The Board of Governors of the Federal Reserve System (Federal Reserve) issued an advance notice of proposed rulemaking (ANPR) on January 14, requesting public comment on issues related to physical commodities activities conducted by financial holding companies (FHCs). Tucked into the ANPR is a section seeking comment on the permitted merchant banking investments of FHCs under section 4(k)(4)(H) of the Bank Holding Company Act (BHCA). This section, however, was not mentioned in the January 14 U.S. Senate testimony given by Michael Gibson, the Federal Reserve’s Director of the Division of Banking and Supervision, or in the press release announcing the ANPR. It is not unexpected that the Federal Reserve would choose to address the issue of physical commodities activities at this time given the increased attention in national and trade media that the physical commodities activities of FHCs have received. However, there has been no prior indication that the Federal Reserve was going to revisit FHC merchant banking activities, and the merchant banking section of the ANPR, thus far, has not received much attention from trade press or other commentators.
Physical Commodities Activities of FHCs
Any physical commodities activities or physical commodities–related activities conducted by an FHC are subject to prior approval by the Federal Reserve (non-FHC bank holding companies are not permitted to conduct such activities). Currently, FHCs are permitted to engage in three types of physical commodities activities: (1) physical commodities trading involving the purchase and sale of commodities in the spot market and taking and making delivery of physical commodities to settle commodity derivatives (Physical Commodity Trading); (2) paying power plant owners 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 (Energy Tolling); and (3) providing transactions and advisory services to power plant owners (Energy Management Services) (collectively, Complementary Commodities Activities). The Federal Reserve has allowed FHCs to engage in these activities under its authority to approve nonfinancial activities that it finds to be “complementary to a financial activity” under section 4(k)(1)(B) of the BHCA, subject to a number of conditions and restrictions that are designed to limit the level of such activities and the risks associated with them.
The ANPR asks a series of questions regarding permissible Complementary Commodities Activities, seeking to determine the nature of the risks to the safety and soundness of FHCs, any potential conflicts of interest faced by FHCs by engaging in Physical Commodity Trading, and the risks and benefits of imposing additional capital requirements or restrictions on Complementary Commodities Activities. The ANPR prominently references recent (and not so recent) environmental disasters and the financial crisis as demonstrating the possible increased risk to the safety and soundness of FHCs posed by Complementary Commodities Activities. The questions that the Federal Reserve has asked also suggest the types of additional measures that the Federal Reserve is considering for Complementary Commodities Activities, including (1) enhanced capital requirements, (2) increased insurance requirements, and (3) reductions in the amount of permitted assets and revenue attributable to the activities, including absolute dollar limits and caps based on a percentage of the FHC’s regulatory capital or revenue.
Merchant Banking Authority
Under section 4(k)(4)(H) of the BHCA, FHCs may make investments in any type of nonfinancial company as part of a bona fide securities underwriting or merchant or investment banking activities. The ANPR seeks comment on whether current merchant banking regulations adequately address the legal, operational, reputational, and financial risks to FHCs posed by merchant banking activities. The ANPR states that the Federal Reserve is considering the appropriateness of a number of actions, including (1) more restrictive merchant banking holding periods, (2) additional restrictions on the routine management of merchant banking investments, (3) capital requirements on some or all merchant banking investments, and (4) enhanced reporting to the Federal Reserve or public disclosures regarding merchant banking investments.
What is notable, if not striking, about the ANPR section that discusses merchant banking activities is that it is not limited to merchant banking activities that involve investments in companies involved in physical commodities activities. Indeed, this section contains only one passing reference to physical commodities and asks four questions relating to the proposed review of merchant banking activities that do not refer at all to physical commodities. While we would expect that the Federal Reserve’s review of merchant banking activities would begin with a review of physical commodities–related merchant banking activities, there is no indication that the Federal Reserve intends to limit its merchant banking review to those specific activities and investments.
Comments on the ANPR are due by March 15, 2014. After reviewing comments, the Federal Reserve will decide whether to proceed with a rulemaking or other further action.