Physical commodity activities: Too risky for banking organizations?

January 2014
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Physical commodity activities: Too risky for banking organizations?

At a glance

Regulators are looking closely at new regulations for banks' physical commodity activities.

On January 14, 2014 the Federal Reserve Board (“FRB”) issued an advance notice of proposed rulemaking (“ANPR”) seeking public comment on physical commodities activities conducted by Financial Holding Companies (“FHCs”). The FRB will conduct a review following the comment period to determine whether any further action, including rulemaking, is necessary. Comments on the ANPR must be received by March 15, 2014.

Historically, US policy has separated banking and commerce on the theory that separation is necessary to prevent undue concentration of resources, conflicts of interest, or unsound banking practices. Among the few exceptions to this policy are those available to FHCs that (a) with FRB approval, are allowed to engage in physical commodity trading and other activities considered to be “complementary to authorized financial activities,” (b) without FRB approval, are permitted to make merchant banking investments in nonfinancial companies, including those engaged in physical commodity activities, and (c) qualify for the statutory grandfathering of certain physical commodities activities lawfully engaged in by a company that became a FHC after the enactment of the Gramm-Leach-Bliley Act.

These relatively obscure exempted activities recently became the subject of congressional hearings at which several private witnesses expressed concerns about the role of financial institutions in commodity markets, and witnesses for the FRB, Commodity Futures Trading Commission and the Federal Energy Regulatory Commission explained their roles in overseeing commodities activities. Following these hearings, the FRB’s ANPR sets forth concerns largely around FHCs’ potential exposure to liability for environmentally catastrophic events due to their physical commodities activities (which the ANPR reviews in grim detail under an assumption of massive lawsuits).

Beyond catastrophic events, the FRB also questions the rationale behind its own exemptive orders allowing FHC’s to expand into “complementary” physical commodities activities to be more competitive and to better serve their clients in the commodity markets. Only a dozen firms have applied for this exemption since it was first provided in 2003, and some of these firms have recently announced their intentions to withdraw from or reduce their presence in the physical commodity markets.

In our view the ANPR will likely lead to proposed regulations that include additional restrictions on physical commodity activities, with stricter limitations when the underlying physical commodities are more likely to cause catastrophic events. Less clear is whether additional restrictions will be proposed for merchant banking portfolio investments in physical commodities or other activities. We believe there could be a Notice of Proposed Rulemaking within six to nine months, if Congress remains interested in the subject.

This Financial Services Regulatory Brief provides the current status of FHCs’ role in physical commodity activities and analyzes the released ANPR.