A review of the US Federal Reserve’s own document: “FEDERAL RESERVE statistical release, H.4.1: Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks”, issued on August 23rd 2011, reveals some interesting information about the state of the Federal Reserve, the US central bank: it's very nearly bust. As it is indirectly the lynchpin of the global financial system, that matters to the UK.
The size of the Fed’s balance sheet is now about $2,843 billion, up from about $800 billion three years ago. The huge increase in the Fed’s balance sheet stems from bailouts, quantitative easing, and other central bank “liquidity” operations. There's been a massive change in the structure of the Fed's assets too.
The Fed’s capital base is $71 billion. That represents about 2.5% of its assets, or a leverage ratio of 40 times its capital. This ratio would have been considered unthinkable prior to the crisis: it is about four times greater than that permitted by the new Basel proposed rules for commercial banks and simply demonstrates that the bailout format and quantitative easing do not make these problems go away. If the patient has been incorrectly diagnosed, taking the wrong medicine will not cure him.
This capital to asset ratio means that a loss on its assets of 2.5% would be enough to make the Fed, by any normal standard, insolvent – unable to pay its debts. So how plausible might such a loss be?
Prudent commercial banks over the last several years have carried about 2% in the form of provisions for expected losses. On this basis, even under the most skewed to generous valuations of the Fed’s assets, which it doubtless employs, overlaid by accounting standards which do not encourage early recognition of expected losses, the Fed has virtually no capital to bolster its assets.
Turning from default risk (credit risk), let us consider interest rate risk. Most of the Fed’s assets are bonds with fixed interest coupons. If interest rates rise by even a smidgeon, the value of the Fed’s assets will fall by more than 2.5%.
There is a very simple rule of thumb that practitioners use to assess bond riskiness at normal market interest rate levels: the duration rule. This rule holds that the riskiness of a bond depends on its duration or average years to repayment. Assuming that the Fed’s bond holdings have an average duration of 5 years – which seems about right, although possibly a little too low – then a 1% rise in interest rates would mean a capital loss of about 5%.Scaling both these numbers down by a factor of a half, they imply that a rise in interest rates of only 0.5% may be enough to sink the Fed.
This explains why the Fed and the Bank of England are both keeping interest rates at near zero levels. They both fear the revelation to the public of the truth: that the bank bailout and QE has not worked, that the commercial banks refuse to lend to each other out of solvency concerns and that this systemic toxicity has now infected the central banks.
Were the two central banks to raise rates by a modest degree, then the fig leaf of solvency would fall to the floor and reveal this naked truth. That is why specious arguments are ventilated about the risk of price deflation when both countries risk accelerating inflation. These arguments are used to justify near zero interest rates, imperilling both countries' hopes of lasting economic recovery.
I am grateful to Professor Kevin Dowd and Gordon Kerr for their help in preparing this article. Gordon is a specialist in structured finance and founder of Cobden Partners, the commercial wing of The Cobden Centre. Kevin has written extensively on the history and theory of free banking, the mechanics of monetary systems without the state and the failings of central banking and financial regulation.