Sorry to break the news to you, but you are exposed to the most leveraged bank in the U.S. All Americans are. Why? The most leveraged bank in the U.S. is the Federal Reserve. Yup, the Federal Reserve—the same bank that issues those green pieces of paper in your wallet. How levered is the Fed? It holds only $1 in capital for every $53 in assets. Before Lehman Brothers went bust, the firm held $1 in capital for every $30 in assets. How does that sit with you? Don’t forget those green pieces of paper are liabilities of the Federal Reserve—similar to a bank deposit. Pull one out of your pocket. It says “Federal Reserve Note” at the top. Would you willingly deposit your money in a bank that was levered 53 to 1? I wouldn’t. A mere 2% drop in the value of assets of a bank that is levered 53 to 1 could wipe out all of the bank’s capital. Yet we all happily exchange Federal Reserve notes with each other without questioning the balance sheet of their issuer.
You can’t help but laugh at the irony. Congress has given the most leveraged bank in the country regulatory authority over the too-big-to-fail banks. The inmates have been put in charge of the asylum. And the Fed, with its 53-to-1 leverage ratio, has the nerve to order the nation’s biggest banks to raise more capital. I’m not disputing that big banks should hold more capital. Any systemically important bank that is too big to fail should indeed hold additional capital, but has it occurred to anybody at the Fed that the central bank itself might fall into the systemically important category? Talk about the pot calling the kettle black.
The Fed is of course a unique bank. It is the only bank in the world that can print U.S. dollars. If the Fed’s capital were wiped out, it could easily be replenished. The Fed would simply print money, buy a few Treasury bonds, and use the interest to rebuild capital. But running a 53-to-1 leverage ratio isn’t prudent financial management, and it doesn’t offer foreign investors much confidence in the dollar as a store of value. If the Fed’s capital base were ever depleted, you might see turmoil in financial markets. At a leverage ratio of 53 to 1, that possibility is uncomfortably high.
Jeremy Jones, CFA
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