How the Price of Beer Cans Led to a Politicized Proposal from the Fed

In this political season, there has been much recent commentary over whether the Federal Reserve is sufficiently independent, or whether the Federal Reserve is instead beholden to the executive branch and driven to keep interest rates low in order to ensure that Democrats retain the presidency.

The Federal Reserve's recent rule proposal regarding physical commodity activities of banks shows the Federal Reserve Board's sensitivity to politics far more cogently than the monetary policy critique. It clearly showcases the Federal Reserve's willingness to put political concerns above the interests of evidence-based regulation.

In 1999, the Gramm-Leach-Bliley Act allowed some banks to engage in a limited set of physical commodity activities. This includes owning minority investments in mines and warehouses that store commodities. Some banks have enough customers hedging their risk exposure to justify limited vertical integration. In the same way that McDonald's can save money for itself and its customers by entering into joint ventures with some of its suppliers, some banks can save money for their customers through limited vertical integration, as well.

The Federal Reserve's proposal threatens to harm customers, including municipalities, who rely on banks to provide commodities transactions. The Wall Street Journal reported in 2014 on concerns from "small-town officials from Alabama, Louisiana, North Carolina and other states are warning of unintended consequences from the Fed's proposal, telling lawmakers and regulators it could prevent municipalities from delivering natural gas to tens of thousands of customers."

For 13 years, banks enjoyed profits from their physical commodities investments with no trouble. A handful of Democratic senators became interested in the physical commodities activities of banks in 2013, alleging that they manipulated the price of aluminum such that beer distributors in the states represented by those senators were seeing the price of beer cans inflate.

Yes, that's right — this all started with politicians worried about the price of beer cans.

Never mind that manipulation of commodities markets is very difficult to do. Consider that the Hunt brothers tried to corner the market in silver and lost almost $2 billion in family wealth trying. No evidence of market manipulation has been put forward to justify limits on bank commodities activity.

The Federal Reserve has responded to the attention from a handful of progressive senators with a proposal that seeks to stop bank investments in physical commodities. The Fed's proposal has focused its justification on the argument that involvement in physical commodities activity could pose a reputational risk to a bank. The initial notice of rule-making referenced the BP disaster in the Gulf of Mexico.

Yet banks are not permitted to own a controlling interest in companies, merely a minority stake. The fact is that the Federal Reserve promulgated rules 15 years ago to protect banks from liability exposure to physical commodities activity. Those rules have protected banks from any liability exposure over that time.

Also consider that just by virtue of being publicly traded, a bank becomes subject to the risk of large securities fraud lawsuits. Large banks have paid billions of dollars in securities class action settlements in the last decade. By the Federal Reserve's logic, merely selling stock in the public markets exposes a bank to excessive risk.

Another version of the Federal Reserve's risk argument is that customers might stop doing business with a bank because of the bank's participation in those activities.

When I was chief economist at the House Financial Services Committee, I asked Federal Reserve lawyers drafting the rule whether they had attempted to measure the expected risk of physical commodities activity. Their response was that "you can never know anything for sure."

It is astounding how confident Federal Reserve officials can be when asked to make incredibly difficult predictions about growth in the global economy. By contrast, when asked to estimate the cost of new banking rules or the benefits to banking activities they seek to inhibit, they suddenly lose all confidence in their economic tool kit.

Yet if the Federal Reserve's goal is merely to obtain political points with the progressive caucus in the Senate, it doesn't want to know the answers to those questions. The Federal Reserve's obtuse approach to this rule proposal is consistent with a politically charged approach.

The Federal Reserve seeks to impose aggressive capital charges onto bank participation in physical commodities activity. In doing so, they seek to stop banks from engaging in activities affirmatively allowed by statute. It isn't easy to challenge your regulator in court, particularly a regulator as powerful as the Federal Reserve. Until then, this farce undermines the Federal Reserve's credibility as a regulator and demonstrates the politicized nature of its approach to bank regulation.