Senate Banking Subcommittee on Regulating Financial Holding Companies and Physical Commodities
At a Senate Banking Subcommittee on Financial Institutions and Consumer Protection hearing entitled, “Regulating Financial Holding Companies and Physical Commodities,” lawmakers heard testimony and questioned regulators on the impacts of certain financial institution’s role in the physical commodities marketplace.
Opening Statements
Subcommittee Chairman Sherrod Brown (D-Ohio) stated that “for years, U.S. banking laws drew sharp lines between banking and commerce, and respected this separation” but that in 1999 “Congress weakened those lines” and regulators have had to adjust to the new lines of business that financial institutions have become engaged in.
He said that the Federal Reserve’s recent advance notice of proposed rulemaking (ANPR), requesting comment on the activities of financial holding companies related to physical commodities, is a “timid step” that was “too slow in coming” and expressed concern about the lack of information available on these types of activities.
Brown added that recent steps by the London Metal Exchange (LME) to change their warehouse rules have left end-users unconvinced that the problem of high premiums and long queues for metals has been solved. He concluded that “these institutions, their executives, and employees” rather than taxpayers should ultimately pay for mistakes or manipulation.
Sen. Jack Reed (D-R.I.) stated that high energy costs are harming his constituents and are a “tremendous burden inhibiting our growth.” He said that he is concerned about potentials effect on energy prices due to manipulation in the financial markets and said regulators “have to be incredibly watchful” and look into the effects of firm’s owning and trading physical commodities.
Witness Testimony
Norman Bay, Director of the Office of Enforcement at the Federal Energy Regulatory Commission (FERC), in his testimony, gave a brief history of how FERC obtained more authority to take stricter enforcement action against market manipulators after the action of Enron caused the power crisis of 2001. He noted that after this additional authority was received, FERC built up their enforcement capabilities which are divided into four divisions: 1) investigations; 2) audits and accounting; 3) market oversight; and 4) analytics and surveillance.
Vince McGonagle, Director of the Division of Market Oversight at the Commodity Futures Trading Commission (CFTC), in his testimony, noted that under the Commodity Exchange Act (CEA), the CFTC was charged with fostering transparent, open, and competitive markets, while protecting the public from fraud, abusive practices, and systemic risk. He explained that under these provisions, the CFTC reviews all terms and conditions of products submitted to be traded on exchanges and that there are prohibitions on listing contracts that are readily susceptible to manipulation.
McGonagle stated that the CFTC takes enforcement actions against manipulative activity in both the cash and physical markets and that the Commission “routinely provides assistance to other regulators” and consults with other domestic and international agencies.
Michael S. Gibson, Director of the Division of Banking Supervision and Regulation for the Board of Governors of the Federal Reserve System, in his testimony, stated that prior to the Gramm-Leach-Bliley Act, bank holding companies were only able to engage in a limited number of commodities activities deemed to be “closely related” to their bank activities.
Gibson then explained that three provisions “have enabled a limited number of financial holding companies to engage in commodities activities.” These are: 1) section 4(k) of the Bank Holding Company (BHC) Act that authorizes financial holding companies to engage in any activity that the Fed finds to be “complementary to a financial activity”; 2) a provision in the Gramm-Leach-Bliley Act that permits financial holding companies to make merchant banking investments, without prior Fed approval, in companies engaged in activities not otherwise permitted; and 3) section 4(o) of the BHC Act that allows a company which became a financial holding company after Nov. 12, 1999 to continue their activities in the commodities business in a capacity of up to five percent of the company’s total consolidated assets.
Gibson noted that the Fed “has no direct role” in overseeing the commodities markets, but that they supervise banks to see if they have strong capital levels and proper risk controls. He said that the Fed’s ANPR on the subject discusses the “unique tail risks” associated with commodities activities, such as oil spills and other incidents, as well as contagion risk that commodity activities may pose. Gibson concluded that the Fed is seeking comment on whether additional restrictions may be warranted to address these risks and is looking for evidence that the commodity activity may “not be as complementary as perceived.”
Question and Answer
Chairman Brown began the discussion by asking why it has taken the Fed so long to put out a request for comment and if there have been any Board level discussions about bank’s physical commodities activities. Gibson replied that there have not been open board meetings on this topic, but that the staff has been working on this issue since 2008 and have held meetings on commodity activities.
Brown stated that he is “still incredulous about the speed” in which the Fed is moving on this issue and said that he received a letter from CFTC Commissioner Bart Chilton expressing dismay with the lack of substantial disclosure about the size and scope of bank’s commodities activities. He asked Gibson if the Fed knows the levels of physical commodities held by firms.
Gibson replied that the Fed requires disclosure about commodity holdings on reports and balance sheets, but that this reported figure is an aggregate number and not separated out by each type of commodity. He also noted that public companies must file quarterly reports with the Securities and Exchange Commission (SEC) where they describe material risks, thus any physical commodities holdings that pose material risks can be found in these publically available documents.
Gibson said he hopes the ANPR will gather more information from the industry and others to inform any further decisions, but Brown retorted that the comments may not be very helpful because the commenters do not have enough access to information.
Brown then referenced articles published by the New York Fed, which said the legal scope of section 4(o) is “seen widely as ambiguous” and asked Gibson if he could clear this ambiguity. Gibson said the authority granted by Congress under section 4(o) is “very broad” and allows certain BHCs to own, store, transport, and extract commodities; activities which he said are not permitted under section 4(k). He added that the Fed hopes to receive comment on this language and that the interpretation is an “issue for our review.”
When Brown asked what kinds of limits are on a firm’s commodity holdings, Gibson explained that under section 4(o) physical commodity assets can be no more than five percent of total consolidated assets, but under the tighter limits of 4(k) these assets must be less than five percent of a firm’s tier one capital.
Next, Brown asked if the Fed can use their authority under section 5, a provision to ensure “general safety and soundness,” to force divestiture and sale of subsidiaries engaged in commodity activities to avoid undue risk. He also asked if this authority has ever been used. Gibson replied that the Fed “certainly has the authority” under this section to impose capital standards and other requirements and that they could force termination of certain commodity activities if they pose a “serious risk” to safety and soundness. He added that he is not aware of any time when this occurred, saying it is “a high bar.”
Sen. Reed asked how the Fed measures an “undue concentration of resources” when looking at a bank’s holding of commodities. Gibson said that there is not a specific methodology, but rather they use a more subjective assessment in their review of net revenues.
Reed then asked if the Fed continues to evaluate a bank’s commodity activities with respect to serving the public interest, after they have been approved to engage in this activity. Gibson said that once the approval is granted, the Fed focuses on risk management and ongoing safety and soundness concerns.
When Reed followed up saying “public interest aspects of the test sort of go by the wayside” after they “clear the first hurdle;” Gibson replied “that is the way it is set up in the statute.”
Next, Reed asked if the Fed looks at the interaction between holding a physical commodity and the investment portfolio of the bank. Gibson replied that the Fed expects banks to have policies and procedures in place to manage conflicts of interest that may arise from “trading something on one side and investing in something on another side.”
In response to a question from Reed on what happens when a Fed examiner finds “something amiss,” Gibson mentioned that they are not the primary regulator for market manipulation but said if they do find a problem, they will raise it with the bank require that it be fixed and take enforcement action if it is not.
Sen. Jeff Merkley (D-Ore.) said many that firms argue that they have a “Chinese wall” between their commodity operations and their trading operations so that no information can pass between the two. He then asked the panel if they thought this wall was a “powerful separation” of information. The panel agreed that “no instrument is perfect.”
Merkley then asked if it is good policy to allow a firm with “enormous assets” to potentially control the supply and demand of a product while trading the product at the same time. Gibson replied that he hopes to receive comments on this situation and said there are a lot of risks associated with physical commodity activity that are difficult to measure.
When Merkley asked why some firms should be allowed to engage in these activities but not others, Gibson replied that it is “a good question why some companies should have different authority than others and broader authority” and that different limits are due to different authorities in statute.
