Federal Reserve System: Potential Implications of Modifying the Capital Surplus Account and Stock Ownership Requirement
Released: 2017-02-24T00:00:00


Highlights: section_title: Why GAO Did This Study
paragraphs: Member banks of the Federal Reserve must purchase stock in their regional Reserve Bank, but historically received a 6 percent dividend annually on paid-in stock. A provision of the 2015 FAST Act modified the dividend rate formula for 85 larger member banks—and currently reduces the amount these banks receive. The FAST Act also capped the surplus capital the Reserve Banks could hold and directed that any excess be transferred to Treasury's general fund. Congress offset payments into the Highway Trust Fund by, among other things, instituting the Reserve Bank surplus account cap.

GAO was asked to report on the effects of these changes and the policy implications of modifying the stock ownership requirement. Among its objectives, this report (1) examines the effects of capping the Reserve Banks' aggregate surplus account and reducing the Reserve Bank stock dividend rate, and (2) evaluates the potential policy implications of modifying the stock ownership requirement for member banks under three scenarios.

GAO reviewed legislative history and relevant literature about the Federal Reserve, prior GAO reports, and interviewed academics and current and former officials of the Board of Governors, Reserve Bank, other banking regulators, and industry associations. In addition, GAO conducted structured interviews with 17 commercial banks, selected based on bank size and regulator.

GAO makes no recommendations in this report. GAO requested comments from the banking regulators and Treasury, but none were provided.

section_title: What GAO Found
paragraphs: According to Federal Reserve System (Federal Reserve) officials, capping the surplus account had little effect on Federal Reserve operations, and GAO found that modifying the stock dividend rate formula had no immediate effect on membership. Reserve Banks fund operations, pay dividends to member banks, and maintain a surplus account before remitting excess funds to the Department of the Treasury (Treasury). Whether the transfers to Treasury's General Fund in the Fixing America's Surface Transportation Act (FAST Act) when the act also funds specific projects should be viewed any differently than the recurring transfers of Reserve Bank earnings to Treasury is debatable. Some stakeholders raised concerns about setting a precedent—future transfers could affect the Federal Reserve's independence and, consequently, autonomy in monetary policymaking. Dividend payments to 85 banks decreased by nearly two-thirds (first half of 2016 over first half of 2015), but GAO found no shifts in Reserve Bank membership as of December 2016. Some member banks affected by the rate change told GAO they had a few concerns with it and some said they might try to recoup the lost revenue, but none indicated they would drop membership.

Assuming that the policy goals—independence, balance of power, and geographical diversity—reflected in the original private-public Federal Reserve structure remain important, the implications of modifying the stock ownership requirement and therefore the Federal Reserve structure could be considerable. The scenarios discussed in this report are illustrative and do not represent all the ways in which the Federal Reserve structure might be altered. Also, the discussion of effects is limited because exact replacement structures are unknown. Retiring the stock could result in changes to the existing corporate structure of the 12 Reserve Banks. These changes could

diminish Reserve Bank autonomy in relation to the Board of Governors of the Federal Reserve System (Board of Governors) by removing or changing Reserve Banks' boards of directors, which could limit the diversity of economic viewpoints in monetary policy discussions and centralize monetary policy decision making in the hands of the Board of Governors,

eliminate the private corporate characteristics of Reserve Banks and convert them to government entities (such as field offices of the Board of Governors), which could lead to less private sector involvement and reduced financial independence of the Federal Reserve, and

remove the authority the Reserve Banks currently have to conduct activities critical to the Federal Reserve, such as executing monetary policy through open market operations and those related to the Reserve Banks' role as fiscal agents for the federal government.

Making stock ownership voluntary could increase fluctuations in outstanding shares, affecting Federal Reserve governance and complicating the Reserve Banks' processes for managing their balance sheets. While modifying the stock ownership requirement could give member banks greater control of the capital tied to the stock, member and nonmember banks with which GAO spoke indicated that they likely would not change their membership in response to any modifications discussed in this report.

section_title: Letter
paragraphs: The Federal Reserve System (Federal Reserve) consists of the Board of  Governors of the Federal Reserve System (Board of Governors), 12  regional Reserve Banks that are federally chartered corporations with  boards of directors, and the Federal Open Market Committee (FOMC). To  become a member of the Federal Reserve, a commercial bank (that is,  one offering banking services to the general public or to businesses) is  required to subscribe to stock in its regional Reserve Bank. Only one-half  of the stock subscription is paid to the Reserve Bank upon joining the  Federal Reserve and the remainder is subject to call and payable on  demand by the Reserve Bank. Membership, and thus stock ownership, in  the Federal Reserve is required of all nationally chartered banks, while  state-chartered banks may become members if they opt to and meet  certain requirements. By statute, historically each member bank received  a fixed 6 percent dividend annually on the amount of paid-in stock, an  illiquid investment which cannot be sold or pledged as collateral.

In addition to the amount of the paid-in stock, the capital accounts of each  Reserve Bank include a capital surplus account that is intended to ensure  adequate capital is available to absorb possible losses. After paying its  operating expenses and dividends, each Reserve Bank funds the capital  surplus account, which, prior to December 2015, was equivalent to the  amount of paid-in capital from member banks. Any remaining earnings  are transferred to the Department of the Treasury (Treasury).

In December 2015, the Fixing America’s Surface Transportation Act  (FAST Act) (which reauthorized the Highway Trust Fund) modified the  formula for dividends paid to certain large member banks by the Reserve  Banks. The FAST Act changed the rate from 6 percent to the lesser of 6  percent or the highest accepted yield at the most recent auction of 10- year Treasury notes prior to the dividend payment date. This new  dividend rate formula only applies to member banks with assets of more  than $10 billion and currently results in dividend payments to these  institutions that are significantly lower than 6 percent. The FAST Act also  capped the aggregate of the Reserve Banks’ surplus accounts at $10  billion and directed that any amounts of the surplus funds of the Reserve  Banks that exceed, or would exceed, that amount be transferred to  Treasury’s General Fund. The Federal Reserve transferred a total of  $117 billion to Treasury’s General Fund during 2015. Of that amount, $19  billion was the amount necessary to reduce the Reserve Bank surplus  accounts to the aggregate $10 billion surplus cap specified in the FAST  Act. Under the Board of Governors’ previous policy of retaining surplus  accounts in an amount equal to paid-in capital, the aggregate of the  surplus accounts was approximately $29 billion in December 2015. The  FAST Act also authorized the transfer of $70 billion from Treasury’s  General Fund to the Highway Trust Fund, and the transfer was offset, in  part, by instituting the Reserve Bank surplus account cap.

You requested that we report on the implications of the dividend rate  change and modifying or eliminating the existing requirement that all  member banks purchase Reserve Bank stock. In this report, we (1)  examine the historical rationale for the Reserve Banks’ stock purchase  requirement and 6 percent dividend, (2) assess the potential implications  of capping the aggregate Reserve Bank surplus account and modifying  the Reserve Bank stock dividend rate, and (3) analyze the potential policy  implications of modifying the Reserve Bank stock ownership requirement  for member banks under three scenarios.

For our first objective, we conducted a literature search on the history of  the Federal Reserve, including the legislative history of the Federal  Reserve Act. We also conducted a literature search on rates of return on  selected investment products dating back to the 1850s. See appendix II  for a selected bibliography of historical accounts we reviewed for this  report. We determined that the sources of the rates of return data were  sufficiently reliable for the purposes of our reporting objectives. In  addition, we interviewed a past Federal Reserve historian and selected  academics.

To assess the potential implications of capping the aggregate surplus  account, we reviewed past GAO, Congressional Research Service, and  Congressional Budget Office reports and Board of Governors financial  documents on the status of the surplus account. We interviewed Federal  Reserve officials, including from the Board of Governors and the 12  Reserve Banks; former members of the Board of Governors who had  written about the changes in the FAST Act; academics who had written  extensively about the Federal Reserve; other federal bank regulators,  including the Federal Deposit Insurance Corporation (FDIC) and the  Office of the Comptroller of the Currency (OCC); and, banking industry  associations. To assess the potential implications of modifying the  Reserve Bank stock dividend rate, we reviewed Board of Governors  financial documents as of June 30, 2016, for dividend payment  information. We also conducted structured interviews with 17 commercial  banks (14 members and 3 nonmembers) to gain their perspectives on the  dividend rate modification and if it would affect their decision to be a  member of the Federal Reserve. We selected the commercial banks to  ensure representation for all size categories and primary federal banking  regulator, using data from SNL Financial. We assessed the reliability of  the data by reviewing information about the data and systems that  produced them, and by reviewing assessments for previous GAO studies.  We determined that the data we used remain sufficiently reliable for the  purposes of our reporting objectives.

To assess the potential implications of modifying the stock ownership  requirement, we reviewed academic literature on the structure and  independence of central banks. We also interviewed selected academics  and economists who had written extensively on central bank  independence; the chairpersons of the board of directors for each  Reserve Bank, who may not be affiliated with commercial banks; staff  from FDIC and OCC; and banking industry associations. In the structured  interviews with commercial banks (described above), we also sought to  learn what factors might influence the banks’ choice to become a member  of the Federal Reserve and if potential modifications to the Reserve  Banks’ stock ownership structure would affect their choice. We presented  three scenarios (of changes to the stock ownership requirement and  therefore the Federal Reserve structure) in the interviews to which  respondents could react and discuss implications. The scenarios are  illustrative and do not represent all of the ways in which the Federal  Reserve structure might be altered nor does our analysis account for all  of the potential consequences of stock ownership modifications.  Furthermore, our discussion of the range of consequences is limited  without knowledge of the mechanisms that could be put in place to retain  the benefits of the current structure or mitigate any negative effects of the  changes. See appendix I for more information on our scope and  methodology.

