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From Securities Regulation Daily, November 21, 2014

Fed Governor Tarullo explains oversight of physical commodities activities to Senate panel

By Jim Hamilton, J.D., LL.M.

Federal Reserve Board Governor Dan Tarullo told a Senate panel that bank holding companies engaging in commodities activities pursuant to either Gramm-Leach-Bliley Act (GLB) amendments to Section 4(k) of the Bank Holding Company Act on merchant banking or changes to Section 4(o) on grandfather authority are typically subject to continuous supervision by the Federal Reserve. In testimony before the Permanent Investigations Subcommittee, chaired by Sen. Carl Levin (D-Mich), he testified that the supervisory oversight  includes  the review of internal management reports, periodic meetings with the personnel responsible for managing and controlling the risks of the firm's commodities activities, and targeted examinations of those activities. The primary goals of the Fed’s supervision of commodities activities are to monitor the management of risks of those activities to the financial holding companies and assess the adequacy of the firms' control environments relating to physical commodities activities.

Senate report. The Levin hearing was spurred by the issuance of a bipartisan Senate report revealing that three major financial holding companies engaged in the physical commodities market at a time when none of the three firms was adequately prepared for potential losses from a catastrophic event related to its physical commodity activities, having allocated insufficient capital and insurance to cover losses compared to other market participants. The report found that new systemic risks have been introduced into the U.S. financial system.

The investigation focused on the recent rise of banks and bank holding companies as major players in the physical markets for commodities and related businesses. It presents case studies of three major U.S. bank holding companies—Goldman Sachs, JPMorgan Chase, and Morgan Stanley—that over the last 10 years were the largest bank holding company participants in physical commodity activities.

The report found that the three financial holding companies currently conduct physical commodity activities under one of three authorities provided in the Gramm-Leach-Bliley Act of 1999: the complementary, merchant banking, and grandfather authorities.

Senator Levin said that the Section 4(o) grandfather authority was designed to grandfather in existing commodities activities as of the time of the enactment of Gramm-Leach-Bliley.  Citing legislative history, he noted that this provision was not designed to authorize new activities in this area. He is concerned that the three bank holding companies have begun significant new physical commodities efforts under the color of Section 4(o).

Tarullo’s testimony. Tarullo said that theGLB Act amendments to Section 4 (o) permit certain companies to engage in a broad range of physical commodities activities. Section 4(o) of the Bank Holding Company Act was amended to authorize a company that was not a bank holding company and becomes a financial holding company after the enactment of Gramm-Leach-Bliley on November 12, 1999, to continue to engage in activities related to the trading, sale, or investment in commodities that were not permissible activities for bank holding companies if the company was engaged in the U.S. in any of these activities as of September 30, 1997.

This authority is automatic, he said, meaning that no approval by or notice to the Federal Reserve Board is required for a company to rely on this authority for its commodities activities. Also, unlike the firms conducting limited commodities activities found to be complementary to financial activities under Section 4(k), the Section 4(o) grandfathered firms are authorized to engage in the transportation, storage, and extraction of commodities. Moreover, while the cap on complementary activities under Section 4(k) is 5 percent of tier 1 capital, commodities activities permitted under the Section 4(o) grandfather provision may represent up to 5 percent of the company's total consolidated assets.

During 2008, both Goldman Sachs and Morgan Stanley became bank holding companies and elected financial holding company status. They each claim the right to conduct commodities activities under the grandfather provision found in Section 4(o). In addition, during this same period, J.P. Morgan Chase & Co. acquired Bear Stearns and Bank of America Corporation acquired Merrill Lynch; both Bear Stearns and Merrill Lynch engaged in a substantial amount of commodities trading activities. However, the range of permissible physical commodities activities of these latter two financial holding companies is limited because they are not grandfathered under Section 4(o).

Tarullo told the Subcommittee that the Board requires financial holding companies that engage in commodities activities to hold regulatory capital to absorb potential losses from those activities. Financial holding companies have long been required to hold capital against the counterparty credit risk from commodity derivatives and other types of over-the-counter derivatives;  and against the market risk of all commodity positions. Following the financial crisis, the Board has strengthened its capital requirements for the credit risk and market risk of these transactions.

All that said, Tarullo acknowledged that physical commodities activities can still pose unique risks to the safety and soundness of financial holding companies. While firms engaged in physical commodities activities employ measures to limit liability, including using a variety of legal structures that attempt to limit liability for catastrophic and environmental events, purchasing insurance, and allocating capital aimed at mitigating operational risk, there are considerable difficulties in estimating the possible damages related to environmental or catastrophic incidents. Moreover, just the uncertainty that can come about after a catastrophic event as observers wait to see the ultimate damages could put extraordinary pressure on a financial institution engaged in these activities that could threaten its safety and soundness.

Proposed rulemaking. Through the vehicle of an advance notice of proposed rulemaking, the Fed is currently exploring what further prudential restrictions or limitations on the ability of financial holding companies to engage in commodities-related activities as a complementary activity are warranted to mitigate the risks associated with these activities. In response to the notice, said Tarullo, the Board received 184 unique comments and more than 16,900 form letters. Commenters included members of Congress, individuals, public interest groups, academics, end-users, banks, and trade associations. He pointed out that the comments present a range of views and perspectives.

Those opposed to financial holding company involvement in physical commodities activities argued that the different roles of financial holding companies in the commodities markets, for example, trading and credit, allow these firms an unfair competitive advantage and present conflicts of interest in dealing with customers. They also contended that physical commodities activities pose a wide range of risks. On the other hand, a number of commodities end-users, including corporate treasurers and municipalities,  argued that financial holding companies provide valuable and hard-to-replace services to end-users. They also argued that financial holding companies are reliable and low-risk counterparties that enhance the efficiency of the commodities markets and provide additional liquidity to those markets.

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