United States: The Federal Reserve's Commodities Proposal: Safety And Soundness Regulation, Or An Indirect Prohibition?

Last Updated: December 12 2016
Article by Arthur S. Long and Jeffrey L. Steiner

On September 23, 2016, the Board of Governors of the Federal Reserve System (Federal Reserve) issued its long-expected proposed rule (Proposed Rule) relating to permissible financial holding company (FHC) commodities activities.1 The Proposed Rule follows up on the Section 620 Study (Study) issued by the U.S. federal banking regulators two weeks earlier, in which the Federal Reserve recommended to Congress that it repeal Section 4(o) of the Bank Holding Company Act (BHC Act) and the Merchant Banking authority.2

In the Proposed Rule, the Federal Reserve suggested the following changes from current law:

  • tightening the conditions imposed on the commodity activities (Section 4(k) Commodity Activities) that are "complementary" to a financial activity under Section 4(k) of the BHC Act – most notably, by counting the value of commodities held in bank subsidiaries towards the 5 percent of Tier 1 capital limit;
  • rescinding the findings underlying the Federal Reserve orders that permitted certain FHCs to engage in energy tolling and energy management services;
  • imposing a super capital charge via a 1,250% risk weighting on commodities purportedly raising environmental liability concerns and related assets held by FHCs under Section 4(o) and the Merchant Banking authority;
  • revising Regulation Y to provide that the owning and storing of copper is not an activity closely related to banking; and
  • imposing new public reporting requirements.

Reminiscent of the Study, the Federal Reserve sought to justify its super capital charge by focusing on the potential risks of environmental liability that it argued could arise from commodities activities not subject to all of the conditions of its Section 4(k) "complementary" orders.

The Federal Reserve did not, however, supply significantly greater information than in the Study as to why these potential risks were likely to affect FHCs and their bank subsidiaries, as opposed to being limited to commodity subsidiaries and Merchant Banking portfolio companies. Nor did the Federal Reserve seek to compare these potential environmental risks to the risks of other assets subject to a punitive 1,250% risk weighting.

As such, there remains a real question as to whether the super capital charge is appropriately calibrated for actual risk, and therefore also as to whether the Proposed Rule effectively seeks to ban non-Section 4(k) commodities activities ahead of Congressional action.

The Federal Reserve is accepting comments on the Proposed Rule until December 22, 2016.

I. Changes in Section 4(k) Authority

Following passage of the Gramm-Leach-Bliley Act, the Federal Reserve found certain commodities activities to be permissible for FHCs under Section 4(k) of the BHC Act, as activities "complementary" to a financial activity. These activities are:

  • Engaging in the physical settlement of commodity derivatives transactions
  • Engaging in the physical trading of commodities in the spot market
  • Engaging in energy tolling and energy management activities

These activities were approved by Federal Reserve order on an FHC-by-FHC basis. In the orders, the Federal Reserve imposed certain conditions for safety and soundness reasons:

  • the market value of the commodities owned could not exceed 5 percent of the FHC's consolidated tier 1 capital;
  • the commodities were limited to commodities for which a derivatives contract had been authorized for trading on a U.S. futures exchange by the Commodity Futures Trading Commission, or other commodities specifically authorized by the Federal Reserve, such as butane, ethane, natural gasoline, asphalt, condensate, boiler cutter, residual fuel oil no. 6, kerosene, straight run, marine diesel, naphtha, ethylene, paraxylene, styrene, propylene, and toluene;3
  • the Federal Reserve prohibited FHCs from owning, operating or investing in facilities for the extraction, transportation, storage or distribution of commodities; and
  • the Federal Reserve prohibited FHCs from processing, refining, or otherwise altering commodities.4

Although the Proposed Rule would permit FHCs to continue to engage in the physical settlement of commodity derivatives transactions and the spot trading of commodities, the Proposed Rule would tighten certain of the related conditions.

