The Federal Reserve Is the Bank Most In Need of a Stress Test

The Federal Reserve Is the Bank Most In Need of a Stress Test
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Do you know a bank which is leveraged at over 100:1-to be exact, with assets of 111 times its equity? You do: it's the Federal Reserve.

The consolidated Federal Reserves Banks on December 14, 2016 had total assets of $4.47 trillion, compared to total capital of merely $40.4 billion, or less than 1% of assets-actually, 0.9%.

The largest Federal Reserve Bank by far, New York, sports $2.47 in total assets and only $13 billion in total capital, for leverage of a pretty remarkable 190 times, and a capital ratio of 0.53%.

The Fed enjoys imposing stress tests on everybody else. What if we give the Fed a stress test? The interest rate risk of the Fed is similar to a 1980s savings and loan-lots of long-term, fixed rate assets, with short funding. So let's apply a simple and standard interest rate stress test. Suppose long-term interest rates rise by 2%, to an historically more normal level. What happens to the Fed?

Well, the Fed now owns $4.4 trillion of long-term, fixed rate assets and unamortized premium paid. It does not disclose the duration of this massive position, but let's say it's 5 years (it could be longer). If interest rates rise by 2%, the market value loss to the Fed is approximately 5 times 2% or 10% of the $4.4 trillion position. That would be an economic loss of $440 billion. That is 11 times the Fed's total capital.

It seems highly likely that the Federal Reserve System, and the Federal Reserve Bank of New York in particular, would then be hugely insolvent on a mark-to-market basis. Stress test score: F.

Defenders of the Fed confidently claim that it doesn't matter if the Fed is insolvent. Maybe they are right. If they are, the Fed should have no hesitation at all in publishing the mark to market of its giant securities portfolio, the way the Swiss central bank is required to do. To the Fed Board of Governors: How about it?


Alex J. Pollock is a distinguished senior fellow at the R Street Institute in Washington, D.C. He was President and CEO of the Federal Home Loan Bank of Chicago from 1991-2004.  

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