We conducted this performance audit from February 2016 to February  2017 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
subsections: section_title: Background
subsections: section_title: Overview of the Federal Reserve System
paragraphs: The Federal Reserve Act established the Federal Reserve to operate  collectively as the country’s central bank. The Federal Reserve Act  established the Federal Reserve as an independent agency with a  decentralized structure to ensure that monetary policy decisions would be  based on a broad economic perspective from all regions of the country.  The Federal Reserve’s monetary policy decisions do not have to be  approved by the President, the executive branch of the government, or  Congress. However, the Federal Reserve is subject to oversight by  Congress and conducts monetary policy so as to promote the long-run  objectives of maximum employment, stable prices, and moderate long- term interest rates in the United States, as specified by law.

The Federal Reserve operates in a unique public and private structure. It  consists of the Board of Governors (a federal agency), the 12 Reserve  Banks (federally chartered corporations), and FOMC.

Board of Governors. The Board of Governors is an independent  regulatory federal agency located in Washington, D.C., and has broad  interest in monitoring and promoting the stability of financial markets. The  Board of Governors’ authorities include: supervising bank and thrift  holding companies, state-chartered banks that are members of the  Federal Reserve, and the U.S. operations of foreign banking  organizations; reviewing and determining discount rates for lending to  depository institutions; conducting monetary policy (in cooperation with  FOMC); and providing general supervision over the operations of the  Reserve Banks. The top officials of the Board of Governors are the  seven members who are appointed by the President and confirmed by  the Senate. Moreover, the Federal Reserve Act requires the Board of  Governors to submit written reports to Congress twice each year  containing discussions of the conduct of monetary policy and economic  developments and prospects for the future. The act also requires the  Chair of the Board of Governors to testify on the conduct of monetary  policy twice each year in connection with the monetary policy report, as  well as economic development and prospects for the future.

Reserve Banks. The Federal Reserve is divided into 12 districts, with  each district served by a regional Reserve Bank. In most cases, each  regional Reserve Bank also operates one or more branch offices (see fig.  1). The Reserve Banks are not federal agencies; rather, each Reserve  Bank is a federally chartered corporation with a board of directors and  member banks that are stockholders.

Under the Federal Reserve Act, Reserve Banks are subject to the general  supervision of the Board of Governors. The Reserve Banks were  established by Congress as the operating arms of the Federal Reserve,  and they combine both public and private elements in performing a  variety of services and operations. These functions include participating in formulating and conducting monetary policy; providing payment services to depository institutions, including  transfers of funds, automated clearinghouse services, and check  collection; distributing coin and currency; performing fiscal agency functions for Treasury, certain federal  agencies, and other entities; providing short-term loans to depository institutions;  serving consumers and communities by providing educational  materials and information on financial consumer protection rights and  laws and information on community development programs and  activities; and  supervising bank holding companies, state member banks, savings  and loan holding companies, U.S. offices of foreign banking  organizations, and designated financial market utilities pursuant to  authority delegated by the Board of Governors.

In addition, certain services are provided to foreign and international  monetary authorities, primarily by the Federal Reserve Bank of New  York.

State-chartered member banks are subject to supervision by the state in  which they are chartered and the Board of Governors (through a regional  Reserve Bank) as a condition of membership. National banks are  chartered and supervised by OCC. State nonmember banks are  supervised by the state in which they are chartered and by FDIC. See  figure 2 for a chart displaying the number and percentage of commercial  banks supervised by each prudential regulator.

FOMC. FOMC plays a central role in the execution of the Federal  Reserve’s monetary policy mandate to promote price stability, maximum  employment, and moderate long-term interest rates in the United States.  FOMC is responsible for directing open market operations—the purchase  and sale of securities in the open market by a central bank—to influence  the total amount of money and credit available in the economy. FOMC  has authorized and directed the Federal Reserve Bank of New York to  conduct open market operations by engaging in purchases or sales of  certain securities, typically U.S. government securities, in the secondary  market. FOMC also plays a central role in monetary policy strategy and  communication.

section_title: Federal Reserve Income, Surplus Account, and Remittances to Treasury
paragraphs: Reserve Banks derive income from various sources, maintain surplus  accounts, and remit earnings in excess of expenses to Treasury. The  Reserve Banks derive income primarily from the interest on their holdings  of U.S. government securities, agency mortgage-backed securities, and  agency debt acquired through open market operations. Other sources of  income are the interest on foreign currency investments held by the  Reserve Banks; interest on loans to depository institutions;  reimbursements for services performed as fiscal agent for Treasury and  other agencies; and fees received for payment services provided to  depository institutions, such as check clearing, funds transfers, and  automated clearinghouse operations. However, Reserve Banks are not  operated for profit. The Reserve Banks use earnings to pay operational  expenses and dividends to member banks and to fund their capital  surplus accounts.

The surplus account is primarily intended to cushion against the  possibility that total Reserve Bank capital would be depleted by losses  incurred through Federal Reserve operations. Until enactment of the  FAST Act, Federal Reserve policy as established in the Financial  Accounting Manual for Federal Reserve Banks required the Reserve  Banks to retain a surplus balance equal to the 3 percent that commercial  banks pay in to purchase Reserve Bank stock. Due to this matching  provision, as the value of member banks’ capital and surplus increased  over time, so did the values of the Federal Reserve’s surplus account  (see fig. 3).

The Reserve Banks then transfer earnings in excess of expenses to  Treasury. About 95 percent of the Reserve Banks’ net earnings have  been transferred to Treasury since the Federal Reserve began operations  in 1914. The transfers, known as remittances, have been above historic  levels since the 2007—2009 financial crisis (see fig. 4).

section_title: Stock Purchase Requirement for Member Banks and Membership Benefits
paragraphs: Under the Federal Reserve Act, a member bank (a national bank or state- chartered bank that applies and is accepted to the Federal Reserve) must  subscribe to capital stock of the Reserve Bank of its district in an amount  equal to 6 percent of the member bank’s capital and surplus. The  member bank will pay for one-half of this subscription upon approval by  the Reserve Bank of its application for capital stock (with the remaining  half of the subscription subject to call by the Reserve Bank). The capital  stock of each Reserve Bank is valued at $100 per share. When a  member bank increases its capital stock or surplus, it must subscribe for  an additional amount of Reserve Bank stock equal to 6 percent of the  increase with half of the stock paid in. Conversely, when a member bank  reduces its capital stock or surplus it is to surrender the same amount of  stock to its regional Reserve Bank. Shares of the capital stock of Reserve  Banks owned by member banks do not carry with them the typical  features of control and financial interest conveyed to holders of common  stock in for-profit organizations. For example, member banks cannot  transfer or sell Reserve Bank stock or pledge it as collateral; voting rights  do not change with the number of shares held; and each member bank  has only a single vote in those director elections in which they are eligible  to vote.

Currently, stock ownership provides a dividend payment and the right to  vote for two classes of Reserve Bank directors, as discussed later. Under  the original Federal Reserve Act, the annual dividend rate was 6 percent  on paid-in capital stock and was cumulative. Therefore, member banks  would earn a dividend of 0.5 percent per month on the amount of their  paid-in capital stock. The Reserve Banks’ long-standing practice is to  make dividend payments on the last business days of June and  December (that is, a dividend payment of 3 percent twice a year).

Provisions in the FAST Act effective January 1, 2016, altered the dividend  rate that some member banks receive on paid-in capital. For banks with  more than $10 billion in consolidated assets, the dividend rate was  reduced from 6 percent per annum to the lesser of 6 percent or the  highest accepted yield at the most recent auction of 10-year Treasury  notes before the dividend payment date. The high yield of the 10-year  Treasury note auctioned on June 30, 2016 (the last auction before the  dividend payment) was 1.702 percent, and on December 30, 2016, was  2.233 percent. The dividend rate for member banks with less than $10  billion in consolidated assets remains at 6 percent. The Reserve Banks  continue to make dividend payments semiannually.

section_title: Reserve Bank Boards of Directors
paragraphs: The composition of boards of directors for Reserve Banks is statutorily  determined and intended to ensure that each board represents both the  public and member banks in its district. The Federal Reserve Act  established nine-member boards of directors to govern all 12 Reserve  Banks. Each board is split equally into three classes of directors. Class A  directors represent the member banks, while Class B and C directors  represent the public. For Class B and C directors, the Federal Reserve  Act requires “due but not exclusive consideration to the interests of  agriculture, commerce, industry, services, labor, and consumers.” The  Federal Reserve Act also requires that member banks elect Class A and  Class B directors and that the Board of Governors appoints Class C  directors. The Federal Reserve Act provides that the chairman of the  board, like all Class C directors, cannot be an officer, director, employee,  or stockholder of any bank. The principal functions of Reserve Bank  directors are to play a role in the conduct of monetary policy; oversee the  general management of the Reserve Bank, including its branches; and  act as a link between the Reserve Bank and the community.

