Members of the powerful U.S. Senate banking committee are set to grill financial regulators Wednesday on their plans to address the risks of Wall Street banks' involvement in physical commodities markets, fueling pressure for a landmark crackdown.
A day ahead of the hearing, the Federal Reserve, for the first time, laid out its heightened concerns that leasing oil tankers or owning power plants could endanger the banking system, and may pose serious conflicts of interest for banks.
In a preliminary notice seeking public comment on possible new curbs, the Fed cited real-world risks including the BP Gulf oil spill and last year's Quebec oil train disaster as examples of the multibillion-dollar catastrophes that banks face by being involved in the risky, messy world of commodities.
The notice also suggested possible remedies, including limits on assets and revenues as well as curbs on trade of some types of commodities, and posed questions to draw public input.
The hearing will offer senators a chance to further probe the Fed's thinking, pressing Michael Gibson, the Fed's director of bank supervision and regulation, on why the central bank is not moving immediately to impose new rules.
"Each day that we wait to rein in these activities means that end users and consumers will pay higher commodity and energy prices, and taxpayers will continue to be exposed to excessive risks at Too Big to Fail banks," Senator Sherrod Brown (D.-Ohio), who will lead the hearing, said on Tuesday.
The session follows months of growing public and political pressure to check banks' decade-long expansion into the commodities supply chain. In the first such hearing last summer, metals users complained that Goldman Sachs and others who own metal warehouses had contributed to higher prices.
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Some saw the Fed's so-called "advance notice of proposed rulemaking"—an optional initial step in a potentially years-long process of writing new rules—as a strategic political ploy to deflect complaints over inaction. It will accept public feedback for 60 days.
But others saw signs of a potentially major crackdown ahead, as the Fed questioned the initial rationale for letting banks trade and invest in raw materials, and said that even arm's length "merchant" investment deals may not be safe enough.
The tenor of the analysis and the questions means the Fed has already made up its mind to limit severely bank participation in physical commodity markets," said Craig Pirrong, a finance professor at the University of Houston.
Two other regulatory enforcers will also testify, although neither have specific power to rein in banks.
The U.S. Federal Energy Regulatory Commission (FERC), which regulates electricity and natural gas markets, will be represented at Wednesday's hearing by Norman Bay, a former New Mexico district attorney who has led a series of high-profile market manipulation cases, including a record $410 million penalty agreed with JPMorgan Chase last year.
Vince McGonagle, market oversight chief at the Commodity Futures Trading Commission, will also appear.
A moot point?
Facing a clearly uneasy regulator, some banks, including JPMorgan are already quitting the physical commodity business, a once-lucrative niche that has reaped billions of dollars of revenue for Wall Street over the years but is now facing diminished margins and stiffer capital rules.
Others, namely Goldman Sachs, have stood firm, defending an activity they say benefits customers. Due to a grandfather provision in a 1999 banking law, the Fed has less leeway to restrict the activities of former investment banks Goldman and Morgan Stanley, Gibson is set to say.
(Read more: CNBCExplains Commodities)
Critics said the Fed did not disclose what it knew of banks' commodities operations, nor reveal its own analysis of the situation, making it tough for the public to comment on activities about which little is known.
"The only two parties that can weigh in with any kind of semblance of specific credibility would be the Fed itself and the banks," said Saule Omarova, a law professor at the University of North Carolina who has been a vocal critic of the banks' involvement with physical commodities trading.
"That's why we have a professional regulatory agency—because we hope they will be looking into this issue on our behalf."
The notice was the Fed's first detailed public comment 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.
That followed measures to eliminate the divide between commercial banking and riskier activities, a distinction some lawmakers would now like to restore.
"The Fed is absolutely right when it says we need to consider strengthening the limits on bank participation in physical commodity activities," Senator Carl Levin (D.-Mich.) said, confirming for the first time that his Permanent Subcommittee on Investigations was also probing the issues.
Risks are 'higher than expected'
In Tuesday's notice, the Fed said that even banks that do not own infrastructure like oil tanks may face a "sudden and severe" loss of public confidence if assets or physical commodities they own are involved in a disaster.
"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.