Background

As previously noted, the capital surplus account is adjusted to a level equal  to the paid-in capital account. This adjustment, however, is made at the end  of the calendar year. During the year, another capital account,  undistributed net income, reflects the amount of net earnings for the  current year that have not been distributed. Each week, the sum of the  balance in the capital surplus account and undistributed net income is  compared with the paid-in capital account. If the amount of the capital  surplus account and undistributed net income combined is greater than  capital paid-in, the excess is paid to the Treasury a week later. This  payment in turn reduces the undistributed net income account. At the end  of the calendar year, the balance in the undistributed net income is  transferred to the capital surplus account up to the amount of paid-in  capital. Any remaining balance is distributed to the Treasury.
Essentially, the capital surplus account represents earnings retained from  prior years, and the undistributed net income represents earnings retained  from the current year. Both the capital surplus account and the  undistributed net income account provide a cushion against losses. Any  Reserve Bank losses first reduce the undistributed net income account.  The capital surplus account is then reduced if the undistributed net income  account is not sufficient to absorb the loss.
Transfers of the Reserve Banks’ net earnings to the Treasury are classified  as federal receipts. Federal receipts consist mostly of individual and  corporate income taxes and social insurance taxes but also include excise  taxes, compulsory user charges, customs duties, court fines, certain license  fees, and the Federal Reserve System’s deposit of earnings.
The Treasury securities held by Reserve Banks are considered part of the  federal debt held by the public. Federal debt consists of securities issued  by the Treasury and a relatively small amount issued by a limited number of  federal agencies. Federal debt is categorized into debt held by the public  and debt held by government accounts. Debt held by the public is that part  of the gross federal debt held outside of federal budget accounts, and this  includes any federal debt held by individuals, corporations, state or local  governments, the Federal Reserve System, and foreign governments and  central banks.
The Consolidated Appropriations Act of 2000 directed the Reserve Banks  to transfer to the Treasury additional surplus funds of $3.752 billion during  fiscal year 2000. The Federal Reserve System transferred the funds on May  10, 2000. Under the act, the Reserve Banks were not permitted to replenish  their accounts during fiscal year 2000. Once the Reserve Banks were legally  permitted to replenish the accounts, they did. By December 31, 2000, the  capital surplus account was replenished for 11 of the 12 Reserve Banks.

	The Federal Reserve System Maintains a Capital Surplus Account to Cushion Against Losses

