The argument about ECB Target2 imbalances, an argument which began in mid 2011 with this article, continues to be reignited in various arenas. One component of the argument is the comparison of Target2 to the Federal Reserve’s mechanism for settling inter-Fed settlement imbalances; the Interdistrict Settlement Account.
Because the various debaters often have such diverging views on how the Interdistrict accounts are settled, I’m donating this post to the blogosphere with the goal of ensuring that the debate doesn't founder on faulty comparisons of Target2 to the Interdistrict Settlement Account. As such, I'm going to talk a bit about the history of Interdistrict settlement, how the process has changed over time, and how it works now. Once that's done I'll bring the discussion back to Target2 in order to pin down the comparison in a more robust way. I don't claim to know everything about these mechanisms; I've just spent a few weeks educating myself, so if I am wrong on any aspect leave me a comment.
In first learning about these two mechanisms I had a very meta reaction. By meta, I mean the same sort of reaction faced by anyone asking who watches the watchers? In this particular case, the more appropriate question is “who clears for the clearers?”
Another thing that makes the Target2 and Interdistrict settlement mechanisms so fascinating is that, within the monetary architecture, they are “core”. Take out the core and the whole structure disintegrates.
Yet despite their centrality to the superstructure, nobody (except for a few cloistered central bankers) really knows much these mechanisms. It is only now that imbalances are cropping up that we the public find the inclination to catch up on how these arcane but vital systems function.
All sorts of commentators have already explained how Target2 works and the imbalances that have arisen. I won’t touch on these; just search Google for Target2. What follows is a discussion of the Federal Reserve Interdistrict Settlement Account.Far older than the Target2 mechanism, the Interdistrict Settlement Account (ISA) dates back to 1915. Now is a good time to remind readers that the Federal Reserve System is not one unified institution, but an amalgamation of twelve regional Federal Reserve banks. One of the early goals of the system was to establish a unified national check clearing and settlement mechanism to replace the ad hoc system that had evolved among US banks till then. This new system would require coordination among the twelve district Feds, and the ISA was to be the central coordination device.
The distinction between clearing and settlement needs to be understood from the outset. Clearing is the process of tallying up all debts and credits, netting them, and assigning each member of a clearinghouse arrangement a final amount owed or owing. Settlement is the actual process of settling the debts and credits assigned via the clearing process. This involves transferring the amount owed from debtor to creditor so that all outstanding balances are cancelled out and return to zero. Settlement media might include base money, gold, are any other asset stipulated by the clearinghouse authorities.
The process of clearing doesn't require immediate settlement. For instance, those participating in a clearing mechanism might go for many days building up clearing debts and credits amongst each other before these outstanding balances are finally settled. In the modern Fed’s case, settlement occurs after a year (more on this later). In some cases, as seems to be happen with the ECB’s Target2 mechanism, the final settling of clearing balances is on hold indefinitely, or at least until those participants in the clearing process decide that the system needs to be broken up.
Within a US Federal Reserve district, all member private banks clear and settle on the books of their district Fed. Clearing and settlement are relatively easy to understand as long as the transacting private banks are within the same district. At the end of the period, the district Fed need only tally the amounts owed/owing, and this can be settled by the transfer of clearing balances (or reserves) from one bank's account at that particular district Fed to the other bank's account.
Note that the ISA has no role to play in the above intradistrict transactions. But once private banks party to a transaction are in different districts, and we switch from intradistrict to interdistrict, the ISA begins to play a role. Say that a customer of bank A in the Atlanta Fed's district sends a $100 check to a customer of bank C in the Cleveland Fed district. The check is deposited by the customer, whose account at bank C is credited. Bank C sends the check on to the Cleveland Fed, and the Cleveland Fed credits bank C’s reserve account. The Cleveland Fed dispatches the cheque to the Atlanta Fed, which proceeds to debit the reserve account of bank A. The cheque is sent on to bank A which now debits the original check writer. The net result of this chain is that the customers of the banks have settled among each other, as have bank A and C. The final debt has been transferred upwards onto the books of the regional Federal Reserve banks. But this final debt has yet to be settled. In crediting bank C’s reserve account, the Cleveland Fed requires a balancing asset. This is an amount owing from the Atlanta Fed. In debiting bank A’s reserve account, the Atlanta Fed requires a balancing liability. This is an amount owed to the Cleveland Fed. Basically, the Atlanta Fed now owes the Cleveland Fed.
Over the course of a day, huge quantities of interdistrict payments are processed by the district Fed banks. The total quantity of the resulting credits and debts among Federal Reserve banks are cleared via the ISA. At the end of a business day, a district Federal Reserve bank is either a net debtor to the other district Feds via the ISA, or it is a creditor to them. A district bank’s respective position can be quickly gleaned by referring to its balance sheet. If the entry “Interdistrict Settlement Account” falls in the liability section of the district bank's balance sheet, then it is a debtor, but if it can be found in the assets section, it is a creditor.
Say there was a run from banks in a certain Fed district towards banks in another district. Ultimately, this would be reflected in increasing transfers of gold from that Fed's gold settlement account towards the settlement account of other Federal Reserve banks. Once the $1 million dollar mark was breached, the district Fed facing the run was required to top up its account back to the $1 million mark. In other words, the Gold Settlement Account did not allow for permanent overdrafts. Theoretically, this placed a major constraint on the district banks and the system as a whole, for once a Federal Reserve bank ran out of gold, it could no longer settle with the other district banks. And once it could no longer settle, the private banks in that district would be unable to do business with other districts. The monetary union would simply collapse.
There were various fail safes that relaxed this constraint. Howard Hackley, for instance, in his 1973 book on the laws governing Federal Reserve lending, points out that Federal Reserve banks were allowed to rediscount amongst each other (see pdf version of Hackley here). This happened on a voluntary basis several times between 1917 and late 1921, says Hackley. By discounting with a surplus district bank, a district bank that was facing outflows would enjoy a counterbalancing credit, ensuring that its balances in the Gold Settlement Account remained topped up.
The rediscounts needn’t be entirely voluntary. Section 11(b) of the Federal Reserve Act (a section which is no longer in existence) allowed the Federal Reserve Board to force district banks to rediscount on other district bank’s behalf. According to Hackley, this only occurred one time. In March 1933, as bank runs swept the nation, several districts were required to rediscount with the New York Fed as this bank’s gold reserves had fallen before their minimum statutory requirements.
The legal basis for the Federal Reserve’s clearing mechanism can be found in Section 16 of the Federal Reserve Act. Specifically, section 16(14) stipulates:
The Board of Governors of the Federal Reserve System shall make and promulgate from time to time regulations governing the transfer of funds and charges therefor among Federal reserve banks and their branches, and may at its discretion exercise the functions of a clearing house for such Federal reserve banks, or may designate a Federal reserve bank to exercise such functions, and may also require each such bank to exercise the functions of a clearing house for depository institutions.
Thus the Federal Reserve board was allowed to undertake the function of clearing house for the Federal Reserve banks. Furthermore, it was allowed to “make and promulgate” the rules governing these interdistrict payments, the significance of which seems to be that it could vary the system’s settlement dates and settlement media.
Given the Board’s broad powers to control the interdistrict clearing and settlement infrastructure, it is not a surprise that the ISA would eventually be changed. By the late 1960s, interdistrict payments were growing in leaps and bounds as the financial system grew and evolved, and as a result it became more common for the gold deposit accounts of the district Federal Reserve banks to be in temporary overdraft. This is first mentioned in the minutes of an August 1975 FOMC meeting by the manager of open market operations, Peter Sternlight:
Mr. Sternlight observed that under existing procedures the Reserve Banks used their gold certificate holdings to settle daily clearings with one another. Because of the large volume of clearings now handled in the Interdistrict Settlement Fund, one or more Reserve Banks might on any one day have an inadequate balance of gold certificates to make settlement. The possibility that adverse clearings might eliminate a Reserve Bank's gold certificate holdings had made it increasingly difficult for Reserve Banks to earmark significant amounts of gold certificates as collateral for Federal Reserve notes.
In that meeting, a change to the clearing and settlement mechanism was proposed:
…it was recommended that the clearings be effected through the use of inter-office accounts among the Federal Reserve Banks that would be settled once each year by increasing or decreasing each Bank's holdings of securities. That approach would obviate the need for monthly reallocations of the System Open Market Account to equalize gold-to-note liability ratios. The new procedure would take effect at the beginning of May--a convenient starting point since the end of April marked a coincidence of a month end and an end-of-week statement date.
The Chairman indicated that the Board planned to act shortly on the related recommendation to discontinue the use of gold certificates as the medium for interdistrict settlements.
Thus began a new procedure of interdistrict clearing and settlement. Rather than require district banks to deposit gold in the ISA and transfer it daily so as to achieve final settlement, shifts in the holdings of the System Open Market Account (SOMA) became the settlement medium. Furthermore, these settlements were to occur on a yearly basis, not a daily basis. Thus, while the ISA would clear each day and allocate Federal Reserve banks amounts due and owing, it would only require once-a-year settlement of these respective balances.
SOMA refers to the portfolio of securities acquired by the Federal Reserve System via open market operations. Prior to 1935, Federal Reserve banks could initiate their own open market purchases and sales, but after changes to the Federal Reserve Act in 1935, the authority for these operations was limited to the Federal Open Market Committee (FOMC). Essentially, the district banks were obliged to buy and sell as the FOMC dictated. All districts were allocated an ownership interest in SOMA. SOMA has historically been comprised almost entirely of Federal government debt, although in recent years this has changed as QEI and QEII brought large quantities of agency debt and agency MBS into the portfolio.
