Note to Readers: What follows is a very technical and somewhat arcane discussion of a new Federal Reserve accounting issue, but one that has potentially significant policy implications when it comes to the Fed’s ability to execute its exit strategy from its current quantitative easing policy.
Bob Eisenbeis is Cumberland’s Chief Monetary Economist. Prior to joining Cumberland Advisors he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta. Bob is presently a member of the U.S. Shadow Financial Regulatory Committee and the Financial Economist Roundtable. His bio is found at www.cumber.com. He may be reached at Bob[dot]Eisenbeis[at]cumber[dot]com.
In a little-noticed statement included as part of the Fed’s weekly report on its balance sheet (the H.4.1 data release) the Fed announced a change in how it reports its transfers of “excess earnings” to the Treasury. The stated rational for the change is to increase the transparency of its financial statements. Specifically, the relevant statement is as follows:
Effective January 1, 2011, as a result of the accounting policy change, on a daily basis each Federal Reserve Bank will adjust the balance in its surplus account to equate surplus with capital paid-in and, in addition, will adjust its liability for the distribution of residual earnings to the U. S. Treasury. Previously these adjustments were made only at year-end. Adjusting the surplus account balance and the liability for the distribution of residual earnings to the U. S. Treasury is consistent with the existing requirement for daily accrual of many other items that appear in the Board’s H.4.1 statistical release. The liability for the distribution of residual earnings to the Treasury will be reported as “Interest on Federal Reserve notes due to the U.S. Treasury” on table 10. Previously, the amount necessary to equate surplus with capital paid-in and the amount of the liability for the distribution of residual earnings to the U.S. Treasury were included in “Other capital accounts” in table 9 and in “Other capital” in table 10.
First let us clear up one possible source of confusion. Since Federal Reserve notes are obviously non-interest bearing, why would the Federal Reserve account for the remittance to the U.S. Treasury as “Interest on Federal Reserve Notes due to the U.S. Treasury”? The answer is rooted in the fact that the Federal Reserve is required to collateralize its issuance of Federal Reserve notes with U.S. Treasury debt. The funds being remitted are the interest on that collateral, plus interest on its other debt holdings that may qualify.
As for the change itself, it appears innocuous and amounts to a simple change in accounting and possible timing of remittances, as distinct from a significant change in practice, but the real import of the change is buried in footnote 15 of supplemental table number 10 of that same report. The footnote states:
15. Represents the estimated weekly remittances to the U.S. Treasury as interest on Federal Reserve Notes or, in those cases where the Reserve Bank’s net earnings are not sufficient to equate surplus to capital paid-in, the deferred asset for interest on Federal Reserve notes. The amount of any deferred asset, which is presented as a negative amount in this line, represents the amount of the Federal Reserve Bank’s earnings that must be retained before remittances to the U.S. Treasury resume. The amounts on this line are calculated in accordance with Board of Governors policy, which requires the Federal Reserve Banks to remit residual earnings to the U. S Treasury as interest on Federal Reserve notes after providing for the costs of operations, payment of dividends, and the amount necessary to equate surplus with capital paid-in. [emphasis added]
What does this really mean? That small accounting change means that the Treasury – and hence the taxpayer – is now in a first-loss position should the Fed become book-value insolvent as the result of potential losses that might be incurred on asset sales as part of its efforts to absorb the excess reserves previously injected into the financial system as part of its liquidity and emergency asset-purchase programs. When a banking firm, for example, incurs losses on its assets, the charge is first made against loss reserves. Should those reserves be exhausted, charges are then made against retained earnings and finally owners’ paid-in capital. That’s not how the Fed will now keep its books.
Normally, Federal Reserve earnings are first used to replenish a Reserve Bank’s surplus account, which as a matter of policy the Fed keeps equal to paid-in capital (the capital account representing a member bank’s ownership in the Federal Reserve Bank in the district in which is headquartered). Under the new procedure, if losses exceed current earnings on the Fed’s securities portfolio, the Fed will debit that loss to a new negative liability account. With this change, the recorded value of surplus will always equal the value of paid-in capital while any shortfall will appear in the new negative liability account. Despite where it appears on the balance sheet, that account is essentially an unconditional commitment by the Treasury permitting the Fed to use future earnings to first reduce the amount of that negative liability account before beginning any remittances to the Treasury. The potential ramifications of this change are many.
First, in normal times, a 6% dividend is paid to member banks out of the surplus account, which is then replenished by retained earnings. Under the new proposal, if earnings are insufficient to cover the 6% payment, dividends can and will still be paid. The accounting change permits the Fed to cover the shortfall by increasing the size of the negative liability account to the Treasury and thereby enables the Fed to maintain the equality of the Fed’s surplus account with its paid-in capital. The Treasury will effectively fund current dividend payments by reducing the amount that it will receive from the Fed out of future earnings. Wouldn’t private-sector firms like to have that kind of a sugar-daddy deal?
Second, it is one thing if the size of the negative liability account is less than the amount in a Federal Reserve Bank’s surplus account. But if the account exceeds the size of the surplus and paid-in capital, then the Fed will be technically insolvent. Our calculations indicate that this is, indeed, a possibility. Will regulators require member banks to write down the value of their holdings of a Federal Reserve Bank’s stock? What about the payment of dividends in that case? Will dividends still be paid or will they be deferred? If the reported surplus and paid-in capital accounts are treated from a regulatory perspective as if the claims by the negative liability account don’t exist, then effectively the Treasury is guaranteeing the value of each Federal Reserve Bank’s shareholder claims, regardless of that Bank’s financial condition.
Third, there are significant budget implications of this change. Under normal conditions, the U.S. Treasury treats Federal Reserve earnings remittances as income for purposes of scoring the budget, even though those transactions are technically just an intra-governmental transfer of funds. It is like shifting coins from one pocket to another and recording the transfer as income. How will the debiting of the new negative liability account be treated for budget scoring purposes? Will it be treated as an expenditure? Will it be treated as an increase in the public debt? Clearly the negative liability account represents a claim on future remittances that the Treasury is willing to forego. Consider the alternative. The Treasury could issue debt and use the proceeds to increase its deposits at the Fed, and those deposits could then be used to reduce the size of the negative liability account. The accounting device is a way to avoid actually issuing new debt, but it is functionally equivalent. What it does do is shift potential government borrowing from the present into the future. Does this open up an end run around Congress, since Treasury debt issuance is usually governed by appropriations and is subject to statutory limits?
The bottom line is that the accounting change largely defuses the concerns that we have expressed about losses that the Fed may incur in the future when it begins to raise interest rates and sell assets to tighten policy and to absorb the liquidity provided during the financial crisis. Those losses will be absorbed by the Treasury out of forgone remittances of future Federal Reserve earnings. While this may solve the Fed’s problem, there are many other issues surrounding this move, and while seemingly arcane, they raise interesting budget and political implications.
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