Review of Bank Commodity Activity Could Bring Limits

In a Senate hearing today, Janet Yellen indicated the Fed may impose new rules on banks that own and trade in physical commodities

The Federal Reserve may consider limits on bank ownership and trading of physical commodities out of concern that an event such as an oil spill could undermine financial stability.

“We are involved in a very comprehensive review” of banks’ commodities activity, Fed Vice Chairman Janet Yellen said today at a Senate hearing on her nomination to become chairman of the central bank. “We want to make sure that these are conducted in a safe and sound manner, and we may be involved in additional rulemaking as we complete this review.”

Banks trade derivatives related to commodities, from oil to corn to gold. To support that business, they often accept delivery of those assets to settle trades, and even store the materials. Many banks have moved beyond trading to owning physical operations such as shipping companies and power plants.

Yellen’s reference to rulemaking suggests officials are growing less comfortable with the possibility of a cataclysmic risk, such as an explosion or spill, undermining the stability of one of the largest banks or financial companies and the overall financial system.

“What it really suggests is banks can be in the business but there will be constraints in terms of how far they can go,” said Gilbert Schwartz, partner at the Washington law firm Schwartz and Ballen LLP.

Fed officials are also considering how firms could face reputational risk from having extensive operations in basic commodities important to businesses and consumers.

“The Fed is working on a new standard that will permit banks to remain in physical commodities, but impose higher capital and other regulatory standards that might make the banks want to stop doing it,” said Karen Shaw Petrou, managing partner at Federal Financial Analytics, a Washington regulatory research firm.

Yellen’s comments reinforce “the very long view at the Fed that they don’t like non-traditional activities in banks,” Shaw Petrou said.

More information about the Fed’s approach to commodities will come in testimony on the topic by Michael Gibson, the Fed board’s director of bank supervision and regulation, on Nov. 20 before a subcommittee of the Senate Banking Committee.

U.S. law restricts banks from owning non-financial businesses unless they get special exemptions. Goldman Sachs Group Inc. and Morgan Stanley were the two biggest U.S. securities firms until they converted into banks in 2008. A 1999 law “grandfathers” any commodities operations they had before Sept. 30, 1997.

The Fed said in July that it’s reconsidering its landmark 2003 decision to grant some lenders, such as Citigroup Inc. and JPMorgan Chase & Co., permission to expand into raw materials.

Yellen made the comments today in response to a question from Senator Jeff Merkley, an Oregon Democrat. She spoke at a hearing on her nomination to succeed Fed Chairman Ben S. Bernanke, whose term expires Jan. 31.

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