Fed Plans to Tighten Commodities Rules for Banks

Updated, 6:25 p.m. | WASHINGTON – The Federal Reserve is preparing to unveil new restrictions aimed at making it harder for Wall Street banks to make big bets in the commodities markets, according to testimony on Friday from the Fed governor Daniel K. Tarullo.

Mr. Tarullo struck an unexpectedly aggressive stance in his appearance on Friday in front of a Senate subcommittee that has been investigating the involvement of big banks in the markets for basic materials like coal, aluminum and gas.

Mr. Tarullo said that the Fed expected to issue a formal notice of potential new rules in the first quarter of next year. Those new regulations could force banks to amass more capital to protect against losses on holdings of commodities and restrict banks from some types of commodities operations that they are currently allowed to do.

In his unscripted remarks, Mr. Tarullo, the Fed governor who oversees regulatory policies, also outlined a number of other areas where he said he wanted the Fed and other regulators to increase oversight of bank activities.

Referring to recent problems involving banks’ foreign exchange and interest rate trading desks, Mr. Tarullo said, “In general the compliance procedures, and expectations within firms for abiding by laws, are not adequate in many cases.”

The testimony from the Federal Reserve governor came during the second day of hearings held by the Senate Permanent Subcommittee on Investigations. The subcommittee released a 400-page report this week that detailed cases in which banks had made enormous investments in the commodities markets that allowed the banks to influence the prices of commonly used materials.

“This is reminiscent of the days of the robber barons,” Senator John McCain, the top Republican on the subcommittee, said Friday morning.

The subcommittee found that regulators were, in some cases, not aware of the extent of the commodities holdings of the banks.

In other cases, regulators found that the banks did not have adequate insurance and capital to protect themselves against legal problems that could result from an environmental or natural disaster.

Mr. Tarullo said that the Fed was already studying both issues. He said he was particularly worried about the potential for a disaster to cause investors and depositors to lose confidence in a big bank and necessitate a bailout.

“That issue of the potential exposure is really quite central to what we are doing,” he said. “That has occasioned the most analysis.”

Executives from three large banks said on the first day of the hearings that they carefully arranged their investments so that they would be shielded from legal liability. But an industry economist, who testified Friday morning, said the measures the banks had taken would be unlikely to protect them in a catastrophe.

The broader concern raised by the chairman of the subcommittee, Senator Carl Levin, was that banks had recently pursued activities that they were banned from doing for decades. But the Gramm-Leach-Bliley Act of 1999 ended the legal provision that separated investment banking and commercial banking, and broadened the potential businesses banks could get into — including holding physical commodity assets.

“The separation between banking and commerce has served markets and our economy quite well for decades,” Senator Levin, a Michigan Democrat, said Friday. “And the erosion of that barrier is clearly doing harm today.”

Mr. Tarullo expressed agreement with Mr. Levin on this broad point and said that the old separation had “been a sound principle and there is no reason to digress from it.”

He said that the Fed was likely to reconsider the so-called merchant banking laws that have allowed banks to own nonbank businesses.

But Mr. Tarullo also said that the subcommittee’s investigation pointed to a new issue to explore, which was that there were some areas of bank business, such as physical commodities, where there did not seem to be any regulator in charge.

“I began to wonder whether there is a gap in regulation more generally,” Mr. Tarullo said. “Whether there are some things that at present no U.S. government regulatory agency has jurisdiction over.”

The buying and selling of raw materials has generally not been regulated because it was a business driven by the industries that needed the materials. More recently, though, financial firms have taken an increasingly prominent role in that sector.

Senators Levin and McCain returned repeatedly to a moment in 2010 when JPMorgan Chase amassed a majority of the available copper stockpiles. This was allowed, in part, because of a rule change that put copper in the same category as precious metals like gold and silver, making it possible for banks to hold more copper.

Mr. Tarullo said he would consult with the other major bank regulator, the Office of the Comptroller of the Currency, about recategorizing copper as an industrial metal so that banks could not take such large stakes.

A JPMorgan executive said Thursday that the bank was already pulling back from the physical commodities markets.