Saturday, May 31, 2014

Financial Plumbing: Europe and the Fed's Interdistrict Settlement Account

One of this blog's most recurrently popular posts is a 2012 ditty entitled the Idiot's Guide to the Federal Reserve Interdistrict Settlement Account. The Interdistrict Settlement Account, or ISA, is a highly esoteric "plumbing" mechanism that lies at the centre of the Federal Reserve System. After a century of being ignored, it suddenly became a popular topic for discussion in late 2011 and 2012 as the breakup of the euro became a real possibility. Groping for a fix, European analysts turned to the world's other large monetary union, the U.S. Federal Reserve System, to see how it coped with the sorts of monetary problems that Europe was then experiencing.

Here's a short explanation of the ISA. Consider that there is no such thing as a unified Federal Reserve dollar. Rather, both the paper dollars that you hold in your wallet and the electronic reserves that a private bank holds in its vaults are the liability of one of twelve distinct Federal Reserve district banks. Thanks to the convention among these Reserve banks of accepting each others dollars at par, a 1:1 exchange rate between each of these twelve U.S. dollar brands prevails. This gives rise to the useful mental short cut of assuming that there is one homogeneous dollar brand. But to do so ignores the heterogeneity at the core of the system —we can imagine worlds, for instance, in which one district's dollars, say those of the St Louis Fed, are considered to be so inferior to the rest that the other Reserve banks will only accept "St. Louis's bucks" at a discount.

All inter-district flows between Reserve banks must be settled, which is where the ISA comes into the picture. The ISA is a ledger that tracks the various imbalances that accrue between Federal Reserve banks. Each April that imbalance is settled by a transfer of assets from debtor to creditor Reserve banks, so that if St. Louis is owing and San Francisco is owed, then bonds will flow from the former to the latter, reducing each district's respective ISA balance (or increasing it) to a sufficient level.

I'm happy to say that my ISA post was useful to a number of researchers, including Karl Whelan (pdf), Kevin H. O’Rourke and Alan M. Taylor, and most recently, Alexander Wolman (pdf), who all made reference to it in recent papers. I like to think that this demonstrates the second purpose of the econblogosphere. The first purpose, of course, is to swarm over polished work by those like Piketty and Reinhart/Rogoff searching for chinks in the armour. The second is to act as an advance scout of sorts. When a completely new problem crops up, a blogger can quickly pump out a few posts, establishing a beachhead from which the main army—academics with time, money, and resource—can begin to launch a larger-scale attack.

While scouts can provide useful hints on where to launch initial sorties, they will always make a few errors, and I want to draw attention to one error I made in my ISA post. I speculated that the Federal Reserve banks may not have bothered to settle the ISA in 2011. Given a visual inspection of the various imbalances that had arisen between several of the Reserve banks, it appeared that the Richmond Fed in particular had been allowed to carryover a large deficit while the New York Fed (FRBNY) was stuck with an outstanding credit. Luckily for the small group of folks interested in the ISA, Federal Reserve researcher Alexander Wolman has recently provided some clarity on this issue.

Wolman has written the definite explanation of how the ISA functions and it is well worth your time if you want to discover how this fascinating mechanism works. (In defense of my old Idiot's Guide, note that I did manage to incorporate the destruction of the Death Star scene into it — I doubt Alex's editors would let him get away with that). He also goes through the data to show how the ISA settled in April 2011. I had originally focused on the New York Fed's ISA balance as the basis for my suspicion that settlement may not have occurred—the FRBNY's ISA balance had not fallen by the proper amount over the settlement month. But if you look at the FRBNY's securities balance on its balance sheet, you'll see that it rose by $100-$150 billion, an amount sufficient to settle the debts that other Reserve banks owed it. If you care to explore more deeply, Alex deals with this on page 135 of his article. I'm tickled pink that he managed to "settle" this bit of trivia since it has been a recurring topics on this blog. (See here and here).

I should point out that the 2011 episode interested me because if non-settlement had occurred, then the ISA would impose very weak constraints on payments imbalances arising between the various district Reserve Banks. European analysts, who were looking to the U.S. for inspiration, needed to know whether the ISA imposed stern limits on imbalances or lenient ones.

Like the Fed, the ECB is composed of a number of member banks, or national central banks (NCBs). Each issues their own brand of Euro while accepting all other Euros at par, thereby ensuring a smooth 1:1 exchange between the various Euros. Unlike the Fed, the ECB has no settlement mechanism. Imbalances that arise between member banks can continue growing perpetually. This is what appeared to be happening between 2008 and 2012 as European depositors, wary of a break up the Eurozone, fled the GIIPS banking systems for safe havens like German and Dutch banks, resulting in the emergence of massive deficits and credits between the various member NCBs. The chart below illustrates the size of these imbalances, which have since shrunk.

Source: Euro Crisis Monitor, Osnabrück University

A number of analysts, led by Hans Werner Sinn, felt that a U.S.-style ISA settlement mechanism should be grafted on to the European payments system. In theory, this would impose strict discipline on NCBs and prevent imbalances from emerging. Many, including myself, felt that this sort of discipline might be a bad idea.

But a better rebuttal of the proposed European ISA is that the Federal Reserve ISA was never the stern mechanism that folks like Sinn made it out to be. Though my point about 2011 non-settlement is false, other features of the ISA provide for long settlement delays, including the "rediscounting mechanism" that I mentioned in my Idiot's Guide. However, the best person to learn from on this topic is economic historian Barry Eichengreen who, in the video that I've linked to below, provides a definitive historical overview of the ISA.

While the whole video is worth watching, I'm going to draw attention to a chart that Eichengreen shows at around minute 14-15 which I reproduce below.

Source: Federal Reserve Bulletin, 1922

During 1920 and 1921, large and persistent imbalances between Federal Reserve banks emerged, much like the imbalances that have plagued the Eurosystem since the credit crisis. It would seem that the Fed, just a young pup at the time, faced the very same problem that the ECB began to face just nine years after its debut and, much like the ECB, it chose to handle it by allowing for non-settlement. Eichengreen (and Mehl, Chitu & Richardson) has an upcoming paper that explores the long history of Reserve bank "mutual assistance", although for now you'll have to be content with the video.

The European payment imbalances debate (or Target2 debate) has long since died out. Germany's ever-growing creditor position halted in 2012 and has been shrinking ever since while debtors like Italy, Spain, and Greece have seen their negative positions return towards zero. No one talks about intra-Eurosystem imbalances or Euro breakup anymore, at least not on the blogosphere. But I have no doubt that somewhere in the ECB's deepest catacombs a group of European monetary architects are debating if, how, and when to import an ISA-style settlement mechanism into Europe. Let's hope that they are very careful in their approach and consider the softest possible solution.


  1. The Federal Reserve System is the issuing authority for banknotes, the 12 districts are just distributors to depositaries institutions + some banknotes do carry the Fed system seal (2 out 7 in my wallet right now).

    1. jck, from Wolman's paper:

      "All currency is designated as issued by one of the 12 Federal Reserve Banks, and is marked with the corresponding district number and letter. As this example suggests, however, currency does not necessarily enter circulation in the district through which it is officially issued."

  2. Check this and some notes have no district ID, seal read "united states- federal reserve system"

    1. I suppose that it could be true that some notes carry the seal that you are describing. But I don't think this changes the settlement process that Wolman describes in his paper.

    2. The paper is very good, I particularly like his use of the words "apportionment" and "rebalancing" .
      I also think there is a subtle difference between issuing and distributing, and all notes are backed by the same collateral, so whether it is district a or b issuing/distributing a note, their value is not linked in anyway to ISA imbalances if any. I will tweet a pic of the seal. I am quite intrigued by that switch which happened several years ago.

    3. Thanks for the tweet, I just took a look at it.

      That being said, there is not such thing as "the" Federal Reserves System, since the system is just a collection of regional Reserve banks. If you go to and check out table 9, you'll see that every Federal Reserve note is the liability of one of the 12 regional Reserve banks.