Merkley then asked if a price increase caused by bank commodity activities affects on supply and demand can be viewed as a tax on end-users. Gibson said that he would not consider it a tax, but the Fed would look at the bank’s activities to see if they are conducted in a safe and sound manner. McGonagle replied that the CFTC would review the size and concentration of the market position to determine if there is an impact on price, while Bay said that “any time there’s fraud or manipulation, there is an impact on the end-user, and invariably, that cost is borne by consumers.”
Sen. Elizabeth Warren (D-Mass.) stated that the Fed’s recent action and ANPR is “certainly a step forward, but a meager one” and said there is “ample evidence” that the Fed should place additional restrictions on how banks trade and warehouse commodities. She then asked if the Glass-Steagall Act, which separated commercial and investment banking, were re-instated if the Fed would still need to make decisions on the level of physical commodity trading allowed. Gibson replied that if the authorizations of banks to deal in commodities were removed then the Fed would not have to deal with these issues.
Warren then asked about coordination between the CFTC and FERC and why access to CFTC information, including the ‘large trader report,’ is so important to FERC. Bay replied that having more data is “helpful for us in terms of beefing up our market surveillance” and having access to more financial data, would allow FERC to create more sophisticated, sensitive, and efficient algorithms to screen data.
Bay noted that FERC and the CFTC entered into a memorandum of understanding (MOU) in which the CFTC agreed to provide data for FERC surveillance programs. McGonagle clarified that FERC is now allowed to come to the CFTC premises to access this data, including the large trader report, but they are still working on technical issues to ensure confidentiality, as mandated by Congress, before the information can be viewed off the CFTC’s premises. Bay followed up, saying that FERC hopes to receive a live data stream in the future of gas and power market information from the large trader report.
Question and Answer – Second Round
Brown asked if the Fed can take away 4(k) orders and asked if 4(o) gives less authority to impose restrictions. Gibson said the Fed can, indeed, take away 4(k) orders and noted that this authority allows for a higher level of limits to be imposed on a bank than 4(o).
Brown then asked what it means to allow a firm to divest their holdings under the merchant bank provision. Gibson explained that because certain impermissible activities are allowed under the provision, if they are a small part of a larger permitted acquisition the firm is allowed to divest this restricted activity over a period of 10 years. He then noted that the Fed monitors the progress through quarterly reports.
Next, Brown asked if the queues seen at aluminum warehouses increase prices. McGonagle replied that this issue requires “some degree of evaluation by the CFTC,” and that it will be particularly relevant as LME has applied to become a foreign board of trade. He said the CFTC will be engaged with LME regarding premiums, rents, and incentives to see any potential impacts on supply and demand. He stated that if there is a price effect due to conduct “that interferes with the price of a commodity and interstate commerce,” the CFTC has “jurisdiction for fraud and manipulation and they would undertake that authority pursuant to nonpublic investigatory process.”
Brown asked if the CFTC could use no-action letters and the foreign board of trade approval process “as leverage to force changes.” McGonagle replied that he hopes the CFTC would explore opportunities, “short of revoking a registration,” that would affect real change.
When Brown referenced a statement by CFTC Commissioner Chilton that there is “shockingly little interest” in bank’s commodity activities “that could impact derivative markets,” McGonagle replied that the CFTC’s “connection to cash markets authority is driven primarily through enforcement” and their role to ensure that there is no fraud or manipulation in the market. He then added “I think there’s a different conversation” to consider with respect to “oversight over particular entities and cash market positions.”
In concluding remarks, Brown stated that commodity activities have been justified, in past hearings, by stating the “benefits they are supposed to provide to individuals and companies in the real economy,” but said that “in many ways, speculation in the commodities, futures and derivatives markets has become an end in itself.” He continued that “the issue is as much about financial institutions becoming industrial businesses as it is about the financial-ization of the real economy,” and that “it’s time for us to pick workers, and consumers and taxpayers over the speculators.”
