Proposed Fed Rules Could End Financial Holding Companies’ Participation in Physical Commodities Activities

November 7, 2016

The Board of Governors of the Federal Reserve released proposed regulations on Financial Holding Companies’ (“FHC”) participation in physical commodities activities.[1] Upon review of these activities and concerns about potential legal liability of FHCs for environmental disasters, the Board issued an advanced notice of proposed rulemaking (“ANPR”) in January of 2014 asking for public comment on these concerns.[2] After reviewing the comments, the Board publicly announced its proposal on September 23rd, 2016.

 

The Board received 180 unique comments and 16,900 form letters in response to the ANPR.[3] All of the form letters and two thirds of the unique comments opposed FHC involvement in physical commodities activities.[4] These comments cited risks to the financial system as a whole and whether or not FHCs could properly protect against those risks.[5] Another common concern was the ability of FHCs to manipulate the commodities market.[6] Those in support of FHC participation in physical commodities activities were heavily end users who believe FHCs are reliable providers of commodity services and can adequately protect against the risks associated with these activities.[7] Supporters also said that FHC participation of this sort increases the liquidity of the commodities market.[8] Considering these comments, the Board is proposing somewhat of a middle ground—much tighter restrictions on but not an outright ban of FHC participation in physical commodities activities.

 

Who Will Be Affected

 

The proposed regulations will affect FHCs acting under three types of authority. First, FHCs practicing under “complementary authority” were authorized by the Board under the Bank Holding Company Act (“BHC Act”) to engage in physical commodity, energy management, and energy tolling activities.[9] The purpose of this is to allow FHCs to engage in activities that appear to be of a commercial nature but have a meaningful connection to financial activities.[10] Twelve FHCs have complementary authority, including Bank of America, JPMorgan Chase, and Wells Fargo.[11] The second type of authority is grandfather authority, which allows companies engaged in physical commodities activities before becoming FHCs to continue those activities.[12] The only two FHCs operating under grandfather authority are Goldman Sachs and Morgan Stanley.[13] Finally, a provision in the BHC Act allows FHCs to make merchant banking investments in a nonfinancial company, including one engaged in physical commodities activities.[14] The proposed rules will affect each FHC differently depending on the type of authority under which it is participating in physical commodities activities.

 

Proposed Rules

 

The first proposed rule would increase the risk-based capital requirements for FHCs holding covered physical commodities.[15] Covered physical commodities are physical commodities for which liability will be imposed if released into the environment.[16] For FHCs involved in covered physical commodities under complementary authority, a 300 percent risk weight must be assigned to the covered physical commodities.[17] The rationale for this is to require that FHCs have a comparable level of capitalization to nonbank commodities trading firms.[18] FHCs holding covered physical commodities pursuant to grandfather authority must assign a 1,250 percent risk weight to the covered physical commodities.[19] The Board believes the risks associated with activities under grandfather authority are higher than activities under complementary authority, and this proposed increase would better reflect that higher risk.[20]

 

Risk-based capital requirements would also be increased for FHCs engaged in merchant banking activities.[21] A 1,250 percent risk weight must be assigned to these investments unless the activities of the portfolio company are permissible under complementary authority.[22] If the activities of the portfolio company are all permissible under complementary authority, a 300 percent risk weight must be assigned if the portfolio company is publicly traded and a 400 percent risk weight must be assigned if it is a private company.[23] These capital requirements would not be applied if the portfolio company only participates in physical commodities activities as necessary to power or support the underlying business.[24]

 

Another proposed regulation would limit the value of commodities held by FHCs under complementary authority to 5 percent of the consolidated tier 1 capital.[25] This would include physical commodities held by the consolidated organization, but would not include activities pursuant to authority other than complementary authority.[26] Furthermore, this proposed rule would strengthen current restrictions that prohibit FHCs from operating companies involved in physical commodities activities.[27] An FHC would not be allowed to directly participate in management or operational decisions of the company or give advice to the company.[28]

