Paul Kupiec on Problems with the Fed’s Balance Sheet and Calls to End Interest on Reserves

Paul Kupiec is a senior fellow at the American Enterprise Institute. In Paul’s first appearance on the show, he discusses life at a think tank, the insolvency of the Fed, theories on how to fix the Fed’s balance sheet, Ted Cruz’s call to end interest on reserves, and much more. 

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This episode was recorded on June 24th, 2025

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected]. 

David Beckworth: Welcome to Macro Musings, where each week we pull back the curtain and take a closer look at the most important macroeconomic issues of the past, present, and future. I am your host, David Beckworth, a senior research fellow with the Mercatus Center at George Mason University, and I’m glad you decided to join us.

Our guest today is Paul Kupiec. Paul is a senior fellow at the American Enterprise Institute, or AEI, and formerly worked at the FDIC, the IMF, the Fed, and Wall Street. Paul joins us today to discuss issues surrounding the Fed’s balance sheet and recent calls by members of Congress to end interest on reserves. Paul, welcome to the show.

Paul Kupiec: Thank you, David. Thanks for inviting me.

Beckworth: It’s great to have you on. Now, we first met at an event that you hosted at the AEI. You graciously invited me to participate on a panel. I think George Selgin had launched his book on the Fed’s new floor system. It was myself, George Selgin, and then Bill Nelson, and yourself. Had a great conversation. Got to know you. Got to know Bill Nelson. Lots of fun conversations since that time with Bill and George on operating systems, which is near and dear to my heart, and I believe to your heart as well.

Kupiec: Yes. You guys are probably more specialized in operating systems than me.

Paul’s Career

Beckworth: You lit the fire. You got us going, so that’s fantastic. You’re doing a lot of interesting work over at the AEI on issues related to banks, to the Fed’s balance sheet, and as it turns out, to some of the recent calls for changes at the Fed right now on its payments on reserves. You’ve looked at that connection between the Fed and banks. You used to be an official at the FDIC, right?

Kupiec: Yes. I was the associate director of research, and I was basically the head of the economics group there. I hired the economists. I did whatever economics-type studies the FDIC wanted back then. It seems like a long time ago.

Beckworth: You’ve had a pretty interesting journey, though. You were at Wall Street, the Fed.

Kupiec: I can’t keep a job. I really have a hard time keeping jobs, as you’ll see. You want the bio. 

Beckworth: Yes, tell us how you got to where you are.

Kupiec: Do I have to go back before high school when I worked at Radio Shack, or should I leave that out?

Beckworth: Let’s leave the ’80s out.

Kupiec: I went to GW, undergrad, and then on to the University of Pennsylvania for my master’s and PhD in economics. I specialized in econometrics and finance, actually took finance in the Wharton School, and I have a third field that was economic theory. That was back in the dark ages, back in the ’80s, the last millennium. I left Penn and went to NC State, where I was an assistant professor teaching finance for three years. During that time, we had the ’87 stock market crash. I was doing equities mainly when I first came out. Fed needed somebody to follow the equity markets, got a call from the Fed, went to the Board.

I was at the Board for about 10 years, a little month or two short of 10 years. A year of that time, I spent over at the Bank for International Settlements. The Federal Reserve System, usually it’s either the Board or the New York Fed, usually sends an economist there for a year. I was one of the ones that went. It was a good experience. Met Claudio Borio, met a lot of people over there, worked with Claudio. Came back, ended up working directly for Alan Greenspan when he did his irrational exuberance speech. I was actually the equity market guy that modeled the equity markets behind the scenes. I didn’t know he was going to give that speech.

Beckworth: Small world. Wow.

Kupiec: I did not have anything to do with him writing the speech, but I was doing the modeling behind the scenes that I think had something to do with him giving that speech. He basically built a Campbell-Shiller dividend type model of the equity markets and fed him that, updates monthly, maybe more than that. Worked on risk management. The Fed created a special division back in the early ’90s when risk management was all the craze. This was, say, around 1993 or ’94. You may recall after the ’87 and ’89 stock market crashes—we’re going way back—there was another crash in ’89. They were blaming the futures markets on S&P 500 for causing the stock market crash and saying margins were too low.

Congress actually delegated the Fed regulatory authority over futures margins on stocks. I was dispatched to recreate the margining system that the Chicago Mercantile Exchange used, the SPAN system. I think they still use a version of the SPAN. I wrote a number of papers about that. I basically built the SPAN system myself for the Board, kicked the tires, tried to make everybody comfortable with it, actually set margins right for futures and options on futures. Spent some time back and forth with the Chicago exchanges. That was a good experience. That kicked off the early days of risk management because the SPAN margining system is a daily mark-to-market margining system. It’s essentially an early risk management model.

They created a group to study the banks and banking risk management because Basel was underway, the planning for Basel II, and the advanced approach for market and credit risk. I worked on that a lot for the Board. In the process, it was interesting. We had a lot of meetings with the banks. The banks told us how fantastically sophisticated their risk management systems were. They were just beyond reproach. I bought that hook, line, and sinker, and figured I really needed to go to Wall Street and J.P. Morgan, since J.P. Morgan was the cream of the crop. I should go there.

J.P. Morgan said, sure, come on up. I went up to J.P. Morgan, and I found out they didn’t have any of the risk management systems in place that they had told the regulators. They barely had one for the bank. It was typical, don’t believe everything you hear. I stayed up there for the better part of a year. The woman, who is now my wife, was working at the Fed, and I was commuting back and forth every week. That got old. I quickly learned that I was more of a researcher and not a Wall Street wheeler-dealer salesman type. I came back and worked at Freddie Mac for the better part of three years. I built some risk models for mortgages and bonds that they bought.

From there, I went to the IMF, where I was a deputy director or something, I forget the exact title I had, it is probably in my vitae, of the International Banking Group. We went around and did things called FSAPs, financial stability assessment of various countries. I did the stress testing. I actually built the IMF stress testing models for most of the major countries the first time they did it. That’s really a black art, and I wouldn’t call it science. What answer do you want, and I’ll come up with a way to get it for you. It’s kind of the way that works. It still does, I think, even with the Fed’s stress test. I did that for the better part of five years. 

Then the FDIC was trying to start a center for financial research, and they needed an inside director. Mark Flannery, they hired him to try to find somebody to do it, and he convinced me to come over and do it. Originally, I went there, I didn’t have any human management responsibilities, which was just fine with me. I was going to run the research center, give out grants, write papers.

Then shortly after I got there, their associate director over at The Economist, he retired. They decided I should do that job, and all of a sudden, I had 40 people reporting to me, which isn’t my idea of a good time. I have hard enough time managing myself, so having 40 people come to you. I did that for 10 years. By that time, my wife was ready to retire from the Federal Reserve Board, and I had had enough of government service. Kevin Hassett, who was in charge of economics at AEI back then, invited me to come over there, and I did. I’ve been there since 2013, I guess, and it’s been a good ride.

Beckworth: You get to do all the research that you want?

Kupiec: I can do whatever research. I can write whatever I want, nobody tells me if I’m productive. I don’t effectively have a boss, I’m my own boss, which I think makes you work harder, actually, because you always feel like you have to be producing or somebody’s going to notice.

Think Tanks

Beckworth: Paul, let me ask you this question because I have this question asked of me many times, because I mentioned to you before we started recording, I commute back and forth between Nashville and here. I’m up here several weeks a month, and I’m back home. When I’m back home, people are like, “What do you do? What does a think tank do?” How do you explain your job, the think tank world job, to someone who’s outside the D.C. bubble, who doesn’t understand this world?

Kupiec: Yes, they probably don’t understand, but I write economic papers and analyses and try to influence the policy debate. My target is the public. It’s academics, but it’s primarily Congress, I would say. Congress doesn’t always catch on all the time to issues that are brewing, and I try to figure out what they are and explain them as clear as I can and be of service to them. I didn’t really understand this for the longest time working in Washington, but Congress itself doesn’t have a huge, highly-paid staff. It cycles through young people every few years, and the ones that stay long enough then get appointed to be head of an agency if they’re lucky, or something like that.

The think tanks in DC, in my opinion, function as auxiliary research staff that tries to feed them their own particular view on what the policy issues are and how they ought to think about it. As you know, there’s Mercatus, there’s AEI, there’s Cato, and then there’s a million on the left side of things, and they’re all writing papers and having opinions.

Beckworth: Screaming for attention.

Kupiec: Screaming for attention.

Beckworth: Listen to me.

Kupiec: Some of them for money, too. That’s what the think tank world is, sort of the auxiliary research staff.

Beckworth: That’s a great way of framing that, because it’s true, in fact, you’ve had this experience where you’ll go to Capitol Hill, you’ll inform the staff about Fed issues or maybe capital markets or banking regulation, and a year later they’re gone, and you’ve got to start over again.

Kupiec: With a new staff.

Beckworth: We’re here manning the fort, so to speak, of ideas. Again, there’s a range of ideas. You have Brookings, you have AEI, and a bunch in between. It’s great to be a part of this experience. I tell people back home I have a great job. I sometimes have to pinch myself, they pay me to do this.

Kupiec: No, I agree. I feel the same way.

Beckworth: I get paid to talk to people like you. Anyway, it’s a great career path. The work you’re doing at the AEI is really interesting, and again, I think important, given where we are. 

Current State of the Fed’s Balance Sheet

Today I want to begin by talking about the Fed’s balance sheet. It’s grown really large. It started to grow, of course, after 2008, but we just got the system’s open market account annual report for 2024. The New York Fed puts this annual report out. Maybe give us a contour of the lay of the land. Where are we in terms of the Fed’s balance sheet? How much has it shrunk? How big is it? What are the losses? All those details one would want to know when we think about the Fed’s balance sheet.

Kupiec: I usually go by the H.4.1s that come out weekly on Thursday, and knowing I was coming on this week, I did the one for June 12. I looked at the one from last week, too. The total assets of the system were almost $7 trillion as of June 12. The balance sheet has shrunk from close to nine at some point. It’s been shrinking. 

The balance sheet is mainly Treasuries and mortgage-backed securities primarily, and most of them are heavily weighted toward the long maturity. The system for almost 100 years made money. Central banks are supposed to make money. Kings of thousands of years ago had central banks, or the equivalent thereof, the mint that made money. Up until September 2022, the Fed made money and remitted money to the Treasury, which reduced the need to tax the citizens. Made seigniorage money. Beginning in early September 2022, a few banks in the system started losing money.

Beckworth: By banks, you mean the regional Fed banks?

