POLITICS
01/13/2014 11:21 pm ET Updated Jan 25, 2014

Wall Street May Win As Federal Reserve Prepares To Punt On Physical Commodities

Big banks are poised to reap a significant victory in their fight to maintain lucrative businesses hoarding, selling and trading physical commodities as the Federal Reserve prepares to punt on the issue, people familiar with the matter said.

The Fed’s move to solicit public input on what it should do, rather than use its authority to regulate the activities of large financial institutions, is expected to be announced by Wednesday afternoon in advance of a Senate Banking Committee hearing on the issue. Some federal financial regulators said the move may be a way for the Federal Reserve’s Board of Governors in Washington to evade calls to curb banks’ risk-taking. It would come despite years of internal warnings at the Fed that Wall Street’s expansion into metals and energy puts the U.S. economy at risk in the form of higher prices due to alleged market manipulation and endangers the financial system because of the possibility that a catastrophic incident such as an oil spill would lead counterparties to flee the affected bank and put it at risk of failure.

The Fed’s planned announcement comes as the central bank faces pressure from lawmakers such as Sen. Sherrod Brown (D-Ohio) and industrial companies to reduce big banks’ commodities activities. Some reports have alleged manipulation of some markets and have raised concerns that banks have too much control over key commodities. It’s likely to stoke criticism that the central bank, while taking some action to reduce the risks large lenders pose to the financial system, is shirking its responsibility to ensure financial stability.

“This is clearly an attempt to avoid dealing with the issues while pushing back against public pressure,” said Joshua Rosner, managing director at independent research firm Graham Fisher & Co.

Saule Omarova, a law professor at the University of North Carolina at Chapel Hill who served as a special adviser for regulatory policy at the Treasury Department during the George W. Bush presidency, said the Fed is gambling by essentially ignoring the developing risks to the financial system posed by banks’ involvement in physical commodities.

“The Fed has always looked at this from the perspective of, ‘Does it enhance the safety and soundness of an individual institution?’ But that inquiry by definition leaves aside systemic risk,” said Omarova. “There is something to be said about the cumulative effect of various activities that may not be particularly scary for individual institutions, but taken together across the system could be very worrisome.”

The problem, according to critics, is one of the Fed’s own making. A Fed spokesman declined to comment.

The Fed has blessed banks’ expansion into commodities such as aluminum and natural gas through regulations and legal opinions. The actions effectively have allowed some financial institutions to transform from pure middlemen, matching buyers and sellers, or borrowers and savers, to commercial enterprises that refine, store, transport, and distribute physical commodities used to heat homes and produce beer cans.

JPMorgan Chase, Goldman Sachs and Morgan Stanley now are among the nation’s biggest suppliers of energy, according to industry rankings and federal data. Over the last several years, the three banks were among a group of select financial institutions to broaden their physical commodities activities as the sector promised substantial revenues that, coupled with the banks’ traditionally low cost of financing, guaranteed steady and at times enormous profits.

In 2012, the most recent year for which annual data is available, JPMorgan, Goldman and Morgan Stanley were the top three global banks in commodities revenue, according to Coalition, a financial data provider. The 10 largest banks generated some $6 billion in commodities revenue that year.

But recent complaints by industrial companies, including Boeing, Coca-Cola, and MillerCoors, that financial companies effectively have been manipulating some markets for their own financial advantage, leading to higher costs for households, have prompted congressional scrutiny of Wall Street’s activities and the Fed’s alleged lack of oversight, and put pressure on the Fed to clamp down on banks. Investigations launched by other regulators and ongoing concerns that some of these same financial institutions remain “too big to fail” more than five years after the height of the financial crisis only intensify that pressure.

There are three main ways for banks to be involved in physical commodities: They could ask the Fed for permission and claim that the business would be complementary to ordinary banking activities; they could buy companies engaged in physical commodities activities under so-called merchant banking provisions that allow for banks to make such purchases solely for the purpose of turning a profit within a decade or so; or they could be exempt from rules normally banning certain physical commodities activities because they were in these businesses prior to passage of the deregulatory law known as the Gramm-Leach-Bliley Act of 1999.

