```
                                                                 
Federal Reserve System: The Surplus Account (18-SEP-02, 	 
GAO-02-939).							 
                                                                 
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				 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-02-939 					        
    ACCNO:   A05099						        
  TITLE:     Federal Reserve System: The Surplus Account	      
     DATE:   09/18/2002 
  SUBJECT:   Bank reserves					 
	     Federal reserve banks				 
	     Budget surplus					 
	     Budget administration				 

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GAO-02-939

                                       A

Report to Congressional Requesters

September 2002 FEDERAL RESERVE SYSTEM The Surplus Account

GAO- 02- 939

Lett er

September 18, 2002 The Honorable Byron Dorgan The Honorable Harry Reid
United States Senate

Our 1996 report to you 1 recommended that the Board of Governors of the
Federal Reserve System (Federal Reserve Board) review its policies
regarding the size of the Federal Reserve Banks* combined capital surplus

account and 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 (Treasury). According to Board publications, the purpose of the

surplus account, a capital account, is to ensure that adequate capital is
available to absorb possible losses, such as losses in its foreign
currency holdings when the dollar appreciates against foreign currencies.
Since our 1996 report, the surplus account has grown from $4.5 billion to
$7. 3 billion as of December 31, 2001.

The Federal Reserve System includes the Board of Governors, a federal
agency, and 12 district banks (Reserve Banks) that are federally chartered
corporations. The Reserve Banks fund their operations primarily through
earnings on the Reserve Banks* portfolios of Treasury securities. The bulk
of Reserve Banks assets are in outright holdings of Treasury securities.
As of December 31, 2001, these assets accounted for about 84 percent of
Reserve Banks* assets.

The Reserve Banks use earnings to pay operational expenses and dividends
to member banks and to fund their capital surplus accounts. By practice,
the Reserve Banks transfer excess net earnings averaging about $500
million to the Treasury weekly, usually every Wednesday. In 2001, these

transfers amounted to more than $27 billion. However, the amount and
timing of the Reserve Banks* payments to the Treasury are not regulated by
law. The Federal Reserve Board has discretion over the amounts the Federal
Reserve System transfers to the Treasury. 1 U. S. General Accounting
Office, Federal Reserve: Current and Future Challenges Require Systemwide
Attention, GAO/ GGD- 96- 128 (Washington, D. C.: June 17, 1996).

Each of the 12 Reserve Banks maintains two capital accounts* a paid- in
capital account and a surplus account. The paid- in capital account
represents the contributions by member banks of the Federal Reserve
System. Under the Federal Reserve Act, members of the Federal Reserve
System, which include state- chartered banks that apply for and have been

granted membership and all national banks, must subscribe to the stock of
their respective Reserve Bank. The subscription is 6 percent of each
member bank*s capital and surplus. Half of the subscription amount is paid
by the member banks to the Reserve Banks* and is reflected in the Reserve
Banks* paid- in capital* and half is on call by the Federal Reserve

Board. 2 The Reserve Banks* paid- in capital changes frequently because
member banks* capital changes. Dividends paid by the Reserve Banks to the
member banks are set by law at the rate of 6 percent on paid- in capital
stock. The Reserve Banks* second capital account is the capital surplus
account.

According to Federal Reserve Board policy, this account is to be
maintained at a level equal to the paid- in capital. The capital surplus
account is funded from the Reserve Banks* earnings after operating
expenses and dividends are paid. In 2001, the value of the capital surplus
account was just over 1 percent of the total assets of the 12 Reserve
Banks. The capital surplus account is adjusted annually so that the target
level is equal to the amount in the paid- in capital account at the time
of the adjustment.

As agreed with your offices, the objectives of this report are to describe
(1) the Federal Reserve Board*s rationale for maintaining the capital
surplus account, (2) policies and practices of selected foreign central
banks regarding accounts that serve similar functions, (3) the frequency
and level

of use by the Federal Reserve Banks of their surplus accounts from 1989 to
2001, and (4) the potential effects of reducing the capital surplus
account on the federal budget and the economy. To address these
objectives, we interviewed officials from the Federal Reserve Board, the
Treasury, and the Office of Management and Budget (OMB); we also spoke
with officials from the Congressional Budget Office

(CBO). We obtained information on the Bank of Canada, the Bank of England,
the Bundesbank (Germany*s central bank), and the European

2 Ownership of Reserve Bank stock does not carry the usual rights of
control and financial interest ordinarily associated with being a
shareholder in a private- sector corporation.

Central Bank (ECB). We also analyzed Board data on the weekly losses that
the 12 Reserve Banks incurred from 1989 through 2001 to determine the
extent to which the Reserve Banks needed to draw down their capital
surplus accounts. Our scope and methodology is discussed in more detail in
appendix I. We conducted our work in Washington, D. C., between April 2002
and August 2002 in accordance with generally accepted government

auditing standards. Results in Brief 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.