The Federal Reserve System maintains a capital surplus account to provide  additional capital to cushion against potential losses. However, Federal  Reserve Board officials have noted that it can be argued that a central  bank, including the Federal Reserve System, may not need to hold capital  to absorb losses, mainly because a central bank can create additional  domestic currency to meet any obligation denominated in that currency.  Federal Reserve Board officials acknowledged that determining the  appropriate level of a central bank’s capital account is difficult. The Federal  Reserve Board’s policy of maintaining the capital surplus account at the  same level as that of the paid-in capital account has resulted in the capital  surplus account growing from $4.5 billion in 1996 to $7.3 billion in 2001.
The Federal Reserve System maintains the capital surplus account  primarily as a cushion against losses. The Financial Accounting Manual  for Federal Reserve Banks states that the primary purpose of the Federal  Reserve capital surplus account is to provide capital to supplement paid-in  capital for use in the event of loss. According to Board officials, the capital  surplus reduces the probability that total Reserve Bank capital would be  wiped out by a loss as a result of dollar appreciation, sales of Treasury  securities below par value, losses associated with discount window  lending, or any other losses. Individual Reserve Banks use the capital  surplus account when they experience losses greater than the amount in  their undistributed net income account.
Federal Reserve Board officials also noted that it could be argued that  maintaining capital, including the surplus account, provides an assurance  of a central bank’s strength and stability to investors and foreign holders of  U.S. currency. Currently, a significant portion of U.S. currency is held  abroad. According to one estimate published by the Federal Reserve Board,  $279.5 billion in U.S. currency was held overseas as of the fourth quarter of  2001. The total amount of Federal Reserve notes outstanding was $611.8  billion as of December 31, 2001. Federal Reserve Board officials stated that  the demand for U.S. currency conceivably could fall if a large loss wiped  out the Federal Reserve’s capital accounts, giving a misimpression that the  Federal Reserve was insolvent. “In the abstract, a central bank with the nation’s currency franchise does not need to hold  capital. In the private sector, a firm’s capital helps to protect creditors from credit losses.  Creditors of central banks however are at no risk of a loss because the central bank can  always create additional currency to meet any obligation denominated in that currency.”
Moreover, an official representing one of the four foreign central banks that  we contacted agreed that the concept of solvency was essentially  meaningless for a central bank in its role as a creator of currency, and that  a massive loss could make a central bank technically insolvent, but that  there would be no impairment of its ability to create and manage assets and  issue currency. However, Federal Reserve Board officials told us that,  because the maintenance of the capital surplus account is “costless” to the  taxpayer and to the Treasury, the argument that a central bank does not  need capital is not a rationale for reducing the surplus to any particular  level, including zero. We will discuss the possible effects of a change in the  surplus account on the federal budget and the economy later in this report.
Federal Reserve Board officials told us that determining the appropriate  level for a central bank’s capital account is difficult. The growth in the  Federal Reserve System’s capital surplus account can be attributed to  growth in the banking system together with the Federal Reserve Board  policy of equating the amount in the capital surplus account with paid-in  capital. The Federal Reserve System surplus has grown along with the paid- in capital account which itself grew as a result of expansion of the banking  industry capital during the late 1990s. In 1996, the capital of all member  banks (state member banks and national banks) totaled almost $157  billion; by December 2001, it was $267 billion. Because the Federal Reserve  Act requires members to subscribe to a stock subscription equaling 6  percent of their capital and surplus, half of which is to be paid in, the  Reserve Banks’ capital paid-in accounts have increased along with member  bank capital and surplus. As a result of the Federal Reserve Board’s policy,  the Federal Reserve capital surplus account grew correspondingly. The  level of the Federal Reserve capital surplus account is not based on any  quantitative assessment of the potential financial risk associated with the  Federal Reserve’s assets or liabilities. According to a Federal Reserve  Board official, the current policy of setting the levels of surplus through a  formula reduces the potential for any misperception that the surplus is  manipulated to serve some ulterior purpose. In response to our 1996  recommendation that the Federal Reserve Board review its policies  regarding the surplus account, the Federal Reserve Board conducted an  internal study that did not lead to major changes in policy.

	Several Foreign Central Banks Maintain Accounts That Function Much Like the Federal Reserve Surplus Account