The boards of directors of Reserve Banks play a role in the conduct of  monetary policy in three primary ways: (1) by providing input on economic  conditions to the Reserve Bank president (all 12 Reserve Bank presidents  attend and participate in deliberations at each FOMC meeting); (2) by  participating in establishing discount rate recommendations (interest rate  charged to commercial banks and other depository institutions on loans  received from their regional Reserve Bank’s discount window) for Board  of Governors’ review and determination; and (3) for the Class B and C  directors, by appointing Reserve Bank presidents with the approval of the  Board of Governors.

section_title: Central Bank Independence
paragraphs: A large amount of research has been produced on the attributes and  effects of central bank independence. According to the research, a high  level of central bank independence is generally considered to be  desirable. The research has generally found that countries with high  central bank independence have been able to maintain lower levels of  inflation. Central bank independence can be divided into three  categories (political, instrument, and financial independence), as  described in the following bullets.

Political independence is based on a central bank’s capacity to define  monetary policy strategy (goals) without political interference. Political  independence encompasses appointing procedures, relationships  with the government, and formal responsibilities.

Instrument independence is based on a central bank’s capacity to  define monetary policy instruments without political interference.  Instrument independence for a central bank includes the ability to  avoid financing public spending by money creation, autonomy in  setting interest rates, and ability to conduct monetary policy without  banking sector oversight responsibilities.

Financial independence is based on a central bank’s capacity to  govern its own budget. Financial independence encompasses  conditions for capitalization and recapitalization, determination of the  central bank budget, and arrangements for profit distribution and loss  coverage.

Independence in the implementation of monetary policy can be a function  of the degree of independence in all three categories: political,  instrument, and financial. Lower degrees of independence in any of these  areas can affect monetary policy independence. Existing research shows  that the Federal Reserve is relatively independent overall compared to  central banks in other advanced economies. The level of political  independence is lower for the Federal Reserve than its instrument or  financial independence due in part to existing appointment procedures for  the Board of Governors, whose members are appointed by the President  and confirmed by the Senate. However, Board of Governors officials  stated that Federal Reserve political independence is strengthened by the  fact that Reserve Bank presidents are not political appointees. In addition,  the instrument independence of the Federal Reserve is high, and the  financial independence of the Federal Reserve is also relatively high.

section_title: Rationales for Stock Purchase Requirement and Dividend Rates
paragraphs: According to legislative history and historical accounts that we reviewed,  the stock purchase requirement in the Federal Reserve Act established  an ownership and control arrangement at Reserve Banks to facilitate a  balance of power between the Board of Governors and private interests,  capitalized the Reserve Banks, and helped support the new national  currency created by the act. Based on our interview with a past Federal  Reserve historian and historical accounts, the dividend rate of 6 percent  was intended to compensate member banks for the requirement to  provide funds to the Reserve Banks to begin operations and the risk of  the Federal Reserve not succeeding, as well as to attract state-chartered  banks to the Federal Reserve.
subsections: section_title: Stock Purchase Requirement Established an Ownership and Control Structure for Reserve Banks as a Counterbalance in the Federal Reserve
paragraphs: According to the legislative history and historical accounts related to the  Federal Reserve Act, debate over the creation of the Federal Reserve  focused on the balance of power among economic regions of the United  States and between the private sector and government. The resultant  corporate structure of Reserve Banks was intended to help balance the  influence of government over the central bank, of different regions, and of  small versus large banks, as well as to help fund the Federal Reserve.  Many Americans were resistant to the creation of a central bank (dating  back to the nation’s founding); thus, early drafts of proposals for a central  bank did not include the term “central bank.” However, there was strong  recognition that the nation needed a central bank to forestall and mitigate  financial panics. There was considerable disagreement about how it  should be structured, including considerations about the role of private  bankers versus government officials, how centralized the new bank  should be, and the extent of its powers.

The Federal Reserve Act as proposed in January 1913 by Representative  Carter Glass generally was viewed as occupying the middle ground  between positions advocating for government control over the Federal  Reserve and positions advocating for more control by private commercial  banks. The Glass bill proposed creating up to 15 Reserve Banks and the  Board of Governors. The Reserve Banks were modeled after  clearinghouses or “banker’s banks” and some European central banks in  that they would be funded by selling stock shares to commercial banks. In  particular, the design adopted for the Federal Reserve was federated,  with independent Reserve Banks overseen by the Board of Governors.

Under the bill, each Reserve Bank was required to have minimum capital  to begin business. According to a past historian of the Federal Reserve,  proponents in Congress of a central bank did not want to fund it, but  needed to raise cash for capital and gold to back Federal Reserve notes  that would serve as the national currency. The original proposal required  member banks to purchase stock equal to 20 percent of their paid-in and  unimpaired capital, with one-half paid on joining the Reserve Bank and  one-half callable from the member bank. The Senate and conference  committees agreed to change the capital of the Federal Reserve to 6  percent of member banks’ capital and surplus rather than 20 percent of  capital alone as provided in the Glass bill. This change yielded almost  the same total capital but satisfied small banks claiming that the Glass bill  discriminated against them. Member banks had to pay for the stock in  gold or gold certificates, which concentrated gold deposits in the Reserve  Banks to support Federal Reserve notes.

The bill also required that each national bank subscribe to the stock of the  Reserve Bank in its district. Only national banks were compelled to  subscribe because their charters were issued by the federal government.  State-chartered banks were not required to purchase Reserve Bank stock  but were permitted to join the Federal Reserve if they met certain  requirements. State-chartered banks opposed mandatory membership  because they did not want to be subject to supervision by a federal  regulator. The mandatory nature of national bank membership and stock  ownership was controversial when the Federal Reserve Act was under  debate. But for Glass, “the compulsory and pro rata capital contribution  were ‘means to the achievement of a democratic organization constituted  by the democratic representation of the several institutions which are  members and stockholders of a reserve bank’” and also “considered  necessary for the establishment of corporate entities that would act  ‘primarily in the public interest.’” In addition, Senator Robert Owen, primary sponsor of the Federal Reserve Act in the Senate, supported the  stock purchase requirement because he believed it would ensure that  commercial banks would have an incentive to safeguard the Federal  Reserve.

section_title: Dividend Rate of 6 Percent Was Intended to Compensate for Bank Costs and Risks and Attract State Banks
paragraphs: The rationales for paying a 6 percent dividend rate included  compensating banks for opportunity costs for providing capital and  reserves to the Reserve Banks and attracting state-chartered banks to  Federal Reserve membership. According to the legislative history and  other information we reviewed, notable proposals for creating a central  bank included stock and dividend payments. One of the early proposals  for a central bank was written in 1910 by Paul Warburg and included  dividends on central bank stock of 4 percent. The original Federal  Reserve Act proposed by Representative Glass provided for a dividend  rate of 5 percent. Glass stated in his report on the 1913 bill that 5 percent  represented the normal rate of return from current bank investments  “considering the high character of the security offered.” Debate in the  Senate and conference committee resulted in a 6 percent dividend rate  on Reserve Bank stock. This rate was comparable to those of European  central banks of the time.

Based on our interviews with a past Federal Reserve historian, one of the  rationales for creation of the 6 percent dividend rate was to compensate  member banks for the opportunity costs of the capital they invested in the  Reserve Bank stock. National banks and state-chartered banks that  chose to join the Federal Reserve were required to purchase the stock  and therefore could not invest this capital in other instruments that might  earn a higher return. Also, the 6 percent dividend rate included a risk  premium associated with the stock of this new institution. While the  Reserve Banks are seen as safe today, during the debates over the  Federal Reserve Act there was worry that they would fail, particularly  smaller Reserve Banks in rural regions of the country that had less initial  capital. However, concerns were raised about making the dividend rate  so attractive that member banks would pull too much bank capital away  from the local community. Lastly, the dividend was intended to help  induce state-chartered banks to join the Federal Reserve. As noted  earlier, state-chartered banks were not required to join the Federal  Reserve and purchase Reserve Bank stock and therefore would not be  subject to supervision by the Federal Reserve. As a result, a low  percentage of state-chartered banks initially joined the Federal Reserve  and there was a gap in the Board’s knowledge of the safety and  soundness of the banking system. Thus, the 6 percent dividend rate was  intended as an incentive for state-chartered banks to voluntarily join the  Federal Reserve.

To examine the comparative value of a dividend rate of 6 percent since  the enactment of the Federal Reserve Act, we examined rate of return  information on Treasury and certain corporate bonds. (See appendix I for  information about our data sources and methodology.) As shown in figure  5, returns on investment-grade and medium-grade corporate bonds and  Treasury bonds varied widely from 1900 through 2015. Before enactment  of the Federal Reserve Act in 1913, returns for investment-grade  corporate bonds and Treasury bonds were around 4 percent and stayed  in that range until about 1960, when they began to rise dramatically.  Returns for each of the instruments (medium-grade corporate bond data  were recorded from the mid-1940s) were consistently above 6 percent  from the early 1970s to the early 1990s, and peaked around 1980 at  about 16 percent. Returns for each of the bond categories above are now  below 6 percent. In addition, we reviewed U.S. stock data and found total  returns to average about 6.5 percent over more than a century. However,  stocks can pose higher variability in returns than corporate bonds and  Treasury securities.

