federal reserve facade 1
The facade of the Federal Reserve Bank.

Wealth & Poverty Review Fed Transfers Risk from Banks to You and Me

The Federal Reserve (i.e. the “Fed”) recently shifted a huge risk from the banking system to the taxpayer through something called the Bank Term Funding Program (BTFP).  The negative consequences of this historic action were lost on many because of the complex nature of the banking system.

To understand why this is bad for you and me, a little background is necessary.  The Fed has the responsibility of being the “lender of last resort” to the banking system since it stands ready to provide funds to banks that face a liquidity shortage. It does so through something called “discount window” by lending money and taking specific U.S. debt as collateral.

U.S. Treasuries (i.e. debt obligations issued by the United States government to raise cash needed to fund its operations and help finance the federal deficit) are often referred to as “risk free” because the U.S. Government guarantees to pay the bondholder in full at maturity. But if a bondholder decides to sell before maturity, the bond must be compared to similar bonds in the marketplace to reflect the current interest rate environment. If the current rate is higher than the rate the bond carries, then its value must be discounted for this unrealized lossto compete with current yields, and it is the value of this collateral which determines the amount that the Fed will lend.Given the recent hike in interest rates, the value of bonds purchased in the past few years has dropped sharply, but the Fed is willing to ignore any reduction in value and, instead, views the bonds as if they were maturing.

Up until BTFP (March 12, 2023), the collateral for a loan by the Fed was priced at its market value based on prevailing interest rates. BTFP changes this by determining the maximum lendable amount of the loan from the collateral’s market value at maturity — the “par value” (one hundred cents on the dollar).This ignores market value, thus removing the market risk from the banks that owned the securities and transferring this risk to the government.

Any competent financial planner will tell you that “diversification” is a critical component of risk management. A debt is more likely to be repaid if more than one debtor is responsible for it. The banking crisis of 2008 showed us the dangers of concentration — concentrating risk in one single asset class wreaked havoc on the whole banking system, demonstrating again the value of diversification of risk. An overwhelming degree of risk was concentrated in one specific asset class (real-estate), resulting in a credit event dangerous enough to threaten the overall economy for years and requiring huge federal bailouts. Indeed, the crisis was great enough for the Fed to embark upon a near-zero interest rate policy (ZIRP) for years.

The Fed is now saying that (for up to a year anyway, but who knows if they will decide to extend), they have eliminated the market risk on US Treasuries for banks when they are used at the discount window. In a very real sense, the Fed has created a line of additional credit for the banking system. The net effect of this action is that market risk on bonds eligible for collateral previously borne by the banking system is now borne by the US Federal Reserve. In one fell swoop, the Fed has concentrated the risk previously disseminated throughout the country’s banks, into their own or, more accurately, to the U.S. taxpayer, something that one would expect only Congress could arrange.

The pen is indeed mightier than the sword!