The Federal Reserve Board (FRB) recently proposed new restrictions on the ability of a financial holding company (FHC) to engage in physical commodity activities. The complex proposal includes (i) heightened capital requirements for certain physical commodity activities, (ii) changes to the maximum amount of specified physical commodities FHCs can hold, (iii) clarification of restrictions on certain physical commodity activities, (iv) elimination of the authority to engage in particular physical commodity-related activities, and (v) termination of the treatment of copper as a precious metal that FHCs and bank holding companies can trade. Comments must be received on or before December 22, 2016.

Background

Bank holding companies under the U.S. Bank Holding Company (BHC) Act are limited to banking activities and activities incidental to banking. Under provisions of the BHC Act added in section 103 of the 1999 Gramm-Leach-Bliley Act, a bank holding company that met certain criteria could elect to become an FHC, which can engage in a broader range of activities that are “financial” in nature or incidental to a financial activity or, pursuant to a specific FRB order, engage in an activity determined by the FRB to be “complementary” to a financial activity. The long list of activities considered to be “financial” in nature includes engaging in, and providing financial and investment advisory services in connection with, certain commodity derivative activities and, subject to certain limitations, making passive investments in nonfinancial companies (called “merchant banking”).

FHCs have been permitted to engage in some physical commodity activities under certain specific authorities:

Complementary Authority: The FRB has authorized a number of FHCs to conduct certain physical commodity activities as “complementary” to a financial activity. These Complementary Authority approvals included (i) trading in specified physical commodities, (ii) providing transactional and advisory services to power plant owners (energy management services) and (iii) paying a power plant owner fixed periodic payments to compensate for its fixed costs in exchange for the right to all or part of the plant’s power output (energy tolling).Under these orders, FHCs are prohibited from owning, operating or investing in facilities that extract, transport, store, or alter commodities.

The FRB imposed limits on the permitted Complementary Authority activity: the aggregate market value of commodities held under the physical commodity trading and energy tolling orders is limited to 5% of the tier 1 (core) capital of the FHC, and the physical trading authority generally is restricted to only those physical commodities approved by the Commodity Futures Trading Commission (CFTC) for trading on a U.S. futures exchange. Energy management services are limited to 5% of an FHC’s consolidated operating revenues.

Under these orders, FHCs are prohibited from owning, operating or investing in facilities that extract, transport, store, or alter commodities.

Grandfathered Authority: The BHC Act also provided authority for companies that became FHCs after November 12, 1999, to engage in activities related to the trading, sale and/or investment in commodities that were not permissible for bank holding companies as of September 30, 1997.

Unlike the Complementary Authority, the grandfathered FHCs can engage in storing, transporting, extracting and altering physical commodities. There are only two conditions: (i) the activities are limited to 5% of the total consolidated assets of the FHC, which is higher than the limit under the Complementary Authority and (ii) the FHC cannot cross-market the services of its subsidiary banks and those subsidiaries engaging in grandfathered activities. Only two FHCs have been able to take advantage of this authority.

Merchant Banking: Provided that it meets the prerequisite for engaging in merchant banking, an FHC can make passive investments in nonfinancial companies, which includes investing in a company that engages in physical commodity activities. There are time limits on how long an FHC may hold a merchant banking investment, and FHCs cannot routinely manage or operate the portfolio company except under certain extraordinary circumstances.

The Proposed Rule

In January 2014, concerned about the substantial risks FHCs may face in engaging in physical commodity activities, the FRB issued an Advance Notice of Proposed Rulemaking to solicit comments on whether it should impose additional prudential restrictions or limitations on any of these activities.

This led the FRB to issue its proposal for comment in late September:

Limitations on physical commodities holdings: The FRB proposes to extend the Complementary Authority limitations to the FHC as a whole. On a consolidated basis, an FHC would be prohibited from purchasing, selling or delivering physical commodities under most permissible authorities if the market value of the commodities exceeds 5% of the consolidated tier 1 (core) capital of the FHC. Investments held under merchant banking authority (and similar authority for insurance company investments) and physical commodities held in satisfaction of debts previously contracted would be exempt from these limits.

Restrictions on Covered Physical Commodities activities: The proposal also would strengthen the restrictions contained in the Complementary Authority to ensure that FHCs are not “operating” an entity engaged in physical trading activities in “covered physical commodities” for purposes of certain federal and state environmental laws. For example, an FHC could not manage, direct, conduct or provide advice regarding decisions related to a facility’s compliance with environmental statutes or regulations.

“Covered Physical Commodities” are proposed to be defined as substances covered under specified federal or state environmental laws that are seen as posing the greatest potential liability for the FHC, regardless of whether these commodities are held in the United States.

Heightened capital requirements: To address the higher potential for legal liability for FHCs engaging in Covered Physical Commodity activities, the proposal would increase substantially the risk-based capital requirements for FHCs engaging in those activities, whether the FHC uses the standardized risk capital standards or its own approved internal risk models. This would be in addition to any risk-based capital requirements that might otherwise apply to those activities. Risk-based capital requirements for other physical commodities would remain the same.

The highest risk weight would be assigned to certain activities under the Grandfathered Authority because the broad range of activities permitted under the Grandfathered Authority includes those carrying the highest potential for legal liability for the FHC, such as refining and storing these physical commodities.

Noteworthy is a paragraph tucked away in the middle of the capital discussion that states that the FRB is considering increasing the risk weight requirements generally for all merchant banking investments

Termination of certain Complementary Authority: The FRB is proposing to rescind the Complementary Authority granted to five FHCs to engage in energy management and energy tolling activities. In the commentary accompanying the text of the proposal, the FRB notes that it is not clear whether having this authority has improved the FHCs’ ability to manage their commodity-related activities, or their understanding of the commodity derivatives markets. As a result, the FRB is proposing to terminate the authority of the approved FHCs to engage in energy management and energy tolling activities.

This termination would not affect an FHC’s authority to engage in derivatives activities with power plants, provide other financial products and services to power plants, or engage in physical commodity trading and hedging activities under the Complementary Authority or other legal authority.

Termination of Copper as a precious metal: The FRB is proposing to terminate the treatment of copper as a precious metal that bank holding companies can buy, sell, hold and store without limitation. Copper was added to the list of precious metals in 1997 after the Office of the Comptroller of the Currency (“OCC”) determined that trading in copper was a permissible banking activity because it could be used as a store of value as “coin, exchange or bullion” similar to gold, silver, platinum and palladium. In the commentary accompanying the text of the proposal, the FRB notes that over time, copper has been used more for industrial purposes, rather than as a precious metal. The FRB thus proposes to treat copper as other non-precious metals, and allow only FHCs to engage in copper activities, and only under a specific Complementary Authority determination. The FRB would not authorize FHCs to store, custody, assay or ship copper, and bank holding companies would no longer be able to take delivery of copper to settle a derivatives contract.

The OCC also has proposed that it withdraw its afore-mentioned determination of buying and selling copper as a permissible banking activity for national banks. The proposed regulation sets out permissible activities for national banks to buy and sell exchange, coin and bullion, and specifically states that metals primarily used for industrial or commercial purposes (such as copper) are not considered exchange, coin or bullion. Acquiring such metals as part of foreclosing on or collecting a debt, or acquiring a nominal amount to hedge a derivative in which the metal is the reference asset would be permissible.

New Physical Commodity Activities Reporting: Finally, the FRB is proposing to revise the consolidated financial statements that FHCs submit to the FRB in order to collect more specific information primarily on the FHC’s physical commodities held in inventory, and to reflect the increased capital requirements for Covered Physical Commodity Activities. This new information would be made available to the public.