WASHINGTON (Reuters) - U.S. lawmakers at a Senate hearing on Wednesday pushed financial regulators to speed up efforts to limit Wall Street's role in physical commodities markets, pressing for a pivotal policy shift after a decade of deepening trade.
A day ahead of the hearing, the Federal Reserve laid out for the first time its growing concerns that risks to the financial system from banks leasing oil tankers or owning power plants are "difficult to limit and higher than expected."
It also raised concerns about serious conflicts of interest for banks.
The packed hearing, which lasted over an hour, offered senators a chance to delve further into the Fed's thinking, pressing Michael Gibson, its director of bank supervision and regulation, on why the central bank is not moving immediately to impose new rules.
"The Fed's proposal yesterday is a timid step, it was too slow in coming, and there is still too much that we do not know about these activities and investments," said Senator Sherrod Brown, who led the hearing.
Gibson told them that new restrictions are likely.
The panel also questioned whether banks should be forced to disclose more about the size and scope of their commodities activities and if banks' involvement in those markets has inflated the costs of key raw materials, such as aluminum.
Senator Elizabeth Warren described the Fed's review as "a step forward, but a meager one".
While the lawmakers raised concerns about banks' exposure to opaque commodity markets, the hearing did not reveal significant new details on Fed policy or any new pledges of action from either side.
In a preliminary notice on Tuesday seeking public comment on possible new limits, the Fed cited real-world risks, including the BP Gulf oil spill and last year's Quebec oil train disaster, as examples of the multibillion-dollar catastrophes banks face by being involved in the risky, messy world of commodities.
The notice also suggested possible remedies, including limits on assets as well as restrictions on trade of some types of commodities, and posed questions to draw public input.
The session follows months of growing public and political pressure to check banks' decade-long expansion into the commodities supply chain.
In the first such hearing last summer, metals users complained Goldman Sachs and others that own metal warehouses had contributed to higher prices.
Some saw the Fed's so-called "advance notice of proposed rule making" - an optional initial step in the potentially years-long process of writing new rules - as a strategic political ploy to deflect complaints over inaction.
It will accept public feedback for 60 days.
Others saw signs of a potentially major crackdown ahead, as the Fed questioned the initial rationale for letting banks trade and invest in raw materials, and said even arm's length "merchant" investment deals may not be safe enough.
"The tenor of the analysis and the questions means the Fed has already made up its mind to limit severely bank participation in physical commodity markets," said Craig Pirrong, a finance professor at the University of Houston.
FERC AND CFTC TOO
Two other regulatory enforcers also testified.
The U.S. Federal Energy Regulatory Commission (FERC), which regulates electricity and natural gas markets, was represented at Wednesday's hearing by the Norman Bay, the agency's director of enforcement and a former U.S. attorney for New Mexico.
Bay has led a series of high-profile market manipulation cases, one of which led to a record $410 million penalty agreed with JPMorgan Chase & Co last year.
Although no FERC rules "apply uniquely to financial institutions," Bay said, banks are active in many markets that the agency oversees, owning less than 4 percent of total U.S. electricity generation capacity and about 14 percent of natural gas pipeline miles.
Despite their relatively small overall market share, they may hold a larger percentage at particular hubs or trading points, which may allow them to "retain the ability to move prices in a manipulative manner," he said.
Also appearing was Vince McGonagle, market oversight chief at the Commodity Futures Trading Commission, the derivatives market regulatory body.
This summer it opened a preliminary inquiry into complaints that banks including Goldman Sachs were inflating aluminum costs through their ownership of metals warehouses.
The banks deny this.
Facing a clearly uneasy Fed, some banks, including JPMorgan, are already quitting the physical commodity business, a once-lucrative niche that has reaped billions of dollars of revenue for Wall Street over the years but is now facing diminished margins and stiffer capital rules.
Others, namely Goldman Sachs, have stood firm, defending an activity they say benefits customers. Due to a grandfather provision in a 1999 banking law, the Fed has less leeway to restrict the activities of former investment banks Goldman and Morgan Stanley, Gibson said.
Critics said the Fed did not disclose what it knew of banks' commodities operations nor reveal its own analysis of the situation, making it tough for the public to comment on activities about which little is known.
"The only two parties that can weigh in with any kind of semblance of specific credibility would be the Fed itself and the banks," said Saule Omarova, a law professor at the University of North Carolina who has been a vocal critic of the banks' involvement in physical commodities trading.
"That's why we have a professional regulatory agency - because we hope they will be looking into this issue on our behalf."
The notice was the Fed's first detailed public comment since it shocked the banking industry last July by announcing a "review" of its 2003 authorization that first allowed commercial banks such as Citigroup to handle physical commodities.
That followed measures to eliminate the divide between commercial banking and riskier activities, a distinction some lawmakers would now like to restore.
"The Fed is absolutely right when it says we need to consider strengthening the limits on bank participation in physical commodity activities," Senator Carl Levin said, confirming for the first time his permanent subcommittee on investigations was also analyzing the issues.
RISKS ARE 'HIGHER THAN EXPECTED'
In Tuesday's notice, the Fed said even banks that do not own infrastructure like oil storage tanks may face a "sudden and severe" loss of public confidence if assets or physical commodities they own are involved in a disaster.
"The recent catastrophes accent that the costs of preventing accidents are high and the costs and liability related to physical commodity activities can be difficult to limit and higher than expected," the Fed said in the notice.
(Additional reporting by Jonathan Leff; Editing by Clarence Fernandez and Sophie Hares)