Ben S Bernanke: The Federal Reserve's balance sheet - an update
Speech by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal
Reserve System, at the Federal Reserve Board Conference on Key Developments in
Monetary Policy, Washington DC, 8 October 2009.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
To fight a recession, the standard prescription for a central bank is to lower its target
shortterm interest rate, thereby easing financial conditions and supporting economic growth. In the
current downturn, however, the Federal Reserve has faced two historically unusual
constraints on policy. First, the financial crisis, by increasing credit risk spreads and inhibiting
normal flows of financing and credit extension, has likely reduced the degree of monetary
accommodation associated with any given level of the federal funds rate target, perhaps
significantly. Second, since December, the targeted funds rate has been effectively at its
zero lower bound (more precisely, in a range between 0 and 25 basis points), eliminating the
possibility of further stimulating the economy through cuts in the target rate. To provide
additional support to the economy despite these limits on traditional monetary policy, the
Federal Open Market Committee (FOMC) and the Board of Governors have taken a number
of actions and initiated a series of new programs that have increased the size and changed
the composition of the Federal Reserve's balance sheet.
I thought it would be useful this evening to review for you the most important elements of the
Federal Reserve's balance sheet, as well as some aspects of their evolution over time. As
you'll see, doing so provides a convenient means of explaining the steps the Federal
Reserve has taken, beyond conventional interest rate reductions, to mitigate the financial
crisis and the recession, as well as how those actions will be reversed as the economy
recovers. I laid out some of these points in April at a conference sponsored by the Federal
Reserve Bank of Richmond, but a lot has happened in the intervening period and so an
update seems timely.1
For those of you who might be interested in learning more about the Federal Reserve's policy
strategy, by the way, an excellent source of information is a feature of the Board's website
titled "Credit and Liquidity Programs and the Balance Sheet."2 This source provides
extensive and regularly updated information on our programs and goes well beyond the
basic balance sheet data that we publish every week.3
To get started, slide 1 provides a bird's eye view of the Federal Reserve's balance sheet as
of September 30, the quarter end, with the corresponding data from just before the crisis for
comparison. As you can see, the assets held by the Federal Reserve currently total about
$2.1 trillion, up significantly from about $870 billion before the crisis. The slide shows the
principal categories of assets we hold, grouped (as I will explain) so as to correspond to the
various types of initiatives we've taken to address the crisis. The liability side of the balance
sheet, also summarized in slide 1, primarily consists of currency (Federal Reserve notes)
and bank reserve balances (funds held in accounts at the Federal Reserve by commercial
banks and other depository institutions). Later in my remarks, I will discuss the relationship
between Federal Reserve liabilities and broader measures of the money supply. I will also
discuss ways we can manage the link between the size of the Federal Reserve's balance
sheet and the broader money supply during the transition back to a more familiar framework
for monetary policy. Our capital, the difference between assets and liabilities, is about $50
billion.
The asset side of the Federal Reserve's balance sheet
Let's now look at the balance sheet in more detail, beginning with the asset side. For
decades, the Federal Reserve's assets consisted almost exclusively of Treasury securities.
Since late 2007, however, the share of our assets made up of Treasury securities has
declined, while our holdings of other financial assets have expanded dramatically. As slide 1
shows, putting aside the miscellaneous "other assets" category, which includes such diverse
items as foreign exchange reserves and the buildings owned by the Federal Reserve
System, the assets on the Federal Reserve's balance sheet can be usefully grouped into four
categories:
(1) short-term lending programs that provide backstop liquidity to financial institutions
such as banks, broker-dealers, and money market mutual funds;
(2) targeted lending programs, which include loans to nonfinancial borrowers and are
intended to address dysfunctions in key credit markets;
(3) holdings of marketable securities, including Treasury notes and bonds, the debt of
government-sponsored enterprises (GSEs) (agency debt), and agency-guaranteed
mortgage-backed securities (MBS); and
(4) emergency lending intended to avert the disorderly collapse of systemically critical
financial institutions. I will say a bit more about each of these in turn.
