Finance - IV

Federal Reserve System

4 Jan 2025

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US banking system prior to the Federal Reserve System

The basis of the US national banking system was initially established by the National Banking Acts of 1863 and 1864. Among the provisions of these acts were the establishments of:

• a system of national banks chartered by the federal government;
• capital and reserve requirements for these banks;
• banknotes issued against US government bonds;
• improved bank supervision under the Office of the Comptroller of the Currency/US Treasury.

However, there were some weaknesses with this system:

• slow and cumbersome check clearing, resulting in checks being redeemed at less than face value to cover the costs of transportation and handling;
• inflexible currency supply, as the supply of currency was tied to the supply of US government bonds, as opposed to the needs of the economy (to issue more currency, banks would be to purchase more bonds, but they can only do so if the returns on the use of the issued currency are greater than the price of the bonds);
• lack of reserves to meet liquidity needs (most reserve balances were held with large city banks, and rural banks can only obtain reserves from these larger banks).

To address these weaknesses, the Federal Reserve System was established (with somewhat strong opposition) in 1913 to extend existing banking system. The Fed is the central bank of the US, responsible for supervising and regulating the US banking system, and for creating and regulating the supply of money in the economy.

Structure of the Federal Reserve System

The Fed is composed of:

• various member banks;
• various Federal Reserve Banks;
• the Board of Governors;
• the Federal Open Market Committee (FOMC);
• a set of advisory committees.

Member banks

All national banks must be members of the Fed. State banks may join if they meet certain requirements, though both member and non-member banks are subject to the Fed's regulations, such as meeting reserve requirements. All members of the Fed must also purchase stock in their respective Federal Reserve District Bank, which entitles them to a capped dividend. We can think of the Reserve Banks as private institutions owned by the member banks.

Federal Reserve District Banks

There are 12 Federal Reserve districts in the US, and each district is served by a Federal Reserve Bank (different from member banks). These district banks have several responsibilities:

• holding reserve balances for other banks (member and non-member);
• lending to banks in need of reserves at the prevailing (discount) rate;
• issuing new currency and withdrawing damaged currency from circulation;
• regulating funds transfers between banks, e.g. check clearing.

Each Reserve Bank is overseen by a board of directors (plus other corporate officers). Nine directors are appointed in a staggered manner. They are also divided into three groups representing various sectors of the economy:

• Class A directors are appointed by member banks of the district;
• Class B directors are also appointed by member banks, but they represent other non-banking sectors of the economy, e.g. commerce, agriculture, culture, and industry;
• Class C directors are appointed by the Board of Governors of the Fed.

Class C directors are also the only directors who are not allowed to be officers, directors, or employees of any bank. One class C director is designated chairperson and Federal Reserve agent (the BOG's representative in the district). Another is designated deputy chairperson.

Below the board of directors are the president and first vice president of the district bank. These are appointed by the board of directors, and must be approved by the Board of Governors. The president is responsible for executing the policies of the board of directors, and for the general administration of the bank.

In addition to the 12 Reserve Banks, the Fed also has a set of branch banks for convenience. For example, the San Francisco district has one Federal Reserve Bank in San Francisco, and four branches in Los Angeles, Portland, Salt Lake City, and Seattle.

Board of Governors

Three of the class C directors of the Reserve Banks are appointed by the Board of Governors. The BOG itself is composed of seven members, each appointed for a 14-year term, by the president of the US (with advice and consent of the Senate). One member is appointed chairperson and another vice chairperson.

The BOG is responsible for formulating monetary policy, such as setting the reserve requirements and the discount rate, and for controlling the money supply through open market operations of the Federal Open Market Committee. Moreover, the BOG is responsible for overseeing the Reserve Banks. They approve state banks applying for membership in the Fed, and they recommend the removal of officers and directors of member banks. The BOG also conducts economic research, and publishes reports on the economy.

Federal Open Market Committee

The Fed achieves its monetary policy objectives coordinating the timing of purchases and sales of US government securities (and other securities) in the open market. The committee responsible for this is the Federal Open Market Committee, which is composed of the seven members of the BOG, and five presidents (not directors) of the Reserve Banks (one of which is the president of the New York Reserve Bank).

Advisory committees

There are several advisory committees that provide advice to the Fed:

• the Federal Advisory Council is made up of one member from each district bank, and provides information on banking-related matters;
• the Consumer Advisory Council is made up of representatives from depository institutions and their customers, and provides information on consumer issues;
• the Thrift Institutions Advisory Council is made up of representatives from various thrift institutions such as S&Ls, savings banks, and credit unions.

Monetary policy functions and instruments

The primary responsibility of the Fed is to formulate monetary policy, including the control of the money supply, to promote economic stability. We can think of Fed operations in several ways:

• in terms of dynamic actions to stimulate or slow down the economy and control inflation, such as by changing the discount rate or reserve requirements;
• in terms of defensive actions to counter unexpected shocks to the economy, such as regulating large acquisitions by corporations which may destabilize reserve balances;
• in terms of accomodative actions to meet the credit needs of the economy, such as by providing liquidity to banks in need of reserves.

The basic policy instruments of the Fed that allow it to control the money supply are:

• changing reserve requirements;
• changing the discount rate;
• conducting open market operations;
• quantitative easing.

Reserve requirements

The US banking system uses a fractional reserve system. Banks are required to hold reserves equal to a certain percentage of their deposits. Any excess reserves can be lent out, which increases the money supply. Banks are inclined to lend out their excess reserves because they can earn interest on them (achieving profitability and liquidity), especially when interest rates are high.

When the banking system as a whole has excess reserves, credit becomes more readily available, and the money supply expands. Thus, the Fed can increase the money supply by lowering reserve requirements. However, this can lead to inflation, as people and businesses are more likely to borrow and spend, raising demand for goods and services.

Generally speaking, the Fed rarely alters the reserve requirements to control money supply, as it is difficult to predict its effects on the economy (the Fed prefers conducting open market operations instead). Nevertheless, there had been historical instances where the Fed had to change reserve requirements to achieve its monetary policy objectives:

• after the stock market crash of 1929, the Fed increased reserve requirements to absorb excess reserves, as businesses were reluctant to borrow during the Great Depression;
• during World War II, reserve requirements were lowered to encourage lending to the government (to finance the war effort). Reserve requirements were raised again after the war to absorb the excess reserves;
• in the 1960s and 1970s, reserve requirements were selectively altered to impose restraints on banks as they experimented with new ways of sourcing funds;
• the Depository Institutions Deregulation and Monetary Control Act of 1980 required all banks (including non-member banks) to maintain reserve requirements set by the Fed; prior to this, reserve requirements for non-member banks were regulated by individual states, which made it difficult for the Fed to control the money supply.

Discount rate policy

The Fed also serves as a lender to banks in need of reserves. Banks can borrow reserves from the Fed at the discount rate, which is set by the Reserve Banks. When the Fed sets a low discount rate, banks are more inclined to borrow reserves, which expands the money supply.

Consider a more thorough example. Suppose the Fed wants to reduce inflation. It can increase the discount rate, which makes it more expensive for banks to borrow reserves, i.e. increases the cost of borrowing. To address this increase in cost, banks may raise their interest rates on loans (bank prime rates have historically tracked the Fed discount rate), which decreases the demand for loans. Businesses who can't afford the higher interest rates may reduce or delay their spending, which decreases demand for capital goods. Labor demand also decreases, which leads to a decrease in wages. Workers who are laid off or have their wages cut may reduce their spending, which decreases demand for goods and services. Businesses who are unable to sell their goods and services may reduce their prices, which decreases inflation.

Like reserve requirements, the Fed rarely uses the discount rate to control the money supply. Instead, the discount rate is used more as an adjustment or fine-tuning mechanism, providing banks some flexibility to respond to other more aggressive policy actions, such as open market operations.

Open-market operations

The most common way the Fed controls the money supply is through open market operations. The Fed buys and sells securities in the open market to alter bank reserves. By purchasing securities from banks, the Fed can increase the amount of reserves in the banking system, which lowers short-term interest rates (as banks are more willing to lend out their excess reserves). This can stimulate the economy, as businesses and consumers become more inclined to borrow and spend.

