ANALYSIS/OPINION:

During 2008, the first full year of the recession, the Federal Reserve system expanded its balance sheet by $1.33 trillion, or 145 percent. The Fed also took on hundreds of billions of mortgage-linked assets with high-default risks, often in exchange for its own low-risk, short-term U.S. Treasury assets.

Because the scale and complexity of these activities raise serious concerns, outside observers should scrutinize the Fed’s every move. But the Fed’s distinctive in-house accounting standards make it difficult for outsiders — including Congress — to evaluate the Fed’s monetary and lending operations and how they might increase the risk to taxpayers.

The Fed’s activities need to be more transparent. This could be accomplished at least in part by requiring the Fed to use the same Generally Accepted Accounting Principles (GAAP) used by commercial banks and other private companies.

The lack of GAAP conformity has hardly mattered in the past because the Fed’s annual balance sheet and income statements didn’t entail serious transparency issues.

All that changed in mid-2007, when the Fed rapidly expanded its assets via some major changes in the credit risk and liquidity profiles of its balance sheet. Outside observers now have to read between the lines to estimate the real costs and benefits of the Fed’s recession-fighting programs.

Consider two examples. One involves the Federal Reserve’s ratio of liabilities to reserves. The second involves the low quality of the newly added — typically mortgage-linked — assets.

The Fed’s use of leverage increased dramatically during 2008, from 24:1 to 53:1. This left the Fed with about the same tiny capital ratio as Fannie Mae, Freddie Mac and Bear Stearns just before they failed. The Fed, however, cannot fail, because its obligations are backed by the full-faith-and-credit of the federal government — in short, by the power to tax.

If the Fed were a commercial bank, its deeply diminished capital — below 2 percent of assets — would subject it to prompt corrective action, including seizure by federal bank supervisory authorities. In 2008, the Fed would have had to add more than $54 billion to its capital accounts to maintain the same approximately 4 percent capital-to-assets ratio as at year-end 2007. It added only $2.6 billion.

An important difference between GAAP and the Fed’s accounting system is the absence of reserves for loan losses stemming specifically from the Fed’s large and growing pool of high-risk assets. The average amount of year-end reserves for loan losses of all banks insured by the Federal Deposit Insurance Corp. in 2008 was 1.2 percent of assets. A comparable measure at the Fed would have caused an expense provision of $26.9 billion. Instead, a comprehensive loss of only $4.7 billion was recognized and charged against current income, despite the Fed’s much riskier array of assets.

While not strictly a matter of accounting standards, a further reason for concern about the Fed’s lack of transparency is the problem of how and whether the Fed will manage to neutralize the excess reserves that have recently piled up in commercial banks.

During 2008, the $1.3 trillion expansion of the Fed’s balance sheet was accompanied by a $901 billion addition to the Fed’s monetary base. As a result, the reserve accounts of depository institutions rose from $21 billion to $860 billion, while currency in circulation rose by only $62 billion, leaving excess reserves of about $800 billion more than necessary to meet legal reserve requirements.

When the economy recovers, the demand for bank loans also will recover. At that point the excess reserves could fuel an explosion of bank lending with accompanying inflationary pressures.

The Fed should stop using its arcane, non-GAAP accounting protocols. In the current financial environment, the Fed’s internal accounting practices hide as much as they reveal, and could result in politically expedient misstatements of the true financial costs and benefits of the Fed’s recession-driven interventions in risky financial markets.

Congress should consider asking the following three questions while overseeing the Fed’s activities: Why not subject the Fed to normal, GAAP-compliant accounting standards? Why is the Fed certain that it easily and readily could shrink its balance sheet the next time that inflation rears its head?

Last and not least, why should the Fed not be required to prepare and give Congress and the public financially transparent quarterly GAAP-compliant reports of its financial operations?

William F. Ford is a visiting research fellow and Walker Todd is a research fellow at the American Institute for Economic Research, Great Barrington, Mass. ( www.aier.org ), a 76-year-old research and education institute.

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