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Federal Reserve Pursues Question of Banks in Commodity Markets

Citing disasters involving commodities, from the Macondo oil spill in the Gulf of Mexico to recent crude oil tanker train crashes to the Three Mile Island nuclear leak in 1979, the Federal Reserve Board on Tuesday said it was re-examining the risk involved in the physical commodity activity of financial holding companies (FHC). The banking agency issued an advance notice of proposed rulemaking seeking comment on how to limit risk.

With the near collapse of the banking system in 2008 and the subsequent Dodd Frank Financial Reform Act as a backdrop, the Federal Reserve said it aims to ensure that associated commodities activities by financial companies do not endanger an institution's viability or threaten the rest of the financial system.

"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 Federal Reserve said. It noted that the Macondo oil spill has cost BP $42.2 billion and the final tally is still out. The rupture of the Pacific Gas & Electric natural gas pipeline in San Bruno, CA, in 2010 has cost about $1.5 billion so far, and the costs of the rupture of the Fukushima Daiichi nuclear power plant are impossible to calculate.

The financial holding company that owns physical commodities involved in a catastrophic event may be liable even if it has hired third parties to store and transport the commodities. The Fed noted that in the recent crude oil tanker train crash in Lac Megantic, QE -- which killed 47 people and left a small town in ruins -- the Transportation Safety Board of Canada stated that the level of hazard posed by the oil transported was not accurately documented, which was the responsibility of the shipper of the oil. The railroad already has gone out of business.

Even if the commodities are held by a non-banking subsidiary, that may not reduce the liability risk to the parent bank, the Fed said.

To help the Federal Reserve assess the risks of physical commodities activities and the adequacy of the safeguards and limitations already in place, it has invited public comment on questions such as:

  • What criteria should the Board look to when determining whether a physical commodity poses an undue risk to the safety and soundness of an FHC?
  • What additional conditions, if any, should the Board impose on complementary commodities activities? For example, are the risks of these activities adequately addressed by enhanced capital and/or insurance requirements for complementary commodities activities, or reductions in the amount of assets and revenue attributable to complementary commodities activities, including absolute dollar limits and caps based on a percentage of the FHC’s regulatory capital or revenue?
  • What additional conditions on complementary commodities activities should the Board impose to provide meaningful protections against the legal, reputational and environmental risks associated with physical commodities and how effective would such conditions be?
  • To what extent does the commitment that an FHC will only hold physical commodities for which a futures contract has been approved by the CFTC or for which the Board has specifically authorized the FHC to hold adequately ensure that physical commodities positions of FHCs are sufficiently liquid?
  • What modifications to this commitment, including additional conditions should the Board consider to ensure that an FHC maintains adequate liquidity in its commodity positions?
  • What additional commitments or restrictions are necessary to ensure FHCs engaging in complementary commodities activities do not develop unsafe or unsound concentrations in physical commodities?
  • Should the type and scope of limitations on complementary commodities activities differ based on whether the underlying physical commodity may be associated with catastrophic risks? If so, how should limitations differ, and what specific limitations could reduce liability from potential catastrophic events?
  • Does the commitment not to own, operate or invest in facilities for the extraction, transportation, storage, or distribution of commodities adequately insulate an FHC from risks associated with such facilities, including financial risk, storage risk, transportation risk, reputation risk, and legal and environmental risks? If not, what restrictions should the Board impose?

The Fed also seeks to determine if  the commodity activities are "complementary or necessary" to the bank's core activities.

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