The Fed holds the majority of its assets in US government securities and mortgage-backed securities. Most of the Fed's liabilities are in the form of Federal Reserve notes (currency).

The Fed conducted some open market operations in its early years, but most of these operations were conducted in an uncoordinated manner. For example, the New York Reserve Bank would use their funds to buy securities in the open market, which would increase reserves in the banking system. However, the funds often flowed to other member banks in New York, which reduced their borrowing from the New York Reserve Bank. This made it difficult for the New York Reserve Bank to maintain control over the money supply in its district. Furthermore, the amount of sales and purchases of securities were so large that they destabilized the market.

Quantitative easing

Quantitative easing is a non-conventional monetary policy tool used by the Fed to stimulate the economy when the standard monetary policy tools are ineffective. The Fed creates new money, and use it to purchase financial assets from banks and other financial institutions. This results in an increase in reserves.

Implementation of monetary policy

Monetary policy has traditionally focused on either trying to control the rate of change in the money supply, or targeting interest rates. For example, the Fed, through FOMC, may set a target for the federal funds rate (the interest rate at which banks lend reserves to each other overnight). If the Fed wants to increase the federal funds rate, it can sell securities in the open market, which decreases reserves in the banking system, and makes it more expensive for banks to borrow reserves from each other. Note that the Fed does not set the federal funds rate directly (the actual rate is determined by the supply and demand for reserves in the banking system), but it can influence it through open market operations.

The Fed can also use its open market operations to provide liquidity to the banking system in times of crisis. For example, the Fed increased money supply after the stock market crash in 1987, the 9/11 attacks, and, most recently, the 2007-08 financial crisis. In December 2008, the FOMC established a near-zero target federal funds rate (0-0.25%) to stimulate the economy (in addition to quantitative easing), and maintained this target rate until December 2015, when it was raised to 0.25-0.5%.

Fed supervisory and regulatory functions

A strong and stable banking system is essential for a healthy economy, therefore the Fed has a number of supervisory and regulatory functions to ensure the safety and soundness of the banking system.

Various authorities are responsible for regulating different parts of the banking system, including all banks (member and non-member, national and state-chartered), thrift institutions, credit unions, S&Ls, and bank holding companies. These authorities include:

• the Office of the Comptroller of the Currency;
• the Federal Deposit Insurance Corporation;
• various state regulatory agencies;
• the National Credit Union Administration;
• the Office of Thrift Supervision.

The Fed is responsible for:

• appraising the soundness of an institution's assets;
• evaluating internal operations, policies, and management;
• analyzing key financial factors, such as capital and earnings;
• reviewing compliance with all banking laws and regulations;
• determining the adequacy of an institution's liquidity, and of its financial condition in general.

The Fed must ensure that banks are operating in a safe and sound manner, and that all banks are fully competitive with each other in financing the trading and investment needs of the economy. Part of this responsibility includes approving or denying applications for mergers and acquisitions by bank holding companies, in accordance various laws and regulations, such as the Bank Holding Company Act of 1956, the Bank Merger Act of 1960, and the Change in Bank Control Act of 1978.

Other consumer protection laws are also enforced by the Fed, such as the Consumer Credit Protection Act of 1968, which requires lenders to disclose the cost of credit to consumers, and Regulation Z (Truth in Lending), which requires lenders to disclose the terms of credit to consumers, so that they can compare credit terms and make informed decisions. These terms include the annual percentage rate (how much the credit will cost over a year), the finance charge (interest, discount, service charge, loan fee, finder's fee, insurance premium, taxes, etc.).

Moreover, other laws are designed to encourage banks to lend to low-income communities, such as the Community Reinvestment Act of 1977.

Fed service functions

The Fed provides a range of services to banks and the US government. One of the most important services is payment processing. Any economy requires a system for transferring funds between buyers and sellers. Thus, the Fed must ensure that the banking system has an adequate supply of currency to meet the needs of the public, and that checks and electronic funds transfers are cleared and settled between banks in a timely manner.