Short-term lending programs for financial institutions
The breakdown of the first category of assets - short-term lending programs for financial
institutions - is shown on slide 2. As you can see, these assets currently total about $264
billion, which is about 12 percent of the assets on the Federal Reserve's balance sheet. This
category of assets consists mainly of loans made directly or indirectly to sound financial
institutions. Such loans are fully secured by collateral and, in almost all cases, by recourse to
the borrowing institution, and are for maturities no greater than 90 days. Thus, they involve
very little credit risk; the Federal Reserve has suffered no losses on any of these loans.
From its beginning, the Federal Reserve, through its discount window, has provided credit to
depository institutions to meet unexpected liquidity needs, usually in the form of overnight
loans. The provision of short-term liquidity is, of course, a longstanding function of central
banks, and - as we know from Bagehot and earlier authors - a principal tool for arresting
financial panics.4 Indeed, when short-term funding markets deteriorated abruptly in August
2007, the Federal Reserve's first response was to try to increase the liquidity available to the
market by lowering the rate charged for discount window loans and by making it easier for
banks to borrow at term. However, as in some past episodes of financial distress, banks
were reluctant to rely on discount window credit, frustrating the Federal Reserve's efforts to
enhance liquidity. The banks' concern was that their recourse to the discount window, if it
somehow became known, would lead market participants to infer weakness - the so-called
stigma problem. To address this issue, in late 2007, the Federal Reserve established the
Term Auction Facility (TAF), which, as the name implies, provides fixed quantities of term
credit to depository institutions through an auction mechanism. The introduction of this facility
seems largely to have solved the stigma problem, partly because the sizable number of
borrowers provides a greater assurance of anonymity, and possibly also because the
threeday period between the auction and auction settlement suggests that the facility's users are
not using it to meet acute funding needs on a particular day. As slide 2 shows, as of
September 30, conventional discount window loans totaled $29 billion, and funds auctioned
through the TAF totaled $178 billion. These programs, along with similar lending by other
major central banks, appear to have helped stabilize the financial system here and abroad by
ensuring depository institutions access to ample liquidity. In particular, increases in Federal
Reserve loans to banks have been associated with substantial improvements in interbank
lending markets, as reflected, for example, in the sharp declines in the spread between the
London interbank offered rate, or Libor, and measures of expected policy rates.
Like depository institutions in the United States, foreign banks with large dollar-funding needs
have also experienced powerful liquidity pressures over the course of the crisis. This unmet
demand from foreign institutions for dollars was spilling over into U.S. funding markets,
including the federal funds market, leading to increased volatility and liquidity concerns. As
part of its program to stabilize short-term dollar-funding markets, the Federal Reserve
worked with foreign central banks - 14 in all - to establish what are known as reciprocal
currency arrangements, or liquidity swap lines. In exchange for foreign currency, the Federal
Reserve provides dollars to foreign central banks that they, in turn, lend to financial
institutions in their jurisdictions. This lending by foreign central banks has been helpful in
reducing spreads and volatility in a number of dollar-funding markets and in other closely
related markets, like the foreign exchange swap market. Once again, the Federal Reserve's
credit risk is minimal, as the foreign central bank is the Federal Reserve's counterparty and is
responsible for repayment, rather than the institutions that ultimately receive the funds; in
addition, as I noted, the Federal Reserve receives foreign currency from its central bank
partner of equal value to the dollars swapped. Because the loan to the foreign central bank,
as well as the repayment of principal and interest, are set in advance in dollar terms, the
Federal Reserve also bears no exchange rate risk in these transactions. Slide 2 shows the
current value of outstanding swap lines at $57 billion, down from $554 billion at the end of
last year, reflecting the marked improvement in dollar-funding markets across the globe.
