WORLDWORKS by Joe Pimbley

Editor’s Note: This is the next in a Continuing Series of Articles by Joe, as excerpted from his Book;“Banking on Failure” co-authored by Laurel McDevitt.

Previous excerpts for Chapter 8 discussed “History of Central Banks,” the “Stated Mission of Central Banks” and Monetary Policy Tools

Balance Sheet of a Central Bank

In our analysis of banks in chapter 5, we found the use and “picture” of balance sheets to be indispensable in understanding both the risk and operation of typical banks. Here we construct and discuss the balance sheet of a modern central bank with a focus on the Fed in the U.S. To aid the explanation, first let’s begin with an earlier vintage central bank during the era of the gold standard.

Bank of England circa 1870

Figures 8-1 and 8-2 below draw the balance sheets for the “Issue Department” and the “Banking Department” of the BoE, respectively, at the end of 1869.[1] As Bagehot notes, the Act of 1844 in Britain established these two halves of the BoE.[2] The Issue Department defined the currency. The legal tender of Britain in 1869 consisted of gold coins and bullion, silver coin (for small amounts only), and Bank of England (BoE) Notes.

Screen Shot 5Figure 8‑1 Bank of England at end of 1869

Figure 8-1 shows that the BoE’s £33.3 million of outstanding Notes (liability side) balanced Issue Department assets of £18.3 million of gold and £15.0 million of government debt securities. Of the several points of interest, the first is the evident “fractional reserve” aspect of Britain’s gold standard. Through the BoE Notes, the public had the right to claim £33.3 million of gold, much more than the BoE gold holdings of £18.3 million, in exchange for the Notes. Chapter 6 discussed fractional reserve banking and its origins in the practices of London goldsmiths. We see the nineteenth-century implementation here.

By issuing more Notes than gold reserves, the BoE increased the money supply by “printing” Notes. Consistent with our earlier discussion of open market operations (OMO), the BoE did not simply print the excess Notes and give them away. Rather, the BoE bought and held government debt securities as assets. The Act of 1844 limited this non-gold component to £15.0 million.[3]

A striking feature of the figure 8-1 balance sheet is the absence of equity (also known as “capital”). In the chapter 5 analysis of bank default risk, balance sheet leverage played a large role. For the BoE Issuing Department, it seems, the leverage would have been exceedingly high (essentially infinite) if there truly had been no equity. To appreciate the logic of “zero equity,” we must first acknowledge that the BoE Notes were not a typical liability. First, they paid no interest. Second, the Notes had no stated maturity. That is, the BoE notes entailed no future payment obligation of the BoE other than the noteholders’ potential demand on any day for redemption in gold.

The BoE Issuing Department did not have conventional need of equity because equity in this entity would not have reduced its default risk. Given that default risk sprang entirely from the extent to which the BoE held less gold (£18.3 million) than Notes issued (£33.3 million), equity was superfluous.

Next let’s move on to the BoE Banking Department balance sheet of figure 8-2. This Banking Department portion of the BoE is essentially the “real bank.” Though the Bank of England was Britain’s central bank, the BoE remained privately owned with private stockholders.[4] In fact, on the balance sheet’s liability side we do now see equity. Specifically, the liabilities are: (i) £14.6 million of “proprietors’ capital” (equity); along with (ii) £27.2 million of deposits and short-term bills; and (iii) £3.1 million of what appears to be “other equity” or long-term debt.[5]

Screen Shot 6Figure 8‑ 2 Bank of England at end of 1869

The BoE Banking Department assets consisted of £13.8 million of government debt, £19.8 million of “other securities” (likely debt), £10.4 million of BoE Notes, and £0.9 million of gold and silver coins. The sum of the BoE Notes and coins, £11.3 million, represented the Banking Department’s liquid reserve. Comparing this £11.3 million reserve to the immediately payable deposit liabilities of £27.2 million, the Banking Department’s reserve ratio was just greater than 40% (11.3 / 27.2). By modern terms, this reserve ratio of 40% was quite high (i.e., low risk). The equity capitalization of £14.6 million relative to total assets of £44.9 million was also quite high (i.e., low risk) relative to modern standards.[6]

