As previously noted, the capital surplus account is adjusted to a level equal to the paid-in capital account. This adjustment, however, is made at the end of the calendar year. During the year, another capital account, undistributed net income, reflects the amount of net earnings for the current year that have not been distributed. Each week, the sum of the balance in the capital surplus account and undistributed net income is compared with the paid-in capital account. If the amount of the capital surplus account and undistributed net income combined is greater than capital paid-in, the excess is paid to the Treasury a week later. This payment in turn reduces the undistributed net income account. At the end of the calendar year, the balance in the undistributed net income is transferred to the capital surplus account up to the amount of paid-in capital. Any remaining balance is distributed to the Treasury. Essentially, the capital surplus account represents earnings retained from prior years, and the undistributed net income represents earnings retained from the current year. Both the capital surplus account and the undistributed net income account provide a cushion against losses. Any Reserve Bank losses first reduce the undistributed net income account. The capital surplus account is then reduced if the undistributed net income account is not sufficient to absorb the loss. Transfers of the Reserve Banks’ net earnings to the Treasury are classified as federal receipts. Federal receipts consist mostly of individual and corporate income taxes and social insurance taxes but also include excise taxes, compulsory user charges, customs duties, court fines, certain license fees, and the Federal Reserve System’s deposit of earnings. The Treasury securities held by Reserve Banks are considered part of the federal debt held by the public. Federal debt consists of securities issued by the Treasury and a relatively small amount issued by a limited number of federal agencies. Federal debt is categorized into debt held by the public and debt held by government accounts. Debt held by the public is that part of the gross federal debt held outside of federal budget accounts, and this includes any federal debt held by individuals, corporations, state or local governments, the Federal Reserve System, and foreign governments and central banks. The Consolidated Appropriations Act of 2000 directed the Reserve Banks to transfer to the Treasury additional surplus funds of $3.752 billion during fiscal year 2000. The Federal Reserve System transferred the funds on May 10, 2000. Under the act, the Reserve Banks were not permitted to replenish their accounts during fiscal year 2000. Once the Reserve Banks were legally permitted to replenish the accounts, they did. By December 31, 2000, the capital surplus account was replenished for 11 of the 12 Reserve Banks. The Federal Reserve System maintains a capital surplus account to provide additional capital to cushion against potential losses. However, Federal Reserve Board officials have noted that it can be argued that a central bank, including the Federal Reserve System, may not need to hold capital to absorb losses, mainly because a central bank can create additional domestic currency to meet any obligation denominated in that currency. Federal Reserve Board officials acknowledged that determining the appropriate level of a central bank’s capital account is difficult. The Federal Reserve Board’s policy of maintaining the capital surplus account at the same level as that of the paid-in capital account has resulted in the capital surplus account growing from $4.5 billion in 1996 to $7.3 billion in 2001. The Federal Reserve System maintains the capital surplus account primarily as a cushion against losses. The Financial Accounting Manual for Federal Reserve Banks states that the primary purpose of the Federal Reserve capital surplus account is to provide capital to supplement paid-in capital for use in the event of loss. According to Board officials, the capital surplus reduces the probability that total Reserve Bank capital would be wiped out by a loss as a result of dollar appreciation, sales of Treasury securities below par value, losses associated with discount window lending, or any other losses. Individual Reserve Banks use the capital surplus account when they experience losses greater than the amount in their undistributed net income account. Federal Reserve Board officials also noted that it could be argued that maintaining capital, including the surplus account, provides an assurance of a central bank’s strength and stability to investors and foreign holders of U.S. currency. Currently, a significant portion of U.S. currency is held abroad. According to one estimate published by the Federal Reserve Board, $279.5 billion in U.S. currency was held overseas as of the fourth quarter of 2001. The total amount of Federal Reserve notes outstanding was $611.8 billion as of December 31, 2001. Federal Reserve Board officials stated that the demand for U.S. currency conceivably could fall if a large loss wiped out the Federal Reserve’s capital accounts, giving a misimpression that the Federal Reserve was insolvent. “In the abstract, a central bank with the nation’s currency franchise does not need to hold capital. In the private sector, a firm’s capital helps to protect creditors from credit losses. Creditors of central banks however are at no