In March 2008, following a sharp deterioration in funding conditions and the near failure of
the investment bank Bear Stearns, the Federal Reserve opened up its short-term lending
facilities to primary dealers.5 Discount window lending and swap lines are part of the Federal
Reserve's standard toolkit and are recognized in the Federal Reserve Act with provisions
specifically identifying and authorizing each practice. However, the extension of credit to
primary dealers is not authorized by the act in routine circumstances. To make these loans,
which we judged to be necessary for the stability of the financial system and of the economy,
the Board of Governors invoked general emergency lending authority provided by section
13(3) of the act, which allows the Federal Reserve to make secured loans under "unusual
and exigent" circumstances to any individual, partnership, or corporation. Using this
authority, the Federal Reserve made short-term collateralized loans available to primary
dealers through an analogue to the discount window called the Primary Dealer Credit Facility
(PDCF). In serving as a lender of last resort to this important class of financial institutions,
the Federal Reserve supported broader market and systemic stability. Reflecting a gradual
improvement in financial markets, outstanding PDCF credit dropped to zero this past spring.
For similar reasons, the Federal Reserve also invoked the 13(3) authority to provide liquidity
to another type of financial institution, money market mutual funds. The money fund industry
suffered a significant run in September 2008 after a prominent fund "broke the buck" - that
is, was unable to maintain a net asset value of $1 per share. Together with an insurance
program offered by the Treasury, the Federal Reserve's lender-of-last-resort activity helped
to end the run and stabilize the money funds. The final row of slide 2 shows that credit
outstanding under the Federal Reserve programs aimed at stopping the run on money funds
has also dropped essentially to zero.6
The unstinting provision of liquidity by the central bank is crucial for arresting a financial
panic. By the same token, the pricing and terms of central bank lending facilities should
discourage usage and encourage firms to return to the private markets when the panic
subsides. Slide 2 shows that this has been the case. Short-term lending to financial
institutions was zero in June 2007, just before the crisis began, and exceeded $1.1 trillion at
the end of last year. Currently, as I mentioned, this category has fallen to about $264 billion,
a decline of more than 75 percent since the turn of the year. We expect this trend to continue
as markets improve.
Targeted lending to address credit market dysfunction
The second category of assets on the Federal Reserve's balance sheet, shown on slide 3,
consists of targeted lending programs aimed at improving the functioning of certain key credit
markets, thereby providing critical support to the economy. Unlike the first category of assets,
some of these loans are to nonfinancial borrowers. As the slide shows, this category
comprises the Commercial Paper Funding Facility (CPFF) and the Term Asset-Backed
Securities Loan Facility (TALF). The current amount of credit outstanding under these
programs is about $84 billion, or four percent of the assets held by the Federal Reserve.
The commercial paper market is an important source of short-term funding for both financial
and nonfinancial firms in the United States. In September 2008, the collapse of the
investment bank Lehman Brothers set off a chain reaction: The money fund that broke the
buck, to which I just alluded, did so because of its losses on Lehman Brothers commercial
paper. Because money market funds are major investors in commercial paper, the run on the
money funds that ensued also severely disrupted the commercial paper market. During this
period, commercial paper rates spiked, even for the highest-quality firms. Moreover, most
firms were unable to borrow for terms longer than a few days, exposing both the borrowing
firms and the lenders to significant rollover risk. The Federal Reserve's CPFF addressed this
risk by offering to lend at a term of three months, at a rate above normal market rates plus
upfront fees, to high-quality commercial paper issuers. This program appears to have been
quite successful. Since the CPFF was created, commercial paper spreads have returned to
near-normal levels, and - as anticipated - borrowings from the CPFF have declined sharply,
from $334 billion at the turn of the year to less than $50 billion today.
Before the crisis, securitization markets were an important conduit of credit to the household
and business sectors; some have referred to these markets as the "shadow banking system."
Securitization markets (other than those for mortgages guaranteed by the government) were
virtually shut down in the crisis, eliminating an important source of credit.7 To address this
concern, the Federal Reserve, in conjunction with the Treasury, launched the TALF. Under
the TALF, eligible investors may borrow to finance purchases of the AAA-rated tranches of
certain classes of asset-backed securities. The program originally focused on credit for
households and small businesses, including auto loans, credit card loans, student loans, and
loans guaranteed by the Small Business Administration. More recently, we have added
commercial mortgage-backed securities to the program, with the goal of mitigating a severe
refinancing problem in that sector.