First, the 5 percent of Tier 1 capital limit would apply to the market value of physical commodities owned by the FHC and its subsidiaries on a consolidated basis under any authority other than the Merchant Banking authority, the investment authority for insurance companies (Section 4(k)(4)(I) of the BHC Act), and debts-previously-contracted authority.5 The principal effect of this change would be to include the market value of physical commodities held by a national bank subsidiary of the FHC under authority of the National Bank Act.6

Depending on the FHC, this could be a substantial departure. Under the National Bank Act, it is permissible for a national bank to acquire a physical commodity in connection with derivatives hedging in an amount equal to 5 percent of the notional value of the bank's derivatives in that particular commodity. FHCs would have two years from the effective date of a final rule to conform to the revised 5 percent cap.7

Second, the prohibition on owning, operating or investing in facilities for the extraction, transportation, storage or distribution of commodities would be codified in Regulation Y, and the "operating" restrictions would be strengthened, with the goal of avoiding liability under Federal and state environmental laws. FHCs could not participate in the day-to-day management of any facility; in any management or operational decisions occurring in the ordinary course of the business of any facility; in managing, directing, conducting or providing advice regarding operations having to do with the leakage or disposal of a physical commodity or hazardous waste; or in decisions related to the facility's compliance with environmental statutes or regulations.8

In addition, the Proposed Rule would rescind the authorization for FHCs to engage in energy tolling and energy management service activities under Section 4(k).9 According to the Federal Reserve, only one of the five FHCs that had received Federal Reserve approval to engage in these activities was still doing so – the Federal Reserve noted that this was part of the significant pullback in commodities activities by FHCs since the Financial Crisis. The one firm that still engaged in the activities would be permitted two years from the effective date of a final rule to conform its energy management and energy tolling operations.

II. Super Capital Charge for Section 4(o) and Merchant Banking Activities

More punitive than its approach to Section 4(k) Commodity Activities is the Proposed Rule's treatment of certain commodity activities permissible only under Section 4(o) and the Merchant Banking Authority. With respect to certain such activities, the Proposed Rule would impose a super capital charge via an asset risk-weighting of 1,250%, the highest risk weight currently specified under the Federal Reserve's Basel III standardized approach.10

For Section 4(o) activities, this risk-weighting would apply to physical commodity assets (Covered Commodities) that are "substances covered under Federal or relevant state environmental law," whether held in or outside the United States, and to the original cost basis of Section 4(o) infrastructure assets, such as pipelines and refineries.11 Although the proposed definition of Covered Commodities specifically identified the relevant Federal environmental laws for determining Covered Commodity status– CERCLA, the Oil Pollution Act of 1990, the Clean Air Act, and the Clean Water Act – it does not name individual state environmental laws and places the burden for determining coverage on the FHCs benefiting from the Section 4(o) grandfather.

To the extent that the Covered Commodities could be held under Section 4(k)'s conditions limiting the amount of commodities owned to 5% of Tier 1 capital and the other conditions described above, including the prohibition on directly storing and transporting the commodities, the Section 4(o) FHC could receive a 300% risk-weighting for them – the same risk-weighting available for non-Section 4(o) FHCs. This lower risk weight would be available for Covered Commodities up to 5% of the Section 4(o) FHC's Tier 1 capital, applying the proposed new consolidation approach described above.

The 1,250% risk-weighting, therefore, seems transparently designed to move Section 4(o) FHCs toward parity with Section 4(k) FHCs with respect to Covered Commodities and infrastructure assets. In the Gramm-Leach-Bliley Act itself, of course, Congress clearly stated a preference for non-parity – Section 4(o) FHCs were permitted to retain "underlying assets" and a 5 percent of total assets limit was statutorily mandated, with the Federal Reserve granted the authority to increase, but not decrease, the 5 percent limit.12 Congress, moreover, enacted Section 4(o) well in advance of the 5-percent-of-Tier 1 capital limitation imposed by the Federal Reserve in its later Section 4(k) orders.13

The Proposed Rule takes a similar approach with respect to the capital treatment of portfolio companies engaged in commodities activities and held under the Merchant Banking authority. If the portfolio company limits itself to Section 4(k) permissible activities, then the FHC's investment in the company would receive either a 300% or 400% risk weight, depending on whether the portfolio company was publicly traded; non-public companies would receive the higher of the two risk weights. If the company engaged in any other physical commodity activity, then the investment would receive a 1,250% risk weight.

The 1,250% risk-weighting is clearly a punitive one. For example, if there are $500 million in assets subject to the 1,250% risk-weighting, then the FHC is required to hold $625 million in total capital against them in order to remain well-capitalized. (That is because the assets convert into risk-weighted assets of $6.25 billion, thus requiring $625 million in total capital for a 10% Total Capital/RWA ratio, the minimum for well-capitalized status.)

Currently, such a risk-weighting applies to securitization exposures where an FHC is not able to demonstrate a comprehensive understanding of the potential losses that could result from a default on the securitization. The Proposed Rule makes no attempt to compare the risks of such securitization exposures – which caused actual harm in the Financial Crisis, particularly in the case of the lowest tranches of complex mortgage securitizations – with the potential environmental risks it identifies.

