01/14/2014 09:47 pm ET Updated Jan 25, 2014

Federal Reserve: Deepwater Horizon Oil Spill Is What Scares Us About Banks In Physical Commodities


The Federal Reserve took a potential step Tuesday to limit big banks’ activities in physical commodities, publicly outlining concerns with bank investments in ventures that can lead to deadly oil spills, pipeline ruptures and natural gas explosions.

The expected move comes after months of criticism by U.S. lawmakers that large banks’ recent expansion into businesses such as oil fields and tankers, metals warehouses, and chemical pipelines poses risks to the U.S. economy and financial system. Industrial companies, such as MillerCoors, and lawmakers, including Sen. Sherrod Brown (D-Ohio), also have raised concerns about possible manipulation of key commodities markets, which may boost banks' profit while leading to higher costs for households and manufacturers.

In its request for public comment, the Fed appeared skeptical of the benefits of banks' involvement in physical commodities. The Fed pointed out several environmental disasters that resulted from physical commodities activities, such as the Deepwater Horizon oil spill in the Gulf of Mexico and the 2010 explosion of a power plant in Middletown, Conn., that killed six people. BP alone had recognized $42.2 billion in losses as of last year as a result of the oil spill, the Fed said. Having banks involved in physical commodities puts them at risk of similar catastrophes, the Fed suggested, which could lead to a big bank’s failure.

While the Fed detailed numerous concerns and suggested several ways to mitigate risks posed by banks’ involvement in physical commodities, it took no further action. It posed some two dozen questions, but didn’t state any timelines for answers. And the Fed said it’s not guaranteed to issue new rules or otherwise rein in banks’ activities in the sector.

Though Michael Gibson, the Fed’s head of supervision and regulation, plans to tell the Senate Banking Committee on Wednesday that the regulator expects to “engage in additional rulemaking in this area,” according to a copy of his prepared remarks, for the foreseeable future banks can continue operating like they have over the past decade and reap profits off their metals, storage, transportation and energy businesses.

“I suspect ... this will continue to be a slow process and this release is more focused on placating legislators than affirmatively restricting activities of the [banks],” said Joshua Rosner, managing director at independent research firm Graham Fisher & Co.

Brown, who has been pressing the Fed to act since July, said the Fed’s decision, “while a step forward, is still overdue and insufficient.”

“It has been almost 15 years since the passage of Gramm-Leach-Bliley, more than a decade since the first bank received approval from the Fed, and more than five years since investment banks became bank holding companies," Brown said. "Each day that we wait to rein in these activities means that end users and consumers will pay higher commodity and energy prices, and taxpayers will continue to be exposed to excessive risks at Too Big to Fail banks."

The Gramm-Leach-Bliley Act of 1999 enabled financial companies to enter the physical commodities business. Fed decisions since then have allowed banks to expand those activities to include aluminum warehouses, mines and power plants. Goldman Sachs and Morgan Stanley, commodities giants that converted to banks in 2008 during the height of the crisis, have continued their physical commodities activities.

The financial crisis led some banks to boost their physical commodities activities. That expansion, plus recent catastrophes like the BP oil spill, has alarmed some Fed officials, the regulator said.

The Fed, in fact, appeared to go to extraordinary lengths to highlight recent disasters in an effort to convey its concerns. The Fed noted the 2011 earthquake and tsunami that struck Japan, degraded a power plant and resulted in a nuclear disaster. It also pointed to the 2013 derailment in Canada of a cargo train carrying crude oil that killed 47 people and the recent collision of a train carrying crude oil with a train carrying grain near an ethanol plant in North Dakota.

The industrial sector and government organizations charged with overseeing it have struggled with safety issues, the Fed noted.

“Recent events have increased concerns regarding the ability of companies to mitigate potentially extraordinary tail and other risks,” Gibson said in his prepared remarks. The financial crisis, he said, also “highlighted the danger of underappreciated tail risks,” or the danger of an extremely rare and destabilizing event.

Concerns about these commodities activities aren’t new. Some Fed officials internally have been warning for years about the risks. Besides the risk of a large bank’s failure as a result of an environmental disaster, there’s also the potential for banks to manipulate their physical commodities holdings to benefit their positions in financial instruments such as derivatives.

