WASHINGTON, D.C. – Today, U.S. Sens. Sherrod Brown (D-OH), Jack Reed (D-RI), and Jeff Merkley (D-OR) urged the Federal Reserve to strengthen and complete its proposed rules to curb Wall Street banks’ ownership of physical commodities, such as oil, coal, and metals. Brown, the ranking member of the Senate Banking Committee; Reed, a senior member of the Banking panel; and Merkley outlined their concerns in a letter to Fed Chair Janet Yellen.

The Senators commended the Fed’s work on the proposed rules, and for calling on Congress to limit Wall Street’s investments in merchant banking and physical holdings. The long-awaited rules, which the Fed proposed in September, would require banks involved in physical commodity activities to boost capital to cover the risks of such investments. Banks would face tighter limits on trading in these markets, and could no longer engage in the business of running power plants. In addition, banks would be prohibited from owning and storing copper.

In their letter, the Senators said many of the changes outlined in the Fed’s rules are “welcome and overdue.” They also questioned claims from the rules’ opponents who have suggested that banks’ activities in physical commodities have never posed risks to the financial system as a whole. The Senators noted that in the run-up to the 2008 financial crisis, many regulators and policymakers ignored warnings from academics and community groups about the dangers of unfettered derivatives and subprime lending.

“[T]his argument ignores the important lesson from recent history that we should not wait for crises to metastasize before taking action to address their potential consequences,” the Senators wrote. “Failing to learn from our past shortcomings will almost certainly ensure that we repeat them, potentially with disastrous consequences… By trading commodities, [financial holding companies] expose themselves to financial, legal, and reputational risk that may be difficult to fully understand, appreciate, and ultimately value, which in turn creates safety and soundness concerns.”

The Senators outlined a series of ways for the Fed to improve the rules: 

·         Expand the scope of physical commodities covered under the rules to account for additional liability concerns such as the environmental impact and human rights consequences stemming from displacement caused by mining, extraction, and other activity. 

·         Revise the proposed capital rules to address the risks associated with commodity financing.

·         Narrow the scope of physical holdings that were protected by grandfathering that allow two banks to have more flexibility than most banks.

·         Expand the limits on merchant banking.

·         Require more comprehensive disclosure of banks’ activities in physical commodities, such as information about how the institutions manage and analyze risk. 

The Senators also emphasized their support for the Fed’s proposals to rescind the orders allowing banks to provide energy management and tolling services, and remove copper from the list of approved precious metals. 

Owning and storing physical commodities, such as aluminum in bank-owned warehouses or oil in storage tankers, provides banks with opportunities to effectively drive up the cost of everyday commodities and products, including gasoline, canned soft drinks and beer, and electricity. Brown led hearings to shine a spotlight on this issue in 2013 and 2014. After years of assurances and delays, the Fed proposed the long-awaited rules in September.

The Fed’s call for Congress to bar merchant banking and curb big banks’ ownership of grandfathered physical holdings were part of recommendations it proposed with other U.S. financial regulators in September. Their report was required by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act.

The full text of the letter is below and available here.

February 9, 2017

The Honorable Janet L. Yellen


Board of Governors of the Federal Reserve System

20th Street and Constitution Avenue, N.W.

Washington, D.C. 20551

Re: Docket No. R–1547 and RIN 7100 AE–58; Regulations Q and Y; Risk-Based Capital and Other Regulatory Requirements for Activities of Financial Holding Companies Related to Physical Commodities and Risk-Based Capital Requirements for Merchant Banking Investments

Dear Chair Yellen:

We begin by commending the Board of Governors of the Federal Reserve System (the Board) on its efforts in both this Notice of Proposed Rulemaking (NPRM), as well as its recommended legislative changes presented in its report to Congress pursuant to section 620 (Section 620 Report) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). We appreciate the Board’s legislative recommendations and believe that Congress has an obligation to consider and act upon them.

Some have suggested that the NPRM, and the recommendations in the Section 620 Report, are unnecessary because financial holding companies’ (FHCs) physical commodities activities have never before posed any risks to the financial system as a whole. That view ignores the safety and soundness risks that such businesses can pose to individual institutions, which is one element of the Board’s supervisory mandate.[1] It also ignores the policy issues raised by FHCs’ involvement in physical commodities activities, including but not limited to, competitive distortions, interference with the efficient functioning of markets, and the traditional separation of banking and commerce.[2] 

Perhaps most importantly, this argument ignores the important lesson from recent history that we should not wait for crises to metastasize before taking action to address their potential consequences. As the Financial Crisis Inquiry Commission (FCIC) found, in the lead-up to the financial crisis of 2008, “many top officials and regulators were reluctant to challenge the profitable and powerful financial industry.”[3] Regulators and policymakers dismissed as “anecdotal” and “misguided” the concerns raised by academics and community groups about unregulated derivatives and subprime lending.[4] As observers sounded alarms about practices that were happening in their communities, bank executives viewed the collapse in housing prices prior to the financial crisis as “wholly unanticipated.”[5] Regulators likewise “underestimated what systemic risk would be in the marketplace.”[6] Failing to learn from our past shortcomings will almost certainly ensure that we repeat them, potentially with disastrous consequences.