To this day, the above method of managing the ISA continues. The Federal Reserve Financial Accounting Manual (pdf) goes into some depth on this on page 136-138, including the provision of an example. An average is calculated for each district Fed's daily ISA clearing balance over the course of a year. Sometime in the first week of April, the Board allocates SOMA holdings to district Federal Reserve banks so as to settle this average yearly balance. Note that the end of period clearing balance isn't what is settled, but only the average yearly balance. Thus a bank which is owed $10 billion on April 2 settlement, but was only owed on average $6 billion in the twelve months prior, will receive $6 billion in SOMA allocations as settlement, not $10 billion.
[Note: Some elements of the accounting manual's example might confuse the reader. Specifically, it is confusing that each Federal Reserve bank must have the same gold-to-note ratio as the System as a whole. This example is easier to deal with if it is assumed that the gold-to-note ratio of the district Feds doesn’t change over the years. Therefore, each district Fed’s gold-to-note ratio is always equal to the system average. Proceeding from this assumption, all SOMA adjustments are caused directly by clearing imbalances in the ISA. You can ignore changes that stem from one district bank issuing currency at a faster rate than others, which is interesting, but unnecessarily complicates the example.]
This story would be less interesting if there wasn't a modern twist: the ISA seems to no longer be settling. First noted on the Money View, a quick visual inspection of interdistrict settlement balances would indicate that the New York Fed is running up a larger owing balance than what would be expected by the rules stipulated in the accounting manual.
Interdistrict data, available on FRED, goes back to late 2002 and is available on a weekly basis. Let's take a look at the 2011 settlement. From end of March 2010 to March 2011, the New York Fed’s average end-of-week interdistrict settlement balance due comes to about $147 billion. That's a large amount owed to the FRBNY. The system seems to have settled somewhere between April 13, 2011, and April 20, 2011. This seems obvious given some of the large changes in district balances between those two dates. Because we only have weekly data (end of Wednesday), we don't have sufficient granularity to know exactly on what day settlement occurred.
The New York Fed's closing ISA balance was around $288 billion as of April 13. To settle, $147 billion worth of SOMA securities should have been transferred from owing district Federal Reserve banks to the NY Fed, and its interdistrict account should have fallen to around $140 billion ($288b minus $147b). But the next reporting day, April 20, shows that the account fell to just $224 billion, a shortfall of around $83 billion. Thus it seem that the NY Fed did not receive enough SOMA securities to settle average outstanding ISA balances as dictated by the accounting manual.
The Richmond and San Francisco Feds, on the other hand, seem to have disproportionally benefited. Much of the SOMA securities that should have been transferred by these two districts so as to balance the ISA were retained by them, and they were allowed to keep unusually large outstanding ISA debits. From my calculations, San Francisco's debit balance should have fallen by an additional $17.5 billion, and Richmond's by an additional $27.5 billion.
Now it could be the case that the poor resolution of the data – it is weekly, not daily – does not give enough information. Perhaps between April 13 and April 20 settlement was achieved as per the manual's requirements – say on April 15 – but large post-settlement payments from Richmond and San Francisco to New York between April 15 and April 20 caused the ISA accounts to again diverge, giving the semblance of a lack of settlement.
The alternative explanation is that the Board has suspended the manual's requirements for the time being. San Francisco is the district bank for Wells Fargo, the US’s fourth largest bank, while Richmond serves Bank of America, its largest. New York is the hub for almost all the other top banks. Flows from Bank of America and Wells Fargo to, say Citigroup and JP Morgan in New York, might require such large transfers in SOMA security allocations that the district banks in Richmond and San Francisco are being temporarily exempt from full settlement. If this is the case, it is odd that the Fed wouldn't have issued a public notice to that effect.
This brings up the question of a modern US monetary dissolution. We already touched on this briefly in our discussion of the Gold Settlement Account, and how interdistrict rediscounts softened the hard limits of gold settlement. Say that the Richmond Fed experiences such large outflows that, come April settlement, it lacks the SOMA securities necessary for it to settle its account. As a result, the other district banks cease accepting cheques and payments from banks located in the Richmond district, since they don't anticipate that the Richmond Fed will be capable of settling its account. Banks located in the Richmond district would now be effectively frozen out of the US payments system. Well, not entirely, since it would probably be the case that cheques and payments from the Richmond district passed at a discount to par. In effect, the Richmond dollar would be worth less than the US dollar.