Three of the four central banks that we contacted had capital accounts that  included ownership shares as well as “surplus” accounts with functions  similar to the Federal Reserve System capital surplus account (see table 1).  We found the levels of these accounts varied in size and, with the exception  of the Bank of England, officials from the four central banks explained that  the levels were established by law. The Bundesbank and the ECB had also  established additional “provision” accounts that were not part of the  subscribed capital or surplus accounts, but that served as an additional  cushion against losses. The provision accounts were set up primarily to  offset the central banks’ exposure to foreign exchange rate and interest  rate risk and their levels are evaluated on an annual basis. In contrast to  these central banks, the Bank of Canada does not require an additional  account to buffer the impact of foreign exchange rate and interest rate  movements on their assets because it does not hold a significant amount of  assets denominated in currencies other than the Canadian dollar on its  balance sheet. Similarly, its domestic assets holdings of Canadian  government securities are diversified across maturities, approximately  mirroring the issuance of Canadian government securities. It should be  noted that accounts at the four central banks that we contacted are not  fully comparable with the Federal Reserve System capital surplus account  because of differences in accounting practices.
The Bundesbank and the ECB use accounting methods that differ from the  Federal Reserve’s to cushion against foreign currency risk and have set up  “revaluation accounts” representing valuation reserves arising from  unrealized gains on assets and liabilities, including foreign currency. The  levels of these accounts vary automatically in accordance with regular  market valuations of the assets held compared to their original cost.
The Bundesbank, bearing especially the foreign exchange risk in mind, has  established a “provisions” account. When determining how much to put  into this account, the Bundesbank evaluates its exposure to foreign  exchange risk and interest rate risk, to the extent of which these risks are  not already covered by the “revaluation account.” In addition to the  “provisions” account, the Bundesbank also has a  “statutory reserves”  account that serves as an additional financial buffer against risk. This  reserve account may be used only to offset falls in value and to cover other  losses. It is derived from the net profit each year and has a maximum level  established by legislation.
The levels of capital that the central banks maintain are not directly  comparable with the Federal Reserve’s capital (including the surplus  account) for several reasons. First, as previously described, there are  differences in the accounting systems among the central banks. The  Bundesbank and the ECB, for instance, use accounts that are not part of  capital to serve as a cushion against loss. Additionally, when determining  the levels of the “provisions” account, the Bundesbank and the ECB  evaluated their exposure to exchange rate and interest rate risk. The Bank  of Canada and the Bank of England, in contrast, do not face significant  foreign exchange rate exposure in their accounts.

	Reserve Banks Occasionally Have Used Funds from Their Surplus Accounts to Absorb Losses

The Federal Reserve System has not had an annual operating loss since  1915. From 1989 to 2001, the Reserve Banks incurred some weekly losses in  which their weekly earnings were not sufficient to absorb the losses. The  individual Reserve Banks drew on their capital surplus accounts at least  158 times to absorb weekly losses during the years of 1989 to 2001. The  frequency of transferring surplus funds to absorb losses declined during  the years from 1998 and 2001. Although numerous factors can influence a  Reserve Bank’s net earnings, it appears that most of the weekly losses  incurred by the Reserve Banks can be attributed to foreign currency  revaluation. Federal Reserve Board officials noted that since the Reserve  Banks began revaluing the Federal Reserve System’s foreign currency  holdings on a daily basis rather than a monthly basis in July 2001, they  expect the size of these revaluations will be reduced.

		Reserve Bank Earnings Were Not Sufficient to Absorb All of the Reserve Bank Weekly Losses

