to the firm’s trading and investing in financial instruments. The New York-based bank otherwise would have been forced to divest its Phibro energy-trading unit to comply with a federal rule banning banks from dealing directly in materials and fuel.

On June 27, four congressional Democrats wrote a letter asking Fed Chairman Ben S. Bernanke how examiners would account for possible bank runs caused by a bank-owned tanker spilling oil, and how the regulator would resolve a systemically important institution’s commodities activities if it collapsed.

The Fed said in July that it’s reconsidering the 2003 decision giving lenders permission to expand into raw materials.

Exiting Businesses

Banks have already announced plans to exit parts of the business. Bank of America Corp. said on Jan. 7 that it would exit power and natural-gas markets in Europe. Morgan Stanley agreed in December to sell a unit that stores and transports oil products to a subsidiary of Moscow-based OAO Rosneft. (ROSN)

JPMorgan, whose commodities units are overseen by Blythe Masters, said in July it may exit businesses after the Fed announced its review.

Goldman Chief Executive Officer Lloyd C. Blankfein said in September that the bank’s physical commodities unit is a ‘‘core” business that provides crucial service to clients.