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Federal Reserve Plans to Curb Banks' Commodity Holdings

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It seems that tougher days are ahead for banks. Last week, the Federal Reserve proposed a new rule that will make physical commodity trading for banks more costly.

The Fed has invited public comments on the proposed rule that aims to tighten the existing regulations and restrict the major U.S. banks’ ownership in physical commodities assets. Notably, the comments will be accepted till Dec 22, 2016.

Per the Fed officials, 14 banks, including Morgan Stanley (MS - Free Report) and The Goldman Sachs Group, Inc. (GS - Free Report) , are likely to be affected by the proposed rules.

Additional Capital; Limitations on Trading Activity

Based on a broad review of banks’ physical commodity activities and comments on the Fed’s 2014 advance notice of proposed rulemaking, the regulator made several new proposals that are likely to make these activities more expensive for banks.

The Fed’s proposed regulation requires banks to hold additional capital for activities related to physical commodity trading. The Fed officials expect this will lead the banks to hold around $4 billion (in total) more capital for these activities.

Since 2003, the Fed had allowed 12 banks to foray into the physical commodities trading operations. Notably, as per the “grandfather” provision of the Gramm-Leach-Bliley Act in 1999, a firm that was not a bank holding company and converted to a financial holding company after Nov 12, 1999, is permitted to continue conducting activities related to the trading, sale, or investment in commodities that were not permitted for bank holding companies engaged in any of such activities as of Sep 30, 1997 in the U.S.

These grandfathered firms are allowed to engage in the transportation, storage, extraction, and refining of commodities. At present, only two financial holding companies qualify for these grandfather rights – Goldman and Morgan Stanley – that became bank holding companies in 2008. Hence under the proposed rules, these banks will be required to hold 300% of their physical commodity holdings.

In addition, the proposed rule plans to restrict banks’ trading activities on physical commodities. Also, the Fed intends to revoke authorization given to banks for running power plants and remove copper from precious metal category, which banks are allowed to “own and store.”

Further, the new regulation proposes public disclosure requirements for banks that are engaged in physical commodity trading.

What’s the Necessity for New Regulations?
 
The primary goal for these new proposals is to force the banks to protect themselves more against environmental hazards, which may lead to significant liabilities. The Fed is listing significant risks that banks might have to face, which in turn could destabilize the entire financial system. It cited the 2010 Deepwater Horizon oil spill in the Gulf of Mexico and the 2011 Fukushima nuclear power plant meltdown in Japan as examples.

Apart from this, the regulators have put efforts to contain physical trading activities by banks earlier as well. These efforts stem from a 2014 Senate Committee report that probed the extent of banks’ involvement in these types of activities. The Senate report had specifically mentioned JPMorgan Chase & Co. (JPM - Free Report) , Morgan Stanley and Goldman as the companies which amassed huge stakes in commodity market, thereby changing its dynamics (read more: Senate Probe: Banks Exploit Commodity Market).

Moreover, banks were accused of taking undue advantage in commodity markets as they operated mines, owned power plants, warehoused aluminum and shipped oil. At the same time, they also operated trading desks for these commodities. Hence, this led to conflict of interest.

Road Ahead for Banks

Banks have been scaling back their physical commodity trading activities for quite some time now. Last year, Morgan Stanley divested its oil business to Castleton Commodities International LLC, while moving away from metal trading operations. Earlier in 2014, JPMorgan sold parts of its physical commodities business to Mercuria Energy Group Limited.

Despite selling its metals warehousing unit, Metro International Trade Services LLC, in 2014 and its Colombian mining operation in 2015, Goldman continues to maintain significant exposure in the commodity trading. These also remain core part of its business.

As per Natural Gas Intelligence (a trade publication), Goldman’s commodity unit – J. Aron – traded more natural gas than both Chevron Corp. (CVX - Free Report) and Exxon Mobil Corp. (XOM - Free Report) combined, in second-quarter 2016. So, Goldman is expected to be hit hard by the proposed new regulations.

Therefore, given the proposed regulations, banks’ physical commodity trading activities are expected to face more challenges. Already facing a tough operating backdrop, banks’ revenue growth is estimated to be hampered further.

Nevertheless, the increased regulations on banks’ physical commodity operations will go a long way in improving insight and aiding proper oversight. This would also alleviate risks to the U.S. financial system to some extent.

Currently, both Goldman and Morgan Stanley carry Zacks Rank #3 (Hold), while JPMorgan carries a Zacks Rank #4 (Sell). If you wish to see better-ranked stocks in finance as well as other sectors, you can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

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