Kupiec: There are 12 district Federal Reserve banks. Each of them is a separately incorporated entity, and each of them has their own balance sheet and their own profit and loss statement, their own assets, their own Federal Reserve notes. Every one of the Reserve Banks, as you know but your audience may have forgotten, issues their own Federal Reserve notes. They have to collateralize those Federal Reserve notes. They take the deposits of the bank, and they interact in the payment system, and they hold assets.

Starting in September 2022, the largest banks, Boston, New York, San Francisco, started losing money. They started gradually, and then more and more of them started losing money. Up until June 12 of 2025, their accumulated cash losses were $232 billion. Last week, update a week, they lost $225 million more. Their losses to date are sitting right around $232.5 billion cash losses. Those are cash losses. They have more than exhausted the Fed’s capital. 

Under law, each of the member banks has to belong to one of the 12 district banks, as you know, and they have to purchase stock. I think the stock purchase is 6% of their equity, I think, and surplus. They have to purchase that in their Federal Reserve bank. That’s mandatory. They only have to pay for half of that stock, though. They only have to pay for half of their subscription. The subscription gets updated, I think, quarterly, as the balance sheets of the member banks change. The Fed’s total paid-in capital as of June 12, 2025, their paid-in capital was $38.731 billion. They had surplus, which is limited by law, of $6.785 billion. They basically had capital of, what, about $44 billion, roughly. Now they’ve lost $232 billion. Currently, the system, if you use GAAP accounting, would be insolvent to the tune of $186.471 billion. They would be underwater by that much.

On a GAAP basis, the Fed is technically insolvent. Now, not every bank in the Fed’s system is technically insolvent. There are three banks that currently, on a GAAP basis, would be solvent, and two banks that still actually make money. Atlanta still makes money a little bit. St. Louis still makes money, and they still remit to the Treasury. All the rest of the banks are losing money. Dallas has lost a cumulative amount of $874 million, but it still has some capital left. It still has about $450 million in capital left. As we go through time, eventually, they’ll exhaust that capital, and on a GAAP basis, Dallas will also be insolvent.

Now, you might ask why some banks are insolvent and some actually still make money and are solvent. The Fed, of course, has a portfolio of assets of about $6.7 trillion, as we said, and they earn interest on those assets. They have to fund those assets, and they fund those assets first with the Federal Reserve notes that each of the banks issues, and they pay zero interest. That’s historically where the Fed made—

Beckworth: It’s the golden goose.

Kupiec: It’s the golden goose. Ben Bernanke killed the golden goose with paying interest on reserves and QE. He massacred it. 

Beckworth: Initially, it seemed to work—it wasn’t until 2022.

Kupiec: —until it didn’t. 

Beckworth: We’ll come back to that, but go ahead. Go ahead.

Kupiec: They fund their assets with Federal Reserve notes, but that’s limited by the public’s demand for Federal Reserve notes. They just don’t fly Federal Reserve notes out of helicopters. That would literally be helicopter money. They don’t do that. They satisfy the demand for currency, Federal Reserve notes. They also do repurchase agreements with nonbanks, money market mutual funds, and things like that. They have deposits of their member banks, which are called reserves. They pay interest on reserves and they pay interest on the repurchase agreements.

Ever since we had the inflation, the interest rates that banks pay on the deposits of member banks and the repurchase agreements are higher than the interest rate they earn on their massive portfolio. If you pay more on your borrowing than you earn on your assets, you lose money. The Fed’s been losing money since September 2022.

Beckworth: That is so interesting. The fact that some of the regional Federal Reserve banks are still in the black, most are in the red, that was also a new insight for me. I went to the Atlanta Federal Reserve’s Financial Markets Conference. I was talking to people from Atlanta Fed. They said, “Hey, David, guess what? We’re actually making money.” I’m like, “What?” It’s their cash operations. This is one place, that demand for currency in Latin America. They told me they have multiple cash processing centers, but Miami’s a real big one. I understand it’s like a fortress. There’s been some movies about robbing the Federal Reserve. I don’t know if you’ve seen Den of Thieves, but it’s a movie.

Kupiec: I haven’t seen that one.

Beckworth: It’s a recent movie. I think there’s a Den of Thieves 2 now, but Den of Thieves, they try to rob. Of course, it’s an inside job because the security’s so great there. Anyhow, the Atlanta Fed, as you know, it exports a lot of notes to Latin America. Now, you might say, “Oh, that’s drug money.”

Kupiec: You might say that.

Beckworth: Also, there’s the implicit dollarization in Latin America. They don’t trust their own country. It’s yin and the yang, but nonetheless, it keeps the Atlanta Fed more than solvent. It generates income. I guess a question I have for you is, when I was looking over these numbers, once I learned this, you mentioned some of the bigger banks, like the New York Fed, it has the most loss, and then some scales down. I think you told me that the scale loss is driven in part by how much of the SOMA, the Fed’s portfolio, sits at each bank. How do they assign who gets to hold it? Clearly, the New York Fed holds the lion’s share, but why should San Francisco get some and be burdened with it?

Kupiec: This is a deep and good question. I’m not sure I have it exactly right, but I’ll tell you how I think it goes. First of all, there’s some settling up between the interbank accounts that goes on in April. What I understand is, the Federal Reserve looks at all the Federal Reserve notes issued by all the banks. It looks at the gold certificates that it has from the Treasuries, because the Treasury stole the Fed’s gold back in 1933 when Roosevelt made it illegal and gave them a bunch of gold certificates. The Fed has a certain amount of gold certificates, and they’re distributed among the banks.

They look at the total Federal Reserve notes that have been issued, and they look at the total gold certificates that they have in total. They look at the average gold certificate backing of all Federal Reserve notes. Then they try to true it up so that every one of the 12 Reserve banks has that same ratio for the next year. They switch around who owns the gold certificates, and they offset that by changing the SOMA portfolio. They’ll swap some SOMA assets for the gold certificates, and then wherever that ends up, the share of the SOMA assets for the next year, when the New York Fed buys new assets, they get distributed according to whatever that share is.

Beckworth: Interesting.

Kupiec: It’s very complicated, and I’ve never done it myself. Maybe Bill Nelson has done it. I don’t know who does it.

The Federal Reserve and Gold

Beckworth: That is so fascinating. You bring up the history of the gold notes, which makes me think of another question. If the Fed revalued the gold notes according to the market value of the gold, they would no longer have the loss on their balance. They would have income loss, but they wouldn’t have the market loss.

Kupiec: That’s not exactly true. First of all, do you think that it’s legal for the Fed to own gold? Other central banks all over the world are buying gold. We’re told that, right?

Beckworth: Yes.

Kupiec: There’s a big demand. Is the Fed allowed to buy gold? Is it legally allowed to buy gold?

Beckworth: I would guess yes, but maybe the answer is no.

Kupiec: No. I’ve written a paper about it, dug deep into it with my co-conspirator, Alex Pollack. From the 1970s, it looks like every US person—which the Fed is a person, too, the Fed district banks, are corporations—is allowed to buy gold after 1975 or something like that. They passed a series of things after they closed the gold window. Everybody was allowed to buy gold, and that would include the Fed.

Now, you can’t find it anywhere on the Fed’s website whether they can buy gold or not. Alex Pollack and I did a request to the Fed to ask them whether they could buy gold. They never answered us, but we did get an answer from a former, very senior attorney in the Fed, who said, “Yes, I think they can, but don’t quote me on that.” The Fed doesn’t want to get anywhere near this discussion of gold.

Beckworth: They wouldn’t revalue their gold certificates?

Kupiec: They can’t revalue the gold certificates. The gold certificates are valued under law. There’s a law that values them. They were valued, when the Fed got them originally, at $22 and whatever it was, 5/8ths or 5/16ths an ounce of gold. They got the certificates. The Treasury owns the gold. In law, there’s an official price of gold, and it’s $42-and-something right now. That’s how it’s valued.

If they were to revalue it, the Treasury would free up—I’ve forgotten, I’ve written it in a paper—but it’s a lot of money, like $500 billion or something like that, if they just did it to market price, but you have to change the law to do it. That would not go to the Fed, that would go to the Treasury. The Treasury could then issue gold certificates to the Fed and increase and borrow that way.

Beckworth: The Fed just literally has a certificate, fixed face value. It’s not going to change with the market. The Treasury is going to keep any gains on that.

Kupiec: They did in 1933, too, when they revalued it. Roosevelt told the Fed it had to give all its gold to the Treasury. Once they did that, then the Treasury revalued the official price of gold, and the Treasury got the cap. That’s where the foreign exchange stabilization fund came from.

The Fed’s Unique Accounting

Beckworth: If you step back at the end of the day, really, this is the US government, the Fed, and Treasury can be viewed from a consolidated budget. Let me ask a related question to that point. Clearly, there’s income losses. There’s actually a negative loss on the Fed’s balance sheet that would have otherwise been income generated going to Treasury that would have lowered the tax bill on all of us as US taxpayers.

Then there’s these unrealized losses as well. As interest rates have gone up, the value of the bonds have gone down. I’ve heard the argument that the unrealized losses are not as consequential, one, for monetary policy. The second thing is, the losses that the Fed has experienced on its balance sheet is offset by gains on the Treasury’s balance. The losses are a loss on the Fed’s balance sheet, a gain on the Treasury’s. It’s a wash. Really, the issue is just the actual recognized income losses and then also the losses on the mortgage-backed securities.

Kupiec: It’s not quite that simple. In theory, the Fed is part of the government. You might think you would think about a consolidated balance sheet of the Treasury and the Fed as part of the government’s balance sheet. It doesn’t actually work that way because the Fed is not owned by the government. The 12 district Reserve banks are owned by the member banks of the Federal Reserve System. The assets that the Fed has are actually owned indirectly by the member banks that buy stock in the Federal Reserve System. When the Fed makes money, it first pays its expenses. Then it pays banks a dividend on the shares in the member banks. Then it remits the rest to the Treasury.

It used to hold a lot bigger surplus than it does now, but various bills since the ’90s have passed where they funded highways, they stole the Fed surplus. Back in 1933, they first stole the Fed surplus to fund the FDIC. That’s how the FDIC originally got capitalized. They took a whole bunch of the Fed surplus, they gave it to the FDIC and told the Fed, sorry. I guess the Fed had some shares, but they were nonvoting in the FDIC. Then when they made the FDIC permanent, a few years later on, they told the Fed, “Just forget it. You don’t get it back.”