 

Currently, five FHCs have authority from the Board to participate in energy management and energy tolling activities.[29] A proposed rule would revoke this authority and provide a two-year period for the FHCs to end participation in these activities.[30] The Board does not see a sufficient connection of energy management and tolling activities to financial activities to justify this authority as it once did.[31]

 

Other proposed rules include additional reporting requirements and removing copper from the list of precious metals that Bank Holding Companies are permitted to own and store.[32] To increase public transparency and agency monitoring ability, the Board’s proposed rule would require more specific reporting on physical commodities activities and risk-weighted assets associated with these activities.[33] Additionally, the Board proposes removing copper from the list of precious metals that Bank Holding Companies are allowed to own and store, because copper is an industrial metal, not a store of value as it once was.[34]

 

Potential Consequences

 

The Board states the proposed rules would not have a significant effect on the commodities market as a whole, as FHCs represent less than 1 percent of the physical commodities market.[35] The Board also believes the rules would not have a significant effect on the capital ratios of FHCs.[36] Despite these assertions by the Board, there are risks associated with the implementation of the proposed rules.

 

FHC participation in the physical commodities market will likely decrease. The increased capital requirements will mean FHCs have to move cash from other activities to physical commodities activities. Additionally, direct involvement in physical commodities activities helps to inform FHCs’ commodities traders of the realities of the physical market. Little or no involvement will mean FHCs are further removed from first-hand knowledge for commodities trading purposes.

 

The Board invites comments to the proposed rules by December 22, 2016. Comments can be submitted on the Federal Reserve System website, the Federal eRulemaking Portal, by e-mail, by fax, or by mail.

 


 

[1] Press Release, The Federal Reserve Board, Federal Reserve Board invites public comment on proposed rule that would strengthen existing requirements and limitations on the physical commodity activities of financial holding companies (Sept. 23, 2016).

[2] Board of Governors of the Federal Reserve System, Notice of Proposed Rulemaking, Docket No. R-1547 (Sept. 23, 2016).

[3] Id.

[4] Memorandum to Board of Governors of the Federal Reserve System on Proposed Rule Implementing Strengthened Prudential Requirements (Sept. 12, 2016).

[5] Id.

[6] Id.

[7] Id.

[8] Id.

[9] Bank Holding Company Act § 4(k)(1)(B).

[10] Board of Governors of the Federal Reserve System, Notice of Proposed Rulemaking, Docket No. R-1547 (Sept. 23, 2016).

[11] Id.

[12] Bank Holding Company Act § 4(o).

[13] Memorandum to Board of Governors of the Federal Reserve System on Proposed Rule Implementing Strengthened Prudential Requirements (Sept. 12, 2016).

[14] Bank Holding Company Act § 4(k)(4)(H).

[15] Memorandum to Board of Governors of the Federal Reserve System on Proposed Rule Implementing Strengthened Prudential Requirements (Sept. 12, 2016).

[16] Id.

[17] Id.

[18] Id.

[19] Id.

[20] Id.

[21] Id.

[22] Id.

[23] Id.

[24] Id.

[25] Id.

[26] Id.

[27] Id.

[28] Id.

[29] Id.

[30] Id.

[31] Id.

[32] Id.

[33] Board of Governors of the Federal Reserve System, Notice of Proposed Rulemaking, Docket No. R-1547 (Sept. 23, 2016).

[34] Memorandum to Board of Governors of the Federal Reserve System on Proposed Rule Implementing Strengthened Prudential Requirements (Sept. 12, 2016).

[35] Id.

[36] Id.

About

Sarah Brown is a third-year law student at The University of Texas School of Law. She graduated from Texas Christian University in 2014 with a Bachelor of Science in Political Science and minors in business and Spanish. After graduation Sarah will return to her hometown of Dallas to join the litigation group at Norton Rose Fulbright.