For more information on this hearing and to view a webcast, please click here.
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At a Senate Banking Subcommittee on Financial Institutions and Consumer Protection hearing entitled, “Regulating Financial Holding Companies and Physical Commodities,” lawmakers heard testimony and questioned regulators on the impacts of certain financial institution’s role in the physical commodities marketplace.
Opening Statements
Subcommittee Chairman Sherrod Brown (D-Ohio) stated that “for years, U.S. banking laws drew sharp lines between banking and commerce, and respected this separation” but that in 1999 “Congress weakened those lines” and regulators have had to adjust to the new lines of business that financial institutions have become engaged in.
He said that the Federal Reserve’s recent advance notice of proposed rulemaking (ANPR), requesting comment on the activities of financial holding companies related to physical commodities, is a “timid step” that was “too slow in coming” and expressed concern about the lack of information available on these types of activities.
Brown added that recent steps by the London Metal Exchange (LME) to change their warehouse rules have left end-users unconvinced that the problem of high premiums and long queues for metals has been solved. He concluded that “these institutions, their executives, and employees” rather than taxpayers should ultimately pay for mistakes or manipulation.
Sen. Jack Reed (D-R.I.) stated that high energy costs are harming his constituents and are a “tremendous burden inhibiting our growth.” He said that he is concerned about potentials effect on energy prices due to manipulation in the financial markets and said regulators “have to be incredibly watchful” and look into the effects of firm’s owning and trading physical commodities.
Witness Testimony
Norman Bay, Director of the Office of Enforcement at the Federal Energy Regulatory Commission (FERC), in his testimony, gave a brief history of how FERC obtained more authority to take stricter enforcement action against market manipulators after the action of Enron caused the power crisis of 2001. He noted that after this additional authority was received, FERC built up their enforcement capabilities which are divided into four divisions: 1) investigations; 2) audits and accounting; 3) market oversight; and 4) analytics and surveillance.
Vince McGonagle, Director of the Division of Market Oversight at the Commodity Futures Trading Commission (CFTC), in his testimony, noted that under the Commodity Exchange Act (CEA), the CFTC was charged with fostering transparent, open, and competitive markets, while protecting the public from fraud, abusive practices, and systemic risk. He explained that under these provisions, the CFTC reviews all terms and conditions of products submitted to be traded on exchanges and that there are prohibitions on listing contracts that are readily susceptible to manipulation.
McGonagle stated that the CFTC takes enforcement actions against manipulative activity in both the cash and physical markets and that the Commission “routinely provides assistance to other regulators” and consults with other domestic and international agencies.
Michael S. Gibson, Director of the Division of Banking Supervision and Regulation for the Board of Governors of the Federal Reserve System, in his testimony, stated that prior to the Gramm-Leach-Bliley Act, bank holding companies were only able to engage in a limited number of commodities activities deemed to be “closely related” to their bank activities.
Gibson then explained that three provisions “have enabled a limited number of financial holding companies to engage in commodities activities.” These are: 1) section 4(k) of the Bank Holding Company (BHC) Act that authorizes financial holding companies to engage in any activity that the Fed finds to be “complementary to a financial activity”; 2) a provision in the Gramm-Leach-Bliley Act that permits financial holding companies to make merchant banking investments, without prior Fed approval, in companies engaged in activities not otherwise permitted; and 3) section 4(o) of the BHC Act that allows a company which became a financial holding company after Nov. 12, 1999 to continue their activities in the commodities business in a capacity of up to five percent of the company’s total consolidated assets.
Gibson noted that the Fed “has no direct role” in overseeing the commodities markets, but that they supervise banks to see if they have strong capital levels and proper risk controls. He said that the Fed’s ANPR on the subject discusses the “unique tail risks” associated with commodities activities, such as oil spills and other incidents, as well as contagion risk that commodity activities may pose. Gibson concluded that the Fed is seeking comment on whether additional restrictions may be warranted to address these risks and is looking for evidence that the commodity activity may “not be as complementary as perceived.”
