Fed Criticized on Oversight of Bank-Owned Commodity Units

The Federal Reserve faces new pressure to explain why it lets banks trade raw materials and control supplies after congressional witnesses said regulators can’t really grasp what lenders are doing in industrial businesses.

Officials from the Fed and Commodity Futures Trading Commission may testify at hearings in September, U.S. Senator Sherrod Brown said in an interview yesterday after witnesses told his Senate subcommittee that commodities operations owned by lenders are hurting customers and endangering the financial system. He’ll also seek testimony from bankers.

“Should the public generally be forced to feel around in the dark to figure this stuff out?” Brown, an Ohio Democrat, said during the hearing. “This is too important,” he added later. “It does significant potential damage to the economy.”

The Fed said last week it’s reviewing a decade-old decision to break down barriers between finance and commerce by letting banks deal in physical assets like metal and oil. A reversal could put commodity units of JPMorgan Chase & Co., Goldman Sachs Group Inc. and Morgan Stanley in jeopardy.

Witnesses at yesterday’s hearing in Washington said financial regulators can’t effectively oversee units in industries that fall outside of typical banking or foresee the risks they pose to taxpayer-backed firms.

“To expect the regulators to understand the web of relationships that exist here is not rational,” said Joshua Rosner, a bank analyst at New York-based Graham Fisher & Co., which advises clients on investments in the financial industry. Regulators failed similar tasks in the years leading to the 2008 financial crisis, he said.

Commodity Risks

Risks in banks’ commodities businesses can be managed by limiting them to frequently traded products and setting curbs on volume, Randall Guynn, head of the financial institutions group at law firm Davis Polk & Wardwell LLP, said at the hearing. Regulators also can require minimum amounts of capital and liquidity, he said.

“It would be the unusual bank examiner who understands the commodities markets, oil markets and oil tankers, and so forth, but they do have tools that they have used and can use to try to control this risk,” Guynn said.

Barbara Hagenbaugh, a Fed spokeswoman, and the CFTC’s Steve Adamske declined to comment on the prospects for a future hearing.

Yesterday’s hearing featured questions from Brown, Democrats Elizabeth Warren of Massachusetts and Jeff Merkley of Oregon, and Pat Toomey, a Pennsylvania Republican, in front of a full audience. Brown said he’s concerned that lenders may be put at risk when volatile commodity markets move against them or disaster strikes one of their operations.

Making Choices

“What do we want our banks to do? Make small-business loans or refine and transport oil? Issue mortgages or corner the metals market?” Brown said at the hearing’s outset. “Taxpayers have a right to know what’s happening and to have a say.”

Brown is among lawmakers who say banks can drive up prices when they control both the physical products and the financing. Merkley said the arrangement may allow banks to “put a thumb on the scale” to influence supply and demand, and bet accordingly.

U.S. Senator Carl Levin, the Michigan Democrat who leads the Permanent Subcommittee on Investigations, said lawmakers may use his panel’s subpoena power to examine banks’ trading and ownership of physical commodities. Levin said he may hold his own hearings if he isn’t satisfied with the outcome of Brown’s effort, which can’t compel testimony or demand documents.

Aluminum Market

The CFTC told firms involved in commodity warehousing to retain internal documents and e-mails related to the businesses, the New York Times reported, citing people who had reviewed the requests.

The beverage industry has complained that banks and other warehouse owners are manipulating aluminum supplies and slowing deliveries to drive up the price. Costs were inflated by $3 billion worldwide in the past year, Tim Weiner, a global risk manager at brewer MillerCoors LLC, told the panel in prepared remarks.

Goldman Sachs, the most profitable Wall Street securities firm before the 2008 financial crisis, posted a rebuttal to some of the criticism on the company’s website. The firm said about 95 percent of the aluminum used in manufacturing comes from producers and dealers outside the London Metal Exchange warehouse system in which banks participate.

Enron Redux

Banks may have adopted the model for trading both physical commodities and derivatives used by Enron Corp., adding “more and more risk” to the financial system, Warren said at yesterday’s hearing. Enron, was the world’s biggest trader of power and natural gas before it collapsed in 2001 amid an accounting fraud, and some former employees pleaded guilty to charges they tried to manipulate power prices.

Moves by banks to deepen their involvement in physical commodity trading and assets “suggests this movie won’t end well,” she said.

The 10 largest Wall Street banks generated about $6 billion in revenue from commodities in 2012, including $1 billion from dealings in physical materials, according to data from analytics company Coalition Ltd. Goldman Sachs ranked No. 1, followed by New York-based JPMorgan.

Biggest Players

Morgan Stanley, Goldman Sachs and JPMorgan are the biggest Wall Street players in physical commodities. Goldman Sachs held $7.7 billion of commodities at fair value as of March 31 and New York-based Morgan Stanley had $6.7 billion, according to regulatory filings. JPMorgan had $14.3 billion in physical commodities as of March 31, according to a filing.

Critics “don’t provide a shred of evidence to support the view that these potential dangers are likely to be realized,” Guynn said at the hearing. “The connection between banking and commodities is not a new development.”

The knowledge that banks gain from participating “helps the prices in the derivatives markets and the pricing in the physical markets to converge, which is actually a good thing,” he said.

None of the banks discloses how much revenue or profit comes from commodity trading or break out the contribution from physical assets. The Fed has been “less than forthcoming” about its oversight of the units, Brown said.

Regulatory Limits

Saule T. Omarova, a law professor at the University of North Carolina at Chapel Hill, said she doubts regulators are capable of overseeing businesses outside of normal banking.

“It stretches regulatory capacity beyond its limits,” Omarova said in an interview. “No regulator in the financial world can realistically, effectively manage all the risks of an enterprise of financial activities, but also the marketing of gas, oil, electricity and metals. How can one banking regulator develop the expertise to know what’s going on?”

Rosner said the federal backing of U.S. banks gives them a funding advantage that can distort markets. The result could be guarantees that extend beyond the financial industry, said Arthur Wilmarth, a law professor specializing in banking and financial regulation at George Washington University in Washington.

“If you allow banks to get heavily into commerce, then pretty soon you’re going to see the safety net wrapping around the entire commercial sectors that the banks are involved in,” Wilmarth, who wasn’t a witness at the hearing, said in an interview. “They clearly are taking a lot of risk on it, and if something went really bad and endangered the survival of a major bank, I think the federal government’s going to be there” with emergency lending or liquidation measures.

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