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Federal Reserve Proposes Tougher Commodities Limits on Banks

The Federal Reserve Board (FRB) issued a proposed rule calling for tougher limits on the physical commodity activities of financial holding companies (FHCs), citing the risks of such investments in the event of an environmental catastrophe.

The proposed rule, issued last Friday, also calls for increasing the reporting requirements of FHCs and would rescind their permission to engage in physical commodity activities involving power plants.

"A limited number of firms supervised by the Board engage in physical commodity activities and investments," the FRB said. "Some firms are permitted by law to engage in a broad range of physical commodity activities, including the extraction, storage, and transportation of commodities. Others may engage in more limited activities, such as commodities trading.

"The possibility of an environmental accident due to these activities presents significant risks to the firms."

Patrick Rau, NGI’s director of strategy and research, said the FRB's proposals "would all likely have the effect of further decreasing the physical market volumes of investment banks in the various commodities segments, everything else being equal.

"Putting up more capital as a form of physical mark-to-marketing these assets would help insure against significant losses in their energy assets, but that would tie up cash that they could use for other purposes," Rau said Monday. "No doubt that would scare some folks off. Holding fewer physical energy assets would likely negatively impact their commodities trading desks as well, because they may be no longer privy to the same market knowledge that comes with operating assets and being a physical market player."

The FRB began the process of re-examining the risks commodities pose to FHCs in January 2014, citing disasters such as the 2010 Macondo well blowout and oil spill in the Gulf of Mexico (see Daily GPIJan. 14, 2014). Three months later, after the FRB issued an advance notice of a proposed rulemaking (ANPR), U.S. Sens. Sherrod Brown (D-OH) and Elizabeth Warren (D-MA) urged it to prohibit banks from owning commodities businesses, including energy commodities (see Daily GPIApril 21, 2014).

Energy companies and associations, including the U.S. Chamber of Commerce, have petitioned the FRB to continue allowing banks to trade in physical commodities (see Daily GPIOct. 7, 2013). They argue that U.S. companies would find it more difficult to manage their own risks, and would be forced to tie-up their own capital, if FHCs are blocked from participating in commodities markets.

FHCs are currently allowed to participate in physical commodity activities under the auspices of the Bank Holding Company (BHC) Act of 1956. That federal law granted the Federal Reserve Board the authority to allow certain FHCs to participate to physical commodity trading and associated activities. The law also gave FHCs permission to invest in any type of non-financial company, including those involved with the trading of physical commodities.

The BHC Act also grandfathered a broad range of physical commodities activities for companies that later became FHCs. That exception currently allows two banks, Goldman Sachs and Morgan Stanley, to engage in commodities activities.

New capital requirements, tighter limits

Under the proposed rule, new risk-based capital requirements would be imposed on FHCs involved with physical commodity activities. Specifically, banks would be required to risk weight at 300% the value of covered physical commodities held by an FHC pursuant to complementary authority, in addition to any other risks associated with such assets.

The proposed rule would also assign a 1,250% risk weight, the highest ever enacted under the FRB's risk-based capital rules, to covered physical commodities and related on-balance-sheet assets held by an FHC with grandfathered authority -- namely, Goldman Sachs and Morgan Stanley. It would also assign a 1,250% risk weight to the original cost basis of certain infrastructure assets.

The rule would also assign a 300% risk weight to covered commodities held pursuant to certain physical commodity trading, if the company is publicly traded. A 400% risk weight would be enacted on privately-held companies.

"Staff does not believe that the proposed additional capital requirements...would have a significant impact on the broader commodities market," the FRB said. "In addition, while FHCs would need to individually consider the impact of the proposed risk weights on their overall business strategies, staff believes the additional capital requirements would not have a material impact on capital ratios of FHCs."

The proposed rule would also tighten the quantitative limit on the amount of physical commodity trading activity that FHCs may conduct. Specifically, the FRB limited the market value of the commodities an FHC can hold under complementary authority to an aggregate of 5% of the FHC's consolidated tier 1 capital.

"The Board imposed this limit to reduce the safety and soundness risks of holding physical commodities, which include unique risks such as legal and environmental risks...as well as operational risks associated with the storage and transportation of physical products," the FRB said.

Rescinds activities involving power plants

Although the FRB said it once believed certain activities involving power plants -- specifically, energy management services and energy tolling -- were complementary to a financial activity for FHCs, it has now reconsidered and has suggested a two-year period for banks to get out of them. The FRB permitted six FHCs to engage in one or both activities between 2007 and 2010, although one FHC was acquired by another after the board's approvals

Since the ANPR, the FRB said at least four FHCs -- Barclays, Deutsche Bank, JPMorgan Chase and RBC -- have discontinued such activities in the U.S. A fifth, BNP Paribas, is in the process of winding them down.

"The expected benefits of permitting these activities do not appear to have been realized over time," the FRB said, later adding that "energy tolling was permitted in part to allow an FHC to hedge its own, or to assist its client to hedge, positions in energy. However, there are other effective ways for an FHC to hedge its positions, and an FHC may assist clients to hedge their positions without the FHC engaging in energy tolling."

New reporting requirements

The proposed rule would establish new public reporting requirements for commodities holdings and activities of FHCs, which the Fed said would increase transparency and allow for better monitoring by regulators.

Specifically, the Federal Reserve Board is proposing to modify the Consolidated Financial Statements for Holding Companies to create a new Schedule HC-W, under the label Physical Commodities and Related Activities. The Fed also is proposing to add items to Schedule HC-R, Part II, Risk-Weighted Assets.

"Schedule HC-W would collect more specific information on the covered physical commodities holdings and activities of FHCs, and the modifications to HC-R, Part II would report the risk-weighted asset amounts associated with an FHC's engagement in activities that involve covered physical commodities, [certain] infrastructure assets, or investments in covered commodity merchant banking investments," the Fed said.

Under the first part of the new Schedule HC-W, FHCs would be required to report the total fair value of its inventories of petroleum and petroleum products; natural gas; natural gas liquids; fertilizer; propylene; coal and coal products; uranium and uranium products; other covered physical commodities, and all other physical commodities.

Copper no longer 'precious'

The proposed rule would also delete copper from the list of precious metals and would reclassify it as an industrial metal. Copper, which is used in minting coins, was added to an expanded list of precious metals after national banks were allowed to begin trading it as a precious metal. Bank holding companies (BHCs) are currently allowed to buy, sell and store copper on an unlimited basis.

"Over time, copper has become most commonly used as an industrial metal and not as a store of value," the Fed said, adding that the Treasury Department's Office of the Comptroller of Currency has made a similar proposal to reclassify copper under the National Bank Act. BHCs would still be allowed to trade in derivatives and similar financial contracts that include copper as an asset.

The FRB said it would accept public comments on the proposed rule for 90 days after publication in the Federal Register.

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