Managing Crisis-related Fiscal Risks Borne by Central Banks: the Case of the United States

Posted by Ian Lienert.

The consolidated balance sheet of the United States Federal Reserve Banks (“the Fed”) more than doubled during 2008. The Fed’s response to the financial market crisis has transformed it from a key, though small, money market participant into the largest actor and fundamental linchpin of that market and, indirectly, of the world financial system.

What are the fiscal risks and costs of this balance sheet expansion? Could the Fed possibly make a loss? By bailing out financial institutions, including those with “toxic” assets, has the Fed taken on risks that eventually will need to be paid for from budgetary resources? Has the Fed’s role become confused with that of the U.S. Treasury, or vice versa? What exit strategy needs to be developed? A new IMF working paper examines relevant issues.

The new IMF working paper, The Federal Reserve System Balance Sheet—What Happened and Why it Matters http://www.imf.org/external/pubs/cat/longres.cfm?sk=22975.0 by Mr. Peter Stella of the IMF’s Monetary and Capital Markets Department first analyzes the expansion of the Fed’s balance sheet in an historical context.

Dramatic Balance Sheet Expansion

The analysis reveals that the nature of the Fed’s involvement in U.S. financial markets has changed dramatically. Compared to developments during 1951-2007, the working paper’s charts illustrate the extremely rapid expansion of the Fed’s balance sheet expansion during 2008, with a stunning 4,000 percent increase in the Fed’s policy assets between 2006 and 2008. Not only was the expansion of total assets and liabilities also dramatic, so too were the changes in composition.

On the asset side, by comparing end-2006 and end-2008, the Fed took on a number of new assets, notably foreign exchange swaps, term auction credit, commercial paper funding facility and other loans, notably to Maiden Lane LLC holdings. At the same time, there was a rapid decline in the Fed’s holdings of U.S. Treasury securities. These compositional changes raised concerns that the Fed’s balance sheet quality had weakened owing to a decline in both credit quality and liquidity—due to the swapping of “good” assets (treasury securities) for more risky assets, acquired in the context of various special programs/facilities that the Fed implemented in collaboration with the U.S. Treasury.

On the liability side, there was a dramatic increase in both bank deposits and government deposits. In September 2008, following the Lehman and AIG interventions, the Fed began to allow the supply of bank reserves to expand rapidly. At the same time, the Treasury announced a Supplementary Financing Program (SFP), designed to assist the Fed in managing the balance sheet consequences of those interventions by sterilizing the liquidity created with an increase in Treasury deposits held at the Fed. Rather than leaving the Fed to sterilize a large part of the expansion of liquidity through sales to the market out of its own portfolio, the Treasury began to issue short term cash management bills, depositing the proceeds at the Fed. As a result, instead of the usual target of $5 billion for the daily balance of federal government deposits at the Fed, there was a dramatic increase, which peaked at $560 billion.

The SFP has been remarkable for various reasons, including: (1) it is very rare for a central bank to obtain liquidity management assistance from the government’s treasury; and (2) the program almost cedes quasi-monetary policy power to the U.S. Treasury. Although the SFP has been effective, if it remains in place, it could blur institutional responsibilities for monetary policy operations as changes in Treasury deposits at the Fed have a direct impact on the monetary base.

Which Assets are the Most Risky? Possible Consequences

After demonstrating that the Fed’s dramatic balance sheet transformation and new role in the financial system has increased the central bank’s exposure to risk, Mr. Stella explores the Fed’s capacity to absorb the risks without jeopardizing its operational independence. A thorough examination of the risks associated with each Fed program requires an examination of each asset class being supported, its price volatility, projections of future real economy dynamics, assumptions about recovery rates on collateral, and knowledge of the Fed’s asset valuations on which “haircuts” are applied. Consideration of any risk-sharing by the U.S. Treasury is also necessary. Also, the Fed’s balance sheet is evolving day by day so any scenarios need to be based on the latest available data.

With these caveats in mine, the working paper examines the risks associated with various assets, based on the end-2008 balance sheet. Assets considered risk free in the paper are claims on the U.S. government, gold, liquidity providing repos and foreign exchange swaps. Low risk assets include the term auction credit facility (TAF) and the commercial paper funding facility. Four “higher risk” asset classes are identified:
 
• The Term Asset-Backed Securities Loan Facility (TALF). Although the TALF had not been utilized as of end-December 2008, at the time of writing, the Fed Board had authorized up to $1 trillion in lending during 2009. The U.S. Treasury had stated its intention to utilize TARP funds to insure the Fed against the first 10 percent of any losses incurred through the TALF.
• Maiden Lane LLCs, which are special purpose vehicles formed by the New York Fed (FRBNY) to manage its interventions in the JP Morgan acquisition of Bear Sterns and in American International Group (AIG).
• Other loans, in particular $39 billion loaned to AIG.
• Identified Specific Contingent liabilities include FRBNY commitments to provide contingent credit to Citigroup and AIG;  and Richmond Fed’s contingent funding of support to Bank of America
Based on assumptions for default on the above risky assets and possible losses given default, the author identifies a hypothetical loss for the Fed of $183 billion (equivalent to 9 percent of risk assets), based on the end-2008 balance sheet. Three dynamic balance sheet “what if” scenarios are also developed, based on three different assumptions for adverse developments in the risky assets in 2009-10. In each of these scenarios, following a period of negative profit and declines in the Fed’s capital, the central bank would be able to weather the hypothetical storms, with a return to profitability as from about 2013.

