News - Bill's Blog

Are the Federal Reserve Banks 'too big to fail?'

January 12, 2018

The Federal Reserve Bank of Minneapolis recently released its “final plan to end Too Big to Fail.”  Their plan reflects concern that capital requirements for “Too Big to Fail” banks are too low, leaving taxpayers at risk.  The plan calls for dramatically increased capital requirements for larger banks. 

Capital requirements matter for taxpayers.  For banks and other large financial institutions, the higher the capital/asset ratio, the lower the leverage, and the more stability for a given change in the value of assets.  The more capital standing behind a bank’s assets, the more cushion for taxpayers, if they are exposed to making good on the liabilities of a firm deemed “Too Big to Fail” (TBTF).

Bank capitalization decisions are a matter of private governance as well as government regulation.  In theory, the government steps in and sets capital requirements in order to stabilize the financial system. In practice, however, one can make the case that capital regulation itself is the reason bank capital is woefully low, particularly in light of the 2007-2009 financial crisis.  If regulators are ‘captured’ by large TBTF banks, the regulator might have an incentive to draw the line in the capital sand in favor of those banks, at a low level designed to boost returns on the private capital while public capital (taxpayer money) is available on the downside.

Leverage is one of several major sources of risk in financial institutions.

History teaches many lessons we don’t seem to learn very well, including the need to be wary of the combination of rapid growth, high leverage, and off-the-books funding in financial markets. Rapid growth can be easy, at least in the short run, for example by overpaying for financial instruments or underpricing risky credit extensions. In turn, institutional risk can be magnified by slim capitalization. And a good way to grease the wheels is to accumulate debt ‘off the books,’ both as a means of keeping things under wraps as well as (again, in the short run) keeping accountability at bay. Risk can be a function of the credit quality of individual assets and interest rate risk more generally.

The Minneapolis Fed proposal seems to be a step in the right direction, at least for taxpayers.  In light of that proposal, however, it is ironic that we need to be wary of the Federal Reserve Banks themselves.

In the ten years since the end of 2006, just before the onset of the greatest economic and financial crisis since the Great Depression, the reported total assets of the Federal Reserve Banks have mushroomed from $873 billion to almost $4.5 trillion.  And over that decade or so, the combined capital/asset ratio for the Reserve Banks fell from an already-slim 3.5% to less than 1%. 

Not to compare apples and oranges or anything, but the 2006 leverage ratio for the Reserve Banks was roughly equal to the ratio reported for Fannie Mae a decade before its implosion in 2007.  And the growth in Fed assets over the last decade is in line with the growth at Fannie Mae in the decade before 2007, as well.

So, why does this matter for the public purse?

The U.S. Government has issued a financial report, including financial statements, since the late 1990s.  Those statements are audited by the Government Accountability Office (GAO), the audit arm of Congress.  Like the private sector, the annual audit includes an opinion from the GAO, and an opinion letter. 

After the 2007-2009 financial crisis, and the mushrooming Fed balance sheet with the new “quantitative easing” monetary policy, an interesting qualifier/warning appeared in the GAO statement on Uncle Sam’s financial report for 2012.

“Several initiatives undertaken during the last 4 years by the Board of Governors of the Federal Reserve System to stabilize the financial markets have led to a significant change in the composition and size of reported securities on the Federal Reserve’s balance sheet. The value of these securities, which include mortgage backed securities guaranteed by Fannie Mae, Freddie Mac, and the Government National Mortgage Association, is subject to interest rate risk and may decline or increase depending on interest rate changes. Therefore, if the Federal Reserve sells these securities at a loss, future payments of Federal Reserve earnings to the federal government may be reduced.”

The GAO repeated this language in 2013 and 2014.  But in 2015 and 2016, the warning disappeared.

Should we really be worried about this stuff?  What is the risk of lower earnings?  Could losses actually happen?  Is there a possibility that the annual river flow of earnings from the Reserve Banks to the federal government reverses, and turns into a capital call on the U.S. Treasury?

Early in 2017, the Federal Reserve Board of Governors published a paper titled “Confidence Interval Projections of the Federal Reserve Balance Sheet and Income.” This paper – the product of staff economists, not the members of the Board of Governors – developed sophisticated-looking econometric models, leading to conclusions like “… earnings remittances to the U.S. Treasury are projected to decline over the next few years, falling to their annual low of roughly $40 billion, before rebounding toward $62 billion by the end of the projection period. … As shown in Figure 6, we find that inside the 70-percent confidence interval earnings remittances never fall to zero. Thus, transfers to the U.S. Treasury are not suspended …”

Trouble is, it can be difficult to be confident in economic and financial forecasting like this, particularly in light of any candid review of Fed staff forecasts supporting FOMC monetary policy decisions before the 2007-2009 financial crisis.

The Federal Reserve exists because Congress passed a law, signed by the President, back in 1913.  The Federal Reserve is fundamentally a creature of Congress, in important part due to the provision giving Congress the power “to coin money, and regulate the value thereof” in Article I of the U.S. Constitution.

Can we trust Congress to keep taxpayers safe, while overseeing the Federal Reserve?

For that matter, can we trust ourselves? 

Anyone can monitor the Federal Reserve’s financial statements. The Fed produces a weekly report on the consolidated balance sheet for the Reserve Banks, and the Reserve Banks produce their own (audited) financial statements annually.  But the Fed is the master of its own accounting, and sets its own accounting standards. And to date, in the modern (post-1990s) era for federal government financial reporting, it may be a little surprising to learn that the comprehensive financial statements for the federal government do not include the Federal Reserve Banks!  The Fed has argued that doing so would harm its independence, and to date, the Congress has agreed.

The Fed has been growing rapidly, and now owns a massive bond portfolio. The Fed is not immune to interest rate risk, particularly as the share of longer-term bonds in that portfolio has been growing.    And the Fed is highly leveraged.

In a way, it sounds like our government has its own off-the-books hedge fund.

Granted, seigniorage can be a lucrative business.  But expected return is a function of risk.

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