We also compared the 6 percent Reserve Bank dividend rate to the  federal funds rate and 1-year nominal interest rates. We analyzed the  federal funds rate—the interest rate at which depository institutions trade  federal funds (balances held at Reserve Banks) to other depository  institutions overnight—to consider a member bank’s opportunity costs of  holding a share of Reserve Bank stock. The federal funds rate represents  a market of interbank lending at low risk. We collected data on the federal  funds rate since 1954. In addition, we analyzed a nominal interest rate  series to understand opportunity costs prior to 1954. As shown in figure  6, nominal interest rates were between 4 percent and 6 percent in 1913,  but dipped dramatically during the Great Depression and World War II.  Rates reached 6 percent again in the late 1960s and then peaked around  18 percent in the early 1980s. The federal funds rate has been near zero  since the 2007—2009 financial crisis.

section_title: Potential Implications of Modifying the Capital Surplus Account and Dividend Rate
paragraphs: Based on our interviews with Federal Reserve officials, the cap on the  aggregate Reserve Banks’ surplus account had little effect on Federal  Reserve operations, and we found that the modification to the Reserve  Bank stock dividend rate has had no immediate effect on membership.  While it is debatable whether transferring funds from the Federal Reserve  to Treasury when the FAST Act also funded specific projects should be  viewed any differently than the recurring transfers that occur on a regular  basis, some stakeholders raised concerns about future transfers that  could ultimately affect, among other things, the Federal Reserve’s  financial independence and consequently, autonomy in monetary policy  decision making (instrument independence). Although commercial banks  and Federal Reserve officials we interviewed raised a number of  concerns about the stock dividend rate change, it appears to have had no  effect on Reserve Bank membership as of December 2016.
subsections: section_title: Surplus Account Cap Has Not Impeded Federal Reserve’s Operations but Raises Other Questions for Some
paragraphs: According to Board of Governors officials, the statutory requirement to  cap the surplus account and transfer excess funds has not impeded  Federal Reserve operations as of December 2016. However, according to  current and former Federal Reserve officials we interviewed, the nature of  the transfer of funds, which were added to Treasury’s General Fund and  used as an offset to make up a shortfall in the Highway Trust Fund, raises  questions about the possibility of future transfers. They also raised  questions that the cap could negatively affect the Federal Reserve’s  independence in monetary policy decision making by rendering it  dependent on Treasury for recapitalization in the event that total Reserve  Bank capital is depleted.

The FAST Act, which authorized the Highway Trust Fund for fiscal year  2016 through fiscal year 2020, requires that the aggregate of the Reserve  Banks’ surplus funds not exceed $10 billion and directed that amounts in  excess of $10 billion be transferred to Treasury’s General Fund. The  excess of Reserve Bank surplus over the $10 billion limitation as of the  December 4, 2015, enactment date of the FAST Act was $19.3 billion,  which was transferred to Treasury on December 28, 2015. The $19.3  billion transferred from the surplus account was part of $117 billion in  earnings the Federal Reserve transferred to Treasury in 2015. The FAST  Act transferred a total of $70 billion from Treasury’s General Fund to  make up a projected shortfall in the Highway Trust Fund through fiscal  year 2020. In addition to its annual remittances, the Congressional  Budget Office estimates that the Federal Reserve’s transfers to Treasury  will be increased by a total of $53.3 billion from 2016 to 2025 as a result  of capping the surplus account balance at $10 billion.

As we found in our 2002 report on the surplus account, reducing the  Federal Reserve capital surplus account creates a one-time increase in  federal receipts, but the transfer by itself will have no significant long-term  effect on the federal budget or the economy. Because the Federal  Reserve is not included in the federal budget, amounts transferred to  Treasury from reducing the capital surplus account are treated as a  receipt under federal budget accounting but do not produce new  resources for the federal government as a whole. The surplus account  cap reduces future Reserve Banks’ earnings because the Reserve Banks  would hold a smaller portfolio of securities. As a result, the cap reduces  their transfers to Treasury in subsequent periods. Since the one-time  transfer from the Federal Reserve also increases Treasury’s cash  balance over time, 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.

According to Board of Governors officials, the cap on the surplus account  had little effect on Federal Reserve operations as of December 2016, and  the chances of the cap impeding operations in the long term appear to be  small. This is because Federal Reserve operations are funded before  remaining excess funds are transferred to the surplus account. In  addition, if Reserve Bank earnings during the year are not sufficient to  provide for the costs of operations, payment of dividends, and maintaining  the $10 billion surplus account balance, remittances to Treasury are  suspended. A deferred asset is recorded in the Federal Reserve’s  accounts to represent the amount of net earnings a Reserve Bank will  need to realize before remittances to Treasury resume. In our September  2002 report, 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. However,  according to Board of Governors officials, if a central bank exhausts its  capital cushion or its capital position is negative, realized losses that  result from asset sales or draining of monetary liabilities would further  exacerbate the capital deficiency.

According to Federal Reserve officials and academics we interviewed,  transferring Federal Reserve funds to address a budgetary shortfall might  lead the public and financial markets to question if the Federal Reserve  was independent from the executive and legislative branches. In their  view, if these actions set a precedent, the public and financial markets  might conclude that the central bank was not conducting monetary policy  aimed solely at achieving the monetary policy objectives set forth in the  Federal Reserve Act (price stability, maximum employment, and  moderate long-term interest rates in the United States). Instead, some  might believe that the Federal Reserve had been directed to take policy  actions that would help fund government spending.

Whether transferring funds from the Federal Reserve to address  budgetary shortfalls should be viewed any differently than the annual  remittances is debatable. Congress has transferred money from the  surplus account to Treasury’s General Fund on other occasions, most  recently with the Consolidated Appropriations Act of 2000 that directed  the Reserve Banks to transfer to Treasury additional surplus funds of  $3.752 billion during fiscal year 2000. These transfers are deposited in  Treasury’s General Fund and available for appropriation and use for  general support of the government. Nevertheless, Federal Reserve  officials, an industry association, and some commercial banks we  interviewed believed the requirement to transfer funds from the surplus  account, which many see as specifically intended to support the Highway  Trust Fund, was different and set a worrying precedent. In particular,  Board of Governors officials stated that prior transfers from the Reserve  Banks to Treasury did not place a cap on the amount of the surplus  accounts that could be retained by the Reserve Banks.

Several academic experts with whom we spoke noted that countries with  independent central banks have strict provisions against transfers of  central bank funds by the legislative branch. However, as long as rules  regarding the transfer of central bank earnings to the government are  clearly defined, such transfers are consistent with best practices  associated with central bank financial independence. As we discuss  later, concerns may arise if subsequent transfers reduce the capital  surplus to zero, which could lead to dependence on Treasury for capital  integrity. Since capital integrity is required to support monetary policy  autonomy, reliance on Treasury could diminish the independence of the  Federal Reserve. As we discuss later in this report, there are ways to  preserve Federal Reserve independence under varying capital structures.

section_title: Dividend Rate Modification Raises Potential Implications but Has Had No Immediate Effect on System Membership
paragraphs: The FAST Act’s modification of the Reserve Banks’ stock dividend rate  for large member banks from 6 percent to a rate pegged at the lesser of 6  percent or the 10-year Treasury rate, which was below 6 percent in June  2016, increased federal receipts and reduced revenues for large member  banks, but has had no immediate effect on Federal Reserve membership.  In 2015, the Federal Reserve made dividend payments to member banks  totaling more than $1.7 billion. Board of Governors officials told us that  dividend payments to member banks in 2016 totaled $711 million.

The modified dividend rate for the larger member banks reduced the  dividend payment for the first half of 2016 by nearly two-thirds from  the payment for the first half of 2015 (from approximately $850 million  to approximately $300 million).

More specifically, the difference between what larger member banks  received at June 30, 2015, and what they received at June 30, 2016,  ranged from about $185,000 to about $112 million less.

While the current interest rate environment is historically low, the  difference in dividend income earned by large banks due to the dividend  rate modification would decline in a higher interest rate environment,  because the 10-year Treasury rate could increase over time to 6 percent  (the ceiling on the dividend rate for member banks with more than $10  billion in consolidated assets).

Commercial banks and Federal Reserve officials we interviewed  expressed some concerns about the dividend rate modification. We  interviewed 17 member and nonmember commercial banks, including 6  of the 85 Federal Reserve member banks that held more than $10 billion  in assets as of December 31, 2015, and 11 smaller member banks. Four  of the 6 large member banks stated that they would likely act to recoup  this lost revenue. For example, some mentioned employee layoffs and  increased fees on consumers as potential options to recoup the lost  revenue. Two large member banks noted that the dividend rate  modification was made at a time when these institutions were adjusting to  changes in the regulatory and financial environment, and incorporating  the revenue cut made adjusting to these changes even more  challenging. However, these factors also make it difficult to link the  dividend rate modification to any specific effects on employees or  consumers.

Most of the member and nonmember banks we interviewed argued that  the selection of the 10-year Treasury note as a benchmark for the  dividend rate does not appropriately compensate member banks. Several  commercial banks noted that the decision to use the 10-year Treasury  note did not account for the illiquidity of Reserve Bank stock (it cannot be  traded while 10-year Treasury notes can). They added that this illiquidity  should be accounted for by the addition of a premium to the rate paid on  Reserve Bank stock (an illiquidity premium). Additionally, several  commercial banks reported that shifting from a fixed dividend rate to a  floating rate determined during the month when dividends are paid  increased the uncertainty surrounding their business decisions.