The individual Reserve Banks transferred funds occasionally from their  capital surplus accounts to absorb losses from 1989 through 2001. On the  basis of Federal Reserve Board data, 11 of the 12 Reserve Banks reported a  total of 352 weeks in which earnings were less than expenses and losses.  (The 352 weeks were out of 7,337 possible occurrences during the  approximately 13 years of data at the 11 Reserve Banks.)  The individual  Reserve Banks transferred from the capital surplus accounts cumulatively  158 times, when the weekly loss was greater than the amount in the  undistributed net income account. For the other 194 weekly losses, the  undistributed net income was sufficient to absorb the losses.
The amount and frequency of the weekly losses incurred and the use of the  capital surplus accounts varied across Reserve Banks. The Reserve Banks  did not incur losses at the same frequency or magnitude because their  portfolios of Treasury securities and foreign currency were not  proportional across Reserve Banks. The size of a Reserve Bank’s Treasury  securities portfolios is driven largely by the value of Federal Reserve notes  issued by the Reserve Bank, but the size of its foreign currency portfolio  is determined by the prior years’ capital and surplus account levels. Four of  11 Reserve Banks (Atlanta, Dallas, Kansas City, and Philadelphia) had to  transfer funds from their surplus accounts to cover more than 50 percent of  their weekly losses (see table 2). The remaining 7 Reserve Banks  transferred capital surplus funds that ranged from 26 percent to 46 percent  of their weekly losses.
The Federal Reserve Bank of Minneapolis (FRBM) is not included in the  table because, as explained below, the structure of its assets and liabilities  differed significantly from that of the other Reserve Banks over the period  surrounding the century date change and its results would bias the overall  results. If the FRBM’s capital surplus transfers were included, the  frequency would increase to 207 times. From May 2000 to December 2001,  FRBM drew down its surplus account 24 times to absorb its weekly losses,  compared with only 25 times for the entire previous 11-year period (from  Apr. 5, 1989, through Mar. 1, 2000). FRBM’s surplus has not been fully  restored to a level at which its value equates with its paid-in capital, and it  has not made a payment to the Treasury since the statutorily mandated  surplus transfer by the Consolidated Appropriations Act of 2000 was  completed in May 2000.
The Federal Reserve Board staff provided us with two reasons for this  condition. First, FRBM’s share of earnings was lower than that for the  average Reserve Bank compared with its share of the $3.752 billion transfer  in May 2000. According to a Federal Reserve Board official, FRBM’s lower  earnings resulted from its relatively small share of the System Open Market  Account compared with the other 11 Reserve Banks. For Year 2000  contingency purposes, FRBM stored a large amount of currency for the  other Reserve Banks. FRBM was selected because its bank building had a  large cash vault. To obtain currency to store for the other Reserve Banks,  FRBM had to purchase higher level of currency from the other Reserve  Banks. FRBM essentially purchased this currency by reducing its share of  the System Open Market Account. Secondly, increases in FRBM’s capital  paid-in account due to mergers and acquisitions by its member banks  increased the amount of capital surplus needed to match the value of its  paid-in capital. Federal Reserve Board staff expect that FRBM will resume  weekly payments to the Treasury in late 2002 or early 2003.
During the period from 1989 to 2001, none of the Reserve Banks, including  FRBM, entirely depleted their surplus accounts. Thus, the paid-in capital  accounts were never needed to cushion any of the weekly losses the  Reserve Banks incurred. After 1997, the frequency of capital surplus  transfers by the Reserve Banks was considerably lower. From 1998 to 2001,  the Federal Reserve System, excluding FRBM, averaged almost 5 surplus  transfers annually compared with the period from 1989 to 1997, when the  Federal Reserve System averaged over 15 surplus transfers annually. In  2001, the individual Reserve Banks, excluding FRBM, withdrew from their  capital surplus account a total of eight times for a cumulative total of  $292.4 million, almost 4.1 percent of the Federal Reserve System’s capital  surplus account.

		Revaluation of Foreign Currency Assets Appears to Be a Primary Reason for the Reserve Banks’ Losses

