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OF THE JOINT ECONOMIC COMMITTEE
CONGRESS OF THE UNITED STATES

Improvements Needed In The
Federal Reserve Reporting System
For Recognized Dealers In
Government Securities 8.1699o5

BY THE COMPTROLLER GENERAL
OF THE UNITED STATES

OCT. 681971

COMPTROLLER

GENERAL
WASHINGTON.

THE

D.C.

UNITED

STATES

20548

B- 169905

Dear

Mr.

Vice

Chairman:

This is our report
on the improvements
needed in the Federal
Reserve
reporting
system for recognized
dealers
in Government
securities.
Our review was made pursuant
to your request
of May
1970.
As agreed, we discussed
our report
with officials
of the Federal Reserve
Bank of New York.
Although
they agreed with our findings, they felt that formal
comments
should come from the Informal
Treasury-Federal
Reserve
Steering
Committee
which has overall
?e spons ibility
for the reporting
system.
We plan to make no further
distribution
of this report
unless
copies are specifically
requested,
and then we shall make distribution only after your agreement
has been obtained
or public announcement has been made by you concerning
the contents
of the report.
Sincerely

yours,

Comptroller
of the United

LP 2
/

The Honorable
Wright
Patman
Vice Chairman,
Joint Economic
c
-,I
Committee
Congress
of the United States

50TH, ANNIVERSARY

1921- 1971

General
States

IMPROVEMENTSNEEDED IN THE FEDERAL
RESERVE REPORTING SYSTEM FOR RECOGNIZED
DEALERS IN GOVERNMENTSECURITIES
B-169905

COMPTROLLERGENERAL'S REPORT TO
THE VICE CHAIRMAN OF THE
JOINT ECONOMIC COMMITTEE
CONGRESSOF THE UNITED STATES

DIGEST
--w--m

WHY THE REVIEW WAS MADE
I
--

The Federal Reserve Bank of New York operates
a voluntary
reporting
tern to accumulate statistical
and financial
data‘Ktbe
activities
private
dealers in Government securities.

sys- "‘lIp$L
of

Participating
dealers
report statistical
data daily and financial
data
In 1970 the total
transactions
reported
were $738 billion,
annually.
or more than three times the value of transactions
on the New York Stock
Exchange.
At the request of the then Chairman of the Joint Economic Committee,
the
General Accounting
Office
(GAO) reviewed the reporting
system to determine
whether
--good
and

accounting

practices

were being

followed

in preparing

the reports

--the reporting
system afforded
the Committee and the public with an
accurate
picture
of the operations
and profits
of the dealers
as a
group.
--_.
GAO examined into the procedures
and methods of report
preparation
employed
by six of the 20 dealers
in Government securities
recognized
by the Federal
Reserve System.

FINDINGS AND CONCLUSIONS
The daily statistical
information
furnished
by the dealers was reasonably
reliable.
This information
is published
regularly
for the use of Government officials,
financial
analysts,
and the public.
(See p. 18.)
GAO
does not believe,
however, that financial
data which is reported
annually
can be relied
upon because
--sound

accounting

--numerous
--different
reports.

Tear Sheet

errors

methods

were not followed

consistently,

were made, and

accounting

bases were used by the dealers

in preparing

the

The Federal Reserve Bank of New York made reviews of the reported
data;
however, these reviews were not effective
in ensuring that the information
was reliable.
(See pp. 9 to 17.)
As a result
of errors
and inconsistencies,
the annual financial
not published
and little
use is madeof it.
(See p. 24.)

data

RECOMWENDATIONS
OR SUGGESTIONS
The reporting
system functioning
as it does on a voluntary
basis is a
commendatory achievement.
Substantial
improvement in the accuracy of the
annual financial
reports,
however, could be madeby correcting
some of
the problems which GAO found.
(See pp. 26 to 28.)

AGENCYACTIONSAND UNRESOLVED
ISSUES
Officials
of the
they agreed with
Federal Reserve
reporting
system
(See p. 28.)

Federal Reserve Bank of New York told GAO that,
although
GAO's findings
and conclusions,
the Informal
TreasurySteering
Committee which has overall
responsibility
for the
would have to decide what corrective
action would be taken.

MTTERS FOR CONSIDERATION
BY THE
VICE CHAIRMAN,JOINT ECONOMICCOMMITTEE
This report
outlines
some measures that the Federal Reserve System could
take to correct
the inadequacies
in the reporting
systems.
GAO is including these measures for such action as the Vice Chairman may deem appropriate.

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Contents

Page
1

DIGEST
GLOSSARY
CHAPTER

3
3
7

INTRODUCTION
Background
Nature of GAO review

FINANCIAL REPORTS
Income
All gains and losses not reported
in the right reporting
period
Different
methods used to calculate
unrealized
gains and losses
Expenses
Questionable
allocations
Different
methods of accounting
used in reporting
Other
Net worth allocation
Review of financial
statements

9
10

DAILY STATISTICAL REPORTS

OTHEROBSERVATIONS
Problems in analyzing net income
Need for refining
financial
reports
Use made of reports
Financial
reports
Daily reports

20
20
24
24
24
25

SUGGESTED
CORRECTIVEMEASURES
Strengthening
controls
over preparation
of reports
Improving review function
Refine financial
reports
Distribution
of aggregate report data
Agency comments

10
11
12
12
13
13
15
16

26
27
28
28
28

APPENDIX
I

Letter dated May 1970 from the Honorable
Wright Patman, the then Chairman, Joint
Economic Committee, Congress of the
United States
List of financial
report deficiencies
type and primary cause

.31

by
32

-1
1,.

