Chat with us, powered by LiveChat
Menu

Fed's Balance Sheet and Accounting Principles are Risky

goldman sachs
Print Friendly, PDF & Email

EDITOR NOTE: Do standard accounting principles apply to central banks, like the Federal Reserve, who have the capacity to print money out of thin air--in other words, “bend” or even “make” the rules? Perhaps to a certain degree, yes. Another interesting question: do risk principles applicable to other financial institutions apply to the Fed? Let’s step back for a moment and imagine that you want to hold bonds. You have a total amount of, say, $200,000 liquid net worth to your name, but you “borrowed” $1.6 million to buy a bond of your choice. Risky? Yes, especially if the bond price sinks to the point where you lose more than your entire net worth. But what if you didn’t borrow the money and instead printed counterfeit dollars? It’s a different story. Well, that’s the Fed--it holds $40 billion in total capital but holds $7.4 trillion of government Treasuries. What happens if interest rates rise and the Fed has to sell its assets at a loss exceeding its own total capital? You won’t see a negative balance, simply because those rules don’t apply to the rule makers. However, someone will have to pay for it one way or another. And it isn’t going to be the Fed or the government. Guess foots the bill.

The Fed has embarked on a massive expansionary quest in recent years. In 2020, total Reserve Bank assets rose from $4.2 trillion to $7.4 trillion amidst the pandemic and related government lockdown and fiscal “stimulus” policies. That was roughly three times the extraordinary growth in the consolidated balance sheet for the Reserve Banks in the 2008-2009 financial crisis. And in the latest weekly “H.4.1” release, total assets were up to $7.8 trillion – rising about a hundred billions dollars a month so far this year. 

In banking, rapid growth isn’t hard to achieve, if you are willing to assume risk. In fact, rapid growth should always be questioned as a sign of possible undue risk taking. How about the Federal Reserve Banks? How much risk are they taking, and on whose dime? 

To answer these questions, we first have to identify the accounting principles on which the Fed’s balance sheet is based. 

In the United States, there are “Generally Accepted Accounting Principles” (GAAP) – but there are different strokes for different folks. Private sector companies follow accounting standards set by the FASB – the Financial Accounting Standards Board. State and local governments follow a different set of “generally accepted” rules that are set by the GASB – the Governmental Accounting Standards Board. The federal government of the United States follows yet another set of “generally accepted” principles, set by the FASAB – the Federal Accounting Standards Advisory Board.

Put aside for now the question whether “generally accepted accounting principles” can even exist in a world where there are more than three sets of them, including international accounting standards. Who sets the accounting standards for the Federal Reserve?

There are two main parts of the “Federal Reserve.” The Federal Reserve Board of Governors is an independent regulatory commission, a government agency, and it follows the standards for the federal government set by the FASAB. But the Federal Reserve Banks are another story: they follow accounting standards set by the Federal Reserve Board of Governors! Those standards are not GAAP.  

One way the Fed’s principles for the Reserve Banks differ from GAAP matters for understanding material risks facing the Reserve Banks, and in turn, the U.S. Treasury.

The Reserve Banks’ assets include trillions of dollars of bonds, most of them government or government-backed bonds. Like any bond portfolio, those investments are subject to interest rate risk. When interest rates go up, bond prices go down (and vice versa).

Under the Board of Governors’ accounting standards for the Reserve Banks, “unrealized” losses in bond investment value do not immediately find their way into the financial statements. Only when losses are “realized” (for example, when the bonds are sold) does loss enter the financial statements.

Today, short and long-term interest rates on government bonds rest near historic lows, important in part because the Fed massively expanded its purchases of government bonds. But low interest rates can’t be taken for granted, particularly if we get significantly higher inflationary expectations -- which appear to have begun to sprout in recent weeks.  

If we get significantly higher interest rates for that reason, the Reserve Bank balance sheet impact from losses on securities assets would arrive if the losses become “realized” – a realistic prospect if the Federal Reserve  reverses course and starts selling off securities as a means of conducting monetary policy amidst higher inflationary expectations.

This impact, and risk, is higher for entities with significant financial leverage. And the Reserve Banks are some of the highest-leveraged banks on the planet. On the 2020 balance sheet, which reported $7.4 trillion in assets, Reserve Banks reported “only” $40 billion in total capital – a capital/asset ratio of one-half of one-percent.

For a given percentage change in the value of assets, highly leveraged entities will see a greater percentage decline in the value of capital. In this case, Reserve Banks would begin reporting negative capital after losses amounting to just one-half of one percent of their total assets.

That is, if they were required to post the losses. Under current standards set by the Board of Governors, they won’t begin to do that until the losses are realized in sales on the open market. And even then, the Reserve Banks won’t show a negative capital amount because the Fed sets its own accounting standards, a least for the Reserve Banks, and changes them as it sees fit.

Back in 2011, after the first spike upward in Reserve Banks’ balance sheet with the financial crisis, the Federal Reserve Board of Governors changed the accounting standards for the Federal Reserve Banks. These changes limited  the possibility that the Reserve Banks’ capital account could ever turn negative. And more recently, some have argued that the Fed’s control over its own accounting principles could allow for even more creative ways of cushioning the blow from any investment losses.

But a free lunch for the Fed isn’t necessarily a free lunch for the rest of us.

The problem (and risk) facing the Treasury (and the rest of us) is compounded by the Fed’s legally dubious new practice of paying interest on reserves that banks maintain with the Reserve Banks. If short-term interest rates rise amidst heightened concern about inflation, under current policy, the Fed would pay higher interest on the massive multi-trillion dollars worth of reserve balances currently at the Reserve Banks.

Introducing its own balance sheet, a balance sheet with about $6 trillion in assets against nearly $33 trillion in (understated) liabilities, the federal government gives us the following comforting words:

There are, however, other significant resources available to the government that extend beyond the assets presented in these Balance Sheets. Those resources include stewardship PP&E in addition to the government’s sovereign powers to tax and set monetary policy.

In other words, we should be comforted that our government will be able to take our money away, or inflate the value of the dollar away, to pay off its debts. 

Maybe we shouldn’t be comforted by these assertions, especially because they arrive in a document theoretically providing  accountability of the government to the real sovereign in the United States – the people.

The Federal Reserve has returned earnings regularly to the Treasury for decades. And the government appears to see the Fed and monetary policy as its ace in the hole. But this is not  necessarily an ace in the hole for the people.

When justifying the fact that the Fed sets its own accounting standards, Fed leaders regularly assert that the value of central bank independence warrants this state of affairs. But how independent is the Fed, really, under current law and policy?

Back in 2010, the opinion of the Government Accountability Office (GAO) on the financial statements of the U.S. Government began including a cautionary note about the risks of the Fed’s ballooning balance sheet to the Treasury. The GAO opinion letters stopped including these notes in 2015. Now that the Fed’s balance sheet is ballooning again, these issues deserve greater scrutiny.

Original post from MisesInstitute

Bank Failure Scenario Kit - sm2

GET YOUR FREE

BANK FAILURE SCENARIO KIT

  • This field is for validation purposes and should be left unchanged.

All articles are provided as a third party analysis and do not necessarily reflect the explicit views of GSI Exchange and should not be construed as financial advice.

Precious Metals and Currency Data Powered by nFusion Solutions