The following article by Alex Pollock of the American Enterprise Institute on the Federal Reserve’s financial condition is compelling so I asked Alex for permission to post if on my website.

The Fed Considered as a Bank

By Alex J. Pollock

Can you think of a $1.3 trillion-dollar bank that is levered 80 to 1?

It’s the New York Federal Reserve Bank.  This is where the Federal Reserve System takes its principal financial risks, and it does so at pretty remarkable leverage.

To support its $1.3 trillion in assets as of December 30, 2010, the New York Fed has equity of $16 billion.  Expressing its 80 to 1 leverage the other way around, its capital ratio is a mere 1.3%.

Consider the $405 billion of mortgage securities held by the New York Fed, along with the $66 billion of complex securities it took from Bear Stearns and AIG, the $26 billion of preferred stock in AIG bailout vehicles, and the $60 billion of agency debt mostly issued by the insolvent Fannie Mae and Freddie Mac, totaling $557 billion.  It would not take much of a depreciation of these assets, indeed less than 3%, to erase the $16 billion in capital.

So if you look at the New York Fed as a bank, you might well conclude that it is undercapitalized.

But is it fair to view a central bank as a bank? Well, it has $877 billion in deposits, including $582 billion in deposits from financial institutions.  Indeed, in one way it resembles a very large savings and loan, with a heavy concentration in long-term mortgages funded with short-term deposits.  It does issue currency, which regular banks are not allowed to do, but issuing currency was a central function of private banks, until it was monopolized by the Fed.

The stock of the New York Fed is held by the banks of that Federal Reserve district.  If the New York Fed experienced losses on its risk assets which impaired its capital, would the banks have to write down their stock?  That would take a brave accountant!  (Imagine the phone calls from Washington.)  Would the Fed exercise its legal call on the banks for more capital?

An easier and prudent strategy might be for the New York Fed to build up its retained earnings to reflect the increased risk of its balance sheet.  Federal Reserve Banks are enormously profitable: simply by cutting the dividends paid to the U.S. Treasury, a rapid increase in retained earnings could be achieved.

One might argue that it is not fair to view the New York Fed by itself, since it could be financially supported by the other eleven Federal Reserve Banks.  Of course, it would not like the idea that this might be necessary, and the other banks might worry about putting the capital of their own members at risk.  The New York Fed has 52% of the total assets of the combined System, so the other eleven banks together are slightly smaller than it is.

In this context, let us look at the leverage of the combined Federal Reserve Banks.  They have aggregate assets of over $2.4 trillion, and aggregate equity of $56.6 billion, for a combined leverage ratio of about 43 to 1.  Their combined capital ratio is 2.3%.  Still high leverage and a small capital ratio.

The combined Federal Reserve Banks own about $1 trillion in mortgage assets, all funded short.  Thus embedded in their balance sheet is the largest savings and loan in the world.  In addition, they own $147 billion of agency debt, mostly of the insolvent Fannie and Freddie.

The Federal Reserve Banks are unusual central banks, because they own no gold.  Most central banks have gold as one component of their assets, so that the huge increase in the price of gold has augmented the value of their portfolio.  But the Federal Reserve Banks had their gold (they used to own a lot) taken away by the government in the 1930s.  In exchange, they were given “gold certificates,” which you still find on their balance sheets.  But these certificates give them no right to any gold; they are merely non-interest bearing Treasury bonds.

The question of the “dual mandate” of the Fed to address both inflation and employment is currently under discussion.  But neither of these was its original purpose.

The Fed’s original purpose, as conceived by its creators in 1913, was to provide what they called an “elastic currency,” especially to intervene in financial panics and crises.  An exceptionally elastic currency has been provided with considerable élan by the 21st century Fed: it has given rise to the highly interesting balance sheets we have been considering.

Another purpose of the Fed was to maintain a stable currency.  This has interestingly been transformed into a goal of maintaining a stable rate of depreciation of the currency at something like 2% per year.  This means with a current life expectancy of 83 years, the average person will see prices will increase about five times and the dollar depreciate in purchasing power by about 80%.

The Fed is also, needless to say, a major financial regulator.  After each financial bust, including the one whose aftermath we are living in, the authority and prestige of the Fed are expanded– regardless of what mistakes it has made. Even more importantly, as insightfully discussed by Charles Goodhart in The Evolution of Central Banks (1985), the Fed, like all central banks, serves as the Manager of the Banking Club.

A further Fed function is to be a hugely profitable business for the government, since the shareholders get only a tiny slice of the profits, and the U.S. Treasury gets the rest.

Yes, the Federal Reserve Banks are all these things, but they also are banks.  They cannot be understood without considering that.

Alex J. Pollock is a resident fellow at the American Enterprise Institute in Washington, DC.  He was President and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004.