By David Sheppard and Josephine Mason
NEW YORK, July 19 (Reuters) - The U.S. Federal Reserve is "reviewing" a landmark 2003 decision that first allowed regulated banks to trade in physical commodity markets, it said on Friday, a move that may send new shockwaves through Wall Street.
The one-sentence statement suggests the Fed is taking a much deeper, wide-ranging look at how banks operate in commodity markets than previously believed, amid intensifying scrutiny of everything from electricity trading to metals warehouses.
While the Fed has been debating for years whether to allow banks including Morgan Stanley and JPMorgan to continue owning assets like oil storage tanks or power plants, Friday's surprise statement suggests it is also reconsidering whether all bank holding firms should be able to trade raw materials such as gasoline tankers and coffee beans.
By referencing its initial decision a decade ago permitting Citigroup's Phibro unit to trade oil cargoes - setting a precedent for a dozen more banks that followed suit - the Federal Reserve has put in question a key profit center for Wall Street's top players, which have already seen multibillion-dollar commodity revenues shrink in the face of new regulations.
On Tuesday, the Senate Banking Committee is holding its first hearing on the issue, asking whether so-called "Too Big to Fail" banks should be taking on additional risks like moving tankers of crude oil or operating power plants.
Amid growing frustration in Washington over regulators' failure to push through new rules five years after the financial crisis, the Fed's widening area of enquiry came as a shock.
"They must be feeling some pressure on this issue if they've felt compelled to issue a public statement," said Saule Omarova, associate professor of law at the University of North Carolina at Chapel Hill School of Law, who will appear at the hearing.
"Are they using this opportunity to in fact review the entire position of banks in physical commodity markets?"
The pressure may intensify as the U.S. power market regulator levies record fines over manipulating power markets. It levied a $453 million penalty against Barclays this week and is in talks to settle charges against JPMorgan, which is alleged to have used power plants that it owned or operated to game markets.
"The Federal Reserve regularly monitors the commodity activities of supervised firms and is reviewing the 2003 determination that certain commodity activities are complementary to financial activities and thus permissible for bank holding companies," the Federal Reserve said, its first public statement since a 2012 Reuters report brought the issue to light. (Full story:).
A Federal Reserve spokesperson declined to elaborate or provide any details on the scale or timing of the review.
Spokespeople for Goldman Sachs and Morgan Stanley declined to comment on the Fed statement.
PHIBRO SET PRECEDENT
In 2003, the Federal Reserve issued a letter to Citigroup, which had been seeking permission to allow its Phibro unit - acquired in 1998 - to continue trading in physical energy markets. The Bank Holding Company Act (BHC Act) normally prohibits banks from engaging in non-financial activities, but Citi had argued that the activities should be allowed.
Regulated commercial banks had long been permitted to trade in commodity derivatives such as futures, but at the time did not enjoy the same freedom in physical markets, unlike investment banks like Goldman Sachs and Morgan Stanley.
The Fed agreed with Citi, saying that trading in real commodities would allow the banks to "transact more efficiently with customers". It said the trading must be "complimentary" to their main activities, contribute to the public good and should not pose a "substantial risk" to the bank.
That decision, which came at the start of a decade-long boom in commodity trading, opened the door to a dozen more applications from global giants like Deutsche Bank and domestic players like Wells Fargo. With many of the permits, the Fed gave greater and greater leeway in what and how they could trade.
"Maybe the Fed can openly say we think these activities are systemically risky unless they're cut back but I don't know what's going through the Fed's head," said one commodity regulation expert who declined to be named. "This came out of the blue. This has taken everyone by surprise."
Since converting to bank holding companies at the height of the financial crisis, Goldman Sachs and Morgan Stanley have also been subject to the holding company rules.
But up until now, the Fed's focus was believed to be on their ownership of assets, a more clearly controversial issue.
Under the 1999 decision to repeal part of the Glass-Steagall Act, ending the forced separation of commercial and investment banking, any non-regulated bank that converted to holding company status after 1999 would be allowed to continue to own and invest in assets, as long as they held them prior to 1997. The banks have argued that their activities are "grandfathered" in, or that they are simply merchant banking investments.
It is not clear that argument will hold up under political pressure, which is intensifying ahead of a nominal September deadline for Goldman and Morgan to comply with the rules.
"Reviewing Wall Street's expansion into commercial activities is essential," Senator Sherrod Brown, a Democrat from Ohio, said in a statement. "Congress, regulators, and the public need to understand what has happened in the 14 years since the financial floodgates were opened, and reconsider what we want banks to do."
Large industrial consumers of aluminum have accused banks of boosting prices of the metal through their control of London Metal Exchange warehouses, which have been slow to deliver metal to customers, boosting premiums for physical metal and earning big profits on rent for storing the metal.
Four U.S. congressmen wrote to Federal Reserve Chairman Ben Bernanke on June 27 expressing their concern about the issue, and asking for more information on the Fed's position.
Both Goldman Sachs and JPMorgan have explored selling their warehouse businesses they bought in 2010 in recent months, although it is not clear if that is because of increased regulatory pressure.
As commodity prices surged over the past decade, a host of global investment banks piled into the market, pressuring the former duopoly of Goldman and Morgan. At their peak in 2008 and 2009, revenues in the sector reached some $15 billion.
But pressures have mounted over the past few years as regulators crack down on proprietary trading, new capital measures limit trading books and bonus caps shrink.
Commodity revenue from the top investment banks fell to about $6 billion in 2012, consultants Coalition estimated.
While banks generate much of that revenue from trading derivatives - selling indexes to investors or hedging prices for an oil company - many have delved deeply into physical markets in order to get better information on markets, leverage their positions or offer more options to customers.
For instance, many banks are involved in "supply and offtake" arrangements with refineries, providing crude oil to the plant and then selling gasoline or diesel in the market.
The Federal Reserve has generally allowed banks to trade in most major physical commodity markets so long as there is a similar futures contract for the commodity, which means it is regulated by the Commodity Futures Trading Commission. Crude oil and gasoline, for instance, are allowed but iron ore is not.
Friday's statement calls that into question.
While some consumer groups have been critical of the sway that banks can exert on commodity markets by owning key pieces of infrastructure, it is unclear how many would support barring them from trading commercial markets entirely.
"I want them to have physical business because they play a positive role in the business on balance by providing financing," said one senior executive in the metals market who has been critical of the banks' warehouse ownership.