Physical Commodities and Merchant Banking Activities Conducted by Financial Holding Companies: Federal Reserve Seeks Public Comment on New Limitations on Physical Commodities and Merchant Banking Activities Conducted by Financial Holding Companies Under the Bank Holding Company Act

Sullivan & Cromwell LLP - January 16, 2014

Earlier this week, the Board of Governors of the Federal Reserve System (the “Board”) solicited public comment, through an advance notice of proposed rulemaking (the “ANPR”), regarding various issues and questions related to physical commodities activities conducted by financial holding companies (“FHCs”) and the restrictions imposed on these activities. The Board is seeking comment in connection with a review of the scope of the activities that it has authorized under the “complementary” authority in the Bank Holding Company Act of 1956 (the “BHC Act”) (Section 4(k)(1)(B)) to ensure these activities are complementary to a financial activity and do not pose substantial risks to the safety and soundness of depository institutions or to the financial system generally. It is also considering whether additional limitations or conditions on the conduct of physical commodities activities by FHCs and their subsidiaries under “complementary” and other authority granted under the BHC Act, specifically the Gramm-Leach-Bliley Act merchant banking authority and commodities grandfather authority, are warranted in order to mitigate any risks to the safety and soundness of FHCs, as well as any potential risks to financial stability. With respect to “complementary” authority, the Board also questions more broadly whether the relationship between physical commodity markets and commodity derivatives activities “are as close as previously claimed or expected”, especially in light of recent public reports that some FHCs plan to cease their physical commodities activities but continue to conduct the related financial activities or sell their physical commodities business to a nonfinancial firm. As a result, the Board is soliciting comment on narrowing or eliminating altogether the complementary authority to engage in physical commodities activities.

Importantly, several of the questions raised by the Board with respect to merchant banking authority apply to all merchant banking activity and not just such activity relating to physical commodities. This may create the potential for additional restrictions or requirements relating to merchant banking investments, although there appears to be no public evidence of any material losses in these investments during the almost 13 years since they were authorized.

The Board cites as reasons for its review of physical commodities activities an increase in the past several years in these activities conducted by FHCs, the risks of market contagion and the potential danger posed by “tail risks” demonstrated by the financial crisis, and “a variety of events and developments involving physical commodities activities that suggest that the risks of conducting these activities are changing and the steps that firms may take to limit these risks are more limited”.

The ANPR follows a period of heightened focus on the participation of FHCs in physical commodities activities, culminating in the release by the Board of a brief statement in July 2013 that it is “reviewing the 2003 determination that certain commodity activities are complementary to financial activities” and thus permissible for FHCs, referring to the Board’s initial approval of certain physical commodities activities under “complementary” authority. Subsequently, the Senate Subcommittee on Financial Institutions held a hearing at which several witnesses criticized the role of financial institutions in commodity markets. On Wednesday of this week, the Senate Subcommittee held a second hearing examining the physical commodities activities FHCs are authorized to conduct under the BHC Act and the economic impact of such activities on the physical commodity and energy markets and their impact on the safety and soundness of the banking system, featuring testimony from the Board, the Federal Energy Regulatory Commission and the Commodities Futures Trading Commission regarding their respective oversight of these physical commodities activities.

The ANPR includes 24 specific questions seeking comment on the risks and benefits of allowing FHCs to conduct physical commodities activities under the various provisions of the BHC Act and the conditions under which these activities should be conducted. The Board specifically requests comment on whether one or more of the following limitations should apply to complementary commodities activities: (i) enhanced capital requirements, (ii) increased insurance requirements, and (iii) forcing a reduction in these activities through “absolute dollar limits and caps based on a percentage of the FHC’s regulatory capital or revenue”. The Board did not explicitly request comment on the consequences of pushing physical commodities activities into less-regulated companies, although the Enron experience suggests that this should be a relevant consideration. With respect to merchant banking investments, the Board specifically asks whether it is necessary to impose on FHCs: (i) higher or additional capital requirements, (ii) limits on the total amount of such investments, and (iii) additional restrictions on the routine management of merchant banking portfolio companies. Comments on the ANPR are due by March 15, 2014.