Many of the proposed changes are welcome and overdue. In particular, we support the proposals to rescind the orders allowing FHCs to provide energy management and tolling services, and remove copper from the list of approved precious metals.

The recent exit by certain FHCs from certain commodities markets has undermined the argument that FHCs need to be in the physical markets in order to better understand the commodities whose values underlie financial products like swaps and futures.[7] In addition, the case for rescinding orders governing commodities activities that present risks is especially strong where there is documented evidence that the benefits to customers are small or nonexistent. For example, airlines have found that FHCs did not provide financial benefits over nonfinancial companies as providers of crude oil.[8] 

However, we believe that addressing the following issues could strengthen the proposal:

A.    The scope of covered physical commodities should be expanded and any loopholes in the 4(k) cap should be eliminated;

1.      The scope of covered physical commodities should be expanded

While conventional wisdom has come to view commodities as a standard asset class, they are subject to distinct risks that are of a fundamentally different nature from other assets.[9] For example, markets can be volatile and prone to sudden swings, including those caused by questionable trading activity.[10] In 2007, the Chief Financial Officer of a large FHC heavily involved in physical commodities said that commodities trading is “a dangerous business to be in even if you are expert.”[11] In the past year alone, large commodities trading firms have experienced pressure from funding markets based upon a variety of economic factors.[12]

By trading commodities, FHCs expose themselves to financial, legal, and reputational risk that may be difficult to fully understand, appreciate, and ultimately value, which in turn creates safety and soundness concerns. Unfortunately, the NPRM uses a definition of “covered commodities” focused on the potential catastrophic risk that these holdings and activities could pose to the banks under the Oil Pollution Act of 1990 (OPA), the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA), and the Clean Water Act (CWA).

The NPRM fails to account for additional liability concerns related to, for example, reclamation of abandoned mines in the United States,[13] and such liability could attach for such activities in other countries. It also declines to address considerations like the impact on the environment more generally, the human rights consequences from displacement caused by mining, extraction, and the like, and the international frameworks governing such issues.[14] Finally, there could be liability under labor laws.[15]

Commodities activities present risks that are different from financial market risks, for example:

·         political risk;[16]

·         global supply chain disruptions;[17]

·         geopolitical turmoil in unstable resource-rich regions;[18]

·         troubling human rights and labor practices in resource extraction industries and resource-rich regions;[19]

·         bribery and anticorruption risk;[20]

·         vulnerability to international sanctions laws;[21] and

·         other environmental protection concerns.[22]

Even commodities like agricultural commodities that appear vulnerable to fewer of these factors are exposed to the catastrophic macro risks of, for example, climate change.[23] 

They also contain financial risks that apply whether a bank is engaging in financing, physical asset ownership, and the like, including liquidity risk, stock risk, etc.[24] Commodities originating in certain countries may be subject to tariffs, however, a stockpile’s country of origin may not always be easily discernible.[25] In another notable example, fraud at Chinese metals warehouses undermined copper and aluminum transactions, notwithstanding an “extensive internal review process” of such transactions.[26] 

All of this is not to say that some of these risks are not manageable, merely they are numerous and varied, and cannot necessarily be measured using one uniform risk weighting applicable to either covered or non-covered commodities. The risk weighting regime should better reflect the various levels of risk associated with certain commodities. For example, it could distinguish the risks associated with extractive industries as opposed to those associated with agricultural commodities. Proposed changes to the risk weighting scheme are discussed more below.

2.      The risk weighting scheme and the regime for calculating the application of the 4(k) cap should better reflect the risks involved

While FHCs appear to have reduced their commodities holdings and trading activities in recent years, these FHCs still engage in many activities, and may choose to expand again in the near future.[27] The capital rules should be revised, both to properly address the current structure and risks associated with commodities financing, as well as to alter the economics of future physical commodities investments.

For example, FHCs often structure their commodities financing as repo-style transactions.[28] The repo structure offers certain legal and regulatory advantages to the lender over a secured loan, including favorable treatment under capital rules.[29] Repo-style arrangements also offer the ability to move commodities exposures off-balance sheet in certain circumstances.[30] For restrictions, including the 5 percent cap, and capital rules to meaningfully mitigate the risks of 4(k) complementary activities they should ensure that this regime is applied equally, regardless of structure of such transactions.

The Basel III implementing regulations have a risk weighting scheme for physically settled contracts, which serve as a partial basis for the NPRM’s framework.[31]  However, this framework excludes repo-style transactions, and the NPRM is not clear how its risk weights would apply to such transactions; how the potential exposure of these transactions returning to the balance sheet should be calculated; and why the risk weights are only 300 percent for these financing arrangements (that are not covered commodities or held under 4(o)), when the Basel III schedule contains weightings for physically settled transactions that are in many ways significantly higher.[32] The final rule should account for commodities that are used as repo collateral in FHCs’ physical inventories, and use higher risk weights, similar to those in the Basel III physically settled transactions schedule.

