Fed probes catastrophic risks in bank physical commodity trading

The 2010 Deepwater Horizon explosion and oil spill

During the past year, US banks have been embroiled in a public relations nightmare over physical commodity trading. Costly settlements for alleged power market manipulation, accusations of nefarious dealings at aluminium warehouses, and hostile hearings on Capitol Hill have created an environment in which the presence of Wall Street banks in physical markets looks increasingly precarious.

On January 14, the US Federal Reserve Board added its voice to the clamour. In a 19-page document, the Fed expressed its concerns about the physical commodity trading activities of financial holding companies (FHCs), a category of firms that includes both US investment banks and non-US banks with branches in the US. Rather than market manipulation, though, the Fed had a different worry: the risk of environmental catastrophe.

Lawyers who have scrutinised the document – called an advance notice of proposed rulemaking (ANPR) – expect it will eventually result in new restrictions on banks' physical trading, although it could be months or years before the Fed takes concrete action. The move comes after several major banks, including JP Morgan and Morgan Stanley, announced plans to exit or sharply cut back their presence in physical commodities.

"The tone of it suggests [the Fed does] want to tighten its control over the activities," says Arthur Long, a New York-based partner at law firm Gibson, Dunn & Crutcher. "There is obviously some pressure from particular members of Congress on this."

Catastrophic risk

It's over the top to compare anything that a bank is going to do in its trading operation to the BP disaster

The section of the Fed's ANPR on environmental catastrophes makes for grim reading. Under the dry heading "recent events", it cites a litany of deadly disasters, such as the July 2013 derailment and explosion of a crude oil train in Lac Mégantic, Quebec, the Fukushima nuclear disaster of 2011 and the 2010 Deepwater Horizon explosion and oil spill.

Most FHCs are barred from directly owning or operating assets such as oil tankers and gas pipelines. Instead, when a bank seeks to store a volatile commodity such as crude oil or natural gas, or to transport that commodity from one location to another, it will typically subcontract that work to a commercial firm with greater expertise in shipping and logistics. In most cases, the subcontracting is done by a subsidiary of the bank, rather than the bank itself.

Lawyers say that tends to shield banks from liability, but much depends on the details of the contract, the circumstances of the incident and the degree to which bank employees exert control over the subcontractor. "If the banks actually control operations, they are more likely to be in the line of fire," says Ken Rivlin, the New York-based head of law firm Allen & Overy's global environmental and regulatory law group. "But provided that the parties establish appropriate transaction structures and adhere to both corporate formalities and their agreed allocation of responsibilities, the banks' legal risk should be limited."

Still, the Fed expresses concern that banks could be found liable even if they hire third parties to store and transport the oil or gas. In addition, the Fed presents a hypothetical scenario in which confidence in a bank could "suddenly and severely be undermined" because of an environmental catastrophe. Even before the courts have determined whether the bank is liable, depositors could pull their money out and the bank's access to funding could be curtailed, the Fed says.

Critics say the Fed's worries are overblown. "It's over the top to compare anything that a bank is going to do in its trading operation to the BP disaster," says Craig Pirrong, a professor at the University of Houston's Bauer College of Business. "It's almost as if they had a desired outcome in mind and they're trying to come up with scare stories to support that."

Sharon Brown-Hruska, a former acting chairman of the US Commodity Futures Trading Commission, notes the Fed did not cite any concrete examples of FHCs being impacted by an environmental incident caused by their physical trading. "It doesn't seem to me that there's any sort of smoking gun here," says Brown-Hruska, who is now a Washington, DC-based vice-president at Nera Economic Consulting.

No major bank agreed to speak on the record for this article, but industry sources who spoke to Energy Risk agree there is little hard evidence that banks would be implicated in such a scenario.

"Even with banks that have historically been very, very active in the physical commodity business, I don't actually think that any of their activities would jeopardise the safety and soundness of the financial system in the way that's being suggested," says a New York-based veteran energy trader. "So while it's a good question that the Fed is asking, I don't think it's really that much of an issue, because financial institutions are already pretty substantially restricted in what they can do. The banking industry doesn't own nuclear power plants. The banking industry doesn't own, as a principle, any oil tankers or drilling rigs."

