The bigger the balance sheet becomes, the more a future rise in interest rates will squeeze the Federal Reserve’s net interest margin. Some worry that this exposure to higher short-term rates could conceivably affect the Federal Reserve’s monetary policy credibility in the future. Some market participants might worry that the Federal Reserve could become reluctant to raise short-term rates in a timely way because this would constrain the amount of revenue that it would earn and remit to the Treasury. I am confident there is nothing to worry about on this score. Even if the Federal Reserve was not obliged to act in keeping with its dual mandate – which it is – with its assets skewed toward longer-duration securities, the Federal Reserve would have every incentive to ensure price stability over the long term. It is true that the larger the size of the balance sheet, the more likely it is that the Fed would ultimately sell assets back into the market, potentially at prices that could result in losses. Although some fear that such losses could compromise the Federal Reserve’s independence, there is no reason why this should be the case, providing we stick closely to our mandate at all times. To date, the Fed’s actions in responding to the crisis have resulted in abnormally large profits that might reasonably be set against any subsequent losses.
The day after the results were published, I remember that Bridgewater Associates – which had said the banks needed considerably more resources – published a paper evaluating the SCAP results. The banner headline was: “We Agree.” So this was important. However, I would note that it is important not to draw too strong a conclusion from just one episode. In the SCAP process, I also think it is important that we had some good luck. First, the banks’ needs were not that great. What people didn’t appreciate going in was that U.S. banks have strong revenue-generation capabilities: the banks had already set aside a large amount of reserves and taken large mark-to-market losses, and the banks had already bolstered their capital resources via capital raises and the sale of ancillary businesses. Second, the economy started to look a bit better in May at the time the SCAP results were released. This made the stress scenario more credible. Third, the capital markets were open to the banks. This was important because, as we saw, private capital was viewed as very much superior to Treasury mandatory convertible preferred shares. Fourth, although we made the correct decision to disclose, this was a difficult and close call. The fact that the loss experiences for the different asset classes varied across the banks helped to bolster the credibility of the results. Going into the spring of 2009, there was a prevailing view that several of the largest banks would have to be nationalized.