Question and Answer
Chairman Brown began the discussion by asking why it has taken the Fed so long to put out a request for comment and if there have been any Board level discussions about bank’s physical commodities activities. Gibson replied that there have not been open board meetings on this topic, but that the staff has been working on this issue since 2008 and have held meetings on commodity activities.
Brown stated that he is “still incredulous about the speed” in which the Fed is moving on this issue and said that he received a letter from CFTC Commissioner Bart Chilton expressing dismay with the lack of substantial disclosure about the size and scope of bank’s commodities activities. He asked Gibson if the Fed knows the levels of physical commodities held by firms.
Gibson replied that the Fed requires disclosure about commodity holdings on reports and balance sheets, but that this reported figure is an aggregate number and not separated out by each type of commodity. He also noted that public companies must file quarterly reports with the Securities and Exchange Commission (SEC) where they describe material risks, thus any physical commodities holdings that pose material risks can be found in these publically available documents.
Gibson said he hopes the ANPR will gather more information from the industry and others to inform any further decisions, but Brown retorted that the comments may not be very helpful because the commenters do not have enough access to information.
Brown then referenced articles published by the New York Fed, which said the legal scope of section 4(o) is “seen widely as ambiguous” and asked Gibson if he could clear this ambiguity. Gibson said the authority granted by Congress under section 4(o) is “very broad” and allows certain BHCs to own, store, transport, and extract commodities; activities which he said are not permitted under section 4(k). He added that the Fed hopes to receive comment on this language and that the interpretation is an “issue for our review.”
When Brown asked what kinds of limits are on a firm’s commodity holdings, Gibson explained that under section 4(o) physical commodity assets can be no more than five percent of total consolidated assets, but under the tighter limits of 4(k) these assets must be less than five percent of a firm’s tier one capital.
Next, Brown asked if the Fed can use their authority under section 5, a provision to ensure “general safety and soundness,” to force divestiture and sale of subsidiaries engaged in commodity activities to avoid undue risk. He also asked if this authority has ever been used. Gibson replied that the Fed “certainly has the authority” under this section to impose capital standards and other requirements and that they could force termination of certain commodity activities if they pose a “serious risk” to safety and soundness. He added that he is not aware of any time when this occurred, saying it is “a high bar.”
Sen. Reed asked how the Fed measures an “undue concentration of resources” when looking at a bank’s holding of commodities. Gibson said that there is not a specific methodology, but rather they use a more subjective assessment in their review of net revenues.
Reed then asked if the Fed continues to evaluate a bank’s commodity activities with respect to serving the public interest, after they have been approved to engage in this activity. Gibson said that once the approval is granted, the Fed focuses on risk management and ongoing safety and soundness concerns.
When Reed followed up saying “public interest aspects of the test sort of go by the wayside” after they “clear the first hurdle;” Gibson replied “that is the way it is set up in the statute.”
Next, Reed asked if the Fed looks at the interaction between holding a physical commodity and the investment portfolio of the bank. Gibson replied that the Fed expects banks to have policies and procedures in place to manage conflicts of interest that may arise from “trading something on one side and investing in something on another side.”
In response to a question from Reed on what happens when a Fed examiner finds “something amiss,” Gibson mentioned that they are not the primary regulator for market manipulation but said if they do find a problem, they will raise it with the bank require that it be fixed and take enforcement action if it is not.
Sen. Jeff Merkley (D-Ore.) said many that firms argue that they have a “Chinese wall” between their commodity operations and their trading operations so that no information can pass between the two. He then asked the panel if they thought this wall was a “powerful separation” of information. The panel agreed that “no instrument is perfect.”
Merkley then asked if it is good policy to allow a firm with “enormous assets” to potentially control the supply and demand of a product while trading the product at the same time. Gibson replied that he hopes to receive comments on this situation and said there are a lot of risks associated with physical commodity activity that are difficult to measure.
When Merkley asked why some firms should be allowed to engage in these activities but not others, Gibson replied that it is “a good question why some companies should have different authority than others and broader authority” and that different limits are due to different authorities in statute.