GLOSSARY
Accrual

accounting

recording of financial
transactions
in the accounts as they actually
take
place (that is, as goods and services
are purchased or used and as revenues
are earned) even though the cash involved in such transactions
is paid or
received at other dates

Borrowings

funds borrowed to maintain

Cash accounting-

recording
of financial
transactions
only at the time that cash is received
or paid for goods and services

Commitment basis

recording
of securities
transactions
in the accounts on the date agreement
to purchase or sell is made

Delivered

recording
of securities
transactions
in the accounts on the actual date the
securities
are delivered

basis

positions

Margin requirements

difference
between market value and
the maximum loan value of securities

Market value

estimated selling
or purchase price of
security
based on bid and ask quote of
dealer

Position

the total value of the securities
a dealer holds for resale

Recognized

dealers

that

Government security
dealers who--the
Federal Reserve Bank of New York considers--have
established
a satisfactory financial
credit
standing and can
handle a large volume of trading and
accordingly
are permitted
to deal directly with the trading desk

Repurchase agreement

arrangement for borrowing money
whereby securities
are "sold" by the
dealer with a commitment to buy identical
securities
back at a specific
price

Settlement

recording
securities
transactions
the date agreed upon for delivery
the securities

basis

on
of-

System open market
account

the Government securities
Federal Reserve System

Trading

the personnel who buy and sell securities
for the Federal Reserve Bank of
New York

desk

Transactions

purchase

held by the

or sale of securities

COMPTROLLERGENERAL% REPORT -TO ..
THE VICE CHAIRMAN'OP THE
JOINT ECONOMIC COMMITTEE
CONGRESSOF THE UNITED STATES

:,- IMPROVEMENTS
NEEDED IN

THE FEDERAL
RESERVE REPORTING SYSTEM FOR RECOGNIZED
DEALERS IN GOVERNMENTSECURITIES
B-169905

..:.

DIGEST
-----WHY THE REVIEW WAS JddDEThe Federal Reserve Bank of New York operates
a voluntary
reporting
tem to accumulate statistical
and financial
data on the activities
private
dealers
in Government securities.

sysof

Participating
dealers report
statistical
data daily and financial
data
annually.
In 1970 the total transactions
reported
were $738 billion,
or more than three times the value of transactions
on the New York Stock
Exchange.
At the request of the then Chairman of the Joint Economic Committee,
the
General Accounting
Office
(GAO) reviewed the reporting
system to determine
whether
--good
and

accounting

practices

were being

followed

in preparing

the reports

--the reporting
system afforded
the Committee and the public with an
accurate
picture
of the operations
and profits
of the dealers
as a
group.
GAO examined into the procedures
and methods of report
preparation
employed
by six of the 20 dealers
in Government securities
recognized by the Federal
Reserve System.

accounting

--numerous
--different
reports.

errors

methods

were not followed

consistently,

were made, and

accounting

bases were used by the dealers

in preparing

the

data

RECOMi'dENDATIONS
OR SUGGESTIONS
The reporting
system functioning
as it does on a voluntary
basis is a
commendatory achievement.
Substantial
improvement in the accuracy of the
some of
annual financial
reports,
however, could be madeby correcting
the problems which GAO found.
(See pp. 26 to 28.)

AGENCYACTIONSAND UNRESOLVED
ISSUES
Officials
of the
they agreed with
Federal Reserve
reporting
system
(See p. 28.)

MlTTERS FOR CONSIDERATION
BY THE
VICE CRAIRMAN,JOINT ECONOMICCOMMITTEE
This report outlines
some measures that the Federal Reserve System could
take to correct
the inadequacies
in the reporting
systems.
GAO is including these measures for such action as the Vice Chairman may deem appropriate.

CHAPTER1
INTRODUCTION
In May 1970 the Chairman of the Joint Economic Committee requested that the Comptroller
General look into the reporting system established
by the Federal Reserve System
for dealers in Government securities
and advise him as to
whether the reporting
system was likely
to afford the public
and the Joint Economic Committee an accurate picture of the
operations
and profits
of these dealers as a group and
whether the accounting practices
used in reporting
were in
accord with good accounting
standards.
A copy of the Chairman's request is included as appendix I.
BACKGROUND
The Federal Reserve System, among its other functions,
is responsible
under the Federal Reserve Act for maintaining
a flow of credit and money that will foster orderly economic
growth and a stable dollar.
This function
is, in part, accomplished through the public sale and purchase of Government securities
(U.S. Government and Federal agency securities).
To carry out this function,
Committee of the Federal Reserve
ity of determining
the policy to
and sale of Government securities.
Federal Open Market Committee is
machinery from undue stress and
affecting
the cost and availability

the Federal Open Market
System has the responsibilbe followed in the purchase
The objective
of the
to protect the monetary
to influence
the economy by
of credit.

The Federal Open Market Committee has delegated the
responsibility
for executing its policy for all Reserve
banks to the Federal Reserve Bank of New York (Federal Reserve Bank).
Each year the Federal Open Market Committee
appoints a senior officer
of the Federal Reserve Bank to
The manager mainmanage the system open market account.
tains a trading desk at the Federal Reserve Bank to handle
all purchases and sales of Government securities.

Marketable Government securities
are traded daily in
an over-the-counter
market by dealers in Government securiCertain dealers,
called recognized dealers,
are perties.
mitted by the manager of the system open market account to
trade directly
with the trading desk and are expected to
respond to the trading desk's needs for buying and selling
This procedure is designed to ensure that
these securities.
dealers admitted to trading have the resources and ability
to undertake large volumes of trading.
The number of recognized dealers varies from year to
As of March 31, 1971, there were 20 recognized dealyear.
and nine
ers, of which 11 were nonbank business enterprises
They form a security
market which is the largest
were banks.
in the country in terms of dollar volume and which is heavThe market is not regily vested with the public interest.
ulated by either the Government or a private association.
The volume of purchases and sales by recognized dealers
in Government securities
increased steadily
from $573 billion in 1966 to $738 billion
in 1970. A comparison of the
1970 volume of Government securities
traded with purchases
and sales of the New York Stock Exchange and the American
Stock Exchange is shown in the following
chart.

