The Fastest Growing Bank in the West

Source: Boiling Frogs Post
Bill Bergman

Defending our Future in the Financial System

 

Investors and regulators are frequently cautioned that rapid growth in banking can be a sign of trouble.  With most of their incoming cash protected by public guarantees like deposit insurance, banks can grow by taking on more risk without as much sensitivity to deposit costs as they would if the public safety net were not in place.

For example, the Office of the Comptroller of the Currency (a bank regulator) produces “An Examiner’s Guide to Problem Bank Identification, Rehabilitation, and Resolution.”   In listing six ‘red flags,’ the guide’s first red flag, front and center, is ‘Rapid Growth and Aggressive Growth Strategies.’  This section includes:

Excessive growth, particularly as measured against local, regional, and national economic indicators, has long been viewed as a potential precursor to credit quality problems. Such growth can strain bank underwriting and risk selection standards, as well as the capacity of management, existing internal control structures and administrative processes.

Over the last six years, amidst the worst financial and economic crisis since the Great Depression, a large and significant player in the financial markets has also been one of the fastest growing banks on the planet.  That organization is the Federal Reserve Bank of New York.


What a Financial Crisis Can Do to a Central Bank Balance Sheet

Total assets on the books of the 12 Federal Reserve Banks came to $2.9 trillion by year-end 2011.  The Reserve Bank balance sheets have mushroomed in recent years; their total assets rose sharply with the Fed buying investments from, and lending money to, the private sector.  Their total liabilities also rose sharply as bank deposits at Federal Reserve Banks jumped due to monetary policy actions, and as banks had higher confidence in holding deposits with Reserve Banks compared to holding them at other banks.

Here is a look at total year-end assets on the books of the Federal Reserve Banks since 2003.

 

By year-end 2011, total assets were four times as high as they were at the end of 2003.  The Federal Reserve Bank of New York, with large institutions in New York and internationally at the center of the financial crisis, led the way.  And despite the cessation of the crisis, at least in the US, growth at the New York Fed accelerated again in 2011, likely due to its actions relating to the crisis in Europe.  By year-end 2011, Federal Reserve Bank of New York assets totaled over five times where they were in 2003.

Your Risk, While Standing Behind The Federal Reserve Banks

In Terminator 2: Judgment Day, the Terminator (Arnold Schwarzenegger) protects people in part by standing in between them and flying bullets.  You and I aren’t Terminators, though, and we stand behind the Reserve Banks while they extend credit to large financial institutions.  If the credit goes bad, the Federal Reserve Banks, and taxpayers, take the hit.

In June 2011, former Federal Reserve executives William Ford and Walker Todd penned an article in Barron’s titled “The Fed’s Risky Business: Why Uncle Sam Doesn’t Want You To Know About This Government Gamble.”  Ford and Todd noted the Federal Reserve’s large earnings increase reported for 2010, but also made the case that citizens should view earnings reports from the Fed with caution.  The Fed doesn’t follow GAAP while reporting earnings for the Reserve Banks, and does not mark its largest assets to market (or ‘fair value’) while preparing financial statements. 

In turn, Ford and Todd also noted that the Fed’s large reported earnings increase in recent years has been generated in part with higher risk.  The expansion in the Fed’s balance sheet has also generated significantly higher leverage – by year-end 2011, Reserve Banks’ capital came to just 1.8% of total assets, down from 4.1% in 2007.  Other things equal, higher leverage means higher risk, as a given change in asset value has a higher impact on capital for a more highly levered enterprise.  And a capital/asset ratio of 1.8% is a very high leverage (or gearing) ratio, even for a financial firm.

How This Matters for Payment System Risk, and the Law

As noted in an earlier article for Boiling Frogs, payment system operations make up a third important stool in Fed operations (in addition to monetary policy and the supervision and regulation of banks).  The Federal Reserve’s interbank payment system, Fedwire, moves over one trillion dollars a day among banks with access to it.  The Federal Reserve guarantees all payments over this system to receiving banks, even if sending banks do not have sufficient reserves at the time the Fed processes the payment.  The result is something called a ‘daylight overdraft.’  And during the height of the financial crisis in late 2008, daylight overdrafts on Fedwire were mushrooming; total overdrafts on the Fed’s funds and securities wires rose to nearly $280 billion at their peak.

When the Fed flooded the banking system with reserves through its monetary policy and other actions in late 2008 and early 2009, bank needs for daylight credit declined considerably.  The decline in this credit reduced the risk of loss to the Reserve Banks through the Fedwire system.  But there’s no such thing as a free lunch, the saying goes.  The Fed’s risk on this system declined because of its monetary policy and related actions, and those actions helped lead to higher risk with the massive increase in the Federal Reserve Bank balance sheets.

In the late 1990s, while making their case for the Fed’s position in the hierarchy of financial market supervisors, members of the Federal Reserve Board of Governors were repeatedly referring to access to Fedwire as a source of subsidy for banks.  This certainly appears warranted, when considering how the Fed prices that system and the small rates charged for daylight overdrafts.  Some Fed leaders, including former Chairman Greenspan, explicitly referenced the Fed’s assumption of risk on Fedwire as a source of subsidy.  But the Fed also regularly asserts that Fedwire is NOT a source of subsidy, given that the Fed prices the service to fully recover its costs. 

And the requirement that the Fed fully recovers its Fedwire costs isn’t a matter of independent choice, at least for the Fed.  It has been in place ever since Congress passed the Monetary Control Act, in 1980.  This legislation explicitly required the Fed to fully recover all direct and indirect costs while pricing its payment services.

Assume, as seems quite plausible, that the Fed has NOT priced the Fedwire service (which moves over a trillion dollars a day) to fully recover its cost.  That was a significant source of moral hazard, particularly in light of the Fed’s guarantees on the system, and one component of the overextension and undercapitalization of the largest players in our financial markets heading into the recent financial crisis. Despite law to the contrary.

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Bill Bergman has 10 years of experience as a stock market analyst sandwiched around 13 years as an economist and financial markets policy analyst at the Federal Reserve Bank of Chicago. He earned an M.B.A. as well as an M.A. in Public Policy from the University of Chicago in 1990. Mr. Bergman is currently working with Social Movement Sciences LLC, a new enterprise developing evaluation and funding services for not-for-profit organizations.