Physical Commodity Activities Conducted by Financial Holding Companies: Federal Reserve Proposes Extraordinary Increase in Capital Requirements for Physical Commodity Activities and Certain Merchant Banking Investments, Along With New Prudential Limitations

Sullivan & Cromwell LLP - September 26, 2016

On September 23, 2016, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) issued for public comment a proposal (the “Proposal”) that would impose extraordinary capital and other prudential requirements and limitations with respect to physical commodity activities of financial holding companies (“FHCs”).  The capital requirements would apply to physical commodity activities that, according to the Federal Reserve, have the potential to expose the FHC to environmental liability (“covered physical commodity activities”).  The level of increase is so high that its apparent purpose is to preclude FHCs from exercising at least some of the authorities that were granted by Congress in the Gramm-Leach-Bliley Act of 1999 (“GLBA”).  Most notably, the Proposal would:

  • Impose a 300 percent risk weight for regulatory capital purposes on covered physical commodity assets that a FHC is permitted to hold under “complementary” authority;
  • Impose a 1,250 percent risk weight for regulatory capital purposes on any covered physical commodity held by a FHC in reliance solely on the statutory “grandfather” authority;
  • Impose a 1,250 percent risk weight for regulatory capital purposes on merchant banking investments in companies that engage in covered physical commodity activities (other than activities permitted under “complementary” authority);
  • Require a FHC to include in the 5 percent of tier 1 capital limit imposed on physical commodity “complementary” authority all covered physical commodity activities of the FHC and its subsidiaries, including depository institution subsidiaries, conducted under any authority (subject to certain exceptions);
  • Rescind the Federal Reserve’s energy management and energy tolling approvals previously authorized under “complementary” authority; and
  • Impose a new quarterly public reporting requirement that includes detailed disclosures regarding the FHC’s physical commodities holdings and activities.

The Proposal follows an advance notice of proposed rulemaking (the “ANPR”) issued by the Federal Reserve in January 2014, which solicited public comment on whether additional prudential requirements or restrictions on the physical commodity activities of FHCs would be appropriate in light of “the unique and significant risks that physical commodities activities may impose” on FHCs, particularly relating to potential liability for environmental catastrophes.  Notably, although the Proposal would impose significant capital requirements on covered physical commodity activities that would effectively prohibit many activities, and, in the case of a 1,250 percent risk weight, a dollar-for-dollar capital charge, the Proposal does not cite any situations in which a FHC has suffered material financial losses with respect to these activities, or where any other financial services company has suffered such losses prior to or after the enactment of GLBA.

Although with respect to merchant banking the Proposal relates only to covered physical commodity activity, the Federal Reserve indicates that it is considering the appropriate risk-based capital treatment for all merchant banking investments and specifically asks whether “current capital requirements adequately capture the risks of merchant banking investments not covered under the proposal” and “[i]f not, what additional capital requirements should be applied to merchant banking investments generally.”

Comments on the Proposal are due by December 22, 2016.