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Physical Commodity Activities Conducted by Financial Holding Companies

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Physical Commodity Activities Conducted by Financial Holding Companies September 26, 2016 Physical Commodity Activities Conducted by Financial Holding Companies Federal Reserve Proposes Extraordinary Increase in Capital Requirements for Physical Commodity Activities and Certain Merchant Banking Investments, Along With New Prudential Limitations SUMMARY On September 23, 2016, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) issued for public comment a proposal (the “Proposal”) that would impose extraordinary capital and other prudential requirements and limitations with respect to physical commodity activities of financial holding companies (“FHCs”). The capital requirements would apply to physical commodity activities that, according to the Federal Reserve, have the potential to expose the FHC to environmental liability (“covered physical commodity activities”). The level of increase is so high that its apparent purpose is to preclude FHCs from exercising at least some of the authorities that were granted by Congress in the Gramm-Leach-Bliley Act of 1999 (“GLBA”). Most notably, the Proposal would: Impose a 300 percent risk weight for regulatory capital purposes on covered physical commodity assets that a FHC is permitted to hold under “complementary” authority; Impose a 1,250 percent risk weight for regulatory capital purposes on any covered physical commodity held by a FHC in reliance solely on the statutory “grandfather” authority; Impose a 1,250 percent risk weight for regulatory capital purposes on merchant banking investments in companies that engage in covered physical commodity activities (other than activities permitted under “complementary” authority); Require a FHC to include in the 5 percent of tier 1 capital limit imposed on physical commodity “complementary” authority all covered physical commodity activities of the FHC and its subsidiaries, including depository institution subsidiaries, conducted under any authority (subject to certain exceptions); New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com Rescind the Federal Reserve’s energy management and energy tolling approvals previously authorized under “complementary” authority; and Impose a new quarterly public reporting requirement that includes detailed disclosures regarding the FHC’s physical commodities holdings and activities. The Proposal follows an advance notice of proposed rulemaking (the “ANPR”) issued by the Federal Reserve in January 2014, which solicited public comment on whether additional prudential requirements or restrictions on the physical commodity activities of FHCs would be appropriate in light of “the unique and significant risks that physical commodities activities may impose” on FHCs, particularly relating to potential liability for environmental catastrophes.1 Notably, although the Proposal would impose significant capital requirements on covered physical commodity activities that would effectively prohibit many activities, and, in the case of a 1,250 percent risk weight, a dollar-for-dollar capital charge, the Proposal does not cite any situations in which a FHC has suffered material financial losses with respect to these activities, or where any other financial services company has suffered such losses prior to or after the enactment of GLBA. Although with respect to merchant banking the Proposal relates only to covered physical commodity activity, the Federal Reserve indicates that it is considering the appropriate risk-based capital treatment for all merchant banking investments and specifically asks whether “current capital requirements adequately capture the risks of merchant banking investments not covered under the proposal” and “[i]f not, what additional capital requirements should be applied to merchant banking investments generally.”2 Comments on the Proposal are due by December 22, 2016. BACKGROUND Bank holding companies (“BHCs”) and their subsidiaries are permitted to engage in certain physical commodity activities pursuant to multiple authorities under the Bank Holding Company Act of 1956 (the “BHC Act”), most notably expanded authority for BHCs that qualify for FHC status.3 In the January 2014 ANPR, the Federal Reserve solicited public comment regarding potential environmental and other risks that may result from FHC physical commodity activities and whether additional limitations or restrictions would be appropriate. Like the Proposal, the ANPR focused on the physical commodity activities conducted by most FHCs under “complementary” authority,4 pursuant to which the Federal Reserve authorized several FHCs, on a case-by-case basis and subject to certain prudential limitations, to engage in: Physical commodity trading, involving the purchase or sale of commodities in the spot market and taking and making delivery of physical commodities to settle commodity derivatives, limited to commodities for which a derivative contract has been authorized for trading on a U.S. futures exchange by the Commodity Futures Trading Commission (the “CFTC”) and subject to a 5 percent of tier 1 capital limit; -2- Physical Commodity Activities Conducted by Financial Holding Companies September 26, 2016 Energy management services, involving providing transactions and advisory services to power plant owners; and Energy tolling, involving paying a power plant owner fixed periodic payments that compensate the owner for its fixed costs in exchange for the right to all or part of the plant’s power output. In the ANPR, the Federal Reserve also requested comment on activities conducted pursuant to the “grandfather” authority under section 4(o) of the BHC Act, which permits a company that was not a BHC and became a FHC following the enactment of GLBA to engage in activities related to the trading, sale or investment in commodities and underlying physical properties in which the company was lawfully engaged as of September 30, 1997. The ANPR also solicited comment on merchant banking authority, which permits a FHC to make merchant banking investments in any type of nonfinancial company, subject to certain limitations, and particularly focused on physical commodities and related infrastructure assets that have the potential for environmental consequences. Under the current risk-based capital framework, all exposures to physical commodities are “covered positions” under the market risk rules and are subject to risk-based capital requirements under those rules, whether or not such exposures are trading positions, and, accordingly, capital requirements for commodities positions are determined under those rules but not under the standardized and advanced approaches.5 The Proposal, as released on September 23, 2016, does not propose an amendment to the definition of “covered position” in the market risk rules to exclude from covered position status under those rules covered physical commodity assets that the Proposal would subject to capital requirements under the standardized and advanced approaches. The Federal Reserve comments, in the Supplementary Information included in the Proposal, that “[t]he resulting increase in capital requirements . would be in addition to any existing capital requirements relating to market risk or operational risk applicable to assets associated with physical commodity activities of an FHC.”6 It is not clear whether the Federal Reserve in fact intends there to be a doubling up of risk-based capital requirements for covered physical commodity assets. If it does, however, such a doubling up and resulting capital requirements exceeding dollar-for-dollar capital would be extraordinary and unprecedented. The Proposal, which solicits comment on the Proposal generally and on specific questions provided therein, follows a recent report submitted by the Federal Reserve, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency (the “OCC”), to the U.S. Congress and the Financial Stability Oversight Council pursuant to Section 620 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Section 620 Report”), in which the Federal Reserve recommended that Congress repeal the authority of FHCs to engage in merchant banking activities of any kind (including activities relating to physical commodities) and also repeal the commodities “grandfather” authority.7 It also follows a notice of proposed rulemaking issued by the OCC on the same day as the Section 620 -3- Physical Commodity Activities Conducted by Financial Holding Companies September 26, 2016 Report that proposes to repeal the authority of national banks and federal savings associations to deal and invest in copper.8 THE PROPOSAL The risk-based capital requirements and financial reporting and disclosure provisions in the Proposal would apply predominantly to “covered physical commodities”, which are defined as any physical commodity that is, or a component of which is, specifically named in the Comprehensive Environmental Response, Compensation, and Liability Act; the Oil Pollution Act; the Clean Water Act; or the Clean Air Act. The covered physical commodities actually enumerated in the Proposal include oil and oil products, natural gas and natural gas liquids, fertilizer, propylene, coal and coal products, and uranium and uranium products. The aforementioned statutes also apply to certain metals and agricultural products, including lead and nickel. The Proposal also applies to commodities covered by state environmental statutes that may impose similar liability and would require a FHC to
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