Each time the Fed undertakes a new program of quantitative easing, questions arise about the possible impact on its solvency. I addressed that concern in November 2010, at the time QE2 was announced. Here is an updated version of that post that looks at the solvency issue in the context of QE3.
The Fed’s new program of quantitative easing, QE3, once again raises an old question: Can central banks go broke? Conventional analysis, aptly summarized by Willem Buiter in a 2008 report, says “Never–Well, hardly ever.” The Fed is most assuredly not going to suffer a run or become unable to meet its obligations, but under some scenarios, keeping it from going going broke could raise difficult political issues and perhaps even threaten its independence.
We can start by noting that the Fed, like most central central banks, is rather thinly capitalized. As of September 2012, it had capital of some $55 billion, about 1.9 percent of its assets of $2,825 billion. By comparison, the consolidated balance sheet for all commercial banks showed assets that exceeded liabilities by 11.5 percent. If the Fed were a commercial bank, it would not be insolvent, but it would be on the watch list.
Of course, the Fed is not a commercial bank. The unique nature of its assets and liabilities allows it to operate safely with just a sliver of capital. Normally, the Fed’s assets have consisted largely of short-term Treasury securities, which are as close to risk-free as you can get. As for liabilities, as recently as the end of 2007, 90% of them consisted of Federal Reserve currency. Currency is a truly marvelous kind of liability, since it is neither interest-bearing nor redeemable. Together, those assets and liabilities generate a healthy net interest income, most of which it turns back to the Treasury. With a balance sheet like that, who needs capital?
Since 2008, however, things have changed a bit. First, the nature of its assets has changed. Treasury securities now account for only 58 percent of the Fed’s assets. As of September, it held some $843 billion in mortgage-backed securities (30 percent of assets), and it is committed to buying $40 billion more each month under QE3. Those securities are neither very liquid nor risk-free. In addition, under QE3, the Fed will continue to lengthen the maturity of its Treasury portfolio. On balance, these activities create a growing exposure to market risk in the event of a rise in interest rates.
On the liability side, nonredeemable monetary liabilities still predominate, but the composition of the monetary base has changed. More than half of the base (as opposed to less than 10% five years ago) now consists of reserve deposits of commercial banks. Reserves are no longer interest free. While the rate paid on reserve deposits is now just 0.25%, that could increase.
Under QE3, the Fed is committed to continue increasing the size of its balance sheet until the employment situation begins to improve. That is unlikely to happen while inflation remains below its 2 percent target, as it has recently, and the Fed has left open the possibility that inflation will be allowed to rise above the target temporarily. At that point, the Fed will begin to execute its “exit strategy” from its current highly accommodative policy. The exit strategy could very possibly put strains on its income statement and balance sheet.
One element of the exit strategy could be to raise the interest on reserve deposits in order to discourage banks from using those reserves as a basis for making new loans. Doing so would raise the Fed’s interest expense. At the same time, the Fed could begin selling off the securities it has acquired under successive waves of quantitative easing. If market interest rates are higher by then, as they very likely would be, the Fed would have to sell them at a loss compared to their purchase price. Under those circumstances, the Fed’s capital could rather rapidly fall toward zero. What then?
First, it should be made clear that even if the Fed slipped into balance-sheet insolvency (negative capital), that would not bring about equitable insolvency (inability to meet financial obligations as they fall due). Because of the nonredeemable character of its monetary liabilities, and because both its liabilities and assets are denominated in dollars, any kind of run on the Fed is absolutely impossible. The Fed’s net interest income is currently more than $50 billion per year. Even if that were much reduced, it would easily be able to meet its operating expenses many times over. Still, a position of negative capital would be uncomfortable even if the Fed were able to keep up with its current obligations. Recapitalization would clearly be desirable. But just how could it be accomplished?
Recapitalization would be complicated by the odd legal status of the 12 Federal Reserve Banks as joint-stock entities that are “owned” by private commercial banks, yet are in every functional sense a part of the federal government. The only conceivable entity that could recapitalize the Fed is the Treasury, but this would be no ordinary capital injection. For commercial banks, a capital injection means a swap of good assets for equity, but the Federal Reserve Banks could not just issue new common or preferred shares to the Treasury, at least not without a revision of their charters. Instead, a recapitalization would have to take the form of an outright grant, in which the Fed transferred tens or hundreds of billions of dollars in newly issued bonds to the Fed completely gratis. It is hard to see how that could be done without an act of Congress–and would Congress in its current mood approve this mother of all bailouts?
Let me emphasize this: The Fed is NOT a private corporation in any ordinary sense of the word. If the Treasury were to gift the Fed with a $100 billion capital grant, that would NOT amount to putting it in the pockets of the Rothschilds, whatever you might read to the contrary on the internet. But who could guarantee that all those paranoid myths about the Fed would not be raised in Congressional debate or on talk radio? Who could guarantee quick passage of the Treasury Asset Recapitalization Package of 20**, or whatever they might call it. Whatever the name, it would be called TARP II and it would be controversial. It would be so controversial that in return for passage, Congress might insist on new audit or oversight authority, something already high on the agenda of certain members.
So, what is the bottom line? Could the Fed go broke if QE3 creates a bond bubble that suddenly bursts in a surge of inflationary expectations? Theoretically, yes, at least in the balance sheet sense. Presumably, it could not become insolvent in the equitable sense. In the end, no one can rule out the emergence of a situation from which the Fed could be extracted only at the cost of a high degree of political discomfort and perhaps a loss of independence.
By. Ed Dolan