Federal Reserve Board officials noted that the capital surplus account
absorbs losses that a Reserve Bank may experience, for example, when its
foreign

currency holdings are revalued downward. Federal Reserve Board officials
noted, however, that it could be argued that any 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. On the other hand, it
can

also be argued that maintaining capital, including the surplus account,
provides an assurance of a central bank*s strength and stability to
investors and holders of its currency, including those abroad. The growth
in the

Reserve Banks* capital surplus accounts can be attributed to growth in the
size of the banking system together with the Federal Reserve Board*s
policy of equating the amount in the surplus account with the amount in
the paidin capital account. The level of the Federal Reserve capital
surplus account is not based on any quantitative assessment of potential
financial risk associated with the Federal Reserve System*s assets or
liabilities. According to Federal Reserve officials, the current policy of
setting 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 capital surplus account, it conducted an
internal study that did not lead to major changes in policy. 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 ECB
have capital surplus or reserve accounts in addition to their paid- in
capital accounts that are used as cushions against loss. The Bank of

Canada does not require an account to buffer the impact of foreign
currency movements because it does not hold a significant amount of
foreign currency on its balance sheet. According to central bank
officials, the levels of these accounts were set by law for the Bundesbank
and the

ECB. In the United Kingdom, the level is negotiated between the Bank of
England and Her Majesty*s Treasury (Treasury of the United Kingdom). The
Bundesbank and the ECB have created additional accounts to cushion against
financial risk.

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. 3
Individual Reserve Banks relied on their capital surplus accounts at least

158 times during 1989 to 2001 to absorb weekly losses, primarily from
foreign revaluation losses, but the frequency of transferring surplus
funds to absorb losses declined during this time frame. 4 Although
numerous

factors can influence a Reserve Bank*s net earnings, in most cases,
according to Federal Reserve Board officials, these losses can be
attributed to increases in the U. S. dollar*s foreign currency value,
leading to lower values for the Reserve Banks* holdings of foreign
currency. Until 2001, the Federal Reserve System recognized foreign
currency revaluations at month*s end, a process that at times led to large
downward revaluations of foreign currency assets that would exceed the
Reserve Banks* earnings for that week, resulting in a weekly loss. The
capital surplus accounts were generally replenished from subsequent
earnings. According to Federal Reserve Board officials, the Federal
Reserve System now revalues its

foreign currency holdings on a daily basis rather than a monthly basis.
They 3 A weekly loss is defined as a week in which the Reserve Bank
expenses and losses are greater than the revenues and gains. The Federal
Reserve Board data we analyzed did not include the weeks in which the
revenues and gains for a week were greater than the expenses and any
losses. 4 These 158 weekly losses were out of 7, 337 possible occurrences
during the approximately 13 years of weekly data for the 11 Reserve Banks
included in this analysis. The analysis and number of weekly losses do not
include the Federal Reserve Bank of Minneapolis because it would skew the
overall total. The Federal Reserve Bank of Minneapolis, which will be
discussed in greater detail later in the report, had a lower level of
earnings relative to its capital than the other Reserve Banks. The Federal
Reserve Bank of Minneapolis*s lower

earnings were the result of its lower level of Treasury securities in
comparison to its other assets and capital than other Reserve Banks, which
primarily reflected its purchase and storage of currency issued by the
other Reserve Banks.

note that daily revaluations, which began in July 2001, generally lead to
smaller revaluation losses than do monthly revaluations. 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. Absent
offsetting policy changes, the one- time transfer would reduce the federal
budget deficit or increase the budget surplus at the time of the transfer,
and federal debt held by the public likewise would decrease by the amount
transferred. In turn, federal interest outlays on debt held by the public
would be lower in subsequent periods. However, Reserve Banks* earnings

payments to the Treasury also would be lower in subsequent periods because
the Federal Reserve would hold a smaller portfolio after the transfer.
Over time, lower receipts from Federal Reserve earnings would
approximately offset the lower interest payments to the public. 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. 5 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

5 If significant losses over the following week would cause this planned
payment to Treasury to exceed the undistributed net income, the payment
amount would be lowered to avoid reducing the capital surplus account.

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 6 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.

6 Pub. L. No. 106- 113, 13 Stat. 1501A- 304 (1999) 12 U. S. C. S: 289 (b)
(2000).

The Federal Reserve The Federal Reserve System maintains a capital surplus
account to provide

System Maintains a additional capital to cushion against potential losses.
However, Federal

Reserve Board officials have noted that it can be argued that a central
Capital Surplus bank, including the Federal Reserve System, may not need
to hold capital Account to Cushion

to absorb losses, mainly because a central bank can create additional
Against Losses

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. 7

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. 7 As of September 4,
2002, the paid- in capital account was $8. 2 billion. At the end of the
year,

the surplus account will be adjusted to reflect the growth in the paid- in
capital account.