Merkley then asked if a price increase caused by bank commodity activities affects on supply and demand can be viewed as a tax on end-users. Gibson said that he would not consider it a tax, but the Fed would look at the bank’s activities to see if they are conducted in a safe and sound manner. McGonagle replied that the CFTC would review the size and concentration of the market position to determine if there is an impact on price, while Bay said that “any time there’s fraud or manipulation, there is an impact on the end-user, and invariably, that cost is borne by consumers.”
Sen. Elizabeth Warren (D-Mass.) stated that the Fed’s recent action and ANPR is “certainly a step forward, but a meager one” and said there is “ample evidence” that the Fed should place additional restrictions on how banks trade and warehouse commodities. She then asked if the Glass-Steagall Act, which separated commercial and investment banking, were re-instated if the Fed would still need to make decisions on the level of physical commodity trading allowed. Gibson replied that if the authorizations of banks to deal in commodities were removed then the Fed would not have to deal with these issues.
Warren then asked about coordination between the CFTC and FERC and why access to CFTC information, including the ‘large trader report,’ is so important to FERC. Bay replied that having more data is “helpful for us in terms of beefing up our market surveillance” and having access to more financial data, would allow FERC to create more sophisticated, sensitive, and efficient algorithms to screen data.
Bay noted that FERC and the CFTC entered into a memorandum of understanding (MOU) in which the CFTC agreed to provide data for FERC surveillance programs. McGonagle clarified that FERC is now allowed to come to the CFTC premises to access this data, including the large trader report, but they are still working on technical issues to ensure confidentiality, as mandated by Congress, before the information can be viewed off the CFTC’s premises. Bay followed up, saying that FERC hopes to receive a live data stream in the future of gas and power market information from the large trader report.
Question and Answer – Second Round
Brown asked if the Fed can take away 4(k) orders and asked if 4(o) gives less authority to impose restrictions. Gibson said the Fed can, indeed, take away 4(k) orders and noted that this authority allows for a higher level of limits to be imposed on a bank than 4(o).
Brown then asked what it means to allow a firm to divest their holdings under the merchant bank provision. Gibson explained that because certain impermissible activities are allowed under the provision, if they are a small part of a larger permitted acquisition the firm is allowed to divest this restricted activity over a period of 10 years. He then noted that the Fed monitors the progress through quarterly reports.
Next, Brown asked if the queues seen at aluminum warehouses increase prices. McGonagle replied that this issue requires “some degree of evaluation by the CFTC,” and that it will be particularly relevant as LME has applied to become a foreign board of trade. He said the CFTC will be engaged with LME regarding premiums, rents, and incentives to see any potential impacts on supply and demand. He stated that if there is a price effect due to conduct “that interferes with the price of a commodity and interstate commerce,” the CFTC has “jurisdiction for fraud and manipulation and they would undertake that authority pursuant to nonpublic investigatory process.”
Brown asked if the CFTC could use no-action letters and the foreign board of trade approval process “as leverage to force changes.” McGonagle replied that he hopes the CFTC would explore opportunities, “short of revoking a registration,” that would affect real change.
When Brown referenced a statement by CFTC Commissioner Chilton that there is “shockingly little interest” in bank’s commodity activities “that could impact derivative markets,” McGonagle replied that the CFTC’s “connection to cash markets authority is driven primarily through enforcement” and their role to ensure that there is no fraud or manipulation in the market. He then added “I think there’s a different conversation” to consider with respect to “oversight over particular entities and cash market positions.”
In concluding remarks, Brown stated that commodity activities have been justified, in past hearings, by stating the “benefits they are supposed to provide to individuals and companies in the real economy,” but said that “in many ways, speculation in the commodities, futures and derivatives markets has become an end in itself.” He continued that “the issue is as much about financial institutions becoming industrial businesses as it is about the financial-ization of the real economy,” and that “it’s time for us to pick workers, and consumers and taxpayers over the speculators.”
For more information on this hearing and to view a webcast, please click here.