The Federal Reserve’s De-Risking of Merchant Banking and Commodities Activities

Arthur S. Long is a partner and James O. Springer is an associate at Gibson, Dunn & Crutcher LLP. This post is based on a Gibson Dunn publication by Mr. Long and Mr. Springer.

On September 8, 2016, the Board of Governors of the Federal Reserve System (Federal Reserve), the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC) issued the joint report (Report) on bank activities and investments required by Section 620 of the Dodd-Frank Act. The purpose of the Section 620 Report is to identify bank activities and investments that could pose a threat to the safety and soundness of banking entities and the U.S financial system.

In the Federal Reserve’s part of the Report, it made two shocking recommendations—that Congress repeal two sections of the Bank Holding Company Act of 1956 (BHC Act) added by the Gramm-Leach-Bliley Act:

  • the Merchant Banking Authority contained in Section 4(k)(4)(H) of the BHC Act, and
  • the commodity activity grandfather provision contained in Section 4(o) of the BHC Act.

The Federal Reserve also recommended repealing the BHC Act exemption that allows companies that own industrial loan corporations and industrial banks (ILCs) from being regulated as bank holding companies (BHCs), and the grandfather provision for unitary S&L holding companies, which allows such companies to engage in a full range of commercial activities.

The OCC and FDIC took a more measured approach. Most noteworthy are the OCC’s statement and accompanying rules proposal under which, after over 20 years of practice to the contrary, trading in industrial and commercial metals like copper would no longer be considered “incidental” to the business of banking, and the OCC’s plan to determine that asset-backed securities where the underlying assets are bank impermissible can no longer be considered as Type III investment securities.

I. Federal Reserve

The Federal Reserve’s portion of the study recommends that Congress repeal the Merchant Banking Authority and Section 4(o) of the BHC Act. Under the Merchant Banking Authority, a BHC that qualifies as a financial holding company (FHC) because it meets “well-capitalized” and “well-managed” tests both at the holding company and subsidiary bank levels, and whose banks have satisfactory or better Community Reinvestment Act ratings, may make equity investments in commercial companies, as long as the investments are held for ultimate resale within a reasonable period of time, and the FHC, as a general matter, does not routinely manage or operate the companies invested in (portfolio companies). [1]

Under Section 4(o), firms that were engaged in commodity activities at September 30, 1997 and that become BHCs are permitted to continue to engage in, and directly and indirectly own or control shares of companies engaged in activities related to the trading, sale, or investment in commodities and underlying physical properties, if the aggregate consolidated assets of the companies held under Section 4(o) are not more than 5 percent of the top-tier BHC’s total consolidated assets and certain cross-marketing prohibitions are observed. [2]

In neither case does the Report advance convincing analysis in support of its repeal recommendations. When discussing the Merchant Banking Authority, the Report focuses on “veil piercing” concerns. Because under Merchant Banking, an FHC may routinely manage and operate a portfolio company in certain circumstances, the Report speculates that FHCs could be held legally liable for losses at such managed portfolio companies—for example, liability for a significant environmental event. However, “routine management and operation” is the exception rather than the rule under Merchant Banking, and the Federal Reserve’s regulation implementing Section 4(k)(4)(H) of the BHC Act imposes substantial limitations on its use:

  • Although an FHC may engage in routine management and operation in order to obtain a “reasonable return” on its investment, the examples given in the Federal Reserve’s regulation show a narrower understanding of obtaining a reasonable return—namely, “to avoid or address a significant operating loss,” or “in connection with a loss of senior management.”
  • Routine management and operation may be “only for the period of time as may be necessary to address the cause of the [FHC’s] involvement, to obtain suitable alternative management arrangements, to dispose of the investment, or to otherwise obtain a reasonable return upon the resale or disposition of the investment.”
  • An FHC may not routinely manage or operate a portfolio company for a period greater than nine months without prior written notice to the Federal Reserve.
  • An FHC must maintain and make available to the Federal Reserve upon request a written record describing its involvement in routinely managing or operating a portfolio company. [3]

Under the last regulatory requirement above, it would appear that the Federal Reserve could know precisely the current extent of routine management and operation under the Merchant Banking Authority and therefore discuss in detail how “veil piercing” liability is a significant concern. The Report, however, contains no such analysis of current routine management and operation practices by the twenty-one FHCs that engage in merchant banking activities.

In addition, routine management and operation under the Merchant Banking Authority can take a number of forms, and it is not at all clear that they all pose the same veil-piercing concerns. The Report does not analyze each form of routine management and operation and how each form intersects with veil-piercing principles under state corporate law. Finally, the Report indicates that the amount of merchant banking investments has declined in recent years, from a carrying value of $49.3 billion at December 31, 2012 to $26.78 billion at December 31, 2015—a tiny percentage of the total consolidated assets of the FHCs that engage in merchant banking activities. [4] Perhaps for this reason, the Report focuses on a significant environmental event at a portfolio company.

As for Section 4(o), the Report states the truism that the Section 4(o) authority is broader than that for other FHCs, which must rely on Section 4(k)’s complementary authority and prior Federal Reserve approval to engage in certain commodities activities. Similar to the cursory justifications advanced in the Merchant Banking Authority recommendation, the Report also restates veil-piercing concerns, particularly with respect to environmental liability. But as with merchant banking, the Report does not include any substantive discussion of the likely extent of veil piercing in this context.

It therefore appears that the recommendations seek congressional legislation on the basis of potential risks—six years after Congress enacted the most significant banking legislation since the Great Depression and affirmatively protected one aspect of merchant banking in permitting FHCs to make some investments in FHC-sponsored private equity funds notwithstanding the Volcker Rule. Congress, of course, was presented with no evidence that merchant banking and commodity activities had any meaningful connection to the Financial Crisis.

