Oct. 1 (Bloomberg) -- The Federal Reserve has expanded its scrutiny of banks’ physical commodities operations to encompass businesses run by Goldman Sachs Group Inc. and Morgan Stanley that Congress had previously authorized.
The Fed is examining all legal and regulatory exemptions that allow banks to participate in the commodities markets, said a person briefed on the process who asked not to be named because the review is confidential. The appraisal, intended to minimize potential risks to the financial system, widened since 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.
U.S. law restricts banks from owning non-financial businesses unless they get special exemptions. Goldman Sachs 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 way I read the statute, all commodities activities are grandfathered forever, subject to appropriate risk-management controls,” said Randy Guynn, head of the financial institutions group at law firm Davis Polk & Wardwell LLP, whose clients include Morgan Stanley and Goldman Sachs.
The breadth of the Fed’s review indicates the central bank could narrow its interpretation of what’s grandfathered, potentially limiting Goldman Sachs and Morgan Stanley’s commodities operations to exactly what was held in 1997. Some of their commodity activities, such as Goldman Sachs’s Metro International Trade Services LLC aluminum warehousing business, fall under a separate exemption for “merchant banking” investments. Those can only be held for 10 years.
The Fed is “trying to clear up grandfathering and how it fits merchant banking and the broader context,” said Karen Shaw Petrou, managing partner of Washington-based Federal Financial Analytics, which advises companies on how policies may affect their businesses. Leeway allowed to banks is vague, she said.
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.
The U.S. Chamber of Commerce and companies including Boeing Co. and United Parcel Service Inc. sent a letter today to Fed Chairman Ben S. Bernanke, saying they would face difficulties if banks are forced out of commodities.
“Our ability to manage our risk would be seriously impeded” if banks disappear as counterparties for physical commodities hedges, the group said. “We likely would be forced to tie up our own capital in holding physical inventories and the related infrastructure to manage those inventories, and may find our options for hedging shrink, become less useful, or more expensive.”
Unlike Goldman Sachs and Morgan Stanley, banks such as JPMorgan and Citigroup had to seek an exemption from the Fed that deemed their physical commodities units complementary to their financial operations. That exemption, granted in 2003, was the first to come under the central bank’s review.
The Fed is conducting the review while U.S. lawmakers and regulators raise concerns that banks might abuse their various roles in commodities markets, such as by coordinating their trading platforms and ownership of materials or energy firms to influence prices and profit. Lawmakers and regulators also have questioned whether large banks integral to financial markets should own commodities businesses, such as oil tankers, in which accidents could undermine the firms’ stability.
“There’s a lot of problems with banks engaging in commodities and taking proprietary positions in commodities,” Senator Carl Levin, a Michigan Democrat, said in an interview. The Permanent Subcommittee on Investigations, which he leads, is reviewing banks’ involvement in commodities.
“Congress should reject the policies that allow for bank ownership and reverse the law,” Bart Chilton, a Democratic member of the Commodity Futures Trading Commission, said in an interview.
JPMorgan, whose commodities units are overseen by Blythe Masters, said in July it may exit businesses. The largest U.S. bank could sell or spin off holdings including warehouses, stakes in power plants and trading in materials such as gas and coal. The New York-based firm said it will continue trading commodity derivatives as well as storing and trading precious metals.
Morgan Stanley, whose commodities business is run by Simon Greenshields and Colin Bryce, owns electricity-generating facilities in the U.S. and Europe and markets electric power in the U.S. It also owns Denver-based TransMontaigne Inc., a petroleum and chemical transportation and storage company, and a stake in Heidmar Inc., based in Norwalk, Connecticut, which manages about 100 oil and chemical tankers.
Goldman Sachs, whose commodities trading unit is led by Gregory A. Agran in New York and Magid N. Shenouda in London, owns coal mines in Colombia, a stake in the railroad that transports the coal to port and part of an oil field off the coast of Angola. Spokesmen for both firms declined to comment.
After the Fed granted Goldman Sachs and Morgan Stanley the right to convert into banks in September 2008, the firms got five years to divest any non-financial businesses that didn’t comply with the Bank Holding Company Act. That deadline raised questions about whether the companies will be allowed to keep their physical commodities businesses.
Saule T. Omarova, a law professor at the University of North Carolina at Chapel Hill, said the five-year grace period to convert non-financial operations “strongly implies the Fed has to make that determination.” She wrote a draft report last year on banks’ roles in commodities, sharing it with lawmakers.
“It would be really wise of the Federal Reserve to be more forthcoming on their thinking, their decision,” she said in an interview. “It is just frustrating that with all this public attention, the Fed feels impervious to that pressure, to just ignore.”
Regulators are set to testify before a Senate Banking subcommittee in October on the issue. It will be the panel’s second hearing on the topic.
Senator Sherrod Brown, an Ohio Democrat and chairman of the subcommittee, said in a September interview that the Fed should clarify that banks’ “safety net applies to traditional banking, not trading, not other lines of business.”
Banks’ commodities businesses drew additional congressional scrutiny this year as aluminum users including beverage companies complained that Goldman Sachs, which warehouses the metal, had created delivery delays that drove up its price. Goldman Sachs has said it stores aluminum according to customers’ instructions and noted the price of aluminum has fallen in recent years.
Goldman Sachs divested some physical commodity assets last year when it sold Cogentrix Energy LLC to Carlyle Group LP. The sale included five coal and solar power facilities in Florida, Virginia, Colorado and California.
Morgan Stanley held talks last year with Qatar’s sovereign-wealth fund about selling a stake in its commodities division. The unit cut jobs and shut businesses including agricultural products and dry freight this year.
The six months ended in March were among the worst for the unit’s performance since 1995, Morgan Stanley CEO James Gorman, 55, said earlier this year. The division had a return on equity of less than 5 percent in 2012, the lowest among the bank’s five largest fixed-income units.
“If we could find the right structure to help with our commodities business, we’d move on it,” Gorman said in a Bloomberg Television interview with Erik Schatzker in July. “But as you’ve noted, we’ve been talking about this for a year. We haven’t acted, which is a sense that we’re quite patient.”
Gorman said commodities has been a “tremendous business for Morgan Stanley, but it’s been struggling.”
Goldman Sachs CEO Lloyd C. Blankfein said the firm’s physical commodities unit is a “core” business that provides a crucial service to clients. The bank, whose top three executives trace their roots to commodities trading division J. Aron, has said it plans to remain active in the industry.
“The role we play in that business is very, very important to users in the market,” Blankfein, 59, said in a September interview with CNBC. “Without us in that market, a good credit, a regulated company, the outcomes won’t be very good for the users of the market.”
Banks defended their commodities activities with a September report commissioned by the Securities Industry & Financial Markets Association, in which Goldman Sachs and Morgan Stanley are members. The firms’ ability to trade physical commodities and related financial derivatives helps airlines and natural gas power plants hedge against changes in commodity prices, according to the report from IHS Inc.
The Fed could pursue a variety of strategies for reining in commodities businesses at banks that are grandfathered, Davis Polk’s Guynn said.
“Even if the law says you are permitted to engage in a particular activity, if the Fed thinks you don’t have sufficient risk controls it can insist that you limit the activity until you have proper risk controls,” Guynn said.