risk of a loss because the central bank can always create additional currency to meet any obligation denominated in that currency.” Moreover, an official representing one of the four foreign central banks that we contacted agreed that the concept of solvency was essentially meaningless for a central bank in its role as a creator of currency, and that a massive loss could make a central bank technically insolvent, but that there would be no impairment of its ability to create and manage assets and issue currency. However, Federal Reserve Board officials told us that, because the maintenance of the capital surplus account is “costless” to the taxpayer and to the Treasury, the argument that a central bank does not need capital is not a rationale for reducing the surplus to any particular level, including zero. We will discuss the possible effects of a change in the surplus account on the federal budget and the economy later in this report. Federal Reserve Board officials told us that determining the appropriate level for a central bank’s capital account is difficult. The growth in the Federal Reserve System’s capital surplus account can be attributed to growth in the banking system together with the Federal Reserve Board policy of equating the amount in the capital surplus account with paid-in capital. The Federal Reserve System surplus has grown along with the paid- in capital account which itself grew as a result of expansion of the banking industry capital during the late 1990s. In 1996, the capital of all member banks (state member banks and national banks) totaled almost $157 billion; by December 2001, it was $267 billion. Because the Federal Reserve Act requires members to subscribe to a stock subscription equaling 6 percent of their capital and surplus, half of which is to be paid in, the Reserve Banks’ capital paid-in accounts have increased along with member bank capital and surplus. As a result of the Federal Reserve Board’s policy, the Federal Reserve capital surplus account grew correspondingly. The level of the Federal Reserve capital surplus account is not based on any quantitative assessment of the potential financial risk associated with the Federal Reserve’s assets or liabilities. According to a Federal Reserve Board official, the current policy of setting the levels of surplus through a formula reduces the potential for any misperception that the surplus is manipulated to serve some ulterior purpose. In response to our 1996 recommendation that the Federal Reserve Board review its policies regarding the surplus account, the Federal Reserve Board conducted an internal study that did not lead to major changes in policy. Three of the four central banks that we contacted had capital accounts that included ownership shares as well as “surplus” accounts with functions similar to the Federal Reserve System capital surplus account (see table 1). We found the levels of these accounts varied in size and, with the exception of the Bank of England, officials from the four central banks explained that the levels were established by law. The Bundesbank and the ECB had also established additional “provision” accounts that were not part of the subscribed capital or surplus accounts, but that served as an additional cushion against losses. The provision accounts were set up primarily to offset the central banks’ exposure to foreign exchange rate and interest rate risk and their levels are evaluated on an annual basis. In contrast to these central banks, the Bank of Canada does not require an additional account to buffer the impact of foreign exchange rate and interest rate movements on their assets because it does not hold a significant amount of assets denominated in currencies other than the Canadian dollar on its balance sheet. Similarly, its domestic assets holdings of Canadian government securities are diversified across maturities, approximately mirroring the issuance of Canadian government securities. It should be noted that accounts at the four central banks that we contacted are not fully comparable with the Federal Reserve System capital surplus account because of differences in accounting practices. The Bundesbank and the ECB use accounting methods that differ from the Federal Reserve’s to cushion against foreign currency risk and have set up “revaluation accounts” representing valuation reserves arising from unrealized gains on assets and liabilities, including foreign currency. The levels of these accounts vary automatically in accordance with regular market valuations of the assets held compared to their original cost. The Bundesbank, bearing especially the foreign exchange risk in mind, has established a “provisions” account. When determining how much to put into this account, the Bundesbank evaluates its exposure to foreign exchange risk and interest rate risk, to the extent of which these risks are not already covered by the “revaluation account.” In addition to the “provisions” account, the Bundesbank also has a “statutory reserves” account that serves as an additional financial buffer against risk. This reserve account may be used only to offset falls in value and to cover other losses. It is derived from the net profit each year and has a maximum level established by legislation. The levels of capital that the central banks maintain are not directly comparable with the Federal Reserve’s capital (including the surplus account) for several reasons.