The TALF has had some success in restarting securitization markets. Rate spreads for
asset-backed securities have declined substantially, and we are seeing some market activity
that does not use the facility. Like our other programs, the TALF carries little credit risk for
the Federal Reserve, because we lend investors less than the value of the collateral and
because capital from the Treasury provides additional loss-absorption capacity. Unlike the
other programs, TALF credit outstanding has increased over time, as the loans made under
this program are for terms ranging from three to five years.
Relative to the Federal Reserve's short-term lending to financial institutions, the CPFF and
the TALF are rather unconventional programs for a central bank. I believe they are justified
by the extraordinary circumstances of the past year and by the need for the central bank's
crisis response to reflect the evolution of financial markets. Nonbank sources of credit, such
as the commercial paper market and the securitization markets, are critical to the U.S.
economy, especially compared with the more bank-centric economies of many foreign
countries. By backstopping these markets, the Federal Reserve has helped normalize credit
flows for the benefit of the economy.
Purchases of longer-term, marketable securities
The third major category of assets on the Federal Reserve's balance sheet is holdings of
high-quality, marketable securities - specifically, Treasury securities, agency debt, and
agency-backed MBS. As shown by slide 4, these holdings currently total about $1.6 trillion,
or about 75 percent of Federal Reserve assets. By way of comparison, slide 4 also shows
that, prior to the crisis, the Federal Reserve held $791 billion in securities, which was about
90 percent of its assets, and that all of these securities were Treasury obligations.
Even as other categories of assets shrink, Federal Reserve holdings of longer-term
securities are set to continue to rise in the near term and will increasingly dominate the asset
side of the balance sheet. As slide 4 shows, our holdings of securities declined from the
period before the crisis to the beginning of this year. The Federal Reserve announced in
November 2008 that it would begin to purchase agency debt and agency MBS; then in
March, it announced plans to increase such purchases to as much as $1.25 trillion in
agency-backed MBS and $200 billion in agency debt, and also announced plans to buy up to
$300 billion in Treasury securities.8 We recently indicated that we expect to purchase the full
$1.25 trillion of agency-backed MBS announced in March.9 The Treasury purchase program
is being completed this month, while the purchases of agency securities will be executed by
the end of the first quarter of 2010. Note, incidentally, that the Federal Reserve's purchases
of Treasury securities have served only to bring its holdings of U.S. Treasury debt back to
roughly the level of before the crisis. The principal goals of our recent security purchases are
to lower the cost and improve the availability of credit for households and businesses. As
best we can tell, the programs appear to be having their intended effect. Most notably,
30year fixed mortgage rates, which responded very little to our cuts in the target federal funds
rate, have declined about 1-1/2 percentage points since we first announced MBS purchases
in November, helping to support the housing market.
Support for specific institutions
In addition to the programs I have discussed, the Federal Reserve has provided financing
directly to specific systemically important institutions. In particular, with the full support of the
Treasury, we used our emergency lending powers to facilitate the acquisition of Bear Stearns
by JPMorgan Chase & Co. and also to prevent the imminent default of the insurance
company AIG. Slide 5 summarizes the amount of credit outstanding from these episodes.
From a credit perspective, these emergency loans obviously carry more risk than traditional
provisions of central bank liquidity. Two observations on this point are worth making: First,
these loans amount to less than five percent of the Federal Reserve's balance sheet. Thus,
Federal Reserve loans that are collateralized by riskier securities are quite small compared
with our holdings of assets with little or no credit risk. Second, and more important, these
financial risks were the result of actions taken to avert what likely would have been a
substantial further intensification of the financial crisis, with potentially dire economic
consequences.
All that said, we undertook these operations with great discomfort and only because the
United States has no workable legal framework for winding down systemically critical
financial institutions in a way that would allow firms to fail and their creditors to lose money
without inflicting massive damage on the financial system. The Administration and other
regulatory agencies have joined the Federal Reserve in calling on the Congress to develop a
special resolution regime for systemically critical nonbank financial institutions, analogous to
one already in place for banks, that could be invoked when the impending failure of such
institutions threatens financial stability. The rules governing such a regime should spell out
as precisely as possible the role that the Congress expects the Federal Reserve to play in
such resolutions.