Holdings under section 4(o) authority should also not be eligible to be counted against the 4(k) cap for the purposes of calculating risk weighting. As the Board has acknowledged, 4(k) imposes additional restrictions that are not required under 4(o).[33] Allowing these holdings to be treated as equivalent to 4(k) allows FHCs to receive favorable capital treatment without being subject to more stringent limitations.

In addition, the NPRM fails to account for risks related to FHCs’ arrangements to contract the storage, production, transport, and/or alteration of a particular commodity.[34] While the specific principal risk involved in operating facilities that engage in, for example, the treatment of crude materials into refined products, is different, there are still risks associated with contracting for these services.[35] The NPRM should account for such risks, because they change the nature of the FHCs’ potential exposures.

Finally, the risks associated with physical commodity portfolio companies is greater than those associated with non-commodities businesses. FHCs have not had an easy time offloading their commodities holdings in recent years[36] – and such sales took place prior to significant declines in certain commodities markets. While many may think that extractive industries are poised for a rebound under new political leadership, there are economic signs that demand may not increase.[37] Any final rule should contain a robust framework to account for these potential exposures and their illiquid nature.

B.     The Scope of 4(o) Permissible Grandfathered Activities Should Be Narrowed

Notwithstanding our support for your recommendation that Congress repeal section 4(o), we continue to believe that the Board has additional authority to interpret the language of section 4(o) in a manner that more narrowly defines the scope of the grandfathered provision.

Section 4(o) of the BHC Act provides a statutory exemption for certain eligible institutions to engage in physical commodities activities and asset ownership. Staff at the Federal Reserve Bank of New York has observed that this provision is “widely seen as ambiguous,”[38] and the Director of the Board’s Bank Supervision and Regulation Division has acknowledged that “there are multiple possible interpretations of section 4(o) of the BHC Act.”[39] 

Board staff told the Senate Banking Committee that “the Board will consider the scope of the grandfather provision in section 4(o)… in connection with its review of physical commodities activities.”[40] However, the ANPR merely states that the “range of activities includes storing, transporting, extracting, and altering commodities.”[41]

While some may argue that the language ties the Board’s hands, the statutory framework appears to provide flexibility.[42] The language of the statute could limit eligible institutions to only the particular activities that they were engaged in prior to such date. The Board should interpret this provision more explicitly, and in as narrow a manner as possible, permitting grandfathered institutions to only engage in the specific activities in which they were engaged prior to 1997. 

In 2013, Morgan Stanley’s CEO reportedly said that the catastrophic risk associated with physical storage and transportation is, “a risk we just can’t take[.]”[43] Rather than relying on FHCs to voluntarily determine that it is beyond their ability to prudently manage the risks of such activities, we believe the Board has the ability to further restrict them, including in the interest of safety and soundness.

C.    The Limits on Merchant Banking Should Be Expanded, Not Merely Codified 

Because FHCs have been found to exercise a high level of control over physical commodity portfolio companies,[44] the proposal’s strengthened restrictions are necessary and important.

However, the concerns regarding FHCs’ involvement with portfolio companies are not confined to operational decisionmaking. Communications with physical operators provide FHCs with additional market information that can aid their trading operations, notwithstanding the ostensible barriers to these inter-relationships.[45] FHCs themselves have also acknowledged that their customers believe their physical operations create potential conflicts of interest.[46] Access to board presentations and participation in business strategy decisions provides problematic openings for such information sharing and creates additional possibilities for conflicts of interest.

As a result, FHCs should be removed from business strategy formulation and decisionmaking as well, including placing employees on the boards of portfolio companies.[47]


D.    Disclosures 

More and better disclosure of these activities will enhance the public’s understanding of these activities.

However, the proposal would not give observers a sense of the full range and scope of these activities. How the spot, futures, swaps, loan, and other components of an FHC’s portfolio fit together may provide a picture that is not readily apparent by looking at each activity in isolation. [48] These markets are often interrelated, and access to information about just one market may obscure actions being taken, and strategies towards, other markets.

A more comprehensive narrative description by each FHC of its full range of activities, how they fit together – for example, how physical trading is actually “complementing” derivatives trading and vice versa. More robust information, along the lines of a management discussion and analysis, would better inform observers as to the views of FHCs, their business practices, and the associated risks and values therein.

E.     Conclusion

Thank you again for your proposal. While some FHCs are exiting certain business lines, they are remaining in others, demonstrating the need for these rules to be finalized and implemented.[49] We were disappointed in the long delay between the ANPR and the NPRM, as well as the decision to extend the NPRM comment period an additional 60 days, and we hope that you will move forward in finalizing your rules without any further undue delay.