(Updates with Tarullo answers to Levin questions at hearing)
By Michael Flaherty
WASHINGTON, Nov 21 (Reuters) - A top Federal Reserve official on Friday pledged to a Senate investigative subcommittee that the U.S. central bank would broaden its review of gaps in its regulation of the physical commodity operations of U.S. banks.
In response to questioning at a hearing on Friday, Fed Governor Daniel Tarullo said the bank would look into filling those holes; that was in addition to a vow in his written testimony to produce new rule proposals on banks’ commodity holdings by the first quarter of 2015.
“It may be worthwhile taking a look at those merchant banking guidelines for all activities, not just commodities,” Tarullo said in response to a question from subcommittee Chairman Carl Levin about a bank’s ability to manage conflicts of interest while owning and trading the same commodity.
Tarullo, the Fed’s point person for bank regulation, sat on the final panel of a two-day hearing called by the Senate’s Permanent Subcommittee on Investigations.
The hearing followed the release of a two-year, 403-page subcommittee investigation into Wall Street’s physical commodities business. The report alleged that U.S. banks manipulated commodity prices and gained unfair trading advantages at the expense of consumers.
In his testimony, Tarullo said the Fed will in early 2015 announce the results of its much-anticipated review of how it regulates banks in commodities, after starting the process earlier this year.
The central bank is considering an increase in capital and insurance requirements for banks with physical commodity arms, limiting the size of the operations and prohibiting certain commodities held by the firms.
“I wonder whether there is a gap in regulations and more generally, I wonder whether there are some things that at present no government regulatory jurisdiction has no oversight over,” Tarullo said during questioning.
After Friday’s hearing ended, Levin said he was satisfied with Tarullo’s responses but raised concerns that a big portion of alleged pricing manipulation detailed in the report was on the London Metal Exchange, which is regulated by Britain.
He plans to meet with the Commodity Futures Trading Commission (CFTC) to discuss the scope of its oversight of the world’s biggest and oldest metal market in the United States.
“Something has to be done here ... So the question is, how then do we protect the American consumer from all these metal trades on the LME?” the Michigan Democrat asked after the hearing.
“Does the CFTC have the authority? I’m going to meet with the CFTC on this issue.”
Goldman Sachs Group Inc, Morgan Stanley and JPMorgan Chase & Co built huge inventories of aluminum, oil, jet fuel and other commodities, the report said, and not only failed to properly insulate themselves from potential losses, but in the case of Goldman and JPMorgan, manipulated prices.
The subcommittee report pointed the finger at the Fed, saying the central bank has taken insufficient steps to address the risks taken by financial holding companies gathering physical commodities. The Fed in some cases was unaware of the growing risk, the report said.
At a hearing Levin pointed to a 1995 rule by the Office of the Comptroller of the Currency expanding the definition of bullion to include copper, which followed the inclusion of palladium.
Both inclusions allowed the metals to be free of certain trading restrictions and came at the request of a bank, the report said.
“I would observe a case could be made that copper is different than palladium and so it is something that would bear revisiting,” Tarullo said at the hearing. (Reporting by Michael Flaherty; Editing by Paul Simao and Steve Orlofsky)