Several commercial banks also stated that they would have preferred that  the dividend rate modification were considered on its own merits rather  than utilized to help pay for transportation projects. The American  Bankers Association stated in a comment letter on the interim final rule  implementing the dividend rate modification that the change represented  a breach of contract between the Federal Reserve and member banks  and amounted to “an unconstitutional taking of member banks’ property  without compensation.” It further stated that the “Takings Clause of the  Fifth Amendment provides that ‘private property’ shall not ‘be taken for  public use, without just compensation’” and the dividend rate change was  in violation of the Fifth Amendment. On February 9, 2017, the American  Bankers Association filed a lawsuit against the United States which  included a Fifth Amendment Taking Clause claim.

Certain Federal Reserve officials with whom we spoke were concerned  about increased membership attrition as a result of the dividend rate  modification. However, as of December 2016 there was no evidence that  banks had dropped their Federal Reserve membership as a result of  lower dividend payments. According to data provided by the Board of  Governors and Reserve Banks, membership in the Reserve Banks  dropped by about 2 percent (46 banks) from December 31, 2015, to June  30, 2016. The Reserve Banks generally attributed this drop to normal  attrition and consolidation in the industry. This decrease is consistent with  the general decline in the number of banks supervised by the Federal  Reserve from 2010 through 2015 (as shown in fig. 2).

FDIC officials stated in May 2016 that they had seen no impact of the  dividend rate modification on state-chartered member and nonmember  banks. OCC officials stated that it was too early to determine the impact  of the dividend rate modification on national banks. However, OCC  officials noted that the costs associated with changing membership can  be significant and can be a decision-making factor. For example, industry  association officials said that such costs could include those associated  with changing the institution’s name. Furthermore, of the 14 member  banks with which we spoke, including 6 banks with assets of more than  $10 billion, none indicated that they would drop Federal Reserve  membership as a result of the dividend rate modification. But several of  the banks with less than $10 billion in assets stated that they were  worried that the dividend rate modification would set a precedent for  future transfers from the Reserve Banks, and that they would reconsider  Federal Reserve membership if the dividend rate threshold were reduced  to include banks in their asset range.

section_title: Modifications to Stock Ownership Requirement Would Have Implications for the Federal Reserve’s Public and Private Balance and Reserve Bank Operations
paragraphs: Modifying the Reserve Bank stock ownership requirement could have a  number of wide-ranging policy implications on the structure of the Federal  Reserve. We examined potential implications of three scenarios for  modifying the purchase requirement: (1) permanently retiring Reserve  Bank stock and eliminating the stock ownership requirement, (2) making  ownership of Reserve Bank stock voluntary for member banks, and (3)  modifying the capital requirement associated with the stock to allow  member banks to hold the entire 6 percent capital contribution as callable  capital.

In scenario 1, permanently retiring Reserve Bank stock could change  the existing corporate structure of the Reserve Banks.

In scenario 2, Federal Reserve membership would not require stock  ownership; however, Reserve Bank stock would remain available for  purchase by member banks.

In scenario 3, the full capital contribution would be retained by  member banks, could be called at any time by the Reserve Banks,  and could be available for use by the member bank.

The primary benefit to making any of the changes to the stock purchase  requirement is that member banks would gain more control over the  capital currently committed to ownership of Reserve Bank stock. Banking  associations that we interviewed said that the capital contribution for the  stock places a burden on member banks. Specifically, the capital is  illiquid and cannot be used as collateral, so it represents a significant  opportunity cost to member banks. Despite the cost associated with the  capital requirement, 11 of the 17 banks we interviewed indicated that the  capital requirement is either not an important factor or only somewhat of  an important factor in their decision on Federal Reserve membership.  More frequently, familiarity with their Reserve Bank as a supervisor was  more important to their decision to join the Federal Reserve.

The three scenarios are not an exhaustive representation of possible  modifications to the structure of the Federal Reserve, nor does our  analysis account for all of the potential consequences of such  modifications. Our discussion of the implications of each scenario should  not be interpreted as a judgment on how or whether the Federal Reserve  should be restructured. Instead, our intent is to identify policy implications  that warrant full consideration and additional research should changes to  the Federal Reserve stock requirement and therefore, the Federal  Reserve’s structure, be made. Furthermore, the discussion of the impacts  of the three scenarios is limited without identification of the exact  replacement structures, which is beyond the scope of this study. As each  scenario has a number of potential structures, each structure would have  to be evaluated on its own merits to assess its ability to better ensure the  benefits Congress seeks to achieve in the central bank, such as price  stability and maximum employment. This discussion assumes that the  goals reflected in the original construction of the Federal Reserve remain  (independence, balance of power, and geographical diversity).

Reserve Bank and Board of Governors officials with whom we spoke said  that changes to the stock ownership requirement should not be evaluated  in isolation because any changes would have ripple effects on the  governance structure, financial independence, and Reserve Bank  operations that would warrant consideration in any discussion. In the  following discussion, we focus on the impacts of modifying the purchase  requirement that were of primary concern to regulators, commercial  banks, and academics. Many were concerned that such modifications  could undermine the governance of a central bank with a combined  private and public structure—key attributes of the current structure  designed to construct some barriers to political pressures and provide  nationwide input for monetary policies. Nevertheless, these governance  elements could be maintained through legislation and other mechanisms  if the current Federal Reserve structure were altered.
subsections: section_title: Retiring Reserve Bank Stock and Making Reserve Banks Field Offices
paragraphs: Retiring Reserve Bank stock could have a number of implications,  including disrupting the Federal Reserve’s public and private balance, but  other mechanisms could be used to preserve the structure’s key  attributes. As discussed previously, the stock purchase requirement  reflects the desire of the founders of the Federal Reserve to strike a  balance between control by commercial banks and government control of  the Federal Reserve. Under the Federal Reserve Act, the Reserve Banks  were established as corporate entities after national banks subscribed to  the minimum amount of Reserve Bank stock. Therefore, a structural  change could result if Congress decided to retire the stock and the  corporate structure of the Reserve Banks were not preserved. The  corporate structure, which includes a board of directors to oversee  operations, enables the Reserve Banks to maintain a degree of autonomy  from the Board of Governors. Furthermore, the stock ownership  requirement enables the Federal Reserve to maintain financial  independence from the federal government because it allows the Reserve  Banks to maintain a capital base that is not funded at the discretion of the  government. Retirement of Reserve Bank stock could have implications  for the autonomy of the Reserve Banks, the independence of the Federal  Reserve, and the operations of the Reserve Banks, all of which would  warrant consideration.

Diminished Reserve Bank autonomy. One of the policy goals of the  Federal Reserve’s structure is to provide Reserve Banks with a degree of  autonomy or regional authority in relation to the Board of Governors.  Eliminating Reserve Bank stock would have implications for this goal.  According to Reserve Bank officials, all else being equal, retirement of the  stock coupled with elimination of the current corporate structure of the  Reserve Banks could result in removal of Reserve Bank boards of  directors or limit the benefits currently provided by their participation. The  existence of the boards of directors is tied to member banks’ equity  ownership in their regional Reserve Bank. Specifically, this action could  limit the diversity of views in monetary policy by weakening the link to  regional input in FOMC discussions. Reserve Bank officials said that  Reserve Bank boards serve an important function in the Federal Reserve,  including providing important business advice and perspectives to the  Reserve Banks. In our 2011 report on Federal Reserve governance, we  found that directors of the Reserve Bank boards provide a link to the  regions that the Reserve Banks serve, and give information on economic  conditions to the Reserve Bank presidents who may use it to inform  FOMC discussions about regional conditions.

With the loss of member bank equity ownership and the absence of  Reserve Bank boards, advisory boards or advisory councils are  mechanisms that could be used to serve the same function. However,  according to Reserve Bank officials and directors, this approach might not  be as effective as a formal corporate board. They said that, as appointed  directors of a Reserve Bank board, they have a fiduciary responsibility to  perform their duties and place the interests of the Reserve Bank and the  nation ahead of personal interests. They noted that it may be difficult to  attract high-caliber members to an advisory council or board in a different,  more removed relationship. However, we found in our 2011 report that  existing Reserve Bank branch boards and advisory councils are  sometimes a source of director candidates for the Reserve Banks.  Reserve Bank officials and directors also said that the level of  commitment and engagement from members of an advisory board or  council would be less than that of directors of a formal corporate board.  Many different mechanisms could be employed to mitigate the effects of  eliminating Reserve Bank boards, but without further analysis on specific  mechanisms it is difficult to determine whether those mechanisms would  be feasible.

Reserve Bank officials, academics, and banks said that another potential  consequence of retiring Reserve Bank stock and eliminating the  incorporated entities could be diminished Reserve Bank autonomy in  relation to the Board of Governors. For example, retirement of Reserve  Bank stock could result in eliminating the current corporate structure, and  one structural option that we examined was to convert the Reserve Banks  into field offices of the Board of Governors—that is, Reserve Banks would  become part of a federal agency. Reserve Bank presidents currently are  appointed by and accountable to Reserve Bank boards of directors.  Some officials we interviewed believed that Reserve Bank presidents  might feel less comfortable voicing dissenting opinions in FOMC meetings  if they were leading field offices directly accountable to the Board of  Governors. Therefore, a loss of autonomy could limit the diversity of  views in FOMC meetings. More importantly, it could concentrate power  and influence within the Board of Governors—for example, by centralizing  FOMC decision making in the hands of the Board of Governors. The  diversity of economic views that Reserve Bank presidents bring to FOMC  meetings is illustrated by dissenting votes at FOMC meetings from July  1996 to July 2016. In that time, Reserve Bank presidents cast 80  dissenting votes while members of the Board of Governors cast 2  dissenting votes.

