When the federal reserve buys bonds or other assets from banks, do the banks make a profit?

Question

My understanding is that the federal reserve is injecting money in the market by buying bonds and debt from banks. Do the banks make a profit on the sale of their bonds or corporate debt to the feds? If not, what is their motivation for selling bonds or debt to the feds?

Answer 1

Any profit would be incidental. Banks make money by loaning money. Federal debt is a form of a loan. The return is small, relatively. While a bank could buy or sell securities for the purposes of making an accounting gain or loss, to support tax timing, in general, securities sales are for asset allocation reasons or to comply with Federal law.

The TT&L program requires banks to hold federal securities as collateral to allow banks to hold funds they should otherwise transfer to the Treasury. That is one example of the required holdings of Federal securities. However, that influences the decisions. It does not cause them. It is a binding constraint.

Banks are not required to sell to the Fed. Instead the Fed tries to make its monetary decisions attractive to the banks.

Consider a bank that bought a 30 2% Treasury bond one year ago today. Imagine that the economy is heating up and the Fed wants to raise rates to 2.25%. That bond is now worth 94.69% of its previous value. So it has lost money and the Fed wants to sell it more bonds.

Now imagine that the bank can either make a car loan at 4% for five years with a 1% chance of loss and added reinvestment risk, or a Treasury bond at 2.25%. Last year the rate was 3.75% The Fed is actually trying to reduce the number of car loans being made by making them less attractive to consumers. The bank would choose the bond for one of two reasons.

First, if the Fed is successful, fewer people will apply for the car loans and the bank will have unutilized cash sitting around. It will go to the open market and voluntarily buy the Treasury securities.

Second, even if the Fed is successful, the bank may preference the Treasury security to improve its risk profile.

Accounting gains or losses only matter because they impact tax-related cash flows. What matters are changes in cash flows. Accounting profits or losses are fictions. Enron was still profitable 18 months into its bankruptcy. Banks will either engage in open market operations to improve long-run cash flow or to reduce balance sheet risk, which is risk to cash flows.

Answer 2

I am not sure about this, but the Fed mainly trades with Primary Dealers. These are often subsidiaries of banks, but could be independent financial entities.

• If the dealer is selling from its own inventory, it will make a gain or a loss depending on the price it originally bought the bond at. Since that may be some time ago, there is no certainty about profits.
• The dealer may effectively act as an intermediary. It will buy from clients who are bond investors, and then sell to the Fed. If the trading desk of the primary dealer does a good job, they have a good chance of locking in a small profit. (Making recurring small profits by intermediating trades is the business model of investment dealers.)

Answer 3

In India, such operations are known as OMOs(Open Market Operations). The banks this way get more funds to lend further to their clients and this way register profits. This is one more avenue for banks to raise cheaper funds for their lending operations.