It appears that most of the weekly losses, which drew on the capital  surplus account, resulted from revaluation of foreign currency assets.  Federal Reserve Board officials told us that, in reviewing the data for the  losses, they could not recall or identify reasons other than foreign currency  revaluation as the primary reason for the weekly losses. Although the  Federal Reserve System’s asset portfolio is predominantly Treasury  securities, it does include foreign currency holdings. As of December 31,  2001, the Federal Reserve’s foreign currency holdings were equivalent to  $7.3 billion of euros, $7.2 billion of yen, and $65.6 million of interest  receivables. When the dollar appreciates against a foreign currency, the  value of the foreign currency holdings declines in dollar terms, and the  Reserve Banks may incur a loss. According to Federal Reserve officials,  such losses are the primary reason that Reserve Banks have drawn on their  capital surplus accounts. Federal Reserve Board data on the Reserve  Banks’ weekly losses that occurred since 1997 also suggested that the  losses resulted from downward revaluation of foreign currency assets.
Although none of the Reserve Banks’ capital surplus accounts were ever  entirely depleted, all of the capital surplus accounts were significantly  reduced by one particular foreign currency loss. During the week of April 3,  1991, every Reserve Bank, including FRBM, recognized a loss that drew  down their capital surplus accounts, reducing the Federal Reserve System’s  capital surplus by $1.67 billion. This loss represented almost a 67 percent  reduction in the Federal Reserve System’s capital surplus account. As of  December 31, 1991, the capital surplus account totaled $2.65 billion. For 10  of 12 Reserve Banks, the reductions in capital surplus that week were the  largest incurred for the 12-year period. The reductions that week ranged  from 49 percent to 93 percent of the respective Reserve Banks’ capital  surpluses. The Reserve Banks of Dallas and Philadelphia needed to  withdraw 91 percent and 93 percent of their capital surplus accounts,  respectively, to absorb the size of the loss. According to a Federal Reserve  Board official, the huge net weekly loss was caused by a sharp appreciation  of the U.S. dollar near the conclusion of the Gulf War.
Weekly losses resulting from revaluation of foreign currency holdings may  occur less frequently in the future because of a recent change in Federal  Reserve System’s procedures that resulted from the Federal Reserve Board  study that was conducted following our 1996 report. The Reserve Banks  now revalue their foreign currency holdings on a daily basis rather than a  monthly basis, and Federal Reserve Board staff told us that they expect  daily basis revaluations, which began in July 2001, will lessen the volatility  of these revaluations. Under the previous arrangement, the earnings of the  week during which the revaluation occurred had to absorb any revaluation  loss that had built up during the month since the previous revaluation,  often leading to losses during that week. Daily revaluations generally lead  to smaller revaluation losses than revaluing on a monthly basis, according  to Federal Reserve Board officials, making it less likely that they will  exceed weekly earnings.

	Reducing the Surplus Account Provides One-Time Increase in Federal Receipts but Yields No New Resources for the Federal Government