Some academics with whom we spoke pointed out that eliminating the  Reserve Bank stock purchase requirement could remove the perception  of undue influence from member banks. For example, such perceptions  might be removed if member banks (shareholders) no longer vote on  Class A and B directors of Reserve Bank boards. We previously reported  that the requirement to have representatives of member banks on the  Federal Reserve Bank boards creates an appearance of a conflict of  interest because the Federal Reserve has supervisory authority over  state-chartered member banks and bank holding companies.

Conflicts of interest involving directors historically have been addressed  through both federal law and Federal Reserve policies and procedures,  such as by defining roles and responsibilities and implementing codes of  conduct to identify, manage, and mitigate potential conflicts. Federal  Reserve officials said that the Board of Governors already restricts  Reserve Bank directors’ participation in banking supervision and,  therefore, a field-office structure would address perception, not practice.  For example, Reserve Bank directors cannot access member banks’  confidential supervisory information. Any application of a Class A  director’s financial institution that requires Federal Reserve approval may  not be approved by the director’s Reserve Bank, but instead is acted on  by the Secretary of the Board of Governors. Class A directors cannot be  involved in the selection, appointment, or compensation of Reserve Bank  officers whose primary duties involve banking supervision. And Class B  directors with certain financial company affiliations are subject to the  same prohibition. Class A directors are also not involved in the selection  of the Reserve Bank President or First Vice President.

To the extent that Congress values the benefits conferred by the current  structure characterized by the balance of power and Reserve Bank  autonomy, mechanisms would need to be devised to provide assurance  these benefits remained if the Reserve Bank stock were retired. Eight of  the 14 member banks that we interviewed said that Reserve Bank  autonomy is either important or very important. For example, one bank  stated that Reserve Bank autonomy is “hyper–important” because it  creates a system of checks and balances, limits politicization of monetary  policy, and ensures that viewpoints from across the nation are  considered. Five of the member banks that we interviewed said that the  structural option of converting the Reserve Banks to field offices would  diminish the Reserve Banks’ autonomy and some said that the change  would harm connections to the local communities. But only 1 of the 14  member banks with which we spoke said that they would be likely or very  likely to drop membership if the Reserve Banks became field offices of  the Board of Governors.

Diminished Federal Reserve financial independence. One of the  policy goals of the Federal Reserve System’s structure was to provide it  with independence within the federal government. As noted earlier,  financial independence supports monetary policy autonomy, which  research has shown is important to low levels of inflation. Eliminating  Reserve Bank stock, without a mechanism to re-establish financial  autonomy, would have implications for this goal. The Reserve Banks’  income is generated primarily through interest on their investments and  loans and through fees received for services provided to depository  institutions. Reserve Bank officials said that historically the Federal  Reserve has received enough income to fund its operations and therefore  would be able to capitalize itself. According to the Federal Reserve, if  losses were incurred remittances to Treasury would be suspended and a  deferred asset would be recorded that represents the amount of net  earnings a Reserve Bank would need to realize before remittances to  Treasury could resume. Therefore, Reserve Banks do not need capital to  fund operations. However, operating without a capital base could  exacerbate negative perceptions that the Federal Reserve is insolvent.  Alternatively, Treasury could capitalize the Federal Reserve through  Treasury-owned stock, which would allow the Reserve Banks to maintain  a corporate structure but would result in a central bank dependent, in  part, on government funding.

Depending on how it is structured, dependence on Treasury for  capitalization could diminish the financial independence of the Federal  Reserve. In particular, Federal Reserve independence would be  diminished if recapitalization (in the event of capital base depletion) were  at the discretion of Treasury. One academic we interviewed said that the  $10 billion surplus cap introduced under the FAST Act increased the  likelihood of the depletion of the Federal Reserve’s capital. Some  academics have written that if Treasury capitalized the Federal Reserve,  Congress could include provisions for automatic recapitalization of the  Federal Reserve in the event that its capital were depleted and provide  stronger capital buffers by increasing the surplus account cap. These  provisions would preserve the independence of the Federal Reserve by  removing the discretion of Treasury in recapitalizing the Federal Reserve.  Moreover, according to research, 8 of 166 central banks are capitalized,  in whole or in part, by private shareholders. The remaining 158 central  banks, some of which are considered to be highly independent, are  capitalized by their governments.

None of the 17 member and nonmember banks that we interviewed said  they would be likely or very likely to change their membership status if  Reserve Bank stock were permanently retired. The banks said that the  stock ownership is not a major factor in membership considerations.  Member banks cited familiarity with and reputation of their regulator,  consistency of regulation across the holding company, and their bank  structure as the most important factors for making a membership  choice.

Hindered ability to conduct Reserve Bank operations. The Federal  Reserve Act authorized the Federal Reserve Banks to act as depositories  and fiscal agents of the United States government, at the direction of the  Secretary of the Treasury. Eliminating Reserve Bank stock could have  implications for the Reserve Banks’ ability to perform these functions,  depending on how the Reserve Banks’ structures and authorities were  revised. For example, converting the Reserve Banks to field offices could  preclude them from conducting critical banking functions, and the  activities they could undertake as fiscal agents for the government if they  were to become government entities are unclear. Banking activities  conducted by the Reserve Banks, including executing monetary policy  through open market operations and providing short-term loans to  institutions, are essential to the functioning of the Federal Reserve.

Some Reserve Bank officials said that without the stock, the Reserve  Banks would no longer be corporations and might not be able to conduct  certain banking activities, depending on how the replacement structure  and authorities were configured. If the Reserve Banks were to become  field offices of the Board of Governors, they would no longer be able to  perform certain activities related to their function as Treasury’s fiscal  agent because the Board of Governors currently is not authorized to  provide these services. Some also said that having the Board of  Governors act as Treasury’s fiscal agent could present a conflict of  interest. However, other Reserve Bank officials said that the current  corporate structure could be maintained without the stock, but would at  least require legislation amending the Federal Reserve Act to allow  continuing conduct of banking activities. Reserve Bank officials noted that  Treasury directs the Reserve Banks, as fiscal agents, to conduct auctions  on its behalf and it is unclear whether Treasury could direct another  federal agency to do so. Reserve Bank officials also pointed out that the  Reserve Banks hold accounts for foreign central banks and it is unclear  whether the federal government could hold an account for another  government. As discussed earlier, capitalization by Treasury would allow  the Reserve Banks to maintain their current corporate structure, through  Treasury-owned stock. This could preserve the ability of Reserve Banks  to conduct banking operations; however, as discussed earlier, this  involves many issues that would need to be considered.

Eliminating the current corporate structure and converting the Reserve  Banks into field offices of the Board of Governors could lead to more  centralized functions, which could further improve the net efficiency of  Reserve Bank operations. However, Reserve Bank officials said that  innovation often comes from having private-sector voices on their boards.  Moreover, Reserve Bank officials said that despite their autonomous  structure they have been able to achieve efficiencies in their operations  by consolidating certain activities such as retail payment (check and  Automated Clearing House) processing, which is conducted through the  Federal Reserve Bank of Atlanta; wholesale payment operations (Fedwire  funds and securities services) and open-market operations, which are  primarily conducted through the Federal Reserve Bank of New York, or  information technology and payroll services, which are primarily  conducted by the Federal Reserve Bank of Richmond. In contrast, we  have reported that some efficiencies in Reserve Bank operations were  achieved partly because of external factors such as legislation.

section_title: Voluntary Stock Ownership
paragraphs: Making stock ownership voluntary could have a number of policy  implications. Voluntary ownership likely would not significantly affect  Federal Reserve membership, but according to Reserve Bank officials,  the implications could include concentration of stock ownership and  voting rights and a need for more resources to plan for and manage  increased fluctuations in paid-in capital. Voluntary ownership of Reserve  Bank stock could take many forms. Currently, only nationally chartered  banks and state-chartered banks that opt to join the Federal Reserve are  required to purchase stock. Such a scenario could entail no ownership  requirement for membership and an option for member banks to  purchase (or redeem) stock in their regional Reserve Bank at any time.

As with permanent retirement of the stock, we did not find evidence that  voluntary stock purchase would have a significant impact on Federal  Reserve membership. Member banks that we interviewed suggested that  making stock ownership voluntary would not affect their Federal Reserve  membership decision, but stock ownership could become volatile in  certain interest rate environments, as the following examples illustrate.

Thirteen of the 14 member banks that we interviewed said that they  likely would not change their Federal Reserve membership status if  the ownership of stock became voluntary for member banks.

Of these 13, all 6 member banks with more than $10 billion in assets  also said that they likely would not purchase stock if ownership were  voluntary for members.

Of those 13, 6 of the 7 member banks with assets below $10 billion  indicated they likely would (ranging between somewhat likely, likely,  and very likely) purchase the stock if it were voluntary. They added  that if they could make a better return than 6 percent on the capital  committed to the stock in a higher interest-rate environment, they  would redeem the stock.

Two of the three nonmember banks that we interviewed said that they  likely would not change their Federal Reserve membership status if  the ownership of stock became voluntary for member banks.

The remaining banks (one member, one nonmember) said that they  would be somewhat likely to change their membership status.

