On Sept. 23, 2016, the Federal Reserve issued proposed rules[1] that could put pressure on investment banks, such as Morgan Stanley and Goldman Sachs, to divest certain energy assets and energy trading activities.

Over the past decade, environmental catastrophes involving physical commodities, such as Deepwater Horizon and Fukushima, have led to monetary damages ranging from hundreds of millions to tens of billions of dollars. For example, BP p.l.c. guaranteed the payment of approximately $19 billion as part of a consent decree resolving claims against its subsidiaries resulting from the Deepwater Horizon oil spill.[2]

The Federal Reserve noted, in its proposed regulations, that monetary damages of this magnitude, directed at a bank-owned facility, could trigger a domino effect of fines, cleanup costs and loss of investor confidence that, when taken together, could render a financial institution unstable.

Banks and financial institutions have the authority to engage in certain types of physical commodities activities through the Bank Holding Company Act and Gramm-Leach Bliley Act, including physical commodity trading and investing in companies engaged in activities involving physical commodities.

In its proposed rules, the Federal Reserve cited concerns about the monetary damages associated with environmental catastrophes involving physical commodities reaching tens of billions of dollars. This level of damages could exceed the market value of the physical commodity involved, and could exceed the committed capital and insurance policies of the financial institution.

To address these concerns, the Federal Reserve has proposed to impose a 1,250 percent capital charge on Goldman Sachs and Morgan Stanley, and a lesser capital charge of 300 percent on a dozen other firms, including Bank of America and Wells Fargo.[3] The increased capital charge would reduce the rate of return on energy investments for investment banks. The Federal Reserve would also revoke firms’ ability to engage in physical commodities tied to power plants, and would prohibit institutions from owning or storing copper.

Many banks, in anticipation of these proposed regulations, have started to wind down their commodity businesses (and their ownership of certain energy assets). These regulations, if implemented, could reduce banks’ trading businesses and reduce the profitability of those practices. Fewer participants in the marketplace could mean less pricing competition in the physical commodities trading market, which could be bad news for energy consumers.