Daniel Tarullo, governor of the U.S. Federal Reserve, speaks during a Senate Banking Committee hearing in Washington, D.C., U.S., on Thursday, July 11, 2013. Dodd-Frank Act measures designed to prevent a repeat of the global credit crisis will be largely complete by the end of this year, financial regulators told lawmakers at a hearing today on the 2010 law. Photographer: Andrew Harrer/Bloomberg *** Local Caption *** Daniel Tarullo
Daniel Tarullo, Federal Reserve governor

The Federal Reserve plans to move forward with a rule that could limit banks’ ability to handle physical commodities such as oil and natural gas, taking action after years of review.

Daniel Tarullo, a Fed governor, said the regulator will propose a formal rule in the first quarter of 2015 addressing the risks surrounding what was until recently a lucrative business on Wall Street. Possible measures include requiring more capital to be held against positions, demanding better risk management and improving information on the opaque commodities trading business.

The regulator is under pressure to show it is adequately monitoring the risks an environmental catastrophe such as an oil spill present to the financial system. Critics also say banks blur the line between finance and commerce, a bedrock principle of US banking law, when they serve as commodities merchants.

Mr Tarullo testified at a second day of hearings of the US Senate subcommittee on investigations, which this week published a lengthy report raising concerns about banks’ commodities activities and urging regulators to clamp down.

He said such activities can pose “unique risks”, with potential damages to banks difficult to estimate despite their requirement to buy insurance and build legal structures to insulate commodities units.

“Moreover, just the uncertainty that can come about after a catastrophic event as observers wait to see the ultimate damages could put extraordinary pressure on a financial institution engaged in these activities that could threaten its safety and soundness,” Mr Tarullo said.

When the Fed solicited public comment on the issue in January, it cited the 2010 BP oil spill in the Gulf of Mexico as an example of the kinds of liabilities banks face handling some commodities.

Lawyers for banks argue that liabilities from commodity spills typically are borne by the owners and operators of facilities such as tanks or pipelines, not the owner of the commodity itself.

In any case, many of the dozen banks with Fed permission to trade physical commodities have been trying to reduce their exposure amid public scrutiny and disappointing returns, including JPMorgan Chase, Bank of America and Barclays.

Mr Tarullo said the Fed in 2009 formed a team to examine commodities businesses inside the largest banks. The Senate subcommittee report cited a 2012 Fed document that found four banks had capital and insurance shortfalls of between $1bn-$15bn to cover “extreme loss scenarios” from commodities, contending taxpayers could be forced to bail them out.

Carl Levin, chairman of the subcommittee, said: “The legal arguments advanced by the banks to minimise their liability risk are questionable and likely to be of little comfort in the event of a natural disaster or catastrophic accident. The Federal Reserve should approach those arguments with scepticism and make sure that its responsibility to protect the financial system from 2008-style shocks remains paramount.”

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