WASHINGTON — The Federal Reserve Board made good Friday on a pledge to target big banks' investments in physical commodities like gas pipelines and precious metals, unveiling a proposal that would raise capital requirements for such holdings while stopping short of an outright ban.
Policymakers have been alarmed by some megabanks' exposure to physical commodities, concerned that a catastrophic incident could leave institutions on the hook for billions of dollars.
"Monetary damages associated with an environmental catastrophe involving physical commodities have ranged from hundreds of millions to tens of billions of dollars," the Fed said in its proposal. "These damages can exceed the market value of the physical commodity involved in the catastrophic event, and can exceed the committed capital and insurance policies of the organization."
Banks are generally not permitted to be involved with physical commodities, but there are two exceptions that have proved problematic for regulators. One of those conditions is for a bank to have purchased a firm that owned such assets — known as the "grandfather" section of the Bank Holding Company Act. Only Goldman Sachs and Morgan Stanley currently own assets under that provision.
Bank holding companies can also invest in nonfinancial companies though merchant banking investments, which require the institutions to have ownership ties to the company it is investing in.
Under the Fed's proposal released Friday, those banks would face a 1,250% risk weighting for physical infrastructure properties like oil and natural gas pipelines.
The second exception for physical commodity ownership is the "complementary activity" clause, which allows bank holding companies to engage in activities that are complementary to existing financial activities. For example, if a bank has a lending portfolio related to energy extraction, ownership of the physical commodities themselves would be considered related.
The proposal would establish a 300% risk weight for those investments as well as restrict the amount of physical commodities that could be held under that clause to the equivalent of 5% of the bank's Tier 1 capital.
Overall, the plan would cost an aggregate $4.1 billion in additional capital requirements for the financial institutions involved, Fed officials estimated.
The Fed stressed that the plan was the plan was meant to address the risk of physical commodities exposure, but not be a bulwark against a catastrophe like the Deepwater Horizon spill.
"The proposed risk weight is not intended to require capital against the full amount of legal liability and reputational harm that might result from a catastrophic event, which can vary significantly depending on the nature and extent of an environmental disaster and could be extremely large," the Fed said.
The plan also tightens the cap on banks' exposure to physical commodities by including not just assets held by the holding company, but also those held by subsidiaries.
Additionally, the proposal would bar banks from participating in physical commodity activities related to electricity generation.
These are known as "tolling" — where a bank has a contract to provide a plant such as an oil refinery with crude oil in exchange for the refined product — and "energy management services" — effectively a contract whereby a bank has proprietary rights to provide a power plant with its generation fuel. The Fed said those activities should be barred because they are not related to any bona fide financial activity, and there is no public benefit to having those arrangements held by banks.
"The proposal would rescind the board's prior authorizations regarding energy management services and energy tolling because these activities do not appear over time to have been as directly or meaningfully connected to a financial activity so as to complement the financial activity and the expected benefits of these activities do not appear to have been realized over time," the Fed said.
The plan would also impose additional reporting requirements on banks and bar them from owning or storing copper.
The Fed is not the first agency to ask banks to cut off their ties to copper. In September, the Office of the Comptroller of the Currency issued a proposal that would similarly bar national banks dealing in metals used for industrial purposes. Because copper's use has evolved, the Fed argued, it should no longer be traded as a precious metal. "Over time, copper has become most commonly used as an industrial metal and not as a store of value," the plan states.
The plan has been a long time coming. The Fed first released a preliminary proposal on limiting banks' physical commodities exposure in January 2014. At that time, large banks had already begun divesting from their activities in the field; JPMorgan sold off its physical commodities business in July 2013.
However, the Fed specified Goldman and Morgan as examples of financial institutions that benefited from a grandfathering clause to engage in activities tied to physical commodities that would not be allowed for a bank holding company formed today.
The proposal will be open up to comments until Dec. 22.