Who Owns Federal Reserve Losses and How Will they Impact Monetary Policy?

Between December 31, 2021 and the end of May 31, 2022, the Federal Reserve lost $540 billion in market value on its huge portfolio of investments in Treasury bonds and mortgage securities.

• The Fed has already experienced mark-to-market losses of epic proportions and will soon post large operating losses, something it has never faced in its 108-year history
• Unlike banks and other financial institutions, no matter how big losses it may face, the Fed will not fail
• But if losses, however large, can't end the Fed, who pays for these losses?

Federal Reserve System Current and Prospective Losses

• The Fed's balance sheet now combines paying rising rates of interest on bank reserves and reverse repurchase transactions after more than a decade of Fed quantitative easing and zero interest rate policies that stuffed the Fed’s balance sheet with low-yielding long-term fixed rate securities.
• As interest rates continue to increase, the Fed net interest revenue and operating income will decline as the Fed pays higher interest rates on $3.3 trillion in member bank reserve balances and its nearly $2.3trn in Reverse repurchase agreements while it earns interest on the largely fixed-rate securities its SOMA portfolio.

Does the Federal Reserve Need a Positive Capital Cushion?

• The 1913 Federal Reserve Act required that district banks have positive capital
• Congress established $4 million as the minimum required capitalization of a Federal Reserve district bank
• In return for providing the district bank's capital base, all member banks were initially entitled to receive a generous 6 percent dividend on the par value of their paid-in shares
• This dividend was cumulative in the event a district bank had insufficient operating revenues to cover expenses and dividends in any given year.

Unrealized losses, Realized losses and operating losses

• The Federal Reserve Board decides which accounting standards it uses to report the Federal Reserve system's income and balance sheet positions.
• Realized gains or losses are included in the Fed's reported operating earnings, while negative earnings will not negatively impact the Fed’s reported capital or surplus accounts.

The Federal Reserve Act and Federal Reserve System Operating Losses

• Congress never envisioned that Federal Reserve district banks would suffer large capital losses on their investments since Section 14 of the Act restricts their asset holdings to gold, gold coins, gold certificates, short-term banker's acceptances, real bills eligible for rediscount, US government notes and bonds, etc.
• The Act includes the little-known requirement that member banks contribute additional funds to cover district reserve bank operating losses up to an amount equal to the par value of their membership subscription
• Should there be a need to fortify any Federal Reserve bank's resources because of operating losses, member banks are required to contribute a certain amount

Has the Federal Reserve System Ever had an Operating Loss?

• In the early years after the Fed was organized, district reserve banks operated fairly independently.
• District banks earned revenue primarily from discounting bills of exchange with a small amount of revenue from interest on government bond holdings.
• Bills of exchange were discounted at a penalty rate by design, a feature not conducive to generating district bank revenues.

Modern Federal Reserve Board Policy Regarding Federal Reserve System Losses

• Today, the Federal Reserve official position regarding gains and losses in the market value of its SOMA portfolio is that these fluctuations do not affect the ability of the Fed to carry out its statutory goals of maximum employment and stable prices.
• Regarding realized losses, the Fed's official position is that, should it face operating losses, it would not reduce its book capital surplus, but rather would just create the money needed to meet operating expenses and offset the newly printed money by creating an imaginary "deferred asset" (Section 11.96) on its balance sheet.

Could Federal Reserve Losses Impact Monetary Policy?

• The current Federal Reserve Board plan to manage losses is: ignore any mark-to-market losses on its SOMA portfolio, recognize realized losses on securities sales, if any, monetize any operating losses and offset the liability on the Fed's balance sheet by creating or increasing a deferred asset account.
• If the Fed were to comply with the language in the Federal Reserve Act and exercise its right to assess member bank resources to cover operating losses, monetary policy could be significantly impacted in a number of ways.

Conclusion

• The Fed already has huge market-value losses on its SOMA portfolio that it chooses not to recognize in its formal financial accounting statements
• Failure is not an issue because the Fed can literally print as much money as needed to pay its expenses and member bank dividends
• Monetizing operating losses will enrich the Fed member banks that are supposed to be bearing the loss, while the public at large will face higher interest rates, higher unemployment, reduced growth, and the inflationary consequences

 

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