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On September 23, 2016, the Board of Governors of the Federal Reserve System (the “FRB”) issued a proposed regulation concerning the ability of a financial holding company (“FHC”)1 to engage in physical commodities activities (the “Commodities Proposal”). The Commodities Proposal follows an advanced notice of proposed rulemaking issued by the FRB more than two years ago in early 2014.2
The Commodities Proposal reflects a new approach to restrict activities that the FRB believes to impose excessive risk. Rather than attempt to restrict the commodities activities that are specifically permitted by federal statute, the FRB instead is proposing to use its capital authority to make certain physical commodities activities economically impracticable for FHCs. The Commodity Proposal focuses predominantly – but not exclusively – on certain types of physical commodities that the FRB perceives as high risk to FHCs due to environmental or related litigation risk (a “covered physical commodity”).
Yet, only three weeks ago, in the FRB’s Section 620 report to Congress regarding activities the FRB deemed to pose systemic risk, the FRB conceded that while certain of these physical commodities are believed to create systemic risk, repeal of this authority “require[s] congressional action and cannot be accomplished by the [FRB] unilaterally.”3 It is telling that the FRB did not wait for congressional action but instead used its capital authority effectively to repeal the authority granted by Congress.
An FHC may engage in physical commodities activities under a variety of different legal authorities:
FHCs historically have relied on a variety of these authorities to engage in physical commodities activities. To the extent that these physical commodity activities now involve “covered physical commodities,” the Commodities Proposal greatly increases the internal costs of engaging in such activities.
The FRB’s Commodity Proposal would significantly increase the capital charges associated with an FHC’s activities with respect to covered physical commodities depending on the authority used. The FRB proposal does not explicitly define “covered physical commodity” but rather incorporates by reference certain substances that are deemed hazardous or otherwise subject to regulation under federal and state environmental protection laws and regulations. Such covered physical commodities would likely include, but are not limited to: oil, natural gas, and other petroleum products and by-products; lead; certain fertilizers and emissions; and uranium. The Commodities Proposal would not increase capital charges on physical commodities activities other than those involving covered physical commodities. For example, the ability to trade in agricultural, forestry, and livestock products as well as base metals (other than uranium and, as explained later, copper) would remain unchanged.
The Commodities Proposal would impose the following capital charges on covered physical commodities activities:
The Commodities Proposal establishes detailed procedures regarding how each of these exposures is to be calculated for risk-based capital purposes.
The Commodities Proposal would make a number of other changes to an FHC’s physical commodities trading authority, most of which are not limited to covered physical commodities activities:
(1) Participation in the day-to-day management or operations of the facility;
(2) Participation in management and operational decisions that occur in the ordinary course of the business of the facility; and
(3) Managing, directing, conducting, or providing advice regarding operations having to do with the leakage or disposal of a physical commodity or hazardous waste or decisions about the facility’s compliance with environmental statutes or regulations.
As demonstrated, the FRB’s Commodities Proposal reflects a significant rollback in FHC authority to transact in certain covered physical commodities, such as petroleum products. Trading activity in other physical commodities is less impacted. However, it should not be overlooked that the FRB separately has recommended to Congress that it repeal both merchant bank authority in its entirety (including but not limited to commodities activities conducted under merchant banking authority), and grandfathered commodities authority.14 Thus, further rollbacks may be coming, but they may be dependent on Congressional action.
Comments on the FRB’s Commodities Proposal are due by December 22, 2016.
1 A “financial holding company” is, in essence, a well-managed, well-capitalized bank holding company that has filed a notice with the FRB to engage in expanded, “financial in nature” activities.
2 See Board of Governors of the Federal Reserve System, Advanced Noticed of Proposed Rulemaking, Complementary Activities, Merchant Banking Activities, and Other Activities of Financial Holding Companies Related to Physical Commodities, 79 Fed. Reg. 12,414 (Mar. 5, 2016).
3 See Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency, Report to the Congress and the Financial Stability Oversight Council Pursuant to Section 620 of the Dodd-Frank Act (Sept. 8, 2016) (the “Section 620 Report”) at p. 28, available at http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20160908a1.pdf.
4 See 12 U.S.C. § 1843(k)(4)(H), 12 C.F.R. Part 225 Subpart J.
5 This authority is based on a provision of the Bank Holding Company Act, added in the Gramm-Leach-Bliley Act of 1999, which permits the FRB, by order or rule, to allow an FHC to engage in activities that are complementary to a financial activity. See 12 U.S.C. 1843(k)(1)(B). The authority to engage in physical commodities activities as a complementary activity was first issued in 2003. See Citigroup Inc., 89 Federal Reserve Bulletin 508 (2003). The twelve FHCs with complementary authority are: Bank of America, Credit Suisse, BNP Paribas (formerly Fortis SA/NV), Wells Fargo (formerly Wachovia), Société Générale, Deutsche Bank, JP Morgan Chase, Barclays, UBS, Citigroup, RBS and Scotiabank.
6 12 U.S.C. § 1843(o).
7 Only two FHCs have grandfathered commodities authority – Goldman Sachs and Morgan Stanley.
8 See 12 U.S.C. § 1843(c)(2).
9 See 12 C.F.R. § 225.28(b)(8)(iii).
10 See, e.g., OCC Interpretive Letter No. 632 (June 30, 1993); OCC Banking Circular 277 (Oct. 27, 1993).
11 A covered commodity trading portfolio company would be defined as:
a covered commodity merchant banking investment that engages in covered physical commodity activities that are only the purchasing and selling of one or more covered physical commodities (each of which is an approved physical commodity) in the spot market and the taking and making physical delivery of one or more covered physical commodities (each of which is an approved physical commodity) to settle forward contracts, options, futures, options on futures, swaps, or similar contracts.
12 See Office of the Comptroller of the Currency, Notice of Proposed Rulemaking, Industrial and Commercial Metals, 81 fed. reg. 63,428 (Sept. 15, 2016).
13 See Fortis S.A. I N.V., 94 Federal Reserve Bulletin C20 (2007); The Royal Bank of Scotland Group PLC, 94 Federal Reserve Bulletin C60 (2008).
14 See the Section 620 Report, supra note 3.