The Federal Reserve System, more commonly known as the “Fed,” is the central banking system in the United States. As the term “central” implies, the Fed is the bank for other banks. As such, it plays a very important role in maintaining the stability of our financial system. Like other banks, the Fed basically uses a combination of its own money and deposits from others to make loans. The combination of these items can be expressed as a “capital ratio” which tells us how much of a bank’s assets are owned versus are borrowed. “Capital” can be defined in different ways, but regardless of the definition the lower the ratio is, the higher the borrowing or leverage is.
It’s important to keep an eye on these figures because history has shown us time and again that excessive leverage is a tell-tale sign of financial trouble. For example, when Lehman Brothers failed it had a capital ratio of around 3.33%. FNMA (Fannie Mae) went under around 2.50%. Currently, there are dozens of US banks teetering on the brink of failure with capital ratios in the low 2s. With that in mind, it’s unsettling to see that the Fed is sporting a capital ratio of about 1.85%!
Of course, the Fed has one major out that other banks don’t (not explicitly anyhow). As a semi-public entity, the Fed is ultimately backed by our tax dollars. That’s right, you, me, and our taxes will be paying for any losses the Fed takes. While that may be hard to swallow, it also means that this systemically important institution is unlikely to fail. It is, however, being grossly mismanaged. Levered to that extent, it won’t take much in losses to completely wipe out the Fed’s capital base – rendering it technically defunct and leaving everyone wondering “what happened to the Fed’s reserves?”
Victor K. Lai, CFA
This blog is for informational purposes only. Nothing on this blog constitutes investment advice. Bellwether Capital Management LLC does not provide tax or legal advice. You should conduct proper due diligence and/or consult with your professional advisers before taking any investment action.