Reducing the Federal Reserve surplus account would create a one-time  increase in federal government receipts, thereby reducing the budget  deficit (or increasing the federal budget surplus) at the time of the transfer.  Because the Federal Reserve System is not included in the federal budget, a  Reserve Bank transfer to the Treasury is recorded as a receipt under  current budget accounting. This move would reduce future Reserve  Banks’ earnings and in turn reduce their transfers to the Treasury in  subsequent periods. Since the one-time transfer from the Federal Reserve  System also increases Treasury’s cash balance over time, the Treasury  would sell fewer securities to the public and thus pay less interest to the  public. Over time, the lower interest payments to the public approximately  offset the lower receipts from Federal Reserve earnings.
After the temporary capital surplus reduction in 2000, transfers of Reserve  Bank net earnings to the Treasury were lower as the Reserve Banks  replenished their capital surplus accounts. However, a permanent capital  surplus reduction would also reduce future Reserve Bank earnings because  the Reserve Banks would hold a smaller portfolio of securities. Since  reducing the surplus does not produce new resources for the government,  however, there would not be significant economic effects from its  reduction. “…the transfer of surplus funds from the Federal Reserve to the Treasury has no import for  the fiscal status of the Federal government… Where the funds reside has no economic  significance. Hence, any transfer of the Federal Reserve surplus fund to the Treasury would  have no effect on national savings, economic growth, or income.”
Permanently reducing the Federal Reserve System’s capital surplus  account would yield a one-time increase in federal receipts, under budget  accounting; the transfer would have no net budgetary effect in subsequent  years. Both OMB and Treasury officials told us that reducing the capital  surplus account would cause the Reserve Banks to sell some of their  Treasury securities portfolio. This move would reduce Reserve Bank  earnings and, in turn, reduce payments to the Treasury in subsequent  periods. This reduction in future transfers to the Treasury would occur  even if the Reserve Banks were not allowed to replenish their capital  surplus accounts.
As a hypothetical example, suppose that the Federal Reserve System were  to reduce permanently its surplus account by $1 billion, and, to simplify the  example, that it did so by selling $1 billion in Treasury securities at the end  of a fiscal year and transferring the proceeds to the Treasury. This one-time  transfer would increase federal revenues by $1 billion and, assuming no  changes in fiscal policy, reduce that year’s deficit by $1 billion. With a  smaller portfolio, the Reserve Banks’ annual earnings on their Treasury  securities would decline by about $43 million, on the basis of the August  2002 interest rate on newly issued 10-year notes. As a result, the Federal  Reserve’s annual payments to the Treasury would also decline by about $43  million for each of the next 10 years. This $43 million, however, is  approximately offset by a decrease in interest that Treasury must pay.
Receipt of the $1 billion permits Treasury to sell less debt to the public.  Continuing the hypothetical example, if the Treasury were to use the $1  billion to reduce its issuance of 10-year notes, its borrowing costs would  decrease by $43 million. Treasury’s continued outlays for interest on the $1  billion of securities that the Federal Reserve System sold would thus be  approximately offset by the interest expense that Treasury no longer would  incur in selling the new securities. OMB staff explained that it would be  impossible to quantify the exact budgetary effect of permanently reducing  the capital surplus account, since the securities that the Federal Reserve  System would sell to reduce the surplus account would not necessarily  have the same interest rate as those that Treasury would no longer sell, nor  the same interest rate as Treasury receives on its operating accounts held  at the Federal Reserve System.
In a provision of the Omnibus Budget Reconciliation Act of 1993,  Congress directed for fiscal years 1997 and 1998 that the amount in the  surplus account of any Reserve Bank in excess of the amount equal to 3  percent of the total paid-in capital and surplus of its member banks should  be transferred to the Treasury. Moreover, the act required that the surplus  accounts be reduced an additional $106 million in fiscal year 1997 and $107  million in fiscal year 1998 and that the amounts be transferred to Treasury.  These transfers were made on October 1, 1997, and 1998, respectively. Also,  under the act, the Reserve Banks were not permitted to replenish the  surplus for these amounts during fiscal years 1997 and 1998. As of  December 31, 1998, the capital surplus account and the paid-in capital  account were equal. Although the act did not specifically state the purpose  of those transfers, its effect was to reduce the federal government’s deficit  in those years.
The capital surplus transfer mandated by the Consolidated Appropriations  Act of 2000 resulted in a one-time increase in reported federal receipts but  was clearly offset by lower Reserve Bank net earnings payments to the  Treasury in the subsequent fiscal year. One reason for this is that the 2000  surplus reduction was temporary:  the act prohibited the Reserve Banks  from replenishing their surplus funds by the amounts they transferred in  that fiscal year but did not prohibit subsequent replenishment. As  previously stated, the Consolidated Appropriations Act directed the  Reserve Banks to transfer to the Treasury surplus funds of $3.752 billion  during fiscal year 2000. Under the act, the Reserve Banks were not  permitted to replenish the capital surplus amounts transferred during fiscal  year 2000. Because the Federal Reserve Board has discretion over how  much it transfers to the Treasury, the Reserve Banks began replenishing the  accounts as soon as they were legally allowed to in October 2000. To  replenish the capital surplus accounts, the Reserve Banks ceased payments  of their net earnings to the Treasury until the capital surplus accounts were  replenished. In November 2000, CBO reported that receipts from the  Federal Reserve System were $1 billion lower in October 2000 than they  had been in October 1999 because the Federal Reserve System had  temporarily stopped its weekly payments to the Treasury. Moreover, CBO  noted that the Reserve Banks were replenishing their capital surplus  accounts from earnings that would otherwise be paid to the Treasury and  were not likely to resume their weekly payments until December 2000 or  possibly later. Federal Reserve Board data on the replenishment of the  Reserve Bank surplus accounts indicated that the Reserve Banks of  Boston, Chicago, Dallas, Kansas City, and Philadelphia did not transfer any  earnings to Treasury for as long as 5 to 6 weeks.
Any reduction in the capital surplus account would not have a significant  effect on Treasury’s financial management, according to Treasury officials.  First, the capital surplus account represents a small fraction of the total  federal budget. The capital surplus account was $7.3 billion as of December  31, 2001, while total federal outlays during fiscal 2001 totaled $1,863.9  billion; thus the capital surplus account was less than 1/10 of 1 percent of  outlays. These officials observed that the capital surplus account balance  represented a small percentage of the total amount of Treasury securities  outstanding in a year. As of June 30, 2002, the total amount of Treasury  securities outstanding was $6,126.5 billion. Finally, these officials noted  that while the surplus account would be significant relative to Treasury’s  cash balances, these balances vary considerably on a monthly basis. While  Treasury monthly cash balances averaged about $24 billion in fiscal 2001,  for instance, average monthly balances ranged from $12.1 billion to $43.2  billion.