The Fed surplus is now tiny compared to its balance sheet. It’s been that way since the aughts, I think, is the last time they adjusted it down. It might have been 2017 or 2018. I’m not sure exactly when. One time I knew the date, but I don’t right offhand. Anyway, when it comes to the Federal Reserve earnings and capital and expenses, the federal budget only includes, and only in the footnotes to the federal government’s financial statements, it only includes remittances that the Fed banks make to the Treasury.

Currently, if you were to look at the annual reports, since Atlanta and St. Louis Fed have always been making a little bit of money, it turns out the 12 banks, if they have money left over after their expenses and the dividends they pay to their members and their surpluses is at the maximum amount allowed, they have to give the rest of the money to the Treasury, and that’s bank by bank by bank. Atlanta and St. Louis have been remitting, and some other banks along the way, they drop along the way as losses build, but they’ve been remitting. Even in last year’s consolidated federal budget, it looks like the Fed made money, and the expenses aren’t recorded anywhere.

Now, the expenses are cash expenses of running the government, but they’re not in the federal statement anywhere. Even in the Fed’s account, they are stated as an asset. The Fed records its cash loss as a negative liability, and it puts it on its balance sheet, and it works like an asset. As its cash losses grow over time, it’s creating this bigger and bigger negative liability, which a negative liability is like an asset on a balance sheet.

It works something like this. Think about this logic. Say you’re just a regular person, and, say, you get $100,000 cash income, but your expenses are $120,000, and you haven’t paid your taxes yet. You lost $20,000 in the hole, but you create a balance sheet for yourself that says that I don’t have to pay government taxes because I have $20,000 in the hole, and I don’t have to start paying the government taxes until I make enough money to earn back that $20,000. It’s like a deferred tax asset. The Feds created this thing. When it loses money, it doesn’t reduce its capital or surplus account. It leaves it alone.

If you’re a regular corporation and you lose money, you lose money for a year, what do you do? You have to take that loss away from your retained earnings. If that continues, you take it away from your retained earnings until you have no retained earnings. Then if you still lose it, you take it away from your capital stock, your equity, until it’s zero, and you’re insolvent. Your liabilities are bigger than your assets. The Fed’s liabilities are bigger than their assets, and they create this fake accounting entry that only they could do.

They create their own accounting standard that says, “Oh, we’re really not insolvent. We’re not going to pay the Treasury anything until we make back this $232 billion sometime over the next 10 years. We’re just not going to pay the Treasury.” Did Congress agree to that officially? I never saw a hearing where they said, “Oh, yes, it’s okay with us.” The Fed created this accounting standard on its own.

There is a FASB, Federal Accounting Standards Board, for federal agencies that sets the accounting standards. It doesn’t apply to the Fed. The Fed doesn’t follow GAAP accounting. They create their own accounting manual. It’s online. You can read it. You can read about the deferred asset. They’re the only government agency I know of that is allowed to create its own accounting standard, which is a fictitious accounting standard.

Beckworth: Let me ask a question about that before we get any further into the weeds here. We do want to go deeper in the weeds because you have a great article on this accounting issue, and you actually have some recommendations on how to fix things. If they did not use this deferred asset, this accounting fiction, as you call it, other central banks like the Bank of England, they’ve also lost money, and they’re just literally being recapitalized by the Treasury.

Kupiec: The government reimburses them, as does the Bank of Canada.

Beckworth: I guess maybe we should talk about your reforms. Is that what you would want them to have the Treasury recapitalize the Fed in some fashion, make it more transparent what’s actually going on?

Kupiec: What I want about the accounting is transparency, and I’ll explain that in a minute. No, the Federal Reserve Act 1913 and subsequent revisions, actually tells you how it’s supposed to be recapitalized. The member banks have to buy stock in the Fed. 

Beckworth: The regional Federal Reserve banks.

Kupiec: Yes. National banks have to be Fed members. State banks can join. They have to buy stock in their Federal Reserve bank equal to 6% of their capital and surplus. They only pay for half of it, so they only pay in 3%. Now, the Fed has a call on the other 3%. Back when the Federal Reserve Act was created in 1913, national banks had double liability. If you were a national bank and you went bankrupt, you had to lose all of your equity, and then the managers and directors of the bank had to pay in that amount in addition to cover losses. They had double liability.

When the Federal Reserve Act was created, the member banks in the Federal Reserve Act have double liability. The Fed has a call on the other 3% of their capital that they could call in, and they have a call on 6% for this covering of losses. Now, they’ve never done this. Not only haven’t they done it to recapitalize any of these insolvent banks, they’re still borrowing cash money to pay these banks dividends every year, which is bizarre when you think about it.

Beckworth: Seems odd.

Kupiec: They’re not making any money.

Beckworth: They’re losing money and they’re borrowing money to pay the banks.

Kupiec: To pay dividends, and interest on their reserves.

Beckworth: You’re saying, on paper or legally, the private banks should be coughing up money and paying the extra 3% because the Fed has—

Kupiec: It’s not near enough to recapitalize.

Beckworth: How far would it go? A ballpark figure. 

Kupiec: I think it’s something like 39 is the call-in capital, and twice 39 is 78 would be the other call.

Beckworth: It wouldn’t get you all the way.

Kupiec: No. 

Beckworth: It would be a decent chunk, though.

Kupiec: It would, and they could stop paying dividends. Dividends on Federal Reserve member stock are cumulative.