The liability side of the Federal Reserve's balance sheet
Having reviewed the main categories of assets on the Federal Reserve's balance sheet, let
me touch briefly on the liability side (slide 6). The two main components of our liabilities are
Federal Reserve notes (that is, paper currency) and reserves held at the Federal Reserve by
depository institutions. In addition, as the government's fiscal agent, the Federal Reserve
holds Treasury deposits.
The amount of currency in circulation is determined by the public's demand. The "public"
here includes non-U.S. residents, as, by some estimates, more than one-half of U.S.
currency by value is held outside the country. Banks are required to deposit with the Federal
Reserve a certain quantity of reserves, which depends on the amount of customer deposits
that the banks hold.10 Reserves exceeding the required amounts are called excess reserves.
As you can see from slide 6, the large majority of bank reserves are currently excess
reserves.
Effectively, the Federal Reserve funds its lending and securities purchases primarily through
the creation of bank reserves. As you can see, the quantity of bank reserves held at the
Federal Reserve has risen dramatically as the Federal Reserve's balance sheet has
expanded, and reserves are likely to continue to grow as the Federal Reserve purchases
additional agency-backed securities. Currency and bank reserves together are known as the
monetary base; as reserves have grown, therefore, the monetary base has grown as well.
However, because banks are reluctant to lend in current economic and financial
circumstances, growth in broader measures of money has not picked up by anything
remotely like the growth in the base. For example, M2, which comprises currency, checking
accounts, savings deposits, small time deposits, and retail money fund shares, is estimated
to have been roughly flat over the past six months.
Large increases in bank reserves brought about through central bank loans or purchases of
securities are a characteristic feature of the unconventional policy approach known as
quantitative easing. The idea behind quantitative easing is to provide banks with substantial
excess liquidity in the hope that they will choose to use some part of that liquidity to make
loans or buy other assets. Such purchases should in principle both raise asset prices and
increase the growth of broad measures of money, which may in turn induce households and
businesses to buy nonmoney assets or to spend more on goods and services. In a
quantitative-easing regime, the quantity of central bank liabilities (or the quantity of bank
reserves, which should vary closely with total liabilities) is sufficient to describe the degree of
policy accommodation.
Although the Federal Reserve's approach also entails substantial increases in bank liquidity,
it is motivated less by the desire to increase the liabilities of the Federal Reserve than by the
need to address dysfunction in specific credit markets through the types of programs I have
discussed. For lack of a better term, I have called this approach "credit easing."11 In a
crediteasing regime, policies are tied more closely to the asset side of the balance sheet than the
liability side, and the effectiveness of policy support is measured by indicators of market
functioning, such as interest rate spreads, volatility, and market liquidity. In particular, the
Federal Reserve has not attempted to achieve a smooth growth path for the size of its
balance sheet, a common feature of the quantitative-easing approach.
Exit strategy
My colleagues at the Federal Reserve and I believe that accommodative policies will likely be
warranted for an extended period. At some point, however, as economic recovery takes hold,
we will need to tighten monetary policy to prevent the emergence of an inflation problem
down the road. Looking at the Federal Reserve's balance sheet is useful, once again, in
helping to understand key elements of the Federal Reserve's exit strategy from its current
policies (slide 7).
As we just saw in slide 6, banks currently hold large amounts of excess reserves at the
Federal Reserve. As the economy recovers, banks could find it profitable to be more
aggressive in lending out their reserves, which in turn would produce faster growth in broader
money and credit measures and, ultimately, lead to inflation pressures. As such, when the
time comes to tighten monetary policy, we must either substantially reduce excess reserve
balances or, if they remain, neutralize their potential effects on broader measures of money
and credit and thus on aggregate demand and inflation.
