The federal reserve bank has found itself as the centre of attention in recent months,
what with everything from, money printer MEMEs to “the future of capitalism as we know” on the line,
the fed has obviously been an incredibly influential entity.
But it’s also something that most people really don’t know much about,
or worse… think they know a lot about when they really don’t.
But that’s ok because the federal reserve bank is a bank,
so the best way to get to really get a good understanding of how it works is
just to follow the money and answer a simple question, Is the reserve bank profitable?
Now because I hate youtube video’s than needlessly drag out a question to get
their average watch time up the short answer is.. Yes, Massively Profitable,
it’s actually the most profitable organisation in the world after recently beating out Saudi Aramco.
But don’t click away yet… For starters I need that average watch time too,
but more importantly, finding out how money works to generate massive profits at the federal reserve
bank will teach you a lot about how this almost mythical institution actually operates day to day.
So the core responsibility of the reserve bank is not to generate profits for it’s
shareholders like it is for any other bank out there, or any other company for that matter.
Instead the reserve bank has two primary goals, the first and most important is
to maintain the value of the currency that they represent, or put another way, control inflation.
The second goal is to maintain a healthy level of economic growth and employment,
but curiously enough, this cannot come at the expense of the first goal.
A year where the US economy grew by 50% but prices also rose by 50% would be seen as a
failure in the eyes of the reserve bank although this is of course a very extreme example.
However! This does not mean that the US federal reserve does not have shareholders,
infact it doesn’t even mean that it is one single entity.
The US Federal Reserve Bank is actually an organisation of 12 banks spread out across
the US. It was set up like this because back in 1913 banking was done primarily with paper notes
and paper records, so having a central bank geographically close to different regions was
crucial in allowing them to swiftly carry out their operations when required.
It was also politically popular to have a series of central banks that would each individually be
compassionate to the needs and requirements of their individual region of the economy.
Now as for the shareholders, who are they?
Well they were regular old banks. If you want to start a bank in the united states to loan
money and take deposits you actually need to be a shareholder in the federal reserve bank.
Individual banks need to maintain share ownership
equal to 6% of the total amount of money they raise from shareholders.
This might sound like a weird rule, but there is a reason it is done. There are basically 3 ways that
banks can raise money. They can take deposits, they can borrow, or they can sell shares.
Those first two options come directly under the control of the federal reserve through
interest rate changes, but selling shares is not directly impacted by these rates because
shares are not an interest-bearing asset.
You don’t get 5% interest paid out on apple shares,
you get market returns… whatever they may be, positive, negative, side to side….
By mandating ownership of shares equal to a portion of a banks paid in contributions the
reserve bank knows that participating institutions will always have “skin in the interest game”
What’s weird about these shares though is that they always pay out 6% of their value every year,
which is interesting for 2 reasons.
The first is that it is a fantastic, guaranteed rate of return especially in a world where similar
guaranteed investments are paying less than 1%. Many have lamented that this is basically
a subsidy paid for by the American taxpayer and paid too big banks, which is not entirely unfair.
The second reason this is interesting is because this will be paid out whether the
fed makes a profit or not, which is not how normal dividends work. So in a way these “shares” in the
federal reserve bank kind of blur the line between typical company stocks and fixed interest bonds.
Either way this still doesn’t explain how the federal reserve bank turns a profit.
Unfortunately it is not as simple as what the money printer memes might have you believe.
You see the federal reserve bank doesn’t just create money to use on whatever they please.
They instead carefully purchase select assets like government
bonds and mortgage securities with the money they create.
They are also somewhat limited with who they can purchase off with this newly created cash.
For example, the treasury department of the united states issued trillions of
dollars worth of government bonds in order to finance the stimulus spending of 2020.
Unfortunately the fed could not buy these bonds directly.
Instead, these get purchased by private parties, this could be anybody from
mere mortals like you or I, but more often than not it is large financial institutions like banks.
Banks love government bonds because they can use them as part of their reserve
requirements while still earning interest on them. Not much interest mind you but
it’s better than the 0% they would get holding onto pure cash reserves.
Now if there is ever a situation where either the banks or the government needs a lot of cash,
the reserve bank is ready to step in. In 2020 the fed purchased trillions of dollars worth
of these bonds from banks so that those banks could in turn go and purchase more
bonds from the treasury without the price of these bonds been too heavily impacted.
Now as we have noted, the returns on these bonds were not huge,
most of them still being under 1%, but 1% of trillions of dollars is still a lot of money,
especially when these bonds are being paid for with money that was created for free.
Assuming a simple 1% return on investment, the 4.8 Trillion dollars dollars worth of
us treasuries currently held by the fed would return 48 billion dollars in profit per year.
When you consider that the fed also owns 3 trillion dollars’ worth of private sector
securities like mortgage bonds, then this annual profit figure balloons to
well over 80 billion dollars annually based on even the most conservative of projections.
What’s more is that this isn’t the end of the story,
everything that we have looked at so far is what is known as open market operations.
Meaning the fed is buying assets off the open market… go figure.
But there is an additional revenue source that doesn’t attract nearly
as much attention and that is… well… closed market operations.
You see the federal reserve bank is a bank for banks, they offer deposit facilities,
loans, transfer capabilities and even cash distribution.
Now just like every other bank ever, the fed charges fee’s for all of these services,
and you can actually find a breakdown of these charges on their website,
not that they would ever really matter to you individually. Even still
this is not a small operation and these serves bring in billions of dollar ever year.
Collectively the reserve bank brought in a net profit of over 90 billion
dollars in 2020 from the open and closed market activities which
technically made it the most profitable organisation in the world by some margin.
So you might ask how this is fair? The reserve bank gets to create money from nothing to buy
up debts and then makes massive profits on those debt returns, why are they allowed to do this?
And even further from that, if they create all the money in existence and then demand interest on the
money that they create, won’t we eventually all be in debt to the fed? Well not really…
Tinfoil hats aside, the fed first uses this money to cover its operating expenses,
things like security, staff wages, and maintenance on it’s buildings it will then cover it’s
financial expenses like the interest paid out to banks that have deposits with the fed as well as
that 6% dividend that gets paid ever year. After that whatever is left over will simply be given to
the treasury department. In 2020 for instance, the fed send back over 88 billion dollars.
This effectively makes the fed more of a control mechanism in the circular flow of cash between
households, the government, and financial institutions. Which is not quiet as exciting
as stories of world domination, but it is effectively all that they are.
Now if you were hoping for high finance with a bit more excitement
then you should go check out our video on how EVE Onlines massive virtual wars are
financed using the most realistic video game economy in the world.
Thanks for learning How money works.