Beckworth: Okay, so end dividends and have the banks pay their legal 3% double liability. Let me ask this question before we get any more into those details. You work with banks. You’ve seen both the government side, you’ve seen the private sector side. How would banks react to this? Are they aware of these provisions?

Kupiec: Well when I bring this up with Bill Nelson, of course, who works for the Bank Policy Institute: “Nobody’s ever going to do this. What do you mean? What are you crazy?” It’s in the law. It’s been in the law. It’s there. Nobody’s exercised it. They haven’t even asked him about it in hearing. Did you watch the Powell hearing this morning?

Beckworth: I did not.

Kupiec: I did. Not many consequential questions of anything, no substance, nothing along the lines of this. I wasn’t 100% focused on it every minute, but I didn’t hear anything about Fed losses. I did hear something about what size is your balance sheet going to be. Powell said, “We’re not sure. We’re going to shrink it.”

Beckworth: To your knowledge, are there any other scholars or think tank people or even policymakers who are aware of this double liability and dividend possibility of recapitalizing the Fed?

Kupiec: Yes, it’s not a secret. It’s in the Federal Reserve Act. 

Beckworth: People are talking about it as a possibility. You are, you and your co-authors.

Kupiec: No, I don’t think that would actually happen. There’s another thing in the Federal Reserve Act. When they were setting up the 12 banks, if the banks couldn’t come up with enough capital to open and start a bank, there was a minimum level. It’s meaningless now because that’s a 1913 number. The Treasury could buy stock in Federal Reserve banks, but it would be nonvoting. The Treasury could. I don’t know if that was just its startup or if that would still work. The liability for member banks is clearly still in the law.

Beckworth: They could choose not to pay dividends.

Kupiec: Yes, they could accumulate. Okay, liabilities. The balance sheet. Back to the balance sheet. Federal Reserve Notes have to be 100% collateralized. Now, in the beginning, back in 1913, it was gold and discount paper. It had to be under 90 days. It could be agriculture, it could be a little longer, but they had to back it with gold or that. It had to be at least 40% gold originally. Then over time, that got diluted, and they got rid of the gold standard. Now it has to be backed 100% by any Federal Reserve asset. Anything the Fed owns, they can back the Federal Reserve notes with.

Federal Reserve notes are also guaranteed by the government. Now, then when it comes to repurchase agreements, repurchase agreements are market agreements. Repurchase agreements are always overcollateralized. Looks at the market value, and then it haircuts it, and then that’s what repo agreements are. The Fed is the same way. That takes up collateral. The Federal Reserve notes take up collateral. The repo takes up collateral. The deposits at the Reserve banks, they get whatever collateral is left.

If you’re technically insolvent on a GAAP basis, your liabilities are bigger than your assets. There’s not enough collateral left to fully collateralize the member bank deposits at the Federal Reserve Banks that are GAAP insolvent. They’re not guaranteed by the federal government explicitly. Now, banks keep, obviously, hundreds of billions, trillions of dollars in these insolvent [banks], because they expect the government to back it.

Beckworth: Yes, implicitly there’s a backing. 

Kupiec: Yes, but there’s not. That means that the shortfall at the Fed’s capital is actually an implicit liability of the taxpayer. When the Fed loses money, and it loses more than its capital, it’s actually borrowing money, and it’s actually creating a taxpayer liability, an implicit taxpayer liability that’s not being recorded anywhere. They’re not telling you about it. It’s just like Fannie and Freddie were an implicit taxpayer liability and Treasury ended up having to bail them out. There is a provision in the Federal Reserve Act that you can liquidate a district bank, and it’s in there. They’re insolvent. Would they ever do it? No, they’re not going to do it.

Beckworth: Just to summarize and to make this as clear as possible, the Fed right now is paying out more in interest payments than it’s generating in interest income on its balance sheet. Somehow it has to do this. Somehow it has to meet its obligations. You can think of it as if it’s an individual, they’re taking out their credit card, and they’re borrowing. Who are they borrowing from? The banks, right?

Kupiec: The banks and from money market mutual funds.

Beckworth: And money market mutual funds. The very entities that they’re paying interest to, they’re borrowing from, and they’re creating more liabilities on their balance sheet. In order to pay them, they’re borrowing. Those same entities, at least the banks, could be sharing some of the costs.

Kupiec: They’re supposed to be by law. 

Beckworth: By law, they should be getting fewer dividends or are contributing the other 3% capital double liability. That does seem scandalous at some level that’s not talked about more. Let’s step back from this a little bit. Why do we care about this? Is it because of the tax liability of the taxpayer? Is it also because there’s concerns about losing control of inflation at some point? What do you think?

Kupiec: First of all, it’s a transparency issue. The Federal Reserve is a government agency. It is borrowing money at taxpayer expense. It has borrowed $232 billion-and-change already at taxpayer expense. It’s a taxpayer expense because it’s going to have to earn all that back before it gives the Treasury any more money. It’s borrowing. It’s not recorded anywhere as if it’s doing that. It’s not in the federal budget anywhere, but the remittances show up in the federal budget.

They had a small remittance last year, even though they’ve lost hundreds of billions of dollars, it looks like the Fed is making money and contributing it to the Treasury. Now, that’s not very transparent, I don’t think. They ought to at least record the dividend payments the Fed makes in the notes to the consolidated federal statement and the expenses that the Fed incurred, along with the remittances they gave back. You might have a clearer picture of actually how the Fed is performing.