In a high interest rate environment stock ownership by member banks  could be low, because banks could receive a higher return by investing  the capital in securities other than the Reserve Bank stock. This would  result in a high concentration of voting rights; however, this might not  differ much from current practices. Reserve Bank officials stated that if  voting rights remained with stock ownership, not membership, and if stock  ownership among member banks were low, then the votes to elect board  members would be concentrated in just a few banks. Some Reserve  Bank officials said that the concentration of votes could lead to undue  influence from a few banks. We previously found that, under the current  mandatory stock ownership structure, member bank voter turnout was  often low during some Reserve Banks’ elections. In these cases,  assuming current participation rates persist, voting patterns under  voluntary stock ownership might not significantly differ from those of the  current arrangement.

Reserve Bank officials also said that high volatility of stock ownership  would require a higher level of management of the stock. Officials said  that the processes for issuing, monitoring, and redeeming the stock would  become significantly more complex as a result of a likely increase in the  volume of transactions and require additional personnel. While a  voluntary stock ownership structure is more complicated than the current  structure, it would involve similar stock ownership characteristics as  publicly traded stocks and publicly traded companies have systems to  manage stock ownership.

Reserve Bank officials pointed out that volatility in stock ownership  among member banks also would result in fluctuation in the level of paid- in capital held at the Reserve Banks, which could make it more difficult for  Reserve Banks to predict and manage their capital. If a large number of  member banks chose not to purchase the stock, which member banks  suggested would be likely in a high-interest rate environment, then the  potential public perception issues associated with having a low capital  base, as discussed previously, could apply. However, as we have  discussed, the Reserve Banks could operate without capital, or Treasury  could capitalize the Reserve Banks.

section_title: Callable Stock Purchase Requirement
paragraphs: Allowing member banks to hold the full capital contribution on call could  have a number of implications. For instance, allowing member banks to  hold the entire capital contribution on call would allow Reserve Banks to  maintain their current corporate structure, since the member banks would  retain their equity stakes. However, this scenario would eliminate the  dividend payment to member banks because there would be no Reserve  Bank stock outstanding for which dividend payments would be owed.  Also, it could cause public perception problems and, in theory, exacerbate  financial distress in stressful economic times.

Currently, member banks are required to purchase stock in their regional  Reserve Bank equal to 6 percent of their capital and surplus, with 3  percent paid-in and 3 percent on call by the Reserve Bank. This scenario  would make the entire 6 percent purchase requirement callable, so that  member banks would not have to contribute any capital to the Reserve  Banks on joining the Federal Reserve. This modification would allow the  Reserve Banks to keep their current corporate structure and preserve  their ability to conduct banking operations. The change would also  eliminate the dividend payment to member banks since the capital  associated with the Reserve Bank stock would no longer be paid-in, so  there would no longer be a basis to pay member banks a dividend.  Similar to the scenario of retiring the stock or making its purchase  voluntary for members, the Reserve Banks’ capital base would be  reduced—in this case, to the amount of capital held in each Reserve  Bank’s surplus account.

Reserve Bank officials and some academics said that Reserve Banks can  operate without a capital base but, as discussed previously this could  cause a public perception problem. Specifically, Reserve Bank officials  said that if Reserve Banks incurred losses and called in capital from  member banks, the call could send a signal to the broader markets that  the Reserve Banks were insolvent. In turn, this perception could lead to  negative ripple effects throughout the economy. That is, Reserve Bank  officials said that situations in which Reserve Banks would incur losses  and need to call capital likely would be situations of economic stress for  banks. If banks could not quickly raise sufficient funds to meet the  Reserve Bank’s capital call, their lending capacity could fall and a credit  crunch could follow. Calling in capital from member banks at such a time  could have a procyclical effect; that is, the call would exacerbate financial  distress experienced by the member banks.

Reserve Bank officials added that because of the potentially severe  systemic effects such a capital call would be highly unlikely. Officials  pointed out that the Reserve Banks have never called in the 3 percent  capital at member banks and that Reserve Banks currently do not have  procedures for calling the 3 percent capital held at member banks. As  discussed earlier, if losses were incurred remittances to Treasury would  be suspended. If the Reserve Banks incurred losses over multiple periods  and their capital base were depleted, then the method for recapitalization  would need to be addressed (which, as discussed earlier, involves many  issues that would need to be considered).

Based on our interview responses, most banks would be unlikely to  change their membership status as a result of making the entire capital  contribution callable. All three of the nonmember banks that we  interviewed said that they likely would not become members or would be  only somewhat likely to become members in response to this change.  Member banks likely would not drop membership as a result of this  modification because, as some banks noted, it removes a potential barrier  to membership (paying in 3 percent of capital).

section_title: Agency Comments
paragraphs: We provided a draft of this report to FDIC, the Federal Reserve, OCC,  and Treasury for review and comment. None of the agencies provided  written comments on the draft report. FDIC and the Federal Reserve  provided technical comments, which we have incorporated, as  appropriate.

We are sending copies of this report to FDIC, the Federal Reserve, OCC,  and Treasury. In addition, the report is available at no charge on the GAO  website at http://www.gao.gov.

If you or your staff have any questions about this report, please contact  me at (202) 512-8678 or evansl@gao.gov. Contact points for our Offices  of Congressional Relations and Public Affairs may be found on the last  page of this report. GAO staff who made major contributions to this report  are listed in appendix III.

section_title: Appendix I: Scope and Methodology
paragraphs: In this report, we (1) examine the historical rationale for the Reserve  Banks’ stock purchase requirement and 6 percent dividend, (2) assess  the potential implications of capping the Reserve Banks’ aggregate  surplus account and modifying the Reserve Bank stock dividend rate, and  (3) analyze the potential policy implications of modifying the Reserve  Bank stock ownership requirement for member banks under three  scenarios.

To address our first objective, we conducted a literature search on the  history of the Federal Reserve System (Federal Reserve), including a  review of the legislative history of the Federal Reserve Act. See appendix  II for a selected bibliography of literature we reviewed. We interviewed a  past Federal Reserve historian and selected academics. We also  conducted a literature search on rates of return on selected investment  products. We specifically identified the following data sources:

Roger Ibbotson, 2013 Ibbotson SBBI Classic Yearbook: Market  Results for Stocks, Bonds, Bills, and Inflation1926–2012 (Chicago, Ill.:  Morningstar, 2013).—We reviewed information describing the rates of  return for a number of basic asset classes including large company  stocks, small company stocks, long-term corporate bonds, long-term  government bonds, intermediate-term government bonds, and  Treasury bills. The return rate data include information from 1926  through 2012.

Robert Shiller, Market Volatility (Cambridge, Mass.: MIT Press, 1989).  —We reviewed annual data on the U.S. stock market specifically  concerning prices, dividends, and earnings from 1871 to the present  with associated interest rate, price level and consumption data.

Frederick R. Macaulay, The Movements of Interest Rates, Bond  Yields and Stock Prices in the United States since 1856 (New York:  National Bureau of Economic Research, 1938).—We reviewed  commercial paper rates in New York City from January 1857 to  January 1936.

Sidney Homer and Richard Sylla, A History of Interest Rates, 4th ed.  (Hoboken, N.J.: John Wiley & Sons, 2005).—We reviewed data on  interest rates and yields from prime corporate bonds, medium-grade  corporate bonds, and long-term government securities from 1899 to  1989.

We determined that these sources were sufficiently reliable for the  purposes of our reporting objectives. Our data reliability assessment  included reviewing the methodologies employed by the authors of each  source and cross-checking certain data from the sources against each  other. First, we analyzed return data on investment-grade and medium- grade corporate bonds, and Treasury bonds. We selected these  instruments for comparison with Reserve Bank stock because they  generally present low risk of default and have relatively long maturity  periods. Corporate bonds can be classified according to their credit  quality. Medium-grade corporate bonds can indicate a strong capacity to  meet financial commitments but also can still be vulnerable to a changing  economy. Investment grade corporate bonds are considered more likely  than noninvestment grade bonds to be paid on time and have lower  investment risk. Treasury bonds are obligations by the U.S. government  and are considered to have low investment risk.

Second, we analyzed return data on interest rates based on commercial  paper and certificates of deposit, and the federal funds rate. We selected  these return data for analysis because they are common measures of the  value of money in the markets. Commercial paper consists of short-term,  promissory notes issued primarily by corporations that mature in about 30  days on average, with a range up to 270 days. A certificate of deposit is a  savings account that holds a fixed amount of money for a fixed period of  time, such as 6 months, 1 year, or 5 years, and in exchange, the issuing  bank pays interest. The federal funds rate is the central interest rate in the  U.S. financial market and is the interest rate at which depository  institutions trade federal funds with each other overnight.

We determined not to include rate of return information on stocks and  agency mortgage-backed securities. Stock is a more volatile investment  product than Reserve Bank stock, with wide variation in prices from year  to year. In addition, stock is a relatively liquid investment product  compared to Reserve Bank stock, which cannot be sold or otherwise  posted as collateral. Agency mortgage-backed securities are debt  obligations that represent claims to the cash flows from pools of mortgage  loans, most commonly on residential property. We found that agency  mortgage-backed securities generally return higher yields than Treasury  bonds, but not as high as corporate bonds, which have higher risk.

Therefore, by discussing Treasury and corporate bonds, we are  illustrating a complete range of possible returns.