The veteran energy trader offers one caveat, however: "I can imagine a situation where there's an oil spill involving a financial institution that's involved in the shipping of physical oil. Historically, the owner of the ship would have been the liable party, and rightly so. But a legitimate question would be – if it becomes known that the owner of the actual oil in that ship is a financial institution with extremely deep pockets – could they be viewed as somehow culpable, or at least as a party that should be involved in paying for the cleanup? It hasn't happened before, but it could happen."

Reason to worry

Recent events suggest that the Fed may indeed have legitimate reason to worry about banks that are involved in transporting crude oil.

Consider the case of an oil tanker spillage. While FHCs do not own oil tankers directly, several of them charter tankers or have done so in the past, including Morgan Stanley, JP Morgan and Bank of America Merrill Lynch. International treaties place liabilities for oil spills on the owner of a ship, not its charterer – and yet charterers have repeatedly found themselves shelling out for cleanup costs.

On October 5, 2011, the MV Rena, a container vessel owned by a subsidiary of Athens-based shipping firm Costamare, hit a reef off the coast of New Zealand, spilling hundreds of tonnes of fuel oil in what has widely been described as the country's worst-ever maritime environmental disaster. The Costamare subsidiary, as well as two of the ship's officers, were charged by New Zealand authorities and convicted in connection with the wreck. Meanwhile, the firm that chartered the MV Rena on its ill-fated journey – Geneva-based Mediterranean Shipping Company (MSC) – adamantly denied responsibility. Following intense political pressure in the run-up to the New Zealand election, though, MSC agreed to contribute NZ$1 million towards cleanup costs. "We are doing this because, quite simply, it's the right thing to do," an MSC official said in a statement on October 18, 2011.

Charterers have been forced to pay out in other cases, as in the 1999 wreck of the oil tanker Erika off the coast of France. "In theory, charterers can escape liability, but in practice, increasingly they aren't," says Christopher Raven, a Hong Kong-based marine consultant with Andrew Moore & Associates.

Likewise, the aftermath of the Lac Mégantic train disaster might give the Fed some cause for concern about banks that are involved in moving crude by rail, such as JP Morgan and Morgan Stanley.

Following the deadly blast on July 6, 2013, Quebec authorities opened a criminal investigation into the Maine-based operator of the train, the Montreal, Maine & Atlantic Railway (MMAR), which subsequently filed for bankruptcy protection. But the Quebec provincial government also issued an order requiring another company, Florida-based fuel supplier World Fuel Services (WFS), to help cover the cost of the cleanup; a WFS subsidiary owned the oil aboard the ill-fated train and arranged for it to be loaded onto railcars in North Dakota, where the cargo originated. WFS has also been hit with dozens of lawsuits seeking to establish the firm's liability for the disaster, including a suit filed on January 30 by the MMAR bankruptcy trustee. WFS disputes the legality of the Quebec government order and is fighting the various lawsuits. "We intend to vigorously defend against such claims," a company spokesman told Energy Risk in an emailed statement.

In the next crude-by-rail disaster, it is easy to imagine a scenario where the company fighting off liability claims would not be WFS but a Wall Street bank, says Saule Omarova, a professor at UNC School of Law at the University of North Carolina at Chapel Hill. "If the owner of that oil was not some Florida oil trader but actually JP Morgan, the vehemence with which the various plaintiffs would pursue the claims against JP Morgan would, of course, accordingly be much higher, and there would be a lot more public scrutiny," she says.

Even if a bank could successfully fight off such liability claims, its role in a crude-by-rail disaster would be a source of reputational risk. "It's hard to predict all scenarios," says David Sahr, a London-based partner with law firm Mayer Brown. "But if the oil that explodes belongs to a US bank holding company while it's being moved on somebody else's train, people will say, ‘why didn't you take more care to ensure that the railroad system you used was safe?' Even if the bank has good legal arguments as to why it has no liability, it may be dragged in to protect its own reputation."

Industry sources acknowledge the risk is real. "I would think most banks involved in the physical business are very mindful about catastrophic risk, both from a reputational perspective and a financial perspective," says a senior New York-based commodities trader with a major international bank. "In terms of the legal liabilities, though, the truth is, you don't know."

New rules

In its ANPR, the Fed floats three possibilities for mitigating the risks associated with physical trading: enhanced capital requirements; increased insurance requirements; and caps on the amount of assets and revenue attributable to physical commodities trading activities, which could be expressed as either absolute dollar limits or percentages of banks' regulatory capital or revenue.

