The Wall Street Journal reported Tuesday on a scheme that passed the Senate last July, to supplement the Highway Trust Fund. The legislation would reduce the 6% dividend paid by Federal Reserve Banks on stock that member banks in their respective districts are required to purchase as a condition of system membership. What is involved here? And how would this proposal generate funds to replenish the Highway Trust Fund? Is this yet another backdoor way for Congress to employ central banks funds in lieu of tax increases to fund pet projects?
To understand what is involved, some basic facts need to be inventoried. First, the Federal Reserve System was created by Congress and is a governmental entity, despite the fact that the Federal Reserve District Banks are quasi-public institutions whose stock is owned by member banks in their respective districts. The Fed’s liabilities are guaranteed by the Treasury, so they are risk-free and essentially equivalent to Treasury securities.
Second, member banks are required to purchase Reserve Bank stock equal to 6% of their paid-in capital and surplus, and the Reserve Banks are required by law to pay a fixed 6% dividend on that stock. Member banks must increase or decrease their subscription as their capital increases or decreases.
Third, the Fed’s assets consist of Treasury and agency mortgage-backed securities, which are also essentially government debt. The Fed purchases those assets from the public and pays for them by increasing bank reserve balances that are payable upon demand. In this way, the Fed is extracting duration from the market and substituting one form of government debt for another.
Fourth, the Fed receives interest payments from the Treasury and extracts its operating expenses, which consist primarily of interest on reserves, additions to its capital, the required 6% dividend, and salaries and other expenses. The remainder is remitted to the Treasury. Some view the Fed as a profit-making entity, drawing an analogy with private-sector firms. But this comparison ignores the fact that the Fed is part of the government and that its holding of Treasuries amounts essentially to the government owning its own debt; the payment flows are simply intragovernmental transfers. If the payment process described were settled the way interest-rate swaps are netted, there would always be a net transfer of funds from the Treasury to the Fed. In other words, the Treasury is funding the Fed, and the Fed is not a source of funds to the Treasury.
These facts help us understand the proposed cut in bank dividends on Federal Reserve stock. The Treasury is funding the Fed’s dividend payments in the sense that, were the dividends reduced, the net transfer of funds from the Treasury to the Fed would be reduced, and Treasury resources would be increased by the amount of the dividend cut. Viewing the proposed transaction this way, the dividend cut would have no financial impact upon the Federal Reserve, nor does the dividend cut involve any use of Federal Reserve resources to fund the Highway Trust Fund. It is more accurately regarded as a tax on banks by reducing their dividend income.
What would be the effect of the cut, besides the reduction in bank income? Federal Reserve stock is best viewed as perpetual fixed-rate preferred stock. It is risk-free in terms of credit risk and pays the holder a 6% risk-free fixed rate. It is, of course, subject to interest-rate risk. In the late 1980s, for example, when the 10-year Treasury note hit 16%, the opportunity cost of holding Federal Reserve stock was high; indeed, banks left the Fed, and membership became a big political concern for the Fed. Now, with the 10-year note and 30-year bond under 3%, the 6% risk-free rate on member bank stock holdings is a significant subsidy that member banks would be reluctant to lose, hence the intense bank lobbying effort to kill the provision in the Senate legislation.
Chair Yellen will obviously express concern about possible unintended consequences of the proposal, especially if interest rates were to rise and precipitate another membership problem. But, realistically, the present situation, in which taxes and subsidies are incurred as a result of the stock ownership requirement, makes little sense. Rather, a more sensible approach would be to tie the Fed’s dividend payment to the rate on a suitable long-term Treasury obligation to which the stock is equivalent. This approach would eliminate the subsidy/tax issue and keep Treasury tax receipts in government coffers where they belong.