Fed May Reign in Bank Holdings of Commodities

What do the Deepwater Horizon explosion, Hurricane Katrina, and the tsunami that hit Japan in 2011 have in common? Those disasters serve as the backdrop to potential new restrictions on commodity holdings by banks.

The problem, according to the Federal Reserve, is that catastrophes involving environmentally sensitive commodities—including oil, natural gas, coal, and agricultural products—can wreak economic damages “well in excess of the market value of the commodities involved or the committed capital and insurance policies of market participants.” The damages could have the potential to destabilize large banks and add risks to the financial markets. Liability could also exceed the liability insurance of financial holding companies and capital allocated to the activity. Also, significant costs associated with clean-up may be expressly excluded from insurance policies.

The Board of Governors of the Federal Reserve published an Advanced Notice of Proposed Rulemaking last month, advising banks that it could step in with new regulations because disasters like the Deepwater Horizon spill and Japan's Fukishima nuclear meltdown could expose banks that have large holdings in commodities to mammoth financial losses and threaten the nation's financial stability.

“The Fed offered various doomsday scenarios where being a participant in physical commodity activities could impose a risk to the bank,” says Charles Horn, a partner at the law firm Morgan Lewis.  

An additional concern raised in the notice is that ownership of physical commodities tied to a catastrophic event could “suddenly and severely undermine public confidence in the financial holding company, or its insured depository institution, and undermine access to funding markets.”  

The Federal Reserve is accepting comments through March 15 that will guide the Fed's review of physical commodity activities by financial holding companies and the appropriateness of further restrictions. Among the ideas floated are enhanced capital requirements, increased insurance requirements, reductions in the amount of assets and revenue attributable to complementary commodities activities, and dollar limits and caps based on a percentage of a financial holding company's regulatory capital or revenue. Just the threat of added regulation has already driven some banks out of the commodities marketplace.

Commodities Manipulation?

Still, some say these measures by the Federal Reserve would do little to fix the real problems that banks can cause by holding vast quantities of physical commodities or controlling the transportation, trading, and other services around them.

Much has been made in recent months, particularly by members of Congress, of concerns that financial institutions may manipulate commodities pricing. Aluminum, silver, and gold are just some of the physical commodities critics have accused banks of price fixing—controlling their release from stockpiles they own, driving up prices, and placing a burden on companies that rely on those raw materials.

“What was interesting about the Fed's discussion of these commodity risks was that it was all these natural and man-made disasters they were primarily worried about,” says Horn. “They offered various doomsday scenarios where being a participant in physical commodity activities could create a risk to the bank. The [advance notice of rulemaking] was more focused on prudential issues as opposed to legal or market manipulation questions.”

With the Gramm-Leach-Bliley Act in 1999, Congress created the financial holding company (FHC) framework and allowed bank holding companies with well-capitalized subsidiaries to receive that designation and expand their activities. The Fed was tasked with approving new activities if they were complimentary to financial activities and public benefits outweighed potential negatives. In 2003, prompted by a request from Citigroup, the Fed first started to allow financial holding companies, on a case-by-case basis, to expand into commodities-related activities.

“If you speak to end-users, they are concerned about who they are going to trade with ... Commercial users are concerned there will be nobody to trade with and don't know who is going to provide liquidity to the market.”

—Marvin Goldstein,

Partner,

Stroock

Under its authority, the Fed has since approved requests by financial holding companies to engage in three types of activities:  physical commodity trading; energy tolling; which is when banks pay power plant owners for the right to all or part of the plant's power output; and providing transactions and advisory services to power plant owners. These activities are defined as “complementary commodities activities.”

Current management techniques designed to mitigate risks—such as frequent monitoring, requirements to restrict the age of transport vessels, and review of disaster plans of third-party transporters—“may have the unintended effect of increasing the potential that the FHC may become enmeshed in or liable to some degree from a catastrophic event,” the Fed wrote.

Currently, 11 of the 12 FHCs authorized to engage in one or more complementary commodities activities are also designated as global systemically important banks.

Piercing the Corporate Veil

FHCs typically conduct complementary commodities activities through non-banking subsidiaries. However, despite that corporate structure, they could still face legal liability for the actions of those subsidiaries. Courts may “pierce the corporate veil” when the subsidiary corporation is not treated as an independent entity. Factors courts consider under this analysis include whether the subsidiary is adequately capitalized, holds separate director and shareholder meetings, or keeps assets separate.

Horn views repeated references to “piercing the corporate veil” in the ANPR, imposing a subsidiary's legal liability onto its parent company, as one of its more relevant discussions.

“The doctrine of corporate separateness and limited liability is an important premise for the safe and sound conduct of merchant banking activities,” the ANPR says.

“If you establish a subsidiary and the subsidiary engages in a physical commodity activity that gets caught up in some kind of an environmental catastrophe, will the subsidiary's corporate veil be pierced so that corporate liability could be driven up to the parent organization? They raised that issue several times in the ANPR,” Horn says. “It signals that one of the things they will be paying increased attention to is, organizationally, whether banking organizations have appropriate organizational structures, policies, and procedures in place to reduce or minimize the likelihood of a corporate veil piercing.”

Banks React

Expecting new, potentially costly, regulatory demands on their commodity activities, some banks are extricating themselves from the marketplace.

COMMODITY RULE QUESTIONS

Below is an excerpt from an Advanced Notice of Proposed Rulemaking recently issued by the Board of Governors of the Federal Reserve System.

The Advanced Notice of Proposed Rulemaking serves as a potential prelude to new restrictions or requirements for financial holding companies that engage in commodities activities.

Among the ideas floated are enhanced capital requirements, increased insurance, reductions in the amount of assets and revenue attributable to commodities activities, and dollar limits and caps based on a percentage of the FHC's regulatory capital or revenue. Through March 15, 2014, the public can weigh in on a variety of questions, a sampling of which is included here.

What criteria should the Board look to when determining whether a physical commodity poses an undue risk to the safety and soundness of a FHC?

What additional conditions should be imposed 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 a 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 be considered to ensure an FHC maintains adequate liquidity in its commodity positions?

What additional 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 differ based on whether the underlying physical commodity may be associated with catastrophic risks?

Does the commitment not to own, operate or invest in facilities for the extraction, transportation, storage, or distribution of commodities, adequately insulate a FHC from risks associated with such facilities, including financial risk, storage risk, transportation risk, reputation risk, and legal and environmental risks?

What negative effects, if any, would a FHC's subsidiary depository institution experience if the parent FHC was not able to engage in Complementary Commodities Activities?

How effective is the current value-at-risk capital framework in addressing the risk arising from holdings of physical commodities? Would additional or different capital requirements better address the potential risks?

Source: Federal Reserve.

In December, for example, Deutsche Bank announced it “is significantly scaling back its commodities business,” exiting dedicated trading desks for energy, agriculture, base metals, and dry bulk. “This move responds to industry-wide regulatory change,” it said in a press release. That same month, Morgan Stanley announced it would sell a unit engaged in the storage, trading, and transportation of oil and refined products. Earlier in the year, JPMorgan Chase said it will sell or spin-off its physical commodities business.

Those moves create something of a Catch-22 for banks. The Fed, in its ANPR, suggests their ability to separate those business lines without material financial losses may mean those business lines were not meaningfully connected financial activity, the basis for permission in the first place. Unlike its peers, Goldman Sachs, as recently as in a call last month with investors, has pledged to stay the course, as its commodities activities are crucial to its business and for investors.

“If you speak to end-users, they are concerned about who they are going to trade with,” says Marvin Goldstein, a partner at the law firm Stroock, which focuses on commodities, derivatives, and energy law. “Who will be there to provide the hedging services they need? Who do you do a long-term hedge deal with that has a high credit rating? Commercial users are concerned there will be nobody to trade with and don't know who is going to provide liquidity to the market.”

“Banks play an essential, if poorly understood, role in assuring the smooth functioning of the commodity markets,” says a recent study by the Securities Industry and Financial Markets Association and market research firm IHS. Cited as benefits of banks participating in physical commodity markets are orderly and efficient markets, providing market making, and ensuring efficient pricing.

“The consequences of impairing this role could be far-reaching and negative,” the study adds. Independent oil and gas producers would have limited ability to hedge the price risks associated with investment and inventory. Airlines, for example, vulnerable to jet fuel prices, could be put at risk. Refineries could be shut down, leading to higher gasoline prices.

“What you may hear back from the affected banking organizations is a caution to the Fed not to tread too harshly, and keep in mind the reason that these activities were approved in the first place is because of their public benefits,” Horn says. “The Fed was effectively concluding that the activity is complementary to a financial activity. That requires Fed action on individual applications and, in each case, the Fed [already] had to consider the public benefits, risks to the bank, and whether or not the organization had the proper policies and procedures to manage and oversee the activity.”