That would be one transparency thing that I think the public deserves to know where their taxpayer dollars are going and who’s generating potential taxpayer liability in the future, the implicit taxpayer liability. That’s the capital shortfall of the Fed. The Fed hides that intentionally in its accounting. It doesn’t want to show that the banks are insolvent. Do I think everybody in Congress understands this? Absolutely not. Do some? Maybe. You have to be pretty much in the weeds to do this.

Beckworth: Paul, I’ll say this. We’ve talked about the losses in the Fed’s balance sheet before on the podcast. We’ve talked to Bill Nelson and Andy Levin and some others, but you’re the first guest where we’ve talked about these provisions where the banks could bear some of the losses, and they’re not.

Kupiec: They’re not.

Beckworth: Banks could at least share in the responsibility of them, but they’re not. Paul, this has been super fascinating. I know our listeners will enjoy it as well. Now, you have a new article coming out. Where can they go and read more about these issues?

Kupiec: Alex Pollack and I have an article that is out in Law and Liberty, and it’s called “Duplicity at the Fed.” We discuss this issue about Fed losses, Fed accounting for losses, and how the Fed is represented in the federal budget accounts. I think it’s an interesting read if you’re interested in these topics.

Ending Interest on Reserve Payments to Banks

Beckworth: We’ll provide a link to that in our transcript. In the time we have left, Paul, I want to move to an issue that has come up recently. This has been the calls by Senator Ted Cruz. I understand Senator Rand Paul is also a part of this. The one that I’ve seen in the news most Senator Ted Cruz, calling for the end of interest on reserve payments to banks. We’ve been talking about it. He seems to think this is going to save the US government a lot of money.

My initial response would be, well, given they have a demand for liquidity, given regulations, whatever is driving their current demand, they’re going to hold some other asset like Treasury bills. I’m not sure how much they will say, but I’d love to hear your thoughts on this.

Kupiec: Yes, the intention behind the bill is to save taxpayer money. I think the authors of the bill don’t understand how monetary policy actually works right now. This would totally upset the way the Fed is conducting monetary policy at the moment if they outlawed interest on reserves. Now, first of all, interest on reserves passed or became legal in a 2006 bill that wasn’t supposed to start till, I think, 2010. It sped up at 2008 with the financial crisis. Originally, reserves at the Fed were very small, and it was only supposed to be interest on required reserves. It wasn’t supposed to be on all reserves.

Quickly, in the fall of 2008, it morphed into interest on reserves, and still interest on reserves weren’t that big until they started the QE programs. All of a sudden, interest on reserves could amount to a big number if interest rates were high, but after the financial crisis, they were zero. It didn’t really raise a lot of red flags. It became part of the operating system. When they started doing QE, it’s how they kept the banks from lending out money and causing inflation. They paid them to keep the money in the Fed so that when they increased reserves through QE operations, the banks didn’t loan it out.

Beckworth: To be clear, this was intentionally what they were thinking when they started this 2008. They didn’t want to have to lower the federal funds rate. This was truly a contractionary exercise. Now, maybe different today, but back then, they literally thought, “If we do this, it will prevent us from having to lower the federal funds rate with the growth of our balance sheet.”

Kupiec: Yes, except I don’t think they ever anticipated their balance sheet growing as large as it has or having interest rates, short rates flip so much higher than the earnings, the interest they had on their SOMA portfolio. Anyway, if they were to outlaw interest payments on reserves, the banks clearly wouldn’t want to leave reserves in the Fed. They would want to take the reserves out and buy something with it, maybe consumer loans, maybe auto loans, maybe Treasuries, but who would sell the Treasuries? If the Fed were to sell off its Treasuries, it would lose money at the current interest rates, and it would have even bigger losses.

The Fed wouldn’t remit anything to the Treasury because it has about $1 trillion worth of unrealized interest rate losses in its portfolio. If the banks were to buy Treasuries and they were to buy them from the Fed, the Fed would book $1 trillion more in losses.

Beckworth: Unrealized losses become—

Kupiec: —realized right away. That wouldn’t help the federal budget any. That wouldn’t generate $1.1 trillion. It would just generate longer time before the Fed remits payments. If the Fed didn’t sell its Treasuries, then the banks would go out and buy Treasuries off the market. Maybe it would lower longer-term interest rates somewhat. I don’t know. It would be a huge, huge portfolio change for the banking system. It would be very, very disruptive. At some point, I think interest on reserves has turned into a bad idea operating system. I think you want to talk about some ceiling rates and different things.

If you think about it, central banks, for thousands of years, or Treasury operations of kings, have made money. Central banks are supposed to make money. In a very short time after 2008, Ben Bernanke turned it all upside down by paying interest on reserves and doing QE operations. Now we pay the banks to do monetary policy, which is really crazy since the government has a monopoly on coining money, creating money. It’s bizarre if you think about it. We’re not the only central bank to lose money. Everybody follows suit. They gave Ben Bernanke a Nobel Prize for screwing up thousands of years of central banking, as far as I could tell. 

Beckworth: To be fair to Ben, I think they gave him the Nobel for his work on the Great Depression. This does make me think that this is far more complicated than simply let’s get rid of interest on reserves.

Kupiec: No, it is.

