By David Sheppard and Josephine Mason
NEW YORK, July 19 The U.S. Federal Reserve is
"reviewing" a landmark 2003 decision that first allowed
regulated banks to trade in physical commodity markets, it said
on Friday, a move that may send new shockwaves through Wall
The one-sentence statement suggests the Fed is taking a much
deeper, wide-ranging look at how banks operate in commodity
markets than previously believed, amid intensifying scrutiny of
everything from electricity trading to metals warehouses.
While the Fed has been debating for years whether to allow
banks including Morgan Stanley and JPMorgan to
continue owning assets like oil storage tanks or power plants,
Friday's surprise statement suggests it is also reconsidering
whether all bank holding firms should be able to trade raw
materials such as gasoline tankers and coffee beans.
By referencing its initial decision a decade ago permitting
Citigroup's Phibro unit to trade oil cargoes - setting a
precedent for a dozen more banks that followed suit - the
Federal Reserve has put in question a key profit center for Wall
Street's top players, which have already seen
multibillion-dollar commodity revenues shrink in the face of new
On Tuesday, the Senate Banking Committee is holding its
first hearing on the issue, asking whether so-called "Too Big to
Fail" banks should be taking on additional risks like moving
tankers of crude oil or operating power plants.
Amid growing frustration in Washington over regulators'
failure to push through new rules five years after the financial
crisis, the Fed's widening area of enquiry came as a shock.
"They must be feeling some pressure on this issue if they've
felt compelled to issue a public statement," said Saule Omarova,
associate professor of law at the University of North Carolina
at Chapel Hill School of Law, who will appear at the hearing.
"Are they using this opportunity to in fact review the
entire position of banks in physical commodity markets?"
The pressure may intensify as the U.S. power market
regulator levies record fines over manipulating power markets.
It levied a $453 million penalty against Barclays this
week and is in talks to settle charges against JPMorgan, which
is alleged to have used power plants that it owned or operated
to game markets.
"The Federal Reserve regularly monitors the commodity
activities of supervised firms and is reviewing the 2003
determination that certain commodity activities are
complementary to financial activities and thus permissible for
bank holding companies," the Federal Reserve said, its first
public statement since a 2012 Reuters report brought the issue
to light. (Full story:).
A Federal Reserve spokesperson declined to elaborate or
provide any details on the scale or timing of the review.
Spokespeople for Goldman Sachs and Morgan Stanley declined
to comment on the Fed statement.
PHIBRO SET PRECEDENT
In 2003, the Federal Reserve issued a letter to Citigroup,
which had been seeking permission to allow its Phibro unit -
acquired in 1998 - to continue trading in physical energy
markets. The Bank Holding Company Act (BHC Act) normally
prohibits banks from engaging in non-financial activities, but
Citi had argued that the activities should be allowed.
Regulated commercial banks had long been permitted to trade
in commodity derivatives such as futures, but at the time did
not enjoy the same freedom in physical markets, unlike
investment banks like Goldman Sachs and Morgan Stanley.
The Fed agreed with Citi, saying that trading in real
commodities would allow the banks to "transact more efficiently
with customers". It said the trading must be "complimentary" to
their main activities, contribute to the public good and should
not pose a "substantial risk" to the bank.
That decision, which came at the start of a decade-long boom
in commodity trading, opened the door to a dozen more
applications from global giants like Deutsche Bank and domestic
players like Wells Fargo. With many of the permits, the Fed gave
greater and greater leeway in what and how they could trade.
"Maybe the Fed can openly say we think these activities are
systemically risky unless they're cut back but I don't know
what's going through the Fed's head," said one commodity
regulation expert who declined to be named. "This came out of
the blue. This has taken everyone by surprise."
Since converting to bank holding companies at the height of
the financial crisis, Goldman Sachs and Morgan Stanley have also
been subject to the holding company rules.
But up until now, the Fed's focus was believed to be on
their ownership of assets, a more clearly controversial issue.
Under the 1999 decision to repeal part of the Glass-Steagall
Act, ending the forced separation of commercial and investment
banking, any non-regulated bank that converted to holding
company status after 1999 would be allowed to continue to own
and invest in assets, as long as they held them prior to 1997.
The banks have argued that their activities are "grandfathered"
in, or that they are simply merchant banking investments.
It is not clear that argument will hold up under political
pressure, which is intensifying ahead of a nominal September
deadline for Goldman and Morgan to comply with the rules.
"Reviewing Wall Street's expansion into commercial
activities is essential," Senator Sherrod Brown, a Democrat from
Ohio, said in a statement. "Congress, regulators, and the public
need to understand what has happened in the 14 years since the
financial floodgates were opened, and reconsider what we want
banks to do."
Large industrial consumers of aluminum have accused banks of
boosting prices of the metal through their control of London
Metal Exchange warehouses, which have been slow to deliver metal
to customers, boosting premiums for physical metal and earning
big profits on rent for storing the metal.
Four U.S. congressmen wrote to Federal Reserve Chairman Ben
Bernanke on June 27 expressing their concern about the issue,
and asking for more information on the Fed's position.
Both Goldman Sachs and JPMorgan have explored selling their
warehouse businesses they bought in 2010 in recent months,
although it is not clear if that is because of increased
As commodity prices surged over the past decade, a host of
global investment banks piled into the market, pressuring the
former duopoly of Goldman and Morgan. At their peak in 2008 and
2009, revenues in the sector reached some $15 billion.
But pressures have mounted over the past few years as
regulators crack down on proprietary trading, new capital
measures limit trading books and bonus caps shrink.
Commodity revenue from the top investment banks fell to
about $6 billion in 2012, consultants Coalition estimated.
While banks generate much of that revenue from trading
derivatives - selling indexes to investors or hedging prices for
an oil company - many have delved deeply into physical markets
in order to get better information on markets, leverage their
positions or offer more options to customers.
For instance, many banks are involved in "supply and
offtake" arrangements with refineries, providing crude oil to
the plant and then selling gasoline or diesel in the market.
The Federal Reserve has generally allowed banks to trade in
most major physical commodity markets so long as there is a
similar futures contract for the commodity, which means it is
regulated by the Commodity Futures Trading Commission. Crude oil
and gasoline, for instance, are allowed but iron ore is not.
Friday's statement calls that into question.
While some consumer groups have been critical of the sway
that banks can exert on commodity markets by owning key pieces
of infrastructure, it is unclear how many would support barring
them from trading commercial markets entirely.
"I want them to have physical business because they play a
positive role in the business on balance by providing
financing," said one senior executive in the metals market who
has been critical of the banks' warehouse ownership.