Norman Bay, the Federal Energy Regulatory Commission’s enforcement chief, plans to tell the Banking Committee that market manipulators can rig energy markets by using trades of physical commodities to move prices in a way that benefits their overall financial position, according to his prepared remarks.

In such a scheme, Bay said, “The manipulator may lose money in its physical trades, but the scheme is profitable because the financial positions are benefitted above and beyond the physical losses.”

Rosner and 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, argue that traders at banks that own physical commodities assets have a natural incentive to use inside knowledge gleaned from their co-workers to generate profits from trades of derivatives tied to the underlying commodities.

Bay said the regulator is hamstrung in its ability to bring certain cases because it lacks access to data from financial markets that are held by other federal regulators, notably the Commodity Futures Trading Commission.

In its request for public comment, the Fed pointed to concerns about “undue concentration of resources, decreased or unfair competition, conflicts of interests, unsound banking practices, or risk to the stability of the United States banking or financial system.”

Some federal regulatory officials have said that these concerns have existed for years inside the Fed and other agencies. Omarova said that among U.S. regulators, the Fed is best equipped to act. Its powers are expansive, and banks have little option but to follow the Fed’s demands, she said.

Fed supporters reckon that the regulator deserves the benefit of the doubt as its top officials have been busy over the past few years implementing a host of new rules in hopes of preventing another financial crisis, from requiring banks to reduce their reliance on debt to producing new restrictions on trading activities.

The Fed appears to be finally focusing on the risks associated with physical commodities. It said it is now weighing its options. The regulator said it could restrict certain activities, heighten requirements for banks that engage in certain physical commodities businesses, or in effect make it so expensive for banks to play in physical commodities that banks may conclude it’s simply not worth the hassle.

Some banks, such as Morgan Stanley, Bank of America and JPMorgan Chase, already have announced they either are exiting key physical commodities activities, shuttering certain units or are weighing potential sales of parts of their operations. Their moves coincide with recent scrutiny by the Fed and U.S. lawmakers.

In its public request for information, the Fed, which in 2003 began allowing some banks to enter certain physical commodities markets after the banks argued the activities were “complementary” to the financial side of their business, appeared skeptical of the “complementary” argument now that banks have said they are exiting certain markets. The Fed said the moves suggest the relationship between physical commodities and related derivatives “may not be as close as previously claimed or expected.”

The Fed also appeared doubtful that moves by banks to insulate themselves from liability would sufficiently protect them from an environmental disaster.

Public confidence in a bank facing potential liability from an environmental catastrophe “could suddenly and severely be undermined,” the Fed said. The bank could be shut out of financial markets while counterparties assessed the bank’s liability, potentially a long process that could put the bank at risk of failure.

“Although the likelihood of a catastrophic event is small in the short term, catastrophes involving physical commodities continue to occur, and the resultant damages are very difficult to measure, even after the event has occurred, and may be extremely large,” the Fed noted.

The Fed also pointed out that because banks have not yet had to face the fallout from an environmental disaster resulting from their physical commodities activities, it's unclear how resilient they'd be should one occur.

"The absence of such an experience may hinder [banks'] ability to assess the efficacy of their safeguards," the Fed noted.

Rosner said it was unfortunate the Fed chose not to take more decisive action, such as banning banks from participating in certain physical commodities activities, "given the Fed's own acknowledgement that they are lucky the hand grenade has not yet exploded in their hand up till now."

Despite its apparent concerns, it’s unclear what eventual action the Fed may take, or when it will decide its review is complete. The Fed in effect asked the public for advice on what it should do.

In the meantime, counterparties to banks involved in physical commodities -- and investors in those banks -- now have a public document from the Fed detailing how a bank could face trouble in the event of a physical commodity-related calamity.

“The systemically destabilizing impacts that could occur in the face of catastrophe involving one of these businesses leads one to wonder whether releasing a document without prohibiting the riskiest of these activities only exacerbates the chances that counterparties would step away if such a catastrophe happened tomorrow,” Rosner said.



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