1. The Banking System: Introduction
  2. The Banking System: Commercial Banking - What Banks Do
  3. The Banking System: Commercial Banking - Economic Concepts in Banking
  4. The Banking System: Commercial Banking - How Banks Make Money
  5. The Banking System: Commercial Banking - Business Lending
  6. The Banking System: Commercial Banking - Operations
  7. The Banking System: Commercial Banking - How Banks Are Regulated
  8. The Banking System: Commercial Banking - Where Commercial Banks Are Vulnerable
  9. The Banking System: Commercial Banking - Bank Crises And Panics
  10. The Banking System: Commercial Banking - Key Ratios/Factors
  11. The Banking System: Federal Reserve System
  12. The Banking System: Non-Bank Financial Institutions
  13. The Banking System: Conclusion

ByStephen D. Simpson, CFA

The central bank of the United States is the Federal Reserve System. The Federal Reserve System came into being in 1913, after the passage of the Federal Reserve Act and largely in response to the bank panic of 1907. Since the formation of the Fed, Congress has passed numerous additional laws adding or altering the powers and responsibilities of the Fed, including: the Glass-Steagall Act, the Bank Holding Company Act, the Federal Reserve Reform Act, the Gramm-Leach-Bliley Act and the Dodd-Frank Act.

While arguably initially created to enhance the stability of the banking system and the economy, the Federal Reserve serves many different simultaneous functions. The Fed is the means by which the United States conducts monetary policy, as well as a regulator of banks, and a service provider to the financial system and government of the United States. Although the Fed is supposed to be an independent body, and its decisions are not ratified by the President or Congress, there is often a large degree of consultation and cooperation between the bodies. (To learn more, see our tutorial on The Federal Reserve.)

Federal Reserve Board
The Federal Reserve System is run by a board of governors and the Chairman. The Federal Reserve Board includes seven members and all members, including the Chairman, are appointed by the President of the United States, confirmed by the Senate and serve automatically on the FOMC. While the Board's functions and responsibilities overlap with the FOMC, the Board establishes key policies, like the discount rate and the reserve requirements.

Federal Open Market Committee (FOMC) determines monetary policy. The committee includes a seven-member board of governors and five reserve bank presidents. While four of these five seats rotate among reserve presidents in one-year terms, the president of the New York Federal Reserve Bank has a permanent seat on the committee. The eight annual meetings of the FOMC are closed to the public, but minutes and vote records are made available after the meetings.

Federal Reserve Banks
There are 12 regional Federal Reserve banks that assist in controlling the money supply and executing Fed policy. The 12 banks are located in Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas City, Minneapolis, New York, Philadelphia, Richmond, St. Louis and San Francisco. Perhaps not surprisingly, the New York Federal Reserve bank is the largