By Anna Louie Sussman and Emily Stephenson
NEW YORK/WASHINGTON (Reuters) - The U.S. Federal Reserve on Tuesday took a first formal step toward restricting the role of Wall Street banks in trading physical commodities, citing fears that a multibillion-dollar disaster could bring down a bank and imperil the stability of the financial system.
The Fed board voted to publish its concerns and potential remedies following months of growing public and political pressure to check banks' decade-long expansion into the commodities supply chain. The Fed also questioned the initial rationale for allowing them to trade and invest in risky raw materials and lease oil tanks or own power plants.
The Fed "expect(s) to engage in additional rulemaking in this area," according to prepared remarks of Michael Gibson, the Fed'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 or revenues from such trading, increased capital or insurance, or prohibitions on holding certain types of commodities "that pose undue risk."
Facing a clearly uneasy regulator, some banks including JPMorgan Chase & Co are already quitting the business, a once-lucrative trading niche that has reaped billions of dollars of revenue for Wall Street over the years but is now facing diminished margins and stiffer capital rules.
But others, such as Goldman Sachs Group Inc, have stood firm, defending an operation they say benefits customers. Due to a grandfather provision in a 1999 banking law, the Fed has less leeway to restrict the activities of former investment banks Goldman and Morgan Stanley, Gibson said.
In a 19-page document that included two dozen questions, the Fed offered a host of reasons for imposing new restrictions in the interests of limiting potential conflicts of interest and protecting the safety and soundness of the banking system. It invoked disasters including BP's oil spill in the Gulf of Mexico in 2010 and the derailment and explosion of an oil train in Canada last year.
"The recent catastrophes accent that the costs of preventing accidents are high and the costs and liability related to physical commodity activities can be difficult to limit and higher than expected," the Fed said in its notice.
The "advance notice of proposed rulemaking," which is an optional initial step in the sometimes years-long process of making new regulations, seeks comments until March 15.
CONFLICTS, RISKS AND CAPITAL
It is the Fed's first detailed public comment since it shocked the banking industry last July by announcing a "review" of its 2003 authorization that first allowed commercial banks such as Citigroup to handle physical commodities.
U.S. Senator Sherrod Brown of Ohio, who led the first hearing last summer, said the measure was "overdue and insufficient", warning that consumers and end-users risked paying higher commodity prices until new curbs are imposed.
But others saw it as a likely prelude to tough action that would curtail so-called "too big to fail" banks amid a wider political move to restore the historical division between commercial banking and riskier business. Eliminating that divide 15 years ago helped open the door to commodities trading.
"That was the Greenspan era, and it was anything goes as far as activities. Now, we realize that we made a lot of mistakes during the Greenspan era," said Cornelius Hurley, banking law professor at Boston University and former assistant general counsel to the Fed Board of Governors.
Beyond the financial risks, the Fed is also seeking comment on potential conflicts of interest for banks, and the risks and benefits of additional capital requirements or other restrictions - measures that have been hinted at in the past.
The Fed said that new limits on the three ways in which banks may deal in physical commodities were up for debate: the authority to trade raw materials as "complementary" to derivatives; the investment in commodity-related business as arm'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 cited justifications for allowing banks to trade in physical commodities such as crude oil cargoes and pipeline natural gas -- markets in which some banks such as Goldman Sachs and Bank of America's Merrill Lynch are still active.
It said, for instance, that although most banks are not allowed to actually own infrastructure assets, those that lease storage tanks or own physical commodities held by third parties may nonetheless face a "sudden and severe" loss of public confidence if they are involved in a catastrophe.
They also said that several banks' recent moves to sell all or parts of their physical trading operations "may suggest that the relationship between commodities derivatives and physical commodities markets...may not be as close as previously claimed or expected."
While scoping out possible measures to tighten up commodity trading and merchant investment, the Fed offered little insight into how it might level the playing field by narrowing the grandfather exemption that Goldman and Morgan enjoy.
"Our ability to address the broad scope of activities specifically permitted by statute under the grandfather provision...is more limited," Gibson will tell lawmakers.
Legal experts say the provision - which has long been a bone of contention with other banks who had never been allowed to invest in oil tanks and power plants - was widely written. It may require Congressional action to crack down - a seemingly unlikely 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 risks made it almost certain that some form of regulatory action would follow.
"Given some of the things they've said, it would almost make them look bad if they ultimately decided not to do anything," said the expert, who asked not to be identified because they were not authorized to speak to the media.
(Additional reporting Karey Van Hall and Patrick Rucker; Editing by Leslie Adler and Grant McCool)