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UPDATE 1-Fed considers new limits on banks in physical commodity trade

NEW YORK/WASHINGTON, Jan 14 (Reuters) - The U.S. Federal Reserve on Tuesday took a first formal step toward restricting the role of Wall Street banks in physical commodities markets, seeking feedback on ways to limit the "catastrophic" risks of dealing with oil tanks or power plants.

In a 6-0 vote, the Fed board agreed to publish a preliminary notice laying out its concerns and potential remedies, following months of growing public and political pressure to check banks' decade-long expansion into the raw materials supply chain.

Facing a clearly uneasy regulator, some banks like JPMorgan Chase & Co are already quitting the business.

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 protecting the safety and soundness of the banking system, invoking incidents among which were BP's Deepwater Horizon disaster and last summer's oil-train tragedy in Quebec.

"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 the notice.

It is the Fed's first detailed public discussion 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.

It comes just one day before a senior Fed director goes before a second Senate banking committee hearing on the matter.

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 all three means by 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 than their peers.

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.

The Fed also questioned several previously cited justifications for allowing banks to trade in physical commodities such as crude oil cargoes and copper pallets.

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."