Federal Reserve in 2014

We present in figure 8-3 the early 2014 balance sheet of the Fed, the U.S. central bank.[7] Ignoring de minimis items, the Fed assets consist only of $4.1 trillion of U.S. Treasury, government agency, and mortgage-backed debt obligations and $24 billion of foreign currency denominated assets (likely all foreign government debt obligations). The Fed liabilities are: (i) $1.2 trillion of Federal Reserve Notes (“paper currency”); (ii) $2.7 trillion of deposits almost all of which are payable to banks on demand; (iii) $230 billion of “reverse repo” borrowing that aids the Fed’s OMO mission;[8] and (iv) $56 billion of capital.

Screen Shot 7Figure 8‑3 Early 2014

The Fed balance sheet has no gold! Unlike Great Britain in 1870, the U.S. in 2014 does not define its legal tender as gold (or any other commodity or tangible item) or currency convertible to gold. Hence, there is no need for the Fed to own gold as an asset.[9]

Like the BoE Notes of 1870 Britain, the Federal Reserve Notes pay zero interest and have no maturity date or future payment obligation of any kind. Unlike that earlier central bank, the Fed is not required to convert Federal Reserve Notes to gold or anything else. Though technically the $1.2 trillion of Federal Reserve Notes are a balance sheet liability, there is no true liability in the plain meaning of this word.

The $2.7 trillion of deposits that banks and others hold with the Fed are, similarly, more like pseudo-liabilities than true liabilities. A bank that holds $10 billion in reserves, for example, may withdraw a portion of this amount as Federal Reserve Notes. The Fed would then print the Notes, provide them to the bank, and reduce the bank’s recorded deposit accordingly. Hence, deposits are fungible with Notes – both present no actual liability to the Fed. The bank with $10 billion in reserves might instead wish to pay another bank, say, $5 million to purchase a security. The Fed can simply reduce the first bank’s recorded deposit reserves by this $5 million and increase the second bank’s recorded reserves by the same amount.

Unlike a normal bank or private entity, it is not possible for the Fed to “run out of money.” The Fed creates currency (Notes) and deposits for any payments it makes. For example, the Fed assets include $4.1 trillion of various debt securities (arguably all connected with open market operations over the years). To purchase these assets, the Fed simply increased or created deposits recorded in the accounts of the bank dealers selling the securities.

The Fed or any central bank in such a fiat money system will never default on a payment obligation by “running out of money” because it can always create money. Default of a fiat-money central bank occurs only when the CB chooses to default.[10] For example, if the bank with $10 billion deposited with the Fed receives notice that the Fed is reducing the recorded balance to $9 billion as part of a program to shrink the money supply, this action would be a (voluntary) CB default on the $10 billion deposit liability.

Since there is no true risk that the Fed will default, involuntarily at least, on its debt liabilities, there is no need for equity. Yet the Fed does show $56 billion of equity on its balance sheet. Purchasers and owners of this capital are merely the member banks of the Federal Reserve System. These banks have no voting control, receive only a fixed interest rate on investment rather than the Fed’s net income, and have no effective control over Fed operations. The Federal Reserve Act of 1913 established this largely ceremonial ownership structure.

The absence of true liability to the central bank of currency and deposits in a fiat money economy suggests a new interpretation. Rather than a debt-like liability, currency and deposits are analogous to common equity of the CB. A normal corporate entity can exchange cash at will to increase or decrease its outstanding equity and has no repayment obligation to equity holders. This corporate activity mirrors a central bank conducting open market operations by expanding or shrinking “money” in exchange for debt securities. This analogy that “a country’s money is the country’s common equity” explains several aspects of foreign exchange trading.[11]

The next and final excerpt of Chapter 8 will revisit the old question of the independence of Central Banks.

