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From Banking and Finance Law Daily, April 17, 2014

Senators say bank ownership of physical commodities poses risk to financial system

By Katalina M. Bianco, J.D.

Senators Elizabeth Warren (D-Mass) and Sherrod Brown (D-Ohio), Chairman of the Senate Banking Subcommittee on Financial Institutions and Consumer Protection, have asked the Federal Reserve Board to address the risks associated with financial holding companies’ (FHCs) ownership of physical commodities. The lawmakers have expressed their concern that such ownership poses serious risks to the safety and soundness of the financial system.

In a letter to the Fed, Warren and Brown urged the agency to prohibit ownership of physical commodities by FHCs. “As a general matter, FHCs should be prohibited from owning physical assets like warehouses, pipelines, and tankers," the senators wrote. "These activities pose significant safety and soundness, legal, and reputational risks to institutions."

Background. The senators’ letter to the Fed comes as the comment period to the agency’s advanced notice of proposed rulemaking (ANPR) is about to close. In January, the Fed issued the ANPR seeking comments on the Bank Holding Company Act (BHCA) provisions enabling FHCs under the Gramm-Leach-Bliley Act to engage in various physical commodities. The original comment period was to end on March 15, but the Fed extended the date to April 16 after receiving requests for an extension from a number of industry associations.

The Fed issued the ANPR to explore the scope of the activities that it has authorized under BHCA Sec. 4(k)(1)(B) to ensure that they continue to be activities complementary to a financial activity and do not pose substantial risks to depository institutions or the financial system generally. The Fed also sought feedback on whether it is appropriate to impose limitations or conditions on the conduct of physical commodity activities by bank holding companies and their subsidiaries.

Concerns. The senators outlined for the Fed their concerns with FHCs' expansion into activities that are commercial in nature, particularly their ownership of assets involved in the extraction, transportation, storage, and distribution of commodities and energy. They contend that commercial commodities and energy activities expose financial institutions, regulated by the Fed, to “unprecedented and unmanageable financial, legal, environmental, and reputational risks.”

Brown has held two hearings on the subject of FHC ownership of physical commodities and the impact of this ownership on financial markets. The hearings identified a number of regulatory challenges and safety and soundness risks associated with FHCs' involvement in physical commodities and energy markets, according to the senators. Witness testimony discussed the policy justifications for maintaining a legal separation between banking and commerce under the BHCA, identified potential safety and soundness risks associated with FHCs' direct ownership of physical commodity assets, and outlined the legal and regulatory context “behind the erosion of the legal wall separating banking and commerce over the last two decades.”

Use BHCA authority. The senators urged the Fed to use its full authority under the BHCA, reminding the agency that section 5 of the act permits the Fed to require a bank holding company (BHC) to terminate any activities that pose a serious risk to the financial safety, soundness, or stability of a subsidiary bank of the BHC and are inconsistent with the sound banking principles of the BHCA.

Migration to nonbanks. Warren and Brown assured the Fed that while some commenters have argued that it is better to allow ownership of physical commodities within the banking system rather than at more lightly-regulated commodities trading houses, this should not be a significant concern for the Fed. The senators argued that the Commodity Futures Trading Commission maintains the authority to police fraud and manipulation in the commodities markets, regardless of the party engaging in the behavior. Also, the Financial Stability Oversight Council has the authority to designate firms or activities as systemic, subjecting them to enhanced prudential regulations. “If these tools are insufficient regulators should seek additional authorities, or restrictions on activities, rather than allowing a regulatory race to the bottom among financial institutions and non-financial commodities traders,” the senators wrote.

Private Equity Growth Capital Council. The Private Equity Growth Capital Council (PEGCC) submitted a comment letter on the Fed’s ANPR. The PEGCC describes itself as “an advocacy, communications and research organization established to develop, analyze and distribute information about the private equity and growth capital investment industry and its contributions to the national and global economy.”

The PEGCC is concerned that regulatory activity by the Fed could indirectly affect businesses in which the council’s member firms (portfolio companies) invest. “Given the crucial importance of commodities-related markets to our portfolio companies, we are concerned that potential new restrictions on financial holding companies’ commodities-related activities could disincentivize their participation in the commodities markets and their provision of certain commodities-related services to their customers.”

The council cautioned the Fed against taking any action that could have the effect of restricting FHCs’ engagement in commodities activities, given their benefits to producers and consumers and, thus, to the economy as a whole.

The PEGCC wrote that FHCs play an important role as intermediaries to the portfolio companies that are producers or consumers of commodities and in the commodities markets more broadly. In addition to FHCs being important intermediaries, the PEGCC also told the Fed that the participation of FHCs in both financial and physical commodities markets benefits even those producers and consumers that do not rely on financial holding companies for intermediation services.

Joint trade associations. A group of trade associations jointly commented on the Fed’s ANPR. The associations—The Clearing House Association L.L.C., American Bankers Association, Financial Services Forum, Financial Services Roundtable, and Institute of International Bankers—wrote to address the Fed’s discussion on the general risks associated with merchant banking.

The associations stressed to the Fed that the success of FHCs in managing the risk associated with all types of merchant banking activities over a period of almost 15 years indicates that the existing prudential framework for these activities is “robust and effective.” Though these activities do pose risks, FHCs can manage these risks within the existing supervisory structure by adhering to appropriately designed policies and procedures that are informed by established legal frameworks. There is no need to initiate a fundamental revision of regulatory restrictions or supervisory framework governing FHCs’ merchant banking activities, whether with respect to physical commodities investments or all merchant banking investments, they wrote, “because we do not believe that the risks of merchant banking investments have changed or that firms’ ability to manage these risks are more limited today than in the past.”

U.S. Chamber of Commerce. The U.S. Chamber of Commerce’s Center on Capital Markets Competitiveness and Institute for 21st Century Energy submitted a joint comment letter to the Fed on the importance to commercial end-users of FHC participation. The letter was written by David Hirschmann, President and CEO of the Center, and Karen A. Harbert, President and CEO of the Energy Institute, who explained, “Many of our Members use physical commodities as the raw materials or the fuel for their businesses, and use financial instruments like derivatives to hedge against volatility in the markets for those essential commodities.”

Transacting with FHCs is essential for chamber members because “FHCs are well-regulated, well-capitalized, highly liquid counterparties that have the capacity to enter into highly customized transactions, designed specifically to match the size and duration of a company’s exposure to a particular commodity,” the chamber heads wrote.

Restricting FHCs from engaging in physical commodities or imposing additional regulations that force them to depart from the physical commodities markets would have “a significant adverse effect” on chamber members and their customers, Hirshmann and Harbert argued. “The Board is considering additional regulations, in part, to ensure the safety of the financial system generally. We submit, however, that additional regulation in this area could harm many businesses and consumers, a result that also would burden the financial markets.”

Companies: American Bankers Association; Financial Services Forum; Financial Services Roundtable; Institute of International Bankers; Private Equity Growth Capital Council; The Clearing House Association LLC; U.S. Chamber of Commerce.

MainStory: TopStory BankHolding BankingOperations FederalReserveSystem FinancialStability SecuritiesDerivatives

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