III. Reclassification of Owning and Storing Copper

The Proposed Rule would also remove the owning and storing of copper, now seen only as an industrial metal, from Regulation Y's "laundry list" of activities closely related to banking that are permissible for BHCs. The Federal Reserve seems to be taking a reclassification approach similar to that of the Office of the Comptroller of the Currency, which recently proposed that dealing and investing in copper should no longer be an activity incidental to the business of banking under the National Bank Act.14

If this proposal is finalized, the activity would be permissible only under Section 4(k)'s complementary authority and available only to FHCs. Regulation Y would be amended further to remove copper from the list of metals on which a BHC may enter derivative contracts that require taking delivery of the underlying metal as principal.

The proposal would take effect one year after the effective date of a final rule.

IV. New Reporting Requirements

Finally, the Proposed Rule would impose new reporting requirements on FHCs. A new Schedule HC-W, Physical Commodities and Related Activities, would be created, and data items would be added to Schedule HC-R, Part II, Risk-Weighted Assets. Schedule HC-W would collect more specific information on the covered physical commodities holdings and activities of FHCs, and the changes to the risk-weighted assets schedule would report amounts associated with Covered Commodities, Section 4(o) infrastructure assets, and investments in Covered Commodity merchant banking companies. In this way, the Federal Reserve would be able to track the ownership of particularly those commodity assets that it perceived created the most theoretical risk.

* * * * *

It is clear from its recent actions that the Federal Reserve believes that it is necessary to "de-risk" certain activities from the U.S. banking system – with commodity activities leading the list. Ironically, the Federal Reserve's continued focus in this area is occurring at a time when many FHCs are shedding commodity activities in the United States for independent business reasons. Moreover, in the years since commodity activities have been authorized for FHCs, they have been carried out in a manner at least as safe as certain traditional banking activities. All this makes the capital charge proposed to be imposed on Section 4(o) and Merchant Banking Covered Commodity activities difficult to understand. The logical economic result of the charge will be to shrink the activities of FHCs in the commodities markets even more than has already occurred. For commodities end-users in the United States, this could mean less competition and less market liquidity, and likely greater dependence on less regulated counterparties.

Footnotes

[1] See Proposed Rule, Risk-based Capital and Other Regulatory Requirements for Activities of Financial Holding Companies Related to Physical Commodities and Risk-based Capital Requirements for Merchant Banking Investments, (pending publication in the Federal Register) currently available at https://www.federalreserve.gov/newsevents/press/bcreg/bcreg20160923a2.pdf.

[2] Section 4(o) of the BHC Act provides that a company that becomes an FHC after November 12, 1999, may "continue to engage in, or directly or indirectly own or control shares of a company engaged in, activities related to the trading, sale, or investment in commodities and underlying physical properties that were not permissible for bank holding companies" if the company was engaged in any such commodity activities in the U.S. at September 30, 1997, the amount of such 4(o) commodity assets does not exceed 5 percent of the total consolidated assets of the FHC, and certain cross-marketing prohibitions are complied with. In addition, Section 4(o) grants the Federal Reserve the authority to raise the 5 percent limit.

Under the Merchant Banking authority, many FHCs may make controlling investments in commercial companies as long as the investments are sold within 10 years (up to 15 years if held through a qualifying private equity fund), the FHC does not engage in the routine management and operation of any such portfolio company except in limited circumstances, and certain other conditions are met.

[3] See, e.g., The Royal Bank of Scotland plc, Order Approving Notice to Engage in Activities Complementary to a Financial Activity (March 27, 2008), at 9-10.

[4] See, e.g., id.

[5] Proposed Rule, at 21-22.

[6] See id. at 21.

[7] See id.

[8] The proposal states that this list is "not meant to be exhaustive; an FHC is expected to take other steps as appropriate to limit the types of actions that potentially could impose environmental liability on the FHC or otherwise suggest that the FHC is unduly involved in the activities of third parties." Id. at 23.

[9] See id. at 42-44.

[10] See id. at 26.

[11] See id. at 24.

[12] 12 U.S.C. § 1843(o).

[13] The first Section 4(k) order was in October 2003, for Citigroup's Phibro operations, almost four years after the Gramm-Leach Bliley Act added Section 4(o) to the BHC Act.

[14] See Proposed Rule, Industrial and Commercial Metals, (pending publication in the Federal Register), available at https://www.occ.gov/news-issuances/news-releases/2016/nr-occ-2016-108a.pdf.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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