Federal Reserve Board officials have acknowledged publicly the argument
that a central bank may not need capital to absorb losses because a
central bank can always meet its obligations in its own currency. We found
no widely accepted, analytically based criteria to show whether a central
bank needs capital as a cushion against losses or how the level of such an
account should be determined. In May 3, 2000, congressional testimony,
then Federal Reserve Board Governor Laurence H. Meyer stated the
following:

*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.*
8 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
paidin 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 8 Testimony of Laurence H. Meyer, Board of Governors of the Federal
Reserve System, Committee on Banking and Financial Services, U. S. House
of Representatives, May 3, 2000, p. 7.

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

Three of the four central banks that we contacted had capital accounts
that Central Banks Maintain included ownership shares as well as *surplus*
accounts with functions similar to the Federal Reserve System capital
surplus account (see table 1). Accounts That

We found the levels of these accounts varied in size and, with the
exception Function Much Like

of the Bank of England, officials from the four central banks explained
that the Federal Reserve the levels were established by law. The
Bundesbank and the ECB had also established additional *provision*
accounts that were not part of the Surplus Account subscribed capital 9 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. 9 Capital has broad
meaning and may include other accounts.

Table 1: Summary of *Surplus* Accounts Held at the European Central Bank,
the Bank of England, the Bank of Canada, and the Bundesbank Central bank
Arrangement

The European Central Bank The *general reserve fund* surplus account was
set up in accordance with the ECB statute and is funded through retained
net earnings each year within legally prescribed limits.

The Bank of England The Bank of England*s surplus account is the portion
of retained earnings that the Bank of England keeps every year after it
transfers a predetermined amount to the Treasury. Her Majesty*s Treasury
and the Bank of England negotiate a 5- year plan to determine the amount
that is transferred each year to the Her Majesty*s Treasury. The Bank of
England establishes its posttax profit (loss), pays over to the Exchequer
the

share agreed with the Treasury beforehand, and retains the remainder in
its capital reserve.

The Bundesbank Bundesbank officials told us that, in addition to the paid-
in capital and the statutory reserves, a *provisions* account was created
in accordance with Section 26 (2) of the Bundesbank Act for the *creation
of liability items for general risks associated with domestic and foreign
business.* The Bank of Canada Bank of Canada officials told us that they
do not have a surplus account because

foreign currency accounts for only about 1 percent of the Bank of Canada*s
assets. As a fiscal agent for the Canadian government, the bank manages
the government*s foreign currency reserves but does not keep a significant
amount of foreign reserve holdings on its books. Source: Central bank
officials and documents.

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. 10
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* 10 In
practice, these revaluation accounts show unrealized gains. If unrealized
losses from the previous year exceed the unrealized gains registered in
the revaluation account at the end of the financial year, they are then
transferred over to the profit and loss account as an expense.

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 The Federal Reserve System has not had an annual operating
loss since

Occasionally Have 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

Used Funds from Their individual Reserve Banks drew on their capital
surplus accounts at least Surplus Accounts to

158 times to absorb weekly losses during the years of 1989 to 2001. 11 The
Absorb Losses 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

The individual Reserve Banks transferred funds occasionally from their
Were Not Sufficient to capital surplus accounts to absorb losses from 1989
through 2001. On the Absorb All of the Reserve

basis of Federal Reserve Board data, 11 of the 12 Reserve Banks reported a
Bank Weekly Losses

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 11 The
Federal Reserve Bank of Minneapolis, which is not included in the total
because it would have skewed the overall total, is discussed later in this
section.

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, 12 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. 12 Federal Reserve notes outstanding are
considered a liability of the Reserve Banks. The primary asset counterpart
to the Federal Reserve liability for currency in circulation is the
Treasury securities and federal agency securities that each Reserve Bank
holds.

Table 2: Eleven Reserve Banks* Use of Surplus Account from 1989 to 2001
Percentage of their weekly

Maximum single Maximum single surplus

Number of surplus losses requiring surplus

surplus withdrawal withdrawal as a percentage

Reserve bank transfers funds

(millions) of the total surplus

Boston 5 26. 3% $47.3 49% New York 6 33. 3 344. 6 52 Philadelphia 21 61. 8
107.0 93 Cleveland 11 34.4 75.3 60 Richmond 18 40. 0 183.0 52 Atlanta 21
51. 2 216. 7 88 Chicago 13 46. 4 201. 2 67 St. Louis 7 36. 8 43. 9 69
Kansas City 17 50 66. 0 45 Dallas 24 55. 8 167. 5 91 San Francisco 15 38.
5 258.6 82

Total 158 N/ A N/ A N/ A

Note: This table does not include the Federal Reserve Bank of Minneapolis.