TRANSACTIONS REPORTED BY GOVERNMENT SECURITIES DEALERS
COMPARED
HllTH ACTIVITY ON RECOGNIZED EXCHANGES

BILLIONS
OF DOLLARS

75Of

BILLIONS
DOLLARS

750
$738

700 -

650 -

600 -

550 -

500 -

450 -

400 -

350 -

300 -

250 -

250
$215

200 -

150 -

100 -

50 -

0
CALENDAR
GOVERNMENT
SECURITIES
DEALERS
TO THE FEDERAL RESERVE BANK

YEAR

1970

REPORTiNC

AMERfCAN STOCK EXCHANGE

NEW YORK STOCK EXCHANGE

Because statistical
and financial
information
about
the dealer market was scarce, a formal reporting
system was
established
in 1960. The reporting
program was aimed at
providing
current information
on the functioning
of the market in Government securities
to the public,
to students of
and to market participants,
including
the Federal
the market,
Reserve System and the Treasury Department.
Reports include, in addition
to annual reporting
of balance sheet and
income data,
daily
statistics
covering securities
positions
and borrowings and volumes of transactions.
No,legal or
regulatory
requirements
exist to enforce reporting;
the
dealers have reported voluntarily.

NATUREOF GAO REVIEW
Our work was done at the Federal Reserve Bank and at
business offices
of six dealers in Government securities
located in New York.
The dealers included in our review were
selected with a view toward obtaining
representation
from
each of the three types of dealers which are categorized
as
specialist,
bank, and multioperation.
In the case of financial
reporting,
we reviewed the
requirements
imposed on dealers by the Federal Reserve Bank
instructions.
At each dealer's
office we obtained reports
submitted to the Federal Reserve Bank for the year ended
December 31, 1969. We determined whether the figures on
these reports were taken from the dealers'
books of account
or financial
statements or whether the amounts in the accounts or statements had to be revised to satisfy
Federal
Reserve Bank instructions.
In those instances in which revised figures had been
reported to the Federal Reserve Bank, we identified
the
procedures and methods used to make the changes.
We reviewed some of these adjustments,
calculations,
and other
transactions
to determine whether sound accounting principles and practices
were followed and whether the results
were reasonably accurate.
For the daily reports,
we reviewed the detailed
procedures followed by the six dealers to accumulate, record,
and report information
required by the Federal Reserve Bank.
We selected a few transactions
and traced them through the
dealers'
systems to determine whether the transactions
had
been handled in accordance with dealer procedures,
sound
trade practices,
and Federal Reserve Bank instructions.
We
observed the preparation
of daily reports for one day at
each dealer's
office and traced the information
through the
Federal Reserve Bank processes into its computer file.
Our work was done principally
through discussions
with
the Federal Reserve Bank and dealer officials;
onsite observations
of operations;
and reviews of a limited number

accounting
records, and other data.
The
of transactions,
cooperation
and courtesies
extended to us by the Federal
Reserve Bank and dealers were excellent.
Our review did not cover the activities
Open Market Account.

of the System

The confidential
nature of the data relative
to operations of individual
dealers was maintained in accordance
with rule 23 of the Joint Economic Committee which places
limitations
on the disclosure
of data obtained from individual dealers.

CHAPTER2
FINANCIAL REPORTS
We found that the financial
reports submitted by the
dealers had not been prepared in accordance with sound acFurther,
the dealers used different
bases
counting methods.
in preparing
the reports and made substantial
errors in
compiling the information
in the reports.
Consequently we
have little
confidence that these reports provide accurate
information
on the operations
and profits
of the dealers as
A list of the deficiencies
in the reports we exa group.
amined is included as appendix II.
The deficiencies
in the reports we examined occurred
primarily
because the dealers did not use sufficient
care
in preparation
of the reports and because the Federal Reserve Bank reviews failed to detect them. The inconsistencies in the data contained in reports prepared by the participating
dealers are attributable
to the wide latitude
in
reporting
practices
permitted under the Federal Reserve
Bank instructions,
Before describing
some of the major deficiencies
affecting
the reliability
of the reports,
it is important to
mention the factors
that complicate dealer reporting.
The
Federal Reserve Bank instructions
provide for submission of
reports on a calendar-year
basis, whereas seven out of 20
dealers operate their accounting
systems on a fiscal-year
basis.
Their closing of accounts can be at different
dates
during the calendar year.
Thus their normal year-end adjustments are not made for the period covered by the Federal
Reserve Bank reports.
Also 14 are engaged in activities
other than trading in
Government securities
and their accounting
systems and normal financial
statements relate to the entire operations,
As a result of both these factors,
many adjustments had to
be made to the information
in their formal accounts to prepare the Federal Reserve Bank reports.
It is in this conversion process that most of the problems existed,

INCOME
We found two major problems which affected
income-namely, all trading gains or losses were not reported in the
methods
right reporting
period, and dealers used different
to calculate
unrealized
gains or losses.
All gains and losses not reported
in the right reporting
period
The dealers included in our review used three methods
of recording
security
transactions
(1) the commitment basis,
recording
transactions
on the date that the purchase or sale
is made, (2) the settlement
basis, recording
transactions
on
the agreed-upon date for delivery,
and (3) the delivered
basis, reporting
transactions
on the actual date that the seFor 1969 the Federal Reserve Bank
curities
are delivered.
required
dealers to report on a commitment basis in their
income statements all unrealized
gains or losses on positions as of December 31.
Included in our review were three dealers who were on
other than a commitment basis and who did not make the necThus one dealer reported
essary adjustments for reporting.
unrealized
gains and losses on $649 million
of securities
but did not report in that reporting
period unrealized
gains and losses on an additional
$330 million
of securities
that should have been included in his computation
if it were
made on a commitment basis,
The second dealer, with a position
of $313 million,
omitted from his computation about $44 million
of securithe third omitted $6 million
from his calculation
on
ties;
these
same
dealers
In addition,
$54 million
of position.
did not compute the realized
gains or losses on securities
which were purchased and sold prior to January 1 but which
were not settled until
after December 31.
Although the dealers knew that they were required to
report on the commitment basis, they did not do so because
they said that too much effort
was required.
The dealers
did not provide us with data on what the cost of reporting
on the commitment basis would be and we did not make our own
study of such costs; however, we believe,
with proper planning, the report could be prepared on the commitment basis
without an unreasonable
amount of effort.

we advised
the Federal
Reserve Bank
Early
in our study,
of our findings
regarding
the use of other than the comrnitOn their own initiative,
bank ofment basis of reporting.
ficials
revised
the instructions
to permit dealers
to compute profits
on their
own accounting
bases.
We doubt the
merits
of this revision
because it could have a material
effect on the reported
gains or losses.
This would occur
when there are large variances
in opening and closing
positions
on a commitment
basis which would not be reflected
by
the dealer's
accounting
basis.