[1] See chapter 2 of W. Bagehot, Lombard Street – a Description of the Money Market, Public Domain book, circa 1870.

[2] Id. In chapter 1, Bagehot notes as well that the Act of 1844, also known as “Peel’s Act,” remained highly controversial decades after its enactment.

[3] Id. Chapter 5 of C. W. Calomiris and S.H. Haber, Fragile by Design – The Political Origins of Banking Crises and Scarce Credit, Princeton University Press, 2014, states that this Act of 1844 imposed a requirement on the Bank of England to hold 100% gold reserves against Note issues. To clarify, this requirement pertained to new Note issues. In aggregate, as figure 8-1 shows, the BoE held gold in an amount well below total Note issuance.

[4] The British government nationalized the Bank of England in 1946. See, for example, http://www.bankofengland.co.uk/about/Pages/history/timeline.aspx#5 .

[5] See chapter 2 of W. Bagehot, Lombard Street – a Description of the Money Market, Public Domain book, circa 1870. This last entry of £3.1 million is labeled simply as “Rest” beneath “Proprietors’ capital.” We interpret the meaning as other equity, subordinated debt, or long-term debt.

[6] With these equity and asset values, the ratio is roughly 33% (14.6 / 44.9). Modern banks in the period 2005 to the present have equity ratios many times lower than this value (e.g., less than 5%).

[7] See the Fed’s balance sheet of February 26, 2014 and discussion in “Quarterly Report on Federal Reserve Balance Sheet Developments,” Board of Governors of the Federal Reserve System, March 2014. One may also find a more formal, audited balance sheet presentation for December 31, 2013 at http://www.federalreserve.gov/monetarypolicy/files/BSTcombinedfinstmt2013.pdf .

[8] As we noted earlier, what the Fed calls “reverse repo” transactions are in reality repo transactions by conventional definition. The Fed labels “repo” or “reverse repo” based on the opposing party’s position rather than its own. The Fed began in September 2013 executing “overnight fixed-rate reverse repurchase agreements” as part of its open market operations (OMO). See, for example, http://www.newyorkfed.org/markets/rrp_faq.html .

[9] The Fed did own a negligible quantity of gold certificates at the end of 2013 that it acquired from the U.S. Treasury. See these audited financial statements.

[10] In these last two sentences, we assume the CB has no liabilities in any currency other than the currency it controls (i.e., U.S. dollars for the Fed, Japanese yen for the Bank of Japan, et cetera).

[11] Specifically, when a CB increases the money supply, the value of its currency weakens relative to other (“foreign”) currencies. This is the same supply-demand dilution impact one sees with a corporate firm selling more equity. A CB that raises interest rates also strengthens the country’s currency. One may view this action as raising the “dividend of the equity” or as resulting from reduction of the money supply.


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Joe Pimbley
Joe is Principal of Maxwell Consulting, a firm he founded in 2010. Joe is expert in complex financial instruments, financial risk management (certified as FRM by the Global Association of Risk Professionals), valuation, structured products, derivatives, and quantitative algorithms. His recent and current engagements include financial risk management advisory, valuation and credit underwriting for structured and other financial instruments, and litigation testimony and consultation. In a prominent engagement from 2009 to 2010, Joe served as a lead investigator for the Examiner appointed by the Lehman bankruptcy court to resolve numerous issues pertaining to history’s largest bankruptcy. Joe and his colleagues discovered Repo 105 and also reported the critical importance of pledged collateral mishaps and mischaracterizations to the Lehman failure. Joe holds a Ph.D. in Theoretical Physics and is a co-author of Banking on Failure (2014), Simple Money (2013), and Advanced CMOS Process Technology (1989). He serves on several corporate and academic Boards, has written more than thirty finance articles, presented more than sixty finance seminars, and holds numerous patents for engineering inventions.
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