Hence the recommendations would bluntly “de-risk” FHCs. Perhaps as a reaction to the antipathy shown toward merchant banking and commodity activities in the political realm—as evidenced by hearings in Congress and commentator views that merchant banking is an end-run around the Volcker Rule—the Report’s recommendations evidence a policy shift in the way the Federal Reserve approaches and supervises risk. In the absence of any clear evidence supporting the Report’s recommendations, however, this de-risking could have unfortunate consequences if the original antipathy for merchant banking and commodity activities gains additional traction as a result.

The Federal Reserve’s recommendation that Congress repeal the exemption in the Bank Holding Company Act for companies controlling an ILC is less surprising, since the Federal Reserve has long been an opponent of the exemption as permitting the mixing of banking and commerce. [5] But in criticizing the lack of consolidated supervision for companies controlling ILCs, the Report fails to discuss the effect of Section 616(d) of the Dodd-Frank Act, which provides:

  • If an insured depository institution is not the subsidiary of a bank holding company or savings and loan holding company, the appropriate Federal banking agency for the insured depository institution shall require any company that directly or indirectly controls the insured depository institution to serve as a source of financial strength for such institution[6]

In view of Section 616(d) and the fact that ILCs are generally federally insured, it is odd that the Federal Reserve states that “the parent companies of ILCs are … not required to serve as sources of strength to their subsidiary ILCs.” [7] The Report does not explain this discrepancy.

II. The Federal Deposit Insurance Corporation

The FDIC’s section of the Report focuses on those activities that are not permissible activities for national banks and federal savings associations, but that are permissible for state-chartered banks and savings associations under applicable state law. Under a 1991 provision of federal law, for FDIC-insured state banks and savings associations to engage in such activities, the FDIC must make a determination that the activities pose no significant risk to the Deposit Insurance Fund. [8] Part 362 of the FDIC’s regulations governs this area.

With respect to such activities and investments, the FDIC stated that it plans to review activities related to investments in other financial institutions and other equity investments in light of more recent regulatory and statutory rules governing such investments, and to determine whether the prudential conditions and standards under which the FDIC evaluates Part 362 filings with respect to mineral rights, commodities, and other non-traditional activities will need to be clarified through a policy statement. [9]

III. Office of the Comptroller of the Currency

In considering the activities and investments of national banks, the OCC’s first action was to propose a rule that would rescind a 1995 interpretation that it is a permissible activity for national banks to hold and trade copper. [10] Under the OCC’s proposal, trading and investing in copper and similar industrial or commercial metals (which would include bullion metals in industrial of commercial form) would no longer fall into the basket of activities that are “incidental” to the business of banking.

The OCC reasoned that copper markets had evolved away from precious metal markets in the 20 years since its 1995 interpretation such that copper could no longer be considered “bullion.” [11] Moreover, because few banks traded copper and other industrial and commercial metals, it could not be said that such dealing “significantly enhances national banks’ ability to offer banking products and services.” [12] If the OCC finalizes the rule as proposed, insured state banks from a state that permitted the trading of copper and other industrial and commercial metals would be required to apply to the FDIC for a determination that the activity does not pose a significant risk to the Deposit Insurance Fund.

The other OCC plans are more congruently tied to risk—the OCC stated that it intends to: (i) issue a proposed rule to restrict national banks and federal savings associations from holding asset-back securities backed by bank impermissible assets as Type III securities, (ii) to address concentrations of “mark-to-model” assets and liabilities, (iii) to clarify minimum prudential standards for certain national bank swap dealing activities, and (iv) to consider providing guidance on national bank membership in clearinghouses. [13] Indeed, this first contemplated proposal seems to address an issue left over from the Financial Crisis—the ability of a bank investor not to consider underlying assets when investing in an asset-backed security and rather rely only upon the fact that the security is marketable and investment grade.

* * *

The Report’s purpose, as envisioned by the Dodd-Frank Congress, was to identify banking entity activities and investments that could have a negative effect on the safety and soundness of banking entities and the U.S. financial system. With respect to commodity and merchant banking activities, the Report does not argue convincingly that current regulatory risk mitigants—such as affiliate transaction rules, limitations on Section 4(o) commodity assets to 5 percent of total consolidates assets, and the Basel III capital regime—are insufficient to protect banking entities engaging in those activities, let alone the U.S. financial system as a whole.

The Federal Reserve’s portion of the Report also seems to have forgotten that it was asset concentration (mortgage-backed securities), and not asset diversification, that contributed to the widespread global failures in the Financial Crisis, just as asset concentration was also highly problematic during the S&L Crisis of the 1990s. As the banking regulators consider how to treat the financial activities that were left alone by Dodd-Frank, more thought should be given to how combining activity diversification with prudential limits could advance bank safety and soundness as well as benefit the broader economy.


[1] 12 U.S.C. § 1843(k)(4)(H).
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[2] Id. § 1843(o).
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[3] 12 C.F.R. § 225.171 (emphasis added).
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[4] Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation & Office of the Comptroller of the Currency, Report to Congress and the Financial Stability Oversight Council Pursuant to Section 620 of the Dodd-Frank Act (September 2016), available at, at 15.
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[5] The same desire to restrain the mixing of banking and commerce may be seen in the proposal to end the grandfathered S&L holding company exemption.
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[6] 12 U.S.C. 1831o-1 (emphasis added).
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[7] Report at 34, n.6.
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[8] 12 U.S.C. § 1831a.
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[9] Report at 47.
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[10] OCC Interpretive Letter No. 693 (November 14, 1995).
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[11] Report at 89-90; see also OCC Notice of Proposed Rulemaking, Industrial and Commercial Metals (September 8, 2016), available at
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[12] OCC, Notice of Proposed Rulemaking, at 10.
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[13] Report at 76.
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