Further,
could
tem.

basis

in the case of interdealer
be significant
transactions
lost

For example, if
sold securities

trading,
there
to the reporting

a dealer reporting
on the commitment
on December 31 to another dealer re-

porting
on the settlement
method,
these securities
be reported
in the positions
of either
dealer.
Different
unrealized

sys-

would

not

methods used to calculate
gains and losses

The Federal Reserve Bank also instructs
the dealers to
compute their unrealized
gains or losses on year-end positions
at market value and allows
the dealers
to choose their
own methods of determining
market values.
The dealers whose records we reviewed used four methods of determining
market values for their positions.
Three
dealers used their own judgment of prices.
One used published composite prices;
one used last sale; and one dealer
used a combination of his own judgment and price quotes of
another dealer.
Thus the same class of securities
held by
each dealer may be valued at different
prices for computing
unrealized
gains or losses.
When we advised the Federal Reserve Bank of this problem, they again issued new instructions
requesting
dealers
to use the Federal Reserve Bank composite closing quotations.
This, however, did not fully
resolve the problem because closing quotations
only include'securities
issued by
the Treasury and do not include securities
issued by other
Government agencies.
Agency securities
can represent
significant
sums. For example, one dealer's
position
included
$121 million
in Government agency securities.
11

EXPENSES
The major problems in reporting
expenses were the numerous errors made by dealers in allocating
them and the different methods of accounting
for them,
Questionable

allocations

The Federal Reserve Bank instructs
dealers to allocate
expenses between their Government operation and other operations.
The five dealers who had to make allocations
attempted to comply with instructions;
however, they did not
follow sound accounting
practices
or were not careful
in making distributions.
In pooling their expenses for allocation,
some dealers
did not follow the accepted practice
that there must be some
relationship
between the expenses and the operation
to which
they are allocated.
For example, one dealer overstated
his
reported expenses by about $900,000 because his pool included
commissions and dividends
not related to Government operations and interest
on partnership
capital,
which is not an
expense but a form of profit
distribution.
Another dealer
did not reduce his reported expenses by $84,000 because he
did not allocate
to other operations
the cost of services
performed for those other operations
by his Government operations.
Also Government securities
are used to borrow funds for
all of the dealers'
operations.
In allocating
the related
interest
expense, two dealers charged their Government operations with the total interest
on borrowings made with Government securities
without regard to how much was relatable
to non-Government operations.
Since interest
on borrowed
funds is the dealers'
largest expense, this could have a
material
impact on reported net income.
To illustrate
the
impact that this allocation
can have when done properly,
one
dealer who did allocate
such interest
costs, instead of reporting all of it under Government operations,
showed only
$8.1 million
out of a total of $10.3 million
as relatable
to
Government operations.
In addition,
dealers used various bases for making alOne
dealer
arbitrarily
allocated
administrative
locations.
12

expenses on the basis of the number of people employed in
Government operations
to the total number employed and did
not establish
that this ratio was commensurate with the benefits obtained by the Government activities.
Another dealer
merely had his staff estimate the amount of expenses to be
allocated
to Government operations
without any supportable
basis except judgment.
Different
methods of accounting
used in reporting
The Federal Reserve Bank instructions
are silent as to
whether reports should be prepared on an accrual or cash basis; this is one of the reasons for the lack of uniformity
in reporting.
Three dealers prepared their statements on
an accrual basis and three dealers submitted their stateFor exments on a combination of accrual and cash basis.
one
dealer
reported
interest
earned,
prepaid
insurample 3
ance, and interest
on borrowed funds on an accrual basis but
reported general and administrative
expenses on a cash basis.
We did not make a study to determine the difference
in
profit
and loss that would result from the use of the accrual basis for general and administrative
expenses; however, in view of the size of such expenses, we believe the
difference
could be substantial.
Other
The following
paragraphs illustrate
other
methods employed by dealers in the preparation
reports.

questionable
of financial

Some dealers'
Government securities
positions
were financed with funds borrowed from their other operations.
The
Federal Reserve Bank requires
these dealers to apportion
a
part of these funds as interest
free because they represent
allocated
capital.
Interest
is includable
on the remaining
portion as part of reportable
expenses.
$7.5
fore
est
$7.5

One dealer has been using an estimated amount of
million
since 1965 to represent his allocated
and thereinterest-free
capital
and has been reporting
the interon the remainder as expense.
We were told that this
million
estimate was based on a comparison of the
13

relationship
between capital
and total Government positions
of several other New York City dealers.
We believe that
more exact methods of determining
allocated
capital
should
have been employed.
Another dealer made no allocation
in 1969 and reported
interest
expense on the total borrowings.
He reported
interest-free
borrowings in 1965 of $5 million.
Assuming
the same apportionment
for 1969, the reported interest
costs
for borrowed funds would have been reduced by about $429,000.
The dealers told us that they could not make a realistic
apportionment
unless the Federal Reserve Bank gave them more
guidance.
These same dealers,
in computing interest
on
funds borrowed to finance Treasury bill positions,
used par
value of the securities
as a base rather than the amount
borrowed.
In addition,
one of these dealers used the wrong
interest
rate to make the calculations.
As a result,
the
interest
expense reported by one dealer was $175,000 too
high whereas the other reported a figure that should have
been $9,000 higher.
Also, the Federal Reserve Bank instructs
dealers to
report profits
both before and after income taxes and speincome taxes are not to be included
cifically
states that
as an expense.
We found that three dealers reported correctly.
One of the remaining three dealers included the
New York City income tax as an expense, and two dealers ignored the city tax altogether
in preparing their reports.

NET WORTHALLOCATION
The Federal Reserve Bank requires nonbank dealers to
estimate net worth allocable
to Government activities
for
The methods
use in its profit
studies on return on capital.
used for allocation
did not appear to provide reasonable results because the Federal Reserve Bank has not given dealers
suitable
guidance.
A Federal Reserve Bank study in 1967 indicated
that it
was aware that dealers were having problems and were using
The report also disvarious methods to allocate
net worth.
cusses various concepts of net worth allocation
and the difhowficulties
encountered in applying them. It was silent,
or what guideever) as to which method would be preferable
lines should be followed.
The dealers are apparently
still
having problems in
complying with this requirement
and are still
using various
In some instances the remethods in preparing
the reports.
The following
examples illussults appeared questionable.
trate some of these conditions.
In determining
the amount of net worth used for his
position
in Government securities,
one dealer included
$4 million
of Government securities
held for his own investment purposes plus $2 million
of Government securities
deposited with clearing
corporations
for handling other than
Government transactions.
The $6 million
should have been
treated as applying to his other operations
since these
funds were not used in maintaining
his position.
Another dealer using a ratio of positions
to all company assets reported a net worth allocation
to Government
operations
of $2.4 million.
This dealer did not retain the
details
of his calculations.
We used the method he described in his report to the Federal Reserve Bank to compute--an allocation
of $1.9 million
as applicable
to Government operations,
or $500,000 less than reported.
Although
the dealer agreed with our computation,
he was unable to
determine what caused the difference.
In allocating
net worth, a third
of Government securities
to his total
1.5

dealer used a ratio
position,
This method

appears inequitable
because considerably
pany's own capital
is needed to maintain
rities
positions
since

less of the comGovernment secu-

--large
positions
of Government securities
need less
borrowings owing to their margin requirements
which
range from less than 1 to less than 6 percent, whereas
25 percent margin is necessary on corporate bonds and
65 percent for stocks and
--the low amount of positions
kept by the dealer's
underwriting
activities
(which handles other than Government issues) required substantial
resources to operate.
Under such circumstances,
a disproportionate
amount of net
operaworth can be allocated
to the Government securities
tion.
REVIEW OF FINANCIAL
STATEMENTS
-The
were not
data was
for such

Federal Reserve Bank reviews of dealer reports
effective
in ensuring that the reported financial
reasonably reliable
because the group responsible
reviews did not

--visit
dealers to examine the supporting
view report preparation
practices,

data and re-

--have
and

expertise,

staff

with

--have the authority
tion.

professional
required

accounting
to obtain

dealer

coopera-

Among its other duties,
the Market Statistics
Division
of the Federal Reserve Bank is responsible
for processing,
and distributing
dealer reports.
Its reviews
reviewing,
consisted essentially
of checks for mathematical
accuracy,
completeness,
and consistency
with other reports.
They told
us that they also made certain analyses of the financial
data but did not rely too heavily on them because they felt
that the information
was unreliable,
These reviews were
done at the Federal Reserve Bank. According to the Market
16

Statistics
Division,
visits
were not made to the dealers'
offices
to examine into the reports in more depth because
it did not have the authority
to do so.
Another problem in making such reviews was that the
Market Statistics
Division
did not have any professional
acThe Market Statistics
Dicounting expertise
on its staff.
vision had about 32 individuals
on its staff comprising
11 professional
and junior
economists,
16 statistical
clerks,
About eight of these staff
and five typists
and messengers.
members were assigned to processing,
reviewing,and
distribuing the financial
reports.
The Market Statistics
Division
had no authority
correct errors found in dealer reports or to enforce
provements in dealers'
reporting
practices.

to
im-

If the staff of the Market Statistics
Division
obtained
professional
accounting expertise
and were permitted
to review dealers'
accounting procedures at the site, they could
more effectively
identify
errors and inconsistencies
in the
They could also encourage dealers to
dealers'
reports.
make changes and improvements in the data reported.

CHAPTER

DAILY STATISTICAL REPORTS
daily

The Federal Reserve Bank requires the dealers
the following
statistical
information.
Type of report

to submit

Description

Positions

The amount of securities
held
for trading valued at par by
type of security

Borrowings

The amount borrowed to maintain
positions
by source and type of
security

Volume

The amount of sales and purchases
at par value by source and type
of security

We found a marked contrast
in the procedures and controls covering the processing and reporting
of transaction
data when compared with those used for reporting
financial
information.
The transaction
reports usually came directly
from the dealers'
day-to-day
operating
systems.
The need
to have up-to-date
and accurate data for trading operations
undoubtedly
had an influence
on the reliability
of those
systems.
Although we found that two dealers had reported certain
repurchase agreements incorrectly,
the Federal Reserve Bank
told us that in two instances the incorrect
data had not
materially
affected
the data as a whole and in another the
Federal Reserve Bank had issued corrected
instructions
for
future reporting.
On the basis of our observations,
it
seems that the dealers have adequate internal
control procedures for processing
daily transactions.
Accordingly
we
believe that the information
furnished
to the Federal Reserve
Bank in the aggregate is reasonably reliable.
The following

paragraphs

illustrate

the errors

found.

The Federal Reserve Bank and the dealers regard repurchase agreements as loans secured with collateral.
The thencurrent instructions
requiredthat
repurchase agreements be
reported as borrowings at the actual amount borrowed.
We
found that two dealers were valuing their outstanding
repurchase agreements at par value of the securities
pledged as
collateral
instead of at the amount of funds borrowed.
As
a result,
these dealers were overstating
from 3 to 4 percent
the amount borrowed in the daily transaction
report.
Although this practice
was contrary
to instructions,
Federal
Reserve Bank officials
said that they were aware that some
dealers were doing this but they believed that the aggregate
borrowing statistics
were only slightly
affected by it.
We found also that one of the dealers discussed in the
preceding paragraph had, in accordance with a 1966 instruction, reported a certain type of repurchase agreement as a
sale.
Although the total amount was substantial,
about
$148.6 million,
the transactions
occurred rather infreAfter discussing
this situation
with Federal Requently.
serve Bank officials,
they rescinded the 1966 instruction
and advised the dealer to follow then-current
instructions.

CHAPTER4
OTHEROBSERVATIONS
which we conDuring our review, we noticed conditions
sider important to the subject of the review and which may
be of interest
to the Committee.
These conditions
deal with
problems in analyzing net income, improved disclosure
of
matters that would significantly
affect the reports,
and the
lack of 'use made of the financial
reports.
PROBLEMSIN ANALYZING NET INCOME
Except for information
relating
to
worth, data permitting
analysis
of the
ket operations
in Government securities
situation
stemmed essentially
from the
Bank's inability
to obtain information
income and factors affecting
profits.

net profit
and net
profitability
of marwas limited.
This
Federal Reserve
on certain
sources of

For the period 1966 through 1970, the aggregate of
earnings reported by all dealers,
before taxes, ranged from
a loss of $8.6 million
in 1968 to a net profit
of $188.2 milpage shows the relion in 1970. The chart on the following
ported profits
for each year and the 5-year average.
ures,

In discussing
the difference
in the 1969 and 1970 figa Federal Reserve Bank official
told 'us:

The sharp swing in dealer earnings between 1969 and
1970 stemmed from the turnaround
in interest
rates.
In 1969
interest
rates were rising
and they reached record levels.
Dealers maintained relatively
small positions
and had to
finance them at negative yields.
In 1970 interest
rates declined and dealers increased their positions
in anticipation
of further
reductions.
Also the drop in short-term
money
market rates outpaced declining
yields on long-term securities and allowed dealers to finance their positions
at favorable rates.
The trend toward higher prices enabled the dealers to earn substantial
trading profits.
sible

A more detailed
analysis
of these factors was not posbecause the net income information
obtained by the
20

DEALERS
IN GOVERNMENT
SECURITIES
REPORTING
TO THE
FEDERAL
RESERVE
BANKOF NEWYORK
DEALER
PROFITS
(BEFORE
TAXESI
$188.2

MILLIONS OF DOLLARS

MILLIONS

OF DOLLARS
20

NONBANKS

1OC

00
BANKS
TOTALALLDEALERS

$8.6

-20
1966

I
1967

1968

1969

I
1970

.20
S-YEAR
AVERAGE

Federal Reserve Bank did not provide,
in all cases, for
dealers to segregate trading profits
from interest
earned on
Treasury bills.
Such information
is furnished
only if the
dealer normally makes such a breakdown.
Althaugh bills
constitute
the largest volume of securities
sold, three of the
six dealers that we visited
did not separate interest
earned
from trading profits
but lumped these factors together.
Thus the extent of trading profits
in the aggregate was undeterminable.
An analyst of the Federal Reserve Bank stated that
another important factor influencing
profits
was the interest paid on funds borrowed by the dealers to finance their
We noted that in 1970 the Federal Reserve Bank
positions.
entered into about $34 billion
worth of repurchase agreeThe Federal Reserve Bank enters
ments with nonbank dealers.
into these transactions
in performing
its function
of mainrate paid
taining
a flow of credit and money. The interest
by the dealers on these borrowings is almost always less
than if they obtained the funds from other sources.
For example, during July 1970, the Federal Reserve rate
was as much as 2 percent less than the New York City bank
loan rates for dealers.
Thus these transactions
enable
dealers to finance their securities
at lower costs,
Financial data that would readily
allow assessment of these transactions on nonbank profits
is unavailable.
The rate of return reported on net worth
dealers for the 5-year period is shown below,

by the nonbank

Rate of Return on
Net Worth Allocated
to
Government Securities
Operations
Year
1966

1967
1968
1969
1970

5-year
average

Net income
(millions)

Net worth
(millions)

Percentage
of return

$ 25
25
-5
-5
116

$ 76
97
104
129

33
26
-5
-5
90

102

101

We obtained profit
and net worth data on the profitabilThe First National
ity of other industries
and operations.
City Bank of New York monthly economic letter
of July 1971
showed composite rates of return on net worth, after taxes,
for more than 3,700 leading corporations.
These included
and financial
institutions
transportation,
manufacturing,
To put the
(commercial banks, investment trusts,
etc.).
economic letter
figures on the same basis as those of the
dealers, we adjusted the profits,
after taxes, to arrive at
profits,
before taxes, by assuming a tax rate of 50 percent.
The economic letter
figures as adjusted are shown below.
Percent of return
on net worth
1970
1969
20
25
2
8
13
12
18
21

Manufacturing
Transportation
Financial
Composite

We also obtained from the New York Stock Exchange reported statistics
covering the financial
results
of member
This information
showed that more than‘300 firms
firms.
made a return on net worth, before taxes, of 16 percent in
1969 and 19 percent in 1970,
A General Accounting Office profit
study showed that,
for 74 large defense contractors
in 1969, the average return
on net worth, before taxes, was 17.4 percent on work for the
Department of Defense, 24.8 percent on work for other defense agencies and 20.4 percent on commercial work.1
These figures are shown not for the purpose of assessing the reasonableness
of earnings by the dealers but merely
to provide some information
on how they compare with other
business enterprises
in the economy.

'Defense

Industry

Profit

Study,

B-159896,

March 17, 1971.

NEED FOR REFINING FINANCIAL REPORTS
In addition
we observed:

to the incomplete

1. Federal Reserve
sertions
to the effect
were not prepared on
ceding year.
In our
required to disclose
would produce results

disclosure

of income data,

Bank instructions
did not require asthat financial
statements were or
a basis consistent
with that of the presuch an assertion
should be
opinion,
any accounting procedural
changes that
differing
materially
from-past years.

2, Some dealers adjusted their security
positions
each
month to market values and record the unrealized
gains or
losses in the income accounts.
Under these circumstances,
the more acceptable method of financial
data presentation
requires
that disclosure
be made of the amount of unrealized
profit
which accumulated over the year and is still
in the
Such
disclosure
is
not
specifposition
values at year-end.
ically
required by the Federal Reserve Bank.
USE MADEOF REPORTS
The expressed doubts about the reliability
of the financial reports have limited
their usefulness.
We understand
that the daily reports were meaningful to officials
of the
Federal Reserve Bank.
Financial

reports

We found practically
no use made of the financial
reports and therefore
discussed this matter with officials
of
the Federal Reserve Bank, the Federal Reserve Board, and
the Treasury Department.
Some of their comments follow.
An official
of the trading desk, Federal
told us that the financial
reports were not
its operation.
Such information,
however,
to observe broad trends in the market if it
the problems in allocating
income, expense,

Reserve Bank,
necessary to
could be useful
were not for
and net worth.

A Federal Reserve Board staff member stated that the reports were used for (1) identifying
changes in dealer operations,
(2) evaluating
dealer profits,
and (3) determining
24

those dealers that may have financial
difficulties.
He
added that the reports would be more useful if the allocation methods for expenses and net worth were improved.
Treasury officials
were concerned with whether there were
enough dealers to handle the volume of trading and were also
interested
in such other matters as dealer profits.
They
believed that the reports were necessary but that they could
be more useful if improved.
also found that the financial
data, in the aggregate,
was not regularly
distributed
to the Congress or to the pubAn official
of the Federal Reserve Bank told us that
lic.
this was not done because the reports were considered unreliable
and therefore
meaningless.
We

Daily

reports

Each day the trading desk at the Federal Reserve Bank receives position
data for each dealer and aggregate data on
positions,
dealer borrowings,
and volume of transactions
to
assist it in its open market operations.
In addition,
selected data in the aggregate is sent daily to all the Fedto the Federal Reserve Board,
eral Reserve Bank presidents,
and to the Treasury Department.
Only aggregate statistics
are released to the public
through weekly press releases and the monthly Federal Reserve Bulletin.
The volume of transactions
is publicly
released weekly and position
and borrowings after a 4-week
time lag.
Federal Reserve Bank officials
who operate the trading
desk have told us that the data is useful for several purThe data is used to determine the amount of secuposes.
rities
available
for purchase from dealers and to determine
the amount of money borrowed and the source of borrowings.

CHAPTER5
SUGGESTEDCORRECTIVEMEASURES
Considering
the highly sensitive
nature of the Government security
market operation
and how little
was known
about it in 1960, we believe that the progress made toward
developing and operating
a financial
and transaction
reporting
system merits commendation.
The fact that this
progress was made without regulations
and achieved through
the Federal Reserve Bank and dealer cooperation
also warrants recognition.
Even so, we believe that our findings
show a need for
the Federal Reserve Bank and dealers to improve the reliability
and usefulness
of the financial
data accumulated
under the reporting
system. This will require special effort by them if improvement is to be achieved.
In the remainder of this chapter, we are suggesting some corrective
measures that we believe could be taken by the Federal Reserve System to achieve appropriate
improvements.
STRENGTHENINGCONTROLSOVER
PREPARATIONOF REPORTS
In chapter 2 we pointed out major problems that were encountered:
(1) all income was not being reported for the accounting period because some dealers were not on a commitment
basis and (2) some dealers reported,some
accounts on an accrual basis but reported others on a cash basis.
It is generally recognized
that the accrual method of accounting more
accurately
shows the financial
position
of a concern and mores
precisely
measures the results
of operations
for specific
periods.
Accordingly
we believe that the financial
reports
should be prepared on an accrual basis if a significant
difference might result.
Another problem discussed in chapter 2 was the reasonableness of expenses allocated
to the Government securities
operation.
The inequities
found were mostly attributable
to mistakes made by the dealers and the need for more specific
guidance by the Federal Reserve Bank. We believe
that the following
steps could be taken by the Federal
26

Reserve System to build
the reporting
system.

a greater

degree of assurance

into

--Develop criteria
for the dealers to follow in allocating
expenses with special emphasis on the suitability
of the basis used to allocate
costs and the
relationship
of expenses to Government securities
operations.
--Require
dealers to retain the working papers supporting such items as adjustments,
allocations,
and calculations
in preparing reports so that questions
involving the data submitted can be properly resolved.
--Establish
methods for increasing
awareness on the
part of top management officials
of the dealers that
complete and accurate data is to be provided.
--Establish
and require dealers to use uniform quotations to determine market value of Government agency
securities.
Chapter 2 also covers the question of obtaining
realistic
allocations
of net worth which has been a continuing
Essentially
theri! is a lack of guidance in this
problem.
We believe that problems in such allocations
could
area.
be overcome through the development of specific
criteria
on
the method to be used in allocating
net worth.
IMPROVINGREVIEW FUNCTION
To strengthen
we believe that

the Federal

Reserve Bank review

--the Market Statistics
Division
sional accounting expertise,

should

function

obtain

profes-

--the review procedures of the Market Statistics
Division should be modified to provide for examinations
of financial
data and supporting
workpapers at the
dealers'
offices,
and
--the authority
of the Market Statistics
Division
be broadened to provide for visits
to dealers'
fices and enable it to make changes necessary
27

could
of-

to improve the accuracy
reports.

and usefulness

of financial

REFINE FINANCIAL REPORTS
In chapter 4, we show the advantages that can be gained
by refining
the financial
reports particularly
with respect
to more complete disclosure
of income data.
The following
steps could be taken to provide for better reporting.
--Require
profits
sis.

dealers to segregate Treasury bill
trading
from interest
earned in the net income analy-

--Require dealers to indicate whether reports were prepared on a basis consistent
with that of the prior
If
changes
in
accounting
procedures were made,
year.
the dealer should describe the nature of the change
and the effect on the data.
--Require dealers to disclose
the unrealized
gains and
losses for all Government securities
using cost as a
base. The balance sheet should show the amount of
unrealized
gain or loss included in reported positions.
DISTRIBUTION OF AGGREGATE
REPORTDATA
To ensure distribution
of financial
data to the Congress and the public,
we believe that consideration
should
be given to inclusion
of the dealers'
aggregate data in the
annual report of the Federal Reserve Board.
To accomplish
this, we suggest that the Federal Reserve Bank establish
reporting
dates to coordinate
with the date of the annual
report.
AGENCYCOMMENTS
We discussed the report with officials
of the Federal
Reserve Bank who gave us their informal comments. Although
they agreed with our findings
and conclusions,
they told us
that the Informal Treasury-Federal
Reserve Steering Committee,which has overall responsibility,,for
the reporting
system,would have to decide on what corrective
action would be
taken.
28

APPENDIXES

APPENDIX I

Nay

The Honorable Elmer B. Staats
Comptroller
General of the United
Washin:$on,
D. C.

1970

States

Dear Mr. Staats:
Eleven years ago, at my recrxest,
the staff
of the Joint
Economic Committee developed a set of reportin
forms and accountin? standards
to use in obtaining
information
on tie operations
of
the dealers who make a market in Government securities.
At that
time there were seventeen such dealers.
The results
were published
by the Committee in 1960 in a pioneering
staff
study of this market.
Subsequently
a system of regular
reporting
on this market was developed by.the Federal Reserve System in cooperation
with the dealers.
This system now produces a regular
flow of data about transaction
in
the market and on revenues,
expenses, and profits
of dealers,
both
bank and nonbank.
Now that this system has been operating
for several years,
it would seem appropriate
to review the basic accounting
standards
that are employed to make sure that these are in accord with the
best practices.
This would insure that we could have confidence
in the data, particularly
as to the profits
of the dealers,
With
this aim in view, I am attaching
a set of the forms and instructions
used by the Federal Reserve Bank of New York in operating
this system
of reporting
and I request that your accounting
experts go over this
system and advise me as to whether or not:
(1) the accounting
practices are in accord with the best accounting
standard;
and (2) such
a system is likely
to afford
the public and our Committee an accurate
picture
of the operations
and profits
of these dealers as a group.
Mr. James W. Knowles, Director
of Research for the Joint
Econom$ Committee,
has been involved
with this system from the
beginn+&
in 1959, and is available
to work with you in
needeg'5.n the course of your review.
Sincerely,

APPENDIX II
LIST OF FINANCIAL REPORTDEFICIENCIES
BY TYPE AND PRIMARYCAUSE
Statements

of Financial

Condition
Primary
cause

1. Adjustment

of securities
positions
from the
dealer's
basis of accounting to the commitment
basis was made incorrectly.
UP

2. Various methods were employed for determining
the market value of securities
positions.
(6)

3. Net worth
activities

allocated
to Government securities
(1)
was not adequately supported.

borrowed and the offsetting
4. Securities
ity were not reported.
(1)

liabil-

5. Liability
reflected
of actual

for outstanding
repurchase
par value of the securities
money borrowed.
(1)

6. Securities
derstated

purchased but not yet received
(1)
due to a footing error.

receivable
7. Accrued interest
est payable were inaccurate.
securities
8. Nonreportable
nancial statements.
(2)

and accrued
(2)

were incl;ded

sold but not yet delivered
9. Securities
properly
stated.
(2)
10. Securities

positions

agreements
instead

were overstated.

uninter-

in fiwere im(2)

11. Repurchase agreements were improperly classified as to maturity
and type of security.
(2)
1

See page 34.
2
See page 35.
32

D
D
D
D
D
D
D

APPENDIX II
Primary
cause
12. All contingent
ported.
(1)

liabilities

were not reD

13. Required explanations
ted.
(2)

of data were not submitD

in agency securities
were errone14. Positions
ously classified
as "other securities."
(1)

15. The reported increase
accurate.
(1)

in net worth was not
D

16. Related asset and liability
set even though the Federal
structed otherwise.
(1)

accounts were offReserve Bank in-

Net Income Analysis
were not reported on the com17. Trading profits
mitment basis, as required by Federal Reserve
Bank instructions.
(3)
18. Unrealized gains or losses not reported in the
right
reporting
period.
(1)

19. Unrealized gains on Government securities
cluding Treasury bills were not properly
sified.
(1)

inclas-

20. Unrealized
unrealized

loss was erroneously
gain.
(1)

reported

income was offset
(3)

23. Expenses on certain transactions
against interest
income instead
ported separately as required.
33

21. Income was not reported on a calendar-year
basis as required by the Federal Reserve
Bank. (1)
22. Certain interest
terest expense.

against

D
in-

were offset
of being re(1)

n
D!

APPENDIX II
Primary
cause
24. Required explanations
ted.
(2)
25. Income on Treasury
26. All

of data were not submitD
bills

was overstated.

income items were not reported.

(1)

D
D

(1)

27. Cost of borrowed funds was overstated
because
interest
was on the par value of Treasury
bills
instead of the discounted value.
(2)

28. Unrealistic
interest
rate used for calculating
the cost of own bank funds used.
(1)

29. Miscellaneous
classified.

income items were incorrectly
(2)

30. Miscellaneous
interest
rately reported.
(3)

expense was inaccuD

31. Expenses included certain
items not applicable
to Government securities
activities.
(2)

32. No schedule
submitted.

supporting
(1)

33. Interest-free
dealer
mate was unrealistic

expense allocations
department capital
or not estimated.

34. Local income taxes were treated
tently.
(6)

was
esti(2)

inconsisF

35. Interest
expense was overallocated
as a result
of including
costs incurred in financing
other
than Government securities
activities.
(2)

36. Data submitted
sis.
(3)

was not fully

on an accrual

NCTE: Figures in parentheses
( ] indicate
number of dealer errors.
34

bathe

APPENDIX II

TABULATION OF DEFICIENCIES
Number of
deficiencies
Instances
Type
D = caused primarily
by erroneous
dealer procedures.

by weaknesses in
F= caused primarily
Federal Reserve Bank instructions,
guidelines,
etc.

-4

-15

=36

=67

Full text of GAO Reports & Testimonies : Improvements Needed in the Federal Reserve Reporting System for Recognized Dealers in Government Securities : Report to the Vice-Chairman of the Joint Economic Committee, Congress of the United States

FRASER