By David Sheppard

NEW YORK (Reuters) - A report funded by Wall Street's largest lobby group laid out the most public justification yet of banks' role in physical commodity markets, a lucrative business now under threat from mounting political and regulatory pressure.

The report by IHS Global, commissioned by the Securities Industry and Financial Markets Association (SIFMA), said that banks play a small but vital role in the natural resources supply chain, and that the ability to trade in the underlying commodities - not just derivatives - was significant.

"Banks play an essential role in assuring the smooth functioning of the commodity markets which underpin the $16.6 trillion U.S. economy, and on which consumers ultimately rely," said the report by IHS, a major global research, analysis and specialist information group that in recent years has bought some of the world's foremost energy consultancies.

The report comes just weeks before the Senate Banking Committee is expected to hold its second hearing on the issue of Wall Street's deepened involvement in physical markets, which has come under intense public scrutiny amid allegations that bank-owned metal warehouses have inflated prices.

Regulators and politicians are also questioning whether Wall Street's involvement in risky commercial activities could pose a threat to their financial soundness.

Before Federal Reserve officials go before lawmakers to explain why banks have been allowed to operate oil tankers, power plants and metal warehouses, the Fed is expected to make public key decisions about whether banks will be able to carry on trading as many have for a decade or more.

The IHS report warned that without the ability to trade in the real raw materials themselves, banks would likely either stop providing financial services to certain areas or industries, or be forced to raise costs.

"Physical commodity trade — being able to (take) or make delivery of the underlying commodity — is often required to provide these services. The consequences of impairing this role could be far-reaching and negative," it said.

The report was produced by eight senior IHS Global analysts and was overseen by Daniel Yergin, who won a Pulitzer Prize in 1992 for his seminal history of the oil industry, "The Prize."

It uses five anonymous case studies to demonstrate how banks' involvement in physical commodity trading has benefited the wider economy, including jet fuel supply deals it says helped lower costs for a bankrupt airline, and trading and financing for struggling East Coast oil refineries.