WASHINGTON — The financial services industry is sharply criticizing the Federal Reserve's proposal to set capital risk weights and ownership restrictions on commodities held at bank holding companies, arguing it effectively nullifies federal law and raising the specter of a possible legal challenge.

In comments filed with the central bank, a number of industry groups argued that the plan would raise capital reserves for certain physical commodities and related assets to the point where they would be uneconomical. That would amount to a de facto ban on financial holding companies’ possession of physical commodities and related infrastructure — activities that the 1999 Gramm-Leach-Bliley revisions to the Bank Holding Company Act explicitly allow banks to engage in.

“Imposing these capital requirements would be so punitive as to make, whether intentionally or not, certain activities … effectively prohibited, a result that could only be justified by a finding that the assets held by FHCs are so unsafe and unsound that they ought to be impermissible for FHCs to hold,” wrote Carter McDowell, a managing director at the Securities Industry and Financial Markets Association, and Richard Coffman, general counsel at the Institute of International Bankers. “Yet the Federal Reserve has made no such finding.”

The Fed is worried about the consequences for banks from an environmental catastrophe, such as the Deepwater Horizon spill in 2010. Bloomberg News

Other industry groups argued that if the Fed thought physical commodities were too risky for banks, it could recommend to Congress to rescind the merchant banking authorities granted under Gramm-Leach-Bliley — a step the Fed has already taken. But the central bank should not ban them through rulemaking, especially considering that merchant banking rules are under the joint jurisdiction of the Fed and the Treasury Department.

“The Federal Reserve should not use a capital charge to effectively weaken significantly a clear grant of joint regulatory authority over this activity to the Federal Reserve and the Department of Treasury,” the Clearing House Association, American Bankers Association, Financial Services Forum, Financial Services Roundtable and the international bankers group said in a joint letter. “We are concerned no only about the inappropriateness of that charge in this context, but the precedent it would set for future use of the capital rules to effectively nullify Congressional grants of authority and allocation of rule-writing authority.”

Banks have long been restricted from directly owning physical commodities, but a few major exceptions in Gramm-Leach-Bliley have spurred some of the largest banks in the world to become major players in physical commodity markets.

One of those exceptions is for bank holding companies that purchase a company that owns such assets — the “grandfather” clause, which to date applies only to Goldman Sachs and Morgan Stanley. The other is through so-called merchant banking activities; that exception allows banks to have ownership stakes in nonfinancial firms that have “complementary” activities to the banks’ existing businesses. Those include Bank of America, Citigroup, Wells Fargo, JPMorgan and some international banks, such as Barclays, Credit Suisse and BNP Paribas.

The Fed has been considering closing or narrowing those clauses for several years, in part because of fears that environmental catastrophes like the 2010 Deepwater Horizon oil spill could affect banks’ bottom lines and create systemic risk. But banks have also been involved in various price manipulation suits, including JPMorgan’s $410 million settlement in 2013 over electricity rate manipulation charges and allegations that same year that Goldman Sachs was involved in manipulating the price of aluminum.

The Fed issued an advance notice of proposed rulemaking in 2014, and promised to follow with a concrete proposal in 2015, but it wasn’t issued until last September.

The proposal would set a 1,250% risk weighting for banks that own physical infrastructure properties such as oil and natural gas pipelines under the grandfather rule and a 300% risk weight for complementary physical commodity assets owned under the merchant banking clause. The rule would also bar banks from owning infrastructure related to electricity generation and distribution, would recategorize copper as an industrial metal rather than a precious metal and would restrict total asset volume to 5% of Tier 1 capital.

The proposal does have some supporters, including a number of public interest groups who had been pushing for a pre-Gramm-Leach-Bliley restriction on bank ownership of physical commodities. Still, they said they would prefer that it go even further.

Tyson Slocum, director of Public Citizen’s energy program, and Bartlett Naylor, the group’s financial policy advocate, said in their comment letter that the 1,250% risk weight is “welcome” and that, while an outright ban would be preferable, “we understand the board may view its authority as limited.”

The group further noted that Gramm-Leach-Bliley permitted only “well-managed” banks to engage in the merchant banking ownership exemptions. Under section A of the Bank Holding Company Act, the Fed retains authority to rescind any ownership provisions “if it determines … that such action is necessary to prevent undue concentration of resources, decreased or unfair competition, conflicts of interest, or unsound banking practices.”

“Records of misconduct at the Board, at related agencies, and the Department of Justice on the mega-banks suggest they are not well managed,” the comment letter says.

Dennis Kelleher, president of the industry watchdog Better Markets, argued that contrary to the banks’ contention that Gramm-Leach-Bliley sought to protect banks’ ability to own commodity assets and other related activities, the industry’s expansion into those industries in the intervening period has far exceeded what Congress expected. Those changes have given banks unfair advantages in gathering economic information, created conflicts of interest within FHCs, enabled the manipulation of markets and caused other hazards, Kelleher said.

“These risks may lead to dangerous and unacceptable consequences: unstable FHCs, an anticompetitive environment and market manipulation that unfairly harms other market participants and ultimately consumers,” Kelleher said. “The largest banks have capitalized on what was intended to be a modest conditional expansion in permitted activities, to greatly expand the scope of their commodities and industrial footprints.”

But the role of the proposal in potentially setting new capital standards — or, as the banks would have it, effective prohibitions — on banks’ participation in certain commodity activities may be mooted by the change in political atmosphere since the November election. President Trump and his fellow Republicans in Congress have called for loosening restrictions and capital requirements for banks as part of an overall deregulatory push meant to expand lending and stimulate the economy.

While Trump has not made any nominations to the seven-member Fed board — he came into office with two vacancies, and Fed Gov. Daniel Tarullo announced that in early April he planned to resign — there is reason to expect that his nominees would share his preference for fewer capital rules on banks rather than new ones. As a result, it’s unclear whether the Fed will finalize the commodities plan in time, or whether new governors may seek to quietly kill it.

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