To some extent, excess reserves will automatically contract as improving financial conditions
lead to reduced use of our special lending facilities and, ultimately, to their closure. Indeed,
as I have already noted, the amount of credit outstanding in the first two categories of assets
(short-term lending to financial institutions and targeted lending programs) has already
declined substantially, from about $1.5 trillion at the beginning of the year to about $350
billion. In addition, reserves could be reduced by about $100 billion to $200 billion each year
over the next few years as securities held by the Federal Reserve mature or are prepaid.
However, even if our balance sheet stays large for a while, we have two broad means of
tightening monetary policy at the appropriate time - paying interest on reserve balances and
taking various actions that reduce the stock of reserves. In principle, we could use either of
these approaches alone; however, to ensure effectiveness, we likely would use both in
combination.
The Congress granted us authority last fall to pay interest on banks' balances at the Federal
Reserve. Currently, we pay banks an interest rate of 1/4 percent. When the time comes to
tighten policy, we can raise the rate paid on reserve balances as we increase our target for
the federal funds rate. In general, banks will not lend funds in the money market at an
interest rate lower than the rate they can earn risk-free at the Federal Reserve. Moreover,
they should compete to borrow any funds that are offered in private markets at rates below
the interest rate on reserve balances because, by so doing, they can earn a spread without
risk. Thus, the interest rate that the Federal Reserve pays should tend to put a floor under
short-term market rates. Raising the rate paid on reserve balances also discourages
excessive growth in money or credit, because banks will not want to lend out their reserves
at rates below what they can earn at the Fed. Considerable international experience
suggests that paying interest on reserves is an effective means of managing short-term
market rates. For example, the European Central Bank (ECB) allows banks to place excess
reserves in an interest-paying deposit facility. Even as the ECB's liquidity operations have
substantially increased its balance sheet, the overnight interbank rate has remained at or
above the ECB's deposit rate. The Bank of Japan, the Bank of Canada, and several other
foreign central banks have also used their ability to pay interest on reserves to maintain a
floor under short-term market rates.
Although, in principle, the ability to pay interest on reserves should be sufficient to allow the
Federal Reserve to raise interest rates and control money growth, this approach is likely to
be more effective if combined with steps to reduce excess reserves. I will mention three
options for achieving such an outcome.
First, the Federal Reserve could drain bank reserves and reduce the excess liquidity at other
institutions by arranging large-scale reverse repurchase agreements (reverse repos) with
financial market participants, including banks, the GSEs, and other institutions. Reverse
repos, which are a traditional and well-understood tool of monetary policy implementation,
involve the sale by the Federal Reserve of securities from its portfolio with an agreement to
buy the securities back at a slightly higher price at a later date. Reverse repos drain reserves
as purchasers transfer cash from banks to the Fed. Second, using the authority the
Congress gave us to pay interest on banks' balances at the Federal Reserve, we can offer
term deposits to banks, roughly analogous to the certificates of deposit that banks offer to
their customers. Bank funds held in term deposits at the Federal Reserve would not be
available to be supplied to the federal funds market. Third, the Federal Reserve could reduce
reserves by selling a portion of its holdings of long-term securities in the open market. Each
of these policy options would help to raise short-term interest rates and limit the growth of
broad measures of money and credit, thereby tightening monetary policy.
Overall, the Federal Reserve has a wide range of tools for tightening monetary policy when
the economic outlook requires us to do so. We will calibrate the timing and pace of any future
tightening, together with the mix of tools, to best foster our dual objectives of maximum
employment and price stability.
Conclusion
By using our balance sheet, the Federal Reserve has been able to overcome, at least
partially, the constraints on policy posed by dysfunctional credit markets and by the zero
lower bound on the federal funds rate target. By improving credit market functioning and
adding liquidity to the system, our programs have provided critical support to the financial
system and the economy. Moreover, we have carried out these programs responsibly, with
minimal credit risk and with close attention to the exit strategy. Our activities have resulted in
substantial changes to the size and composition of our balance sheet. When the economic
outlook has improved sufficiently, we will be prepared to tighten the stance of monetary
policy and eventually return our balance sheet to a more normal configuration.
BIS Review 124/2009
BIS Review 124/2009
BIS Review 124/2009