Source: Federal Reserve Board. 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 13 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 It appears that most of the weekly losses, which
drew on the capital Currency Assets Appears to

surplus account, resulted from revaluation of foreign currency assets. Be
a Primary Reason for the Federal Reserve Board officials told us that, in
reviewing the data for the

Reserve Banks* Losses 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 13 The
System Open Market Account includes the Federal Reserve System*s portfolio
of

Treasury and certain other securities that it has accumulated through open
market operations.

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. 14 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,

14 The Reserve Bank of Richmond*s largest single withdrawal from its
surplus account was for the week of April 4, 2001.

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 Reducing the
Federal Reserve surplus account would create a one- time Account Provides

increase in federal government receipts, thereby reducing the budget
deficit (or increasing the federal budget surplus) at the time of the
transfer. One- Time Increase in Because the Federal Reserve System is not
included in the federal budget, a

Federal Receipts but Reserve Bank transfer to the Treasury is recorded as
a receipt under current budget accounting. 15 This move would reduce
future Reserve

Yields No New Banks* earnings and in turn reduce their transfers to the
Treasury in Resources for the subsequent periods. Since the one- time
transfer from the Federal Reserve

Federal Government 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. While a Reserve Bank transfer to Treasury is recorded as a
receipt to the

government, such transfers do not produce new resources for the federal
government as a whole. As the nation*s central bank, the Federal Reserve
System carries out government functions, conducting monetary policy and
promoting the stability of the U. S. financial system. As the Federal
Reserve System describes itself, ** it is *independent within the
government. * It is 15 The 1967 President*s Commission on Budget Concepts
recommended that the Federal

Reserve System not be included in the federal budget even though it is a
government instrumentality and is clearly a federal government operation.
This recommendation was made for two main reasons: inclusion of the
Reserve Banks in the budget might jeopardize the flexibility and
independence of the monetary authorities and projection of operations
forward* as would be required if the banks were included in the budget*
did not appear feasible.

not outside the government.* The Federal Reserve System*s holdings,
including the capital surplus account, may enhance the ability of the
Federal Reserve System to perform these and other government functions.
Reducing the capital surplus account and transferring to the Treasury
would not move resources from private purposes to government purposes.

Thus, the transfer, by itself, would have no significant long- term
economic effects. CBO similarly concluded

** 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.* 16 [Emphasis in original.]

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 16 Congressional Budget Office, Cost Estimate for H. R. 974,
Small Business Interest Checking Act of 2001, April 3, 2001, p. 8.

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, 17
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.
18 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 17 Pub. L. 103- 66, Title III, S: 3002. 107 Stat. 337
(1993).

18 Section 3002( a) of the Omnibus Budget Reconciliation Act of 1993
amended the Federal Reserve Act to provide, in pertinent part, as follows:
*( 3) REPLENISHMENT OF SURPLUS FUND PROHIBITED.* No Federal reserve bank
may replenish such bank*s surplus fund by the amount of any transfer by
such bank under paragraph (1) during fiscal years 1997 and

1998.* Pub. L. No. 103- 66 S: 3002( a) (1993). The transfer amounts under
paragraph (1) were $106 million in fiscal year 1997 and $107 million in
fiscal year 1998.

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. 19

19 Treasury*s operating cash is maintained in an account at the Federal
Reserve Bank of New York as well as in tax and loan accounts in other
financial institutions.

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 We requested comments on a draft of this report from
the Federal Reserve

Our Evaluation 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.

Thomas J. McCool Managing Director, Financial Markets and

Community Investment

Appendi Appendi xes x I

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.

Appendi x II

Comments from the Federal Reserve Board (250070)

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a

GAO United States General Accounting Office

Page i GAO- 02- 939 Federal Reserve System

Contents Letter 1

Results in Brief 3 Background 5 The Federal Reserve System Maintains a
Capital Surplus Account to Cushion Against Losses 7

Several Foreign Central Banks Maintain Accounts That Function Much Like
the Federal Reserve Surplus Account 9 Reserve Banks Occasionally Have Used
Funds from Their Surplus

Accounts to Absorb Losses 11 Reducing the Surplus Account Provides One-
Time Increase in Federal Receipts but Yields No New Resources for the
Federal

Government 16 Conclusions 20 Agency Comments and Our Evaluation 20

Appendixes

Appendix I: Scope and Methodology 22

Appendix II: Comments from the Federal Reserve Board 24 Tables Table 1:
Summary of *Surplus* Accounts Held at the European

Central Bank, the Bank of England, the Bank of Canada, and the Bundesbank
10 Table 2: Eleven Reserve Banks* Use of Surplus Account from 1989 to 2001
13

Abbreviations

CBO Congressional Budget Office ECB European Central Bank FRBM Federal
Reserve Bank of Minneapolis OMB Office of Management and Budget

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Appendix I Scope and Methodology

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Appendix II

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