Financial Mathematics Text

Saturday, August 17, 2013

What about the Fed's Balance Sheet?

So I often see a lot of discussion regarding the Fed's Balance Sheet related both to its size and to its liabilities. A recent example of a question by John Hussman:

The main question I think to ask is: Why does the Fed's balance sheet matter?

The corollary question is this: In what sense is the Fed's balance sheet like that of a balance sheet of a private bank or nonfinancial company?

Because I think the concern over the Fed's balance sheet is often motivated by a false analogy between the Fed's balance sheet and private firm balance sheets.

For a private firm, the liabilities side of the balance sheet corresponds with real claims over the firms assets as specified by the contractual arrangement of those liabilities.

So let's start by looking at some simplified private sector balance sheets. 

Nonfinancial Firm Balance Sheet

Here's a simplified nonfinancial firm balance sheet:

On the asset side, the company has cash (and other cash-like things) and they have operating assets (the assets that enable the company to produce goods and services for sale and profit). 
On the liabilities side, we have accounts payable. This is typically things like suppliers who supplied goods and services and haven't yet received payment. They are entitled to the pay that was contractually agreed upon.

We have debt (bond holders and bank debt). These entitle the holder to specific contractually agreed upon payments of interest and principal.

The equity holders have a residual claim on the firm's assets. They are entitled to what's left over (assuming there's any left over) after everyone else has been paid. In terms of public stocks, they are entitled to receive dividends if the company is able and willing to pay them. And if the company is liquidated, they receive any amount left after other claim holders have been paid.

Bank Balance Sheet

A stylized bank balance sheet has some similarities:

On the asset side, the main difference is the nature of the operating assets. For a bank, the core operating assets are its portfolio of loans to businesses and consumers.

On the liabilities side, the debt and equity are similar to the nonfinancial firm. Debt holders are entitled to contractually specified payments while equity holders have a residual claim on the assets.
The main difference is that banks have depositors. These are a claim on actual cash. For demand deposits (checking accounts) this cash can be "demanded" at any time to make a payment or withdrawn as physical currency. The bank is obligated to supply this cash on demand. Not all deposits are demand deposits but they often behave similarly.

But let's not get too focused on the details. The main point here is that for both banks and nonfinancial institutions, the liability holders have very specific claims on the firms assets and cash flows.

Federal Reserve Balance Sheet

Now here's a look at the Federal Reserve's balance sheet (oversimplified like the others):

Securities are typically US treasuries but recently they've been adding in things like mortgage backed securities (MBS). Securities represent the bulk of the Fed's assets (90%+). Other assets include things like gold and foreign currency related assets.

On the liabilities side there are some pretty significant differences from private firms.

With regard to deposits, these are mainly held by foreign governments and private banks (private citizens are not allowed to deposit with the Fed). This entitles the holder to conversion to reserve notes. So this liability is actually about the same as the reserve note liability.

In what sense is the reserve note a liability to the Fed? What does holding a reserve note entitle one to?

When we were on the gold standard (and there were roughly two phases to that), it actually entitled one to conversion to a specified amount of gold. In the first phase any holder of a reserve note could potentially convert that note for a specified amount of gold. In the second phase (under Bretton Woods), central banks could convert dollars to gold but that was about it. This ended in 1971 with the Nixon shock.

So what does a Federal Reserve Note entitle one to, post Nixon? Perhaps, it entitles one to a newly printed Federal Reserve Note. Beyond that, I doubt you'd be able to redeem it for anything else.

So here's the big rhetorical question to ask:
In what sense are Federal Reserve Notes (and deposits which are convertible into reserve notes), a liability (claim) on the Fed's assets?
There is one interesting thing added in recent years. The Fed instituted interest on bank reserves as a policy measure. But this, I presume, could be changed at any time. So perhaps this is a sort of "claim" over the Fed's assets, but it's one the Fed has complete control over.

The last part which is the capital or equity of the Federal Reserve is an interesting one and it probably deserves its own topic. The issue is highly complex and I'm not knowledgeable enough to even present a simplified version of it.

What I will do is recommend an interesting take on the subject by Bill Woolsey entitled: Who owns the Fed?

The member banks (who are often claimed to be the "owners" of the Fed) don't exactly have an equity (residual) claim on the Fed's assets:
If the Federal Reserve is liquidated, the member banks get back their $100 per share and pending dividends and anything left over goes to the U.S. Treasury.
So they don't get what's left over if it's liquidated. And their dividends are fixed at 6% so they don't have a residual claim on the profits.

So who does have a residual (equity) claim on the firm's profits? I'll quote the end of Bill Woolsey's piece for that:
Who owns the Fed? The owners of a business typically have ultimate authority over operations and serve as residual claimant. Stockholders elect directors, who appoint top management. Stockholders receive the profits — excess revenues after all other claims on funds are paid.

For the Fed, final authority is in the hands of the politicians. They appoint the Board of Governors, who dominate the Federal Reserve banks. Further, any earnings of the Federal Reserve banks beyond expenses, including the 6% dividend to the member banks, goes to the U.S. Treasury. Since the U.S. government has final authority and serves as residual claimant, the most reasonable view is that the Federal Reserve system is government-owned.

So I would contend that the bulk of the Fed's "liabilities" are not real liabilities as they do not entitle the holder to anything more than conversion from reserves to reserve notes and vice versa.

The only real claims seem to be the 6% dividend on capital (which are more akin to preferred shares than common equity), interest on bank reserves (set by Fed policy) and the Treasury which has the residual claim on the Fed's assets.

So in terms of actual leverage, the Fed's balance sheet is not that leveraged since most of its "liabilities" aren't real liabilities. In fact, expanding the Fed's balance sheet actually results in less leverage because it's buying more assets without adding any real liabilities.

Now I do think the Fed's balance sheet matters for other reasons as it tells us and influences the asset mix in the private sector. So it's not irrelevant. But I don't see what the Fed's capital structure matters for its solvency, etc. Most of its liabilities are not real liabilities.

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