To assess the potential implications of capping the aggregate Reserve  Banks’ surplus account, we reviewed past GAO, Congressional Research  Service, and Congressional Budget Office reports and Federal Reserve  financial documents on the status of the surplus account. We interviewed  Federal Reserve officials, including from the Board of Governors and the  Reserve Banks; former members of the Board of Governors who had  written about the changes in the Fixing America’s Surface Transportation  Act (FAST Act); academics who had written extensively about the Federal  Reserve; other federal bank regulators, including the Federal Deposit  Insurance Corporation (FDIC) and the Office of the Comptroller of the  Currency (OCC); and, banking industry associations. To assess the  potential implications of modifying the Reserve Bank stock dividend rate,  we reviewed Board of Governors financial documents as of June 30,  2016, for dividend payment information. We conducted structured  interviews with 17 commercial banks (including 14 member and 3  nonmember banks) to obtain their perspectives on the dividend rate  modification and if it would affect their membership decisions or status.  We selected commercial banks for these interviews to ensure  representation for all size categories and primary federal banking  regulator, using data from SNL Financial. We assessed the reliability of  the data by reviewing information about the data and systems that  produced them, and by reviewing assessments we did for previous  studies. We determined that the data we used remain sufficiently reliable  for the purposes of our reporting objectives.

To assess the potential implications of modifying the stock ownership  requirement, we reviewed academic literature on the structure and  independence of central banks. We also interviewed selected academics  and economists who had written extensively on central bank  independence; the chairpersons of all the Reserve Banks’ boards of  directors, who may not be affiliated with commercial banks; officials from  FDIC and OCC; and banking industry associations. In the structured  interviews with selected commercial banks described above, we also  sought to learn what factors might influence the banks’ choice to become  a member of the Federal Reserve, and whether potential modifications to  the Reserve Banks’ stock ownership structure would affect their choice.  We presented three scenarios (of changes to the stock ownership  requirement and therefore the Federal Reserve’s structure) in the  interviews to which respondents could react and discuss implications. The  scenarios are illustrative and do not represent all of the ways in which the  Federal Reserve structure might be altered nor does our analysis account  for all of the potential consequences of stock ownership modifications.  Furthermore, our discussion of the range of consequences is limited to  the respondents’ responses and the strategy in the interview, without  knowledge of the mechanisms that could be put in place to retain the  benefits of the current structure or mitigate any negative effects of the  changes.

We conducted this performance audit from February 2016 to February  2017 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.

section_title: Appendix II: Selected Bibliography
paragraphs: Alesina, Alberto, and Lawrence H. Summers. “Central Bank  Independence and Macroeconomic Performance: Some Comparative  Evidence.” Journal of Money, Credit and Banking, vol. 25, no. 2 (May  1993): 151–162.

Arnone, Marco, Bernard J. Laurens, Jean-Francois Segalotto. “The  Measurement of Central Bank Autonomy: Survey of Models, Indicators,  and Empirical Evidence.” International Monetary Fund Working Paper  06/227 (October 2006).

Calomiris, Charles, Matthew Jaremski, Haelim Park, and Gary  Richardson. “Liquidity Risk, Bank Networks, and the Value of Joining the  Federal Reserve System.” National Bureau of Economic Research  Working Paper 21684 (October 2015).

Clifford, A. Jerome. The Independence of the Federal Reserve System.  Philadelphia, Penn.: University of Pennsylvania Press, 1965.

Conti-Brown, Peter. The Power and Independence of the Federal  Reserve. Princeton, N.J.: Princeton University Press, 2016.

Cukierman, Alex. “Central Bank Finances and Independence – How  Much Capital Should a Central Bank Have?” in The Capital Needs of  Central Banks, S. Milton and P. Sinclair eds. Sue Milton and Peter  Sinclair. London, England and New York, NY: Routledge, 2011.

Cukierman, Alex, Steven B. Webb, and Bilin Neyapti. “Measuring the  Independence of Central Banks and Its Effects Policy Outcomes.” World  Bank Economic Review, vol. 6, no. 3 (September 1992): 353-398.

Gorton, Gary. “Clearinghouses and the Origin of Central Banking in the  United States.” The Journal of Economic History, vol. 45, no. 2 (June  1985): 277-283.

Homer, Sidney and Richard Sylla. A History of Interest Rates. 4th ed.  Hoboken, N.J.: John Wiley & Sons, 2005.

Ibbotson, Roger. Ibbotson SBBI Classic Yearbook 2013: Market Results  for Stocks, Bonds, Bills, and Inflation 1926-2012. Chicago, Ill.:  Morningstar, March 2013.

Lowenstein, Roger. America’s Bank: The Epic Struggle to Create the  Federal Reserve. New York, N.Y.: Penguin Press, 2015.

Masciandaro, Donato. “More Than the Human Appendix: Fed Capital and  Central Bank Financial Independence.” BAFFI CAREFIN Centre  Research Paper 2016-35 (September 2016).

Macaulay, Frederick R., The Movements of Interest Rates, Bond Yields  and Stock Prices in the United States since 1856. New York: National  Bureau of Economic Research, 1938.

Moen, Jon R., and Ellis W. Tallman. “Lessons from the Panic of 1907.”  Federal Reserve Bank of Atlanta, Economic Review, May/June 1990, pp.  2-13.

National Monetary Commission. Report of the National Monetary  Commission. Washington, D.C.: Government Printing Office, 1912.

Rossouw, Jannie, and Adele Breytenbach. “Identifying Central Banks with  Shareholding: A Review of Available Literature.” Economic History of  Developing Regions, vol. 26, supplement 1 (January 2011): 123-130.

Shiller, Robert J., Market Volatility. Cambridge, Mass.: MIT Press, 1989  (as updated).

Stella, Peter, and Åke Lönnberg. “Issues in Central Bank Finance and  Independence.” International Monetary Fund working paper 08/37 (Feb.  2008).

Timberlake, Richard H., Jr. “The Central Banking Role of Clearinghouse  Associations.” Journal of Money, Credit, and Banking, vol. 16, no. 1  (February 1984): 1-15.

Todd, Tim. The Balance of Power: The Political Fight for an Independent  Central Bank, 1790-Present. 1st ed. Kansas City, Mo.: Federal Reserve  Bank of Kansas City, 2009.

Warburg, Paul M. The Federal Reserve System: Its Origin and Growth. 2  vols. New York, N.Y.: MacMillan, 1930.

section_title: Appendix III: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact

section_title: Acknowledgments
paragraphs: GAO staff who made major contributions to this report include Karen  Tremba (Assistant Director), Philip Curtin (Analyst-in-Charge), Farrah  Graham, Cody Knudsen, Risto Laboski, Barbara Roesmann, Christopher  Ross, Jessica Sandler, Jena Sinkfield, and Stephen Yoder.


Question-summary annotations: questions: question: How did capping the surplus amount affect Federal Reserve operations?
answer: According to Federal Reserve System (Federal Reserve) officials, capping the surplus account had little effect on Federal Reserve operations, and GAO found that modifying the stock dividend rate formula had no immediate effect on membership.
child_questions: question: What must Reserve Banks do before remitting excess funds to the Treasury?
answer: Reserve Banks fund operations, pay dividends to member banks, and maintain a surplus account before remitting excess funds to the Department of the Treasury (Treasury).

question: What concerns have been raised regarding transfers to the Treasury's General Fund under the FAST Act?
answer: Whether the transfers to Treasury's General Fund in the Fixing America's Surface Transportation Act (FAST Act) when the act also funds specific projects should be viewed any differently than the recurring transfers of Reserve Bank earnings to Treasury is debatable. Some stakeholders raised concerns about setting a precedent—future transfers could affect the Federal Reserve's independence and, consequently, autonomy in monetary policymaking.

question: How have dividend payment trends and Reserve Bank membership since 2015?
answer: Dividend payments to 85 banks decreased by nearly two-thirds (first half of 2016 over first half of 2015), but GAO found no shifts in Reserve Bank membership as of December 2016. Some member banks affected by the rate change told GAO they had a few concerns with it and some said they might try to recoup the lost revenue, but none indicated they would drop membership.

questions: question: Under what circumstances would the implications of modifying Federal Reserve structure be considerable?
answer: Assuming that the policy goals—independence, balance of power, and geographical diversity—reflected in the original private-public Federal Reserve structure remain important, the implications of modifying the stock ownership requirement and therefore the Federal Reserve structure could be considerable.
child_questions: question: Why does this report fail to consider all possible implications?
answer: The scenarios discussed in this report are illustrative and do not represent all the ways in which the Federal Reserve structure might be altered. Also, the discussion of effects is limited because exact replacement structures are unknown.

question: How might retiring the stock affect the corporate structure of Reserve Banks?
answer: Retiring the stock could result in changes to the existing corporate structure of the 12 Reserve Banks.

questions: question: What have member banks of the Federal Reserve historically received on paid-in stock?
answer: Member banks of the Federal Reserve must purchase stock in their regional Reserve Bank, but historically received a 6 percent dividend annually on paid-in stock.
child_questions: question: How did the FAST Act affect dividends received by member banks of the Federal Reserve?
answer: A provision of the 2015 FAST Act modified the dividend rate formula for 85 larger member banks—and currently reduces the amount these banks receive.

question: How did the FAST Act affect the volume of surplus capital the Reserve Banks could hold?
answer: The FAST Act also capped the surplus capital the Reserve Banks could hold and directed that any excess be transferred to Treasury's general fund. Congress offset payments into the Highway Trust Fund by, among other things, instituting the Reserve Bank surplus account cap.