Beckworth: Two comments. One, the motivation for this is purely concerns about fiscal pressures. Maybe I’m wrong and I apologize to any senators or congresspeople out there who were thinking from pure theoretical exercise, but my impression is this conversation is being generated by concerns about fiscal pressures. How do we save money? Which, to me, raises a red alarm. This is the rhetoric of fiscal dominance. At some point, if things get bad enough, the Fed’s got to step in and help keep the government solvent.

My second point would be this. If, in fact, the Fed wanted to get rid of interest on reserves and banks wanted to get rid of them, banks cannot collectively get rid of reserves. The Fed would have to literally shrink its balance sheet. A bank might get rid of reserves, but some other bank would have to hold it. This would mean the Fed would have to shrink its balance sheet for reserves to truly go down. That would require, I think you’re alluding to this, the Fed reduces Treasury holdings.

Kupiec: Yes, and mortgage-backed securities. It would lose money.

Beckworth: They would literally have to shrink both sides of the balance sheet, take huge hits.

Kupiec: Unless somehow this pushed interest rates below 2.5% all of a sudden and reinflated the values.

Beckworth: I suspect Senator Cruz is not thinking of another recession, but I hear you.

Kupiec: This is what I’m saying. They may mean well, but it’s not very well thought out. It may not be ideal to be paying banks. Since 2022, I think the banks have been paid something like $400 billion in interest on reserves and a bunch on their dividends, too. That just doesn’t seem right that it should cost that much to run the central bank. It seems like we made a mistake somewhere along the way.

Beckworth: Let me play devil’s advocate here for someone who would support the current floor system. They would say, “Step back, Paul, because look, the Fed generated all these profits leading up to ’22, and you know what? In a year or two, we’re going to turn things around. We’re going to be back in business. Sure, we’ve lost the money now, but take the long view, Paul. We’re going to be cash kings.” What would you say to them?

Kupiec: It’s not their job to make money. It’s their job to full employment and stable prices.

Beckworth: It’s not part of their mandate. That’s the first thing you’d say. Okay, fair enough.

Kupiec: It’s not supposedly part of the mandate to support the Treasury when Treasury auctions don’t work, but it is part of their mandate, in fact, to do that. They’ve been called on to do it many times in their history, and undoubtedly, they’ll be called on to do it in the future. They have made money. These forecasts of them returning to profitability quickly, I think, are misguided. I just did numbers since, say, mid-May of this year and mid-June of this year, they lost a little over $10 billion. If you go back to 2024, the same period, they lost $14 billion. Their losses have fallen by about $4 billion, which is about what you’d expect because interest rates came down about a percentage point.

They’re not on track to start making money anytime soon. The losses started accumulating in September 2022, when the effective federal funds rate went above 2.33. Whatever they held back in 2022, some of it’s runoff. They’ve replaced some of it. The SOMA portfolio interest rates aren’t all that different than what they were, because it was long-term stuff that they bought a long time ago. Rates are going to have to come down somewhere below two-and-a-half before we get close to them starting to make a little bit of profit. Then they’ve got to make back all their losses before they remit to the Treasury.

In January, the CBO, Congressional Budget Office, put out their forecast of when they thought the Fed would start remitting back to the Treasury. They thought 2030 was the earliest. With that forecast, they had interest rates coming down a lot more than they’ve come down. Back in January, people were more optimistic about rate cuts, and now we’ve had all this what we’ve had, and the Fed’s on hold, and they’re not going to cut rates. The Congressional Budget Office had projected more aggressive rate falls, and then the Fed would start remitting sometime after 2030. These guesstimates that they’re going to return to profitability, rates have to come down quite a bit. They could. I don’t know.

Beckworth: I think that’s a fair point. Again, the context of these conversations about lowering interest rates on the debt, like Trump has called on Powell, in fact, he’s insulted him many times, called him “too late,” and some other derogatory terms, but the context this year has been the debt. Trump has said explicitly, if Powell would only lower interest rates, we could save $800 billion. He’s talking about interest payment on the debt. He’s also maybe missing the point that there may be payments from the Fed to Treasury.

This is what concerns me, is it’s the context of fiscal dominance. If, in fact, we are slowly slipping into fiscal dominance, rates are not going to come down unless the Fed has to artificially suppress. We’re going to have inflationary pressure pushing upward pressure on rates.

Kupiec: I think it’s a real concern. Yes. The only way rates come down that low is probably a recession, which probably means more QE or something like that.

Beckworth: Yes, or financial repression, which builds up pressures elsewhere in the system.

Kupiec: Oh, yes, put on reserve requirements again. They’d have to be massive to soak up the reserves if they do lower interest payments, which I don’t think they would get very far with that. There’s a lot of detail here. There’s a lot of weeds, but it’s pretty interesting stuff when you get to digging through it.

Beckworth: I like how you frame that as interesting. It’s sobering, it’s troubling. We’re going to have to end on that heavy note there, Paul. Our guest today has been Paul Kupiec of the AEI. Paul, thank you so much for coming on the program.

Kupiec: Thank you, David. It’s my pleasure.

Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. Dive deeper into our research at mercatus.org/monetarypolicy. You can subscribe to the show on Apple Podcasts, Spotify, or your favorite podcast app. If you like this podcast, please consider giving us a rating and leaving a review. This helps other thoughtful people like you find the show. Find me on Twitter @DavidBeckworth, and follow the show @Macro_Musings.