The reason a scenario like this is unrealistic is because the Fed is required by law to maintain par clearing between Federal Reserve banks. According to Section 16(14) of the Federal Reserve Act:
Every Federal reserve bank shall receive on deposit at par from depository institutions or from Federal reserve banks checks and other items, including negotiable orders of withdrawal and share drafts and drafts drawn upon any of its depositors, and when remitted by a Federal reserve bank, checks and other items, including negotiable orders of withdrawal and share drafts and drafts drawn by any depositor in any other Federal reserve bank or depository institution upon funds to the credit of said depositor in said reserve bank or depository institution.Par clearing means that all dollars are treated equally, no matter which private bank or district bank has created them. Given its authority in setting settlement and clearing laws as per Section 16(13), the Board can effect modifications to make the system more flexible so as to ensure the system operates at par. Perhaps in permitting San Francisco and Richmond to accumulate larger debts on New York than would otherwise be the case, the Board is rendering the system “softer” to prevent any possibility of non-par clearing.
Let's return briefly to the main point of contention in the Target2 debate: that the ECB imposes far less constraints on those central banks that make up the Eurosystem than the Federal Reserve Board imposes on the district banks that make up the Federal Reserve System.
It is true that the Fed has historically called for some form of settlement, whether this be daily gold settlement or yearly settlement in SOMA securities, while the Target2 balances never settle. But Fed settlement is not required by law, it is only a tradition. The Fed can change the system’s clearing and settlement operations so as to ease constraints on district banks facing outflows. Indeed, this could be the case right now. Thus, when push comes to shove the Federal Reserve is not really that different from the ECB when it comes to interdistrict/intra-eurosystem clearing and settlement. The focus of both institutions is on ensuring the par value of all monetary instruments, not on disciplining individual members.
Postscript: A few misconceptions corrected.
In criticising Hans Werner Sinn, Willem Buiter says:
…the Interdistrict Settlement Account System of the Federal Reserve System in the US does not imply a substantially reduced scope for persistent imbalances in credit flows within the US currency area. While it is true that interdistrict imbalances need to be settled once a year with gold-backed securities or Treasury bills, individual district banks can purchase these securities in the open market and finance these purchases with base money creation. Therefore the US system does not effectively constrain interdistrict credit flows.
Buiter is right the ISA need not prevent persistent imbalances. But he claims that the reason for this is that district Federal Reserve banks can purchase securities in the open market. This isn't true because only the FOMC is permitted to purchase or sell securities (Read Section 12A of the Federal Reserve Act). It does so on the entire system's behalf. After a security is purchased, a district Fed is allocated a portion of the security, but it cannot buy said security outright on its own initiative. So in the end, what relaxes the constraints on interdistrict flows is not district open market operations, but the Board’s decision to change settlement procedures so as to protect the integrity of the system as a whole.
Buiter goes on to say that:
The Interdistrict Settlement Account must be settled once a year with gold-backed securities or Federal treasury bills. This would represent a constraint on inter-district credit flows only if the stock of Federal Treasury bills allocated to the individual Federal Reserve banks was exogenous. However, individual regional reserve banks can always buy Federal treasury bills from banks or other holders of the stuff in their own districts, financing this with an increase in base money.
The allocation is indeed exogenous because it is assigned by a formula set by the Board, and the FOMC conducts all purchases. Individual regional reserve banks can't buy assets, and even if they could, they must do so on the open market, and not from a narrow group of banks within a certain geographical area.
As for Peter Garber's Mechanics of Intra Euro Capital Flight, I do like his explanation, although he says that settlement of interdistrict balances is achieved by transfers of gold, whereas nowadays it is via reallocations of SOMA.
Hans Werner-Sinn says:
While that system does allow for Target-like balances resulting from the creation of outside money, i.e. money used for acquiring a net inflow of goods and/or assets from other districts, it has never experienced excessive flows comparable to those now taking place in the Eurozone as a result of the European sovereign debt crisis, wiping out the refinancing credit in its sub-districts and making the local central banks net borrowers of central bank money. As far as we know, Target-like problems never were an issue in US history.
As I’ve pointed out, the Federal Reserve System experienced significant imbalances between 1917 and 1921 and in 1933. In the former, a number of districts voluntarily rediscounted with the district facing outflows so as to soften the gold constraint. Forced rediscounting in 1933 saved the New York Fed from the same. Nowadays, it appears again as if the Federal Reserve system is relaxing requirements so at to allow some districts to continue as net borrowers of money for longer than they would otherwise be allowed.
Sinn also points out that:
According to the official statements of the Federal Reserve, the assets whose ownership shares are transferred are gold certificates. Gold certificates are securities collateralized by gold, issued by the US Treasury, that bear the right to be exchanged for gold on demand. They are safe, marketable securities, which cannot be created by the District Fed itself. However, when a policy of credit easing was adopted during the crisis, this practice was abandoned and US Treasury securities were permitted for settling the balances, accepting in the end even mortgage-backed securities.
In actuality, the credit crisis did not result in the Federal Reserve switching from interdistrict settlement in gold to settlement in securities like US government bonds. This switch happened back in the 1970s.