WASHINGTON — Federal Reserve Gov. Daniel Tarullo told a Senate panel Friday that the agency is planning to issue a proposal early next year that would limit banks' participation in the physical commodities market.

Tarullo agreed with lawmakers that current safeguards against price-fixing by financial institutions may not be enough. He noted recent scandals including alleged manipulation of the London Interbank Offered Rate, foreign exchange rates and electricity prices. Yet since the Fed lacks authority to regulate commodity prices directly, Tarullo said, part of the agency's focus as a prudential supervisor is on whether banks' internal controls can prevent future commodity-related violations.

"The accumulation of violations … suggest that, in general, compliance procedures, mechanisms, expectations within firms … are not adequate in many cases," Tarullo said at a hearing of the Permanent Subcommittee on Investigations. "One of the things that we are thinking about, in general, is how to ensure there are robust enforcement and compliance mechanisms within firms to make sure that you do not have this kind of transgression" in areas beyond prudential oversight.

Tarullo said the Fed has been reviewing more than 180 public comments on its advance notice of public rulemaking released in January. That notice examined possible restrictions and conditions the agency could apply to banks in the commodity markets, Tarullo said, and the comments advocate a range of Fed actions to address risks posed by banks' participation in those markets.

"We are assessing the potential risk of physical commodities activities to the safety and soundness of the financial holding companies engaged in these activities," Tarullo said. "In doing so, we are focusing on the risk to safety and soundness presented by specific activities and on whether those risks can be appropriately and adequately mitigated. We expect to issue a formal notice of public rulemaking regarding these matters in the first quarter of next year."

Chairman Carl Levin, D-Mich., said that while Tarullo's announcement is "good news," the Fed's own investigations have indicated that such a rulemaking is "long overdue." To date, the only safeguards against price manipulation between banks' trading arms and the physical commodity infrastructure they own has been voluntary information barriers, which are inadequate, Levin said.

"Given the recent history of banks improperly sharing information to manipulate electricity, Libor, and foreign exchange rates, reliance on voluntary policies at banks that have an economic interest in ignoring those policies is simply not enough protection for consumers," Levin said.

Sen. John McCain, the panel's top Republican, agreed, calling some bank activities in the commodities arena "shady" and detrimental to ordinary consumers.

"The Fed in particular has the power and responsibility to make important changes that prevent the sorts of abuses that have been demonstrated in this hearing," McCain said. "It clearly has not done enough to prevent harmful commodity activities by the banks."

The subcommittee on Wednesday released a report outlining the commodity activities at three banks: JP Morgan Chase, Goldman Sachs and Morgan Stanley. The report demonstrated the wide extent of those banks' ownership of commodity infrastructure in the U.S. and the potential for collusion between bank affiliates and trading arms, though it contained no definitive proof of real or attempted price manipulation. The report also highlighted banks' risk exposure to potential environmental disasters — such as the 2010 Deepwater Horizon oil spill in the Gulf of Mexico — that results from their owning commodity infrastructure.

Tarullo said his "quick perusal" of the committee report leads him to think "it will be an important input into our deliberations … on how we might adjust our regulatory and supervisory programs to address the risks that can be associated with these activities."

Tarullo also said it is not always clear which agency takes the lead in regulating banks' involvement in commodity markets. The Commodity Futures Trading Commission, for example, polices futures and derivatives markets, while the Federal Energy Regulatory Commission polices natural gas and electricity markets.

Tarullo said the Fed is examining more broadly how to address potential gaps in regulatory policy dealing with commodities.

"I began to wonder whether there is a gap in regulation more generally, where there are some things … that at present no U.S. government regulatory agency has jurisdiction over," Tarullo said. "It would be a good idea for the relevant agencies, including the Fed and [and the Office of the Comptroller of the Currency and] also the market regulators, to take a look at … whether there are any [gaps] in the regulatory structure."

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