A financial industry-sponsored study published in September claimed there would be more risk, less energy investment and increased chance of supply disruptions if banks reduced their commodities activities.

In a Dec. 16 letter to Rep. Alan Grayson (D-Fla.), outgoing Federal Reserve Chairman Ben Bernanke said Goldman and Morgan Stanley conduct physical commodities activities under the Gramm-Leach-Bliley exemption.

Bernanke also said a group of giant global banks conduct certain commodities activities as a result of Fed approval. They are: U.S. banks Citigroup, Bank of America, JPMorgan and Wells Fargo; Swiss banks UBS and Credit Suisse; UK banks Barclays and Royal Bank of Scotland; French banks Societe Generale and BNP Paribas; Deutsche Bank, of Germany; and Bank of Nova Scotia, of Canada.

Bernanke did not identify banks that operated physical commodities businesses under merchant banking provisions. Janet Yellen, Fed vice chair, will replace Bernanke on Feb. 1 after the Senate confirmed her as President Barack Obama's pick to lead the Fed.

Grayson was among a small group of House Democrats who asked Bernanke whether regulators could feasibly track conflicts of interest or market manipulation across the financial and industrial sectors, and warned of "significant macro-economic risk" from having banks significantly involved in non-financial sectors of the economy.

Last year, the Fed responded in July to the criticism by announcing that it would review legal decisions made beginning in 2003 under the complementary rationale. That announcement played a role in some banks’ decisions to preemptively curtail their commodities activities, either by shutting down trading desks, announcing some units such as storage warehouses were for sale or selling parts of their businesses. Spokesmen for JPMorgan, Goldman and Morgan Stanley declined to comment.

The central bank also faced a potential autumn deadline regarding certain commodities operations at Goldman and Morgan Stanley, commodities powerhouses that converted to Fed-supervised banks during the financial crisis in part to avert collapse. The two companies had been involved in some physical commodities businesses that banks normally aren’t allowed to be in, and the Fed could have forced them to shed or restructure units such as those involving oil tankers and pipelines.

Morgan Stanley said in its most recent annual report that it continues to “engage in discussions with the Federal Reserve regarding our commodities activities.” Goldman also has been discussing its exemption with the Fed, though Goldman executives publicly have made clear that it has no intention of exiting key commodities businesses.

“Commodity hedging is a core competency and one of the most important things we do in the firm, and our clients really need us to be in that business. We are staying in the commodity hedging business,” Gary Cohn, Goldman president and chief operating officer, said in July on CNBC when asked whether the company would exit physical commodities.

Some regulatory officials and financial experts outside the government said the potential deadline and outcry from lawmakers and companies in the so-called real economy presented the Fed with an opportunity to take decisive action. Rather than allowing banks to continue profitable yet risky activities, the Fed could limit banks’ involvement in physical commodities on the grounds that they posed too great a risk to the general economy.

Officials familiar with the Fed's supervision of financial groups have said that the agency is struggling to figure out how to oversee banks’ physical commodities businesses, since they’re not traditional banking activities such as lending or helping a company sell stock.

In his letter to Grayson, Bernanke said that because banks’ “industrial commodity activities raise specific concerns,” the Fed had completed what he described as “discovery reviews” during which “specialized teams with expertise in market and operational risk ... examined business exposures, valuation, risk management practices, and capitalization methods ... to assess the range of practices, identify best practices, and address any risk management or other supervisory concerns.”

Despite those concerns, the Fed is set to seek public comment on banks’ involvement in physical commodities. There’s a chance the Fed eventually will crack down and limit banks’ activities. There’s also a chance the Fed will enable more banks to engage in physical commodities businesses on the grounds that the activities are too concentrated among a small group of banks.

“With over a decade to consider merchant banking, complementary activities and more than five years to consider grandfathering provisions, it's amazing the Federal Reserve Board has done nothing, nor held any board meetings to consider the issue, and now puts forth a series of questions to consider just days before a Senate hearing,” Rosner said.

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