Perhaps the most straightforward approach would be to require banks to hold additional capital for their physical trading activities. Tightening capital requirements, after all, is a familiar element of the bank regulator's toolkit. But this approach would raise difficult questions about how much extra capital the banks would need to hold to protect against an environmental catastrophe – a potentially costly but low-probability event that is inherently difficult to model.

"One thing that the Fed could do is give a high risk weighting to the physical commodity trading assets and require banks to maintain large amounts of capital against those assets," says Sahr of Mayer Brown.

"Given the scope of these potential tail risks, though, if there ever was a disaster, it's hard to see that a little bit more capital would do much good," he adds. "It's possible that if the Fed does impose higher capital requirements, they may be so high that they effectively eliminate the appetite of the banks to do these types of activities. I see a high risk that the capital requirements could be raised so high that it just won't be worth anybody's trouble to do this business."

A more fine-tuned approach would be to calibrate the additional capital requirements to the specific operational risks inherent in activities such as transporting crude oil or managing a power plant. "There are existing frameworks that the Fed and others have established, which are in place to measure and monitor potential operational risks such as these," says Edward Hida, New York-based global leader for risk and capital management at Deloitte.

For instance, the Fed could use the Basel II framework of operational risk capital surcharges, issued by the Basel Committee on Banking Supervision in 2004. Under Basel II, banks are required to hold additional capital for potential operational losses, such as those incurred by a rogue trader. Large banks can opt to use the so-called advanced measurement approach, in which they develop their own models – subject to regulatory approval – for assessing potential losses.

Making banks perform such an exercise with respect to their physical commodities trading would help them develop a picture of how much risk they face from an oil spill or similar catastrophe, explains Hida. "One of the challenges with risk and capital management in general, as well as operational risk, is how to deal with events that are infrequent and yet potentially could have a large severity and large impact," he says. "These are difficult risks to deal with... but stress testing and scenario analysis around those risks can often be used to assess the impact, as well as evaluate the environment and strengthen it."

Pirrong at the University of Houston sees insurance as the best way for banks to manage the risks of an environmental catastrophe, rather than additional capital requirements. "Part of what it comes down to is who's better at bearing the risk?" he says. "Is the risk more effectively laid off to the marketplace through insurance, or is it better borne by the bank and its shareholders through some sort of additional reserve or capital?"

Insurance firms have centuries of experience in assessing the risks of disasters and putting a price on the policies they sell to clients, Pirrong points out. "I would think that, in many respects, insurers would have better ability to assess those tail risks than regulators," he says.

Bank response

Many observers who have been following the regulatory process believe some sort of new restrictions on bank physical trading are inevitable. Nonetheless, major banks are tight-lipped about the Fed's ANPR and appear reluctant to be drawn into discussions about environmental catastrophes. At the time Energy Risk went to press, it was unclear how the industry intended to respond.

Some market participants think the ultimate impact of the Fed's initiative will be to flatten the competitive landscape among commodity derivatives dealers. "Knowing actually what is going on in the physical market is clearly an enormous advantage," says Guy Wolf, London-based global head of market analytics with energy broker Marex Spectron. "If no-one has a physical trading operation, then naturally, there would be a certain levelling of the playing field."

A particular worry is how any new rules might affect the role of banks taking title to physical commodities in trade finance transactions. In an oil repurchase deal, for instance, a bank may provide working capital to a refiner while taking title to the crude oil in the refiner's storage tanks – essentially a way of extending a loan, with the oil held on the bank's balance sheet as collateral. Some bankers worry that, in the Fed's alarm over physical trading, it may make such transactions more difficult to execute.

"One of the roles of banks in the commodities universe is to finance global commodity activity in some way, shape or form, and sometimes that means taking ownership of a physical commodity for some period of time," says the senior New York-based commodities trader. "To me, there's a huge difference between a merchant business – where you are moving commodities from one geographical location to another, either because premiums are higher or because your clients want it there – and holding material at a static location for the purposes of financing," he says.

Some companies outside the banking industry have provided the banks with a small boost. On January 29, a group of 33 companies and trade associations submitted a letter in response to the ANPR expressing concern that pushing banks out of physical commodities would imperil their ability to hedge commodity price volatility.

"We each face significant exposure to commodities, and we are not alone," says the letter, whose signatories include oil and gas producers, power generators and Chicago-based aircraft manufacturer Boeing. "If counterparties, such as banks, for financial hedging instruments for our physical commodities begin to disappear, our ability to manage our risk would be seriously impeded."

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