An important conclusion from the analysis is that although risks are considerable, the Fed’s capital, earnings capacity, and reserves are ample to preserve its financial independence, even in the cases of unlikely scenarios.  Nonetheless, even if the Fed does not make an outright loss, it has placed future treasury nontax revenue at risk. That is, losses on some operations would reduce the net revenue transferred to treasury, even if it never became negative. As of end-2008, this had not eventuated: increased profits had exceeded losses.

Shifting Balance Sheet Risk and the Exit Strategy

Since the Fed has taken on a number of new risks, the paper discusses how the Fed is managing those risks, by successively examining risk identification and quantification; how on-balance sheet risk may be managed; and motivations for explicitly shifting fiscal risk from the central bank to the treasury.

Some of the Fed’s recent interventions will be relatively easy to unwind: short duration operations will be allowed to expire and the currently zero interest policy rate can only rise. Longer term assets, with fragile market prices, may be more difficult to off-load. It is also important to prevent overlaps in responsibilities between the Fed and the U.S. Treasury from becoming entrenched. As noted in the paper, present policies are placing at risk federal government nontax revenue received weekly (1) from the Fed, while the SFP opened the door to the Treasury extending its monetary policy influence.

The occurrence of losses, even if immaterial to monetary policy, could easily raise the ire of Congress, particularly as transfers of nontax revenue to Treasury would be immediately reduced and Treasury might have to compensate individual Federal Reserve Banks whose shareholders are private commercial banks. The outcome of a full debate about the financial structure of the Federal Reserve and the legal authorities invested in the Fed to undertake what could be construed as fiscal actions might jeopardize monetary policy independence. Managing this risk would appear a significant priority. In this context, the paper points to the importance of clarifying the roles of the Fed and Treasury:

• First, to define completely their respective institutional roles in determining monetary and fiscal policy. Ideally, such a clarification would take place in the context of a broader clarification of the lead player in the task of preserving macrofinancial stability and an assignment of instruments to enable the attainment of that objective.
• Second, it would place quasi-fiscal actions fully on the Treasury balance sheet, alleviating any concerns about the Fed’s financial independence.
• Third, transparency may be improved or deteriorate with a transfer of responsibilities to the Treasury. Central banks increasingly are adopting modern accounting methodologies and have extensive experience publishing detailed financial information. By contrast, Treasury accounts are rarely accessible with granular detail and with the same rapidity as central banks (daily in some cases). Currently, the Fed might be better equipped than the Treasury to provide information on its exposure to fiscal risk as well as to manage that risk.
• Fourth, the optimal governance structure for the public body charged with preserving financial sector stability and intervening in stressed financial markets may correspond neither to that of the optimal monetary nor fiscal authority. Therefore an alternative governance structure could be contemplated, one combining political representation from Treasury with participation of independent agencies and/or third parties. The working paper discusses the need to spell out the structure of such an entity, which might be named the Market Liquidity Maintenance (MLM) corporation. The risks and profit from the MLM would be clearly on the fiscal accounts—avoiding potential conflict with monetary operations.

Concluding Reflections

The strength of the Fed balance sheet coming into the crisis, the risk control measures employed to date, and the cooperative relationship with the Treasury have ensured that the risks taken by the Fed’s innovative liquidity management operations are well contained. Nonetheless, some enhanced risk management measures could be considered, including : (1) a risk-adjusted level of equity could be agreed with Treasury and nontax revenue transfers adjusted to allow a closer correspondence of reserves and likely recourse to them; (2) loan loss reserves could be established to cope with expected losses; (3) risks can be shifted directly to the Treasury balance sheet. In particular, Treasury deposits could be used to purchase the riskier assets from the Fed’s balance sheet thereby lessening the need for explicit capital. Finally (4) consideration needs to be given to the future structure of U.S. financial regulation and who should execute the role(s) of financial market macroeconomic prudential supervision and capital market crisis intervention.

Finally, central banks in many different countries have quickly taken a leading role in stemming financial crises, with varying degrees of success. Exit from this role has rarely been easy and the damage to the balance sheet and/or central bank institutional reputation in some cases has taken decades to fully repair. It may be, however, that the strength of the Fed balance sheet entering the crisis and the unique closeness of the relationship between the U.S. central bank and Treasury could make implementation of an exit strategy easier than what has been observed in some other countries. However, even if that is true, the conventional model of central bank independence may need to be revisited.

(1) The Fed makes weekly transfers to the U.S. Treasury and the end-year balance sheet typically does not show significant accumulated profit. In contrast, most central banks make treasury transfers annually, after the publication of the yearly audited financial statements.