The Federal Reserve is the bank most in need of a stress test
The consolidated Federal Reserves banks had total assets of $4.47 trillion as of Dec. 14, 2016, compared to total capital of merely $40.4 billion, or less than 1 percent of assets-actually, 0.9 percent.
The largest Federal Reserve Bank by far, New York, sports $2.47 trillion 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 percent.
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 percent, to a 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 five years (it could be longer). If interest rates rise by 2 percent, the market value loss to the Fed is approximately 5 times 2 percent or 10 percent 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?
Image by Photographee.eu