Peter Stella
Turning now to consider assets which can be considered risk free:
Claims on the U.S. government and gold are considered as having zero credit risk. We also consider claims on GSEs, and GSE and Agency mortgage-backed securities (MBS) as having zero credit risk although, depending how their acquisition is financed, they may entail interest rate risk. As of end-December 2008, the FRB had not purchased GSE and Agency MBS and held only $7 billion in Agency and GSE securities.34 The FOMC has currently authorized FRBNY to purchase up to $200 billion in GSE direct obligations; up to $1.25 trillion in GSE and agency backed MBS and up to $300 billion in longer-term U.S. Treasuries.
The same treatment ought to be afforded to liquidity providing repos and foreign exchange swaps which are mainly claims on OECD central banks collateralized by their respective currencies. Although these agreements were designed to provide U.S. dollar liquidity to foreign private financial institutions, the credit risk arising from the provision of the credit resides with the liquidity providing central bank—not with the Fed. Nor is there any foreign exchange risk to the FRB as the swaps were designed so that the FRB receives the dollars it has lent out—regardless of the contemporaneous exchange rates—plus a premium to cover the cost of credit (borne by the ultimate commercial bank borrower). As this effectively means the only risk to the FRB is a default by another central bank, a highly unlikely event, these assets are considered for the purposes of this paper as being risk free.
[Mrt: "Claims on US gov. AND Gold" or "Claim on the US gov. AND US gold"? :o) playing with words.]
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B. Federal Reserve Bank Ability to Absorb Losses
In a given year, the FRBs and any commercial bank have the same two primary sources to absorb losses from any one of their business lines—earnings and capital.
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Other Reserves.
In addition to the assets shown on the balance sheet the FRB has additional sources of strength with which it could cope with losses. The first would involve a revaluation of gold. Although changing nothing in reality, a revaluation of the FRB gold certificates would provide a “paper” profit of approximately $236 billion. If one were concerned with the psychological impact of negative capital, it would be relatively simple to erase it with a revaluation of gold.
A second “reserve” is the difference between the fair market and balance sheet valuation of the UST and Agency securities held in the SOMA. At end-December 2008 this difference amounted to $62.4 billion. In other words, the Fed had $62.4 billion in unrecognized gains on its securities portfolio or, alternatively, were the Fed to have instantaneously sold its entire portfolio into the market at end-December 2008 market prices (clearly an economic impossibility), it would theoretically have absorbed $566.4 billion in monetary base compared with the $502.2 billion balance sheet valuation of the SOMA portfolio at that time. This thought experiment illustrates the ephemeral nature of this “reserve”. Were the Fed actually to sell a large portion of its portfolio outright, interest rates would likely rise, leading to a fall in value of the remaining portfolio. Similarly, in a situation of rising inflationary expectations and rising long-term interest rates, this cushion to absorb liquidity could rapidly evaporate. Conversely, in a situation such as 2008, a deteriorating world economy and sharply declining risk appetite led to a flight to U.S. Treasuries which raised their prices.
Earnings capacity over time.
So far, the discussion has centered on resources available within a one year time frame to cover losses assumed to occur over that time. It is important to recognize however, that the Fed also has a strong ability to generate future income. That is, although current resources might be inadequate to cover losses in a given year, FRB future income generation potential or “franchise” value, would permit it to cover a significant capital shortfall over time without the need to change its policy path. To obtain a hypothetical balance sheet measure of this future income potential, one may consider the present discounted value of an infinite stream of profits amounting to the current 5 year average profit of $30.7 billion per year, discounted by, say, 3 percent. This yields an “asset” valued at over $1 trillion. This hypothetical addition to balance sheet capital may be thought of intuitively as the annuity value of the FRB’s seignorage monopoly.
Coping with a scenario involving one-time losses on the order of $200 billion on a portion of the FRB asset portfolio would entail a decline in FRB capital of approximately $170 billion assuming the other earnings in Table 10 and if none of the “other reserves” discussed above were available or utilized.49 To return to positive equity of $45 billion would then require roughly the retention of all profit during the next 6 years. However, it can legitimately be questioned whether the underlying assumptions on earnings and banknote issuance would hold in a truly catastrophic scenario.
As mentioned above, U.S. banknote demand appears to rise during periods of foreign economic turmoil which may be associated with a “dark” U.S. financial scenario. This correlation appears to have returned in 2008 which witnessed the highest growth rate in banknote demand since 2001. Estimates suggest strong banknote demand from Latin America, Eastern Europe and the United States, particularly in the second half of the year.50
As to the question whether future earnings could be assumed in a dark scenario, readers may be interested in an examination of the Fed balance sheet and earnings profile before and after the Great Depression, which is presented in Appendix I. In one of many ironies connected with the Great Depression, the FRB performed “well” financially but only because they took no balance sheet risk. In fact, bills purchased outright and bills discounted—which at the time was virtually the only form of FRB credit to the private sector, fell from 1 percent of GDP in 1929 to virtually zero in 1934 (see Figure 24). Although the balance sheet did expand sharply during the Great Depression it was driven by an accumulation of government securities and gold..."
[Mrt: Notice the attached picture]
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The idea of assigning a different governance structure to different functional roles is new neither in the United States nor in other countries and might be considered an evolutionary rather than revolutionary change.
In the United States, the powers exercised under the Gold Reserve Act of 1934 to manage the U.S. foreign reserves are shared by the U.S. Treasury and the Federal Reserve.60 Monetary policy authority is also shared between two governance structures. The FOMC determines the policy rate and directs open market operations while the Board of Governors has the authority to set required reserves and authorize changes in the discount rate. Authority granted the Fed under the FRA under section 13.3 is further refined: “in unusual and exigent circumstances” to provide discounts to individuals, partnerships and corporations, requires “...the affirmative vote of not less than five [out of seven] Board members....”61 Similarly, the European System of Central Banks, Argentina, Chile, Costa Rica, Korea and the Philippines require a super majority vote to authorize extraordinary or emergency central bank operations.
In Japan, BoJ emergency lending must be approved by the Prime Minister and the Minister of Finance. In Thailand, both the Bank of Thailand Financial Institutions Policy Board and the Cabinet must approve emergency lending. Such operations must be approved in Jordan by both the central bank board and the Council of Ministers. In both Korea and the Philippines, the Monetary Policy Board, not the general board, holds power in an emergency.
Source: http://www.imf.org/external/pubs/ft/wp/2009/wp09120.pdf
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