	Conclusions

The Federal Reserve System maintains the surplus account to absorb  losses. Since 1989, most of the weekly losses that resulted in using the  capital surplus account were apparently due to monthly revaluation of the  Federal Reserve System’s holdings of foreign currencies. In most cases, the  capital surplus account was replenished soon after absorbing the loss, and  no Reserve Bank ever completely depleted its capital surplus account.
Since 2001, however, the Federal Reserve System has begun recognizing  gains or losses on its foreign currency holdings on a daily basis rather than  a monthly basis. This change should lessen the use of the capital surplus  account. The surplus account has grown substantially since 1996, reflecting  the growth in the member banks’ capital and therefore their paid-in capital,  which the Federal Reserve System uses as the basis for determining the  targeted value of the surplus account.
Reducing the surplus account, however, would provide only a one-time  increase in measured federal government receipts, reflecting a transfer  from Reserve Banks to the Treasury. There would not be a significant  economic effect from reducing the surplus account.

	Agency Comments and Our Evaluation

We requested comments on a draft of this report from the Federal Reserve  Board, OMB, and the Treasury. The Federal Reserve Board’s comments are  reprinted in appendix II. The Federal Reserve Board said that it generally  agreed with the information in and conclusions of the report. The Federal  Reserve Board also noted that it had separately provided technical  corrections; we have incorporated these corrections where appropriate.  OMB and the Treasury declined comment, although their staffs provided  technical corrections that we have incorporated. We also obtained and  incorporated technical corrections on a draft of this report from CBO.
As agreed with your offices, unless you publicly release its contents earlier,  we plan no further distribution of this report until 30 days from its issuance  date. At that time, we will send copies of this report to the Chairmen and  Ranking Minority Members of the Senate Committee on Banking, Housing,  and Urban Affairs, and the House Committee on Financial Services. We will  also send copies to the Chairman of the Board of Governors of the Federal  Reserve System, the Secretary of the Treasury, the Director of the  Congressional Budget Office, and the Director of the Office of Management  and Budget. We will make copies available to others on request. In addition,  this report will be available at no charge on the GAO Web site at  http://www.gao.gov.
If you or your staff have any questions regarding this report, please contact  me or James McDermott, Assistant Director, at (202) 512-8678. Other key  contributors to this report were Nancy Eibeck and Josie Sigl.

Scope and Methodology

To describe the Federal Reserve System’s rationale for maintaining a  capital surplus account and to understand the capital accounts held at the  Reserve Banks, we interviewed Federal Reserve Board officials primarily  from the Division of Monetary Affairs and the Division of Reserve Bank  Operations and Payment Systems. We reviewed and analyzed sections of  the Federal Reserve Act pertaining to the paid-in capital and surplus  transfers and the Consolidated Appropriations Act of 2000. We also  reviewed the financial statements of the Reserve Banks from 1996 to 2001.
To review the policies and practices of foreign central banks regarding  accounts that serve similar functions as the capital surplus account, we  judgmentally selected four central banks: the Bank of Canada, the Bank of  England, the Bundesbank, and the European Central Bank. To verify our  interpretation of their published reports, legal requirements, and financial  statements, we contacted members of the staffs of the Bank of England and  Her Majesty’s Treasury (Treasury of the United Kingdom), the Bank of  Canada, the Bundesbank, and the European Central Bank. We collected  and reviewed annual financial statements from the four central banks for  the years from 1996 to 2001 to compare/contrast capital and surplus  accounts, and asset and liability structures. The comparability of these data  with the Federal Reserve Board is limited, however, due to differences in  accounting practices.
To describe the Reserve Banks’ use of the capital surplus account from  1989 to 2001, we analyzed historical data on weekly losses for all 12  Reserve Banks. These data included the net income or loss of the prior  Wednesday, the amount of weekly loss, the amount of the Treasury  payment, the amount of surplus withdrawn, the amount in the  undistributed net income, and the amount in the surplus before and after  the weekly loss. Federal Reserve Board staff collected the data from the 12  Reserve Banks’ balance sheet information. We did not audit Reserve Bank  accounting from which the data on the weekly losses were derived. Also,  we did not review any weeks during the time period that the Reserve Bank  revenues and gains for a week were greater than the expenses.  The data  we reviewed were for those weeks when the expenses and losses were  greater than the revenues and gains for each of the 12 Reserve Banks. The  data are limited on the identification of the cause of the weekly losses  incurred by the Reserve Banks. Federal Reserve Board staff confirmed the  cause for only those weekly losses that occurred during the time period of  1997 to 2001.
We also analyzed the Board of Governors of the Federal Reserve System’s  Annual Reports from 1996 to 2001 to determine the trend in both the  capital surplus and the paid-in capital accounts. To determine the reason  for the growth in the paid-in capital accounts, we reviewed Federal Reserve  Board data on the aggregate member bank capital and surplus from 1996 to  2001. According to Federal Reserve Board staff, the aggregate data  provided us were drawn from bank call reports.
To describe and determine the potential effects of reducing or eliminating  the surplus account on the federal budget and the economy, we  interviewed officials from the Federal Reserve Board, the Department of  the Treasury, the Office of Management and Budget, and the Congressional  Budget Office (CBO). We reviewed the Consolidated Appropriations Act of  2000 (P.L. 106-113, Section 302). We also reviewed reports from CBO on the  Reserve Banks’ transfers of net earnings to the Treasury.
We conducted our work in Washington, D.C., between April 2002 and  August 2002 in accordance with generally accepted government auditing  standards.

Comments from the Federal Reserve Board

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Summary:
What GAO Found

The Board of Governors of the Federal Reserve System (Federal Reserve Board) reviewed its policies regarding the size of the Federal Reserve Banks' combined capital surplus account to determine if opportunities exist to decrease the amount held in the account. The consolidated capital surplus account is the aggregate of separate surplus accounts held at each of the 12 Reserve Banks, and the account represents cumulative retained net earnings for the Reserve Banks--that is, cumulative net earnings not paid to the Department of the Treasury. The Reserve Banks use their capital surplus accounts to act as a cushion to absorb losses. The Financial Accounting Manual for Federal Reserve Banks says that the primary purpose of the surplus account is to provide capital to supplement paid-in capital for use in the event of loss. Selected major foreign central banks maintain accounts with functions similar to the Federal Reserve System's capital surplus account. Although their accounts are not fully comparable with the Federal Reserve System capital surplus account, the Bank of England, the Bundesbank, and the European Central Bank have capital surplus or reserve accounts in addition to their paid-in capital accounts that are used as cushions against loss. The Federal Reserve System calculates earnings and transfers excess earnings to the Treasury on a weekly basis. Although the Federal Reserve System has not had an annual operating loss since 1915, the Reserve Banks recorded some weekly losses between 1989 through 2001, thus temporarily reducing their capital surplus accounts to cover these weekly losses. Reducing the Federal Reserve System capital surplus account would create a one-time increase in federal receipts, but the transfer by itself would have no significant long-term effect on the budget or the economy. Amounts transferred to the Treasury from reducing the capital surplus account would be treated as a receipt under federal budget accounting but do not produce new resources for the federal government as a whole