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By Anna Louie Sussman and Emily Stephenson
NEW YORK/WASHINGTON, Jan 14 (Reuters) - The U.S. FederalReserve on Tuesday took a first formal step toward restrictingthe role of Wall Street banks in trading physical commodities,citing fears that a multibillion-dollar disaster could bringdown a bank and imperil the stability of the financial system.
The Fed board voted to publish its concerns and potentialremedies following months of growing public and politicalpressure to check banks' decade-long expansion into thecommodities supply chain. The Fed also questioned the initialrationale for allowing them to trade and invest in risky rawmaterials and lease oil tanks or own power plants.
The Fed "expect(s) to engage in additional rulemaking inthis area," according to prepared remarks of Michael Gibson, theFed's director of bank supervision and regulation, to a U.S.Senate banking committee hearing on Wednesday.
The new rules could include a cap on total assets orrevenues from such trading, increased capital or insurance, orprohibitions on holding certain types of commodities "that poseundue risk."
Facing a clearly uneasy regulator, some banks includingJPMorgan Chase & Co are already quitting the business, aonce-lucrative trading niche that has reaped billions of dollarsof revenue for Wall Street over the years but is now facingdiminished margins and stiffer capital rules.
But others, such as Goldman Sachs Group Inc, havestood firm, defending an operation they say benefits customers.Due to a grandfather provision in a 1999 banking law, the Fedhas less leeway to restrict the activities of former investmentbanks Goldman and Morgan Stanley, Gibson said.
In a 19-page document that included two dozen questions, theFed offered a host of reasons for imposing new restrictions inthe interests of limiting potential conflicts of interest andprotecting the safety and soundness of the banking system. Itinvoked disasters including BP's oil spill in the Gulf ofMexico in 2010 and the derailment and explosion of an oil trainin Canada last year.
"The recent catastrophes accent that the costs of preventingaccidents are high and the costs and liability related tophysical commodity activities can be difficult to limit andhigher than expected," the Fed said in its notice.
The "advance notice of proposed rulemaking," which is anoptional initial step in the sometimes years-long process ofmaking new regulations, seeks comments until March 15.
To read the full notice click:
CONFLICTS, RISKS AND CAPITAL
It is the Fed's first detailed public comment since itshocked the banking industry last July by announcing a "review"of its 2003 authorization that first allowed commercial bankssuch as Citigroup to handle physical commodities.
U.S. Senator Sherrod Brown of Ohio, who led the firsthearing last summer, said the measure was "overdue andinsufficient", warning that consumers and end-users riskedpaying higher commodity prices until new curbs are imposed.
But others saw it as a likely prelude to tough action thatwould curtail so-called "too big to fail" banks amid a widerpolitical move to restore the historical division betweencommercial banking and riskier business. Eliminating that divide15 years ago helped open the door to commodities trading.
"That was the Greenspan era, and it was anything goes as faras activities. Now, we realize that we made a lot of mistakesduring the Greenspan era," said Cornelius Hurley, banking lawprofessor at Boston University and former assistant generalcounsel to the Fed Board of Governors.
Beyond the financial risks, the Fed is also seeking commenton potential conflicts of interest for banks, and the risks andbenefits of additional capital requirements or otherrestrictions - measures that have been hinted at in the past.
The Fed said that new limits on the three ways in whichbanks may deal in physical commodities were up for debate: theauthority to trade raw materials as "complementary" toderivatives; the investment in commodity-related business asarm's-length merchant banking deals; and the "grandfather"clause that has allowed Morgan Stanley and Goldman Sachs much wider latitude to invest in assets than their peers.
The Fed also questioned several previously citedjustifications for allowing banks to trade in physicalcommodities such as crude oil cargoes and pipeline natural gas-- markets in which some banks such as Goldman Sachs and Bank ofAmerica's Merrill Lynch are still active.
It said, for instance, that although most banks are notallowed to actually own infrastructure assets, those that leasestorage tanks or own physical commodities held by third partiesmay nonetheless face a "sudden and severe" loss of publicconfidence if they are involved in a catastrophe.
They also said that several banks' recent moves to sell allor parts of their physical trading operations "may suggest thatthe relationship between commodities derivatives and physicalcommodities markets...may not be as close as previously claimedor expected."
While scoping out possible measures to tighten up commoditytrading and merchant investment, the Fed offered little insightinto how it might level the playing field by narrowing thegrandfather exemption that Goldman and Morgan enjoy.
"Our ability to address the broad scope of activitiesspecifically permitted by statute under the grandfatherprovision...is more limited," Gibson will tell lawmakers.
Legal experts say the provision - which has long been a boneof contention with other banks who had never been allowed toinvest in oil tanks and power plants - was widely written. Itmay require Congressional action to crack down - a seeminglyunlikely outcome given the political divisions in Washington.
One legal expert at a private commodity trading firm said the tone of the Fed's notice and mention of catastrophic risksmade it almost certain that some form of regulatory action wouldfollow.
"Given some of the things they've said, it would almost makethem look bad if they ultimately decided not to do anything,"said the expert, who asked not to be identified because theywere not authorized to speak to the media.
