Here's a very big bank that had assets of $1.03 trillion and capital of only $9.6 billion, for leverage of 107 to 1, on Jan. 28, 2009. To put it another way, its capital ratio was less than 1% of its assets. Is this undercapitalized?

At the end of 2007 it had assets of $347 billion and capital of $9.2 billion, for leverage of 37 to 1, or a capital ratio of 2.7%. Assets have tripled, while capital is virtually unchanged — an already very low capital ratio has become a lot lower.

The assets have also become much riskier. During the year, the bank has taken $3 billion in mark to "fair value" losses on its portfolio of illiquid mortgage securities and derivatives.

A troubled bank? No: It's the Federal Reserve Bank of New York, which has undergone a remarkable transformation during the financial crisis. Its balance sheet evidences its heroic efforts to finance the bust as it has become, in the hyperbole of one of my AEI colleagues, "the only bank in town."

The New York Fed is certainly a profitable bank, with a 2007 return on equity of almost 170% — the ability to issue no-interest notes for the public to carry around being a highly remunerative business.

And it has had its deposit business explode, an exceptionally important fact. At the end of 2007, banks were keeping $9 billion on deposit with it. Now they have $455 billion in deposits safely stored at the New York Fed, for a fiftyfold increase. (For all Federal Reserve banks, such deposits from banks are up to $740 billion.) This is the banking equivalent of keeping dollar bills in the mattress.

If the banks are keeping so much of their money simply on deposit at the Fed, what is the Fed to do? Well, if you don't want credit to shrink further, you must lend it out — just like a commercial bank. And that is what is happening.

As the assets of the New York Fed have dramatically increased, their composition has undergone a historical change. Treasury bills in portfolio, the least risky securities, are down from $83 billion in 2007 to $7 billion, an 84% drop. "Maiden Lane LLC," the illiquid mortgage securities and derivatives it acquired from Bear Stearns, are $26 billion, after the $3 billion fair-value writedown. Maiden Lane II and III, the holdings it acquired from American International Group, total $46 billion. The three Maiden Lanes together are eight times capital.

Commercial paper funding, a highly useful program in countering the credit crunch, to be sure, totals $248 billion, or a quarter of the balance sheet and 26 times capital.

Then there is the "term auction credit" to finance Wall Street of $208 billion, or 22 times capital. Programs to buy mortgage-backed securities are still ramping up.

In sum, what has happened is that the Fed, and the New York Fed in particular, has become a credit intermediator, something like a commercial bank, in addition to being a classic central bank short-term lender to banks.

Since the Fed really has gone into the credit business, what about that astronomical leverage?

Some people have argued that the bank's leverage is less than it appears, because the Federal Reserve banks own gold certificates for which the gold collateral is valued at only $42 an ounce ($42 2/9, to be precise), or less than one-twentieth of the market price of gold. The book value of the New York Fed's gold certificates is about $4 billion. Since gold is over $900 an ounce in the market, does that mean the assets and capital are really $80 billion or so greater?

It doesn't appear so. These are gold certificates, not gold itself. The Fed had its gold taken away by the government in the 1930s. As the notes to the New York Fed's financial statements explain, the certificates don't give it the right to get the gold, but are a loan to the Treasury repayable in dollars, not gold: "The U.S. Treasury may reacquire the gold certificates at any time and the Federal Reserve banks must deliver them to the U.S. Treasury. At such time, the U.S. Treasury's account is charged."

Do we care if the New York Fed doesn't have much capital relative to its assets, while the assets grow riskier? Maybe it doesn't matter if the entity that can print up money has any capital or not. If Fed liabilities exceeded assets, would you stop taking dollar bills in payment?

Might the Fed's stockholder — i.e. the banks — care? Though their shares are nonvoting and nonmarketable, they are liable for the Fed's liabilities up to double the par value of their stock. This double liability was an idea brought to the Federal Reserve Act from the old requirement for national bank shareholders, which was dropped in the 1930s.

The stockholders do get a 6% dividend, which while paltry relative to a 170% ROE, still looks pretty good these days. The rest of the ROE goes to the Treasury. Maybe the revamped New York Fed should be retaining some of those earnings instead to build up its capital ratio, given its new commercial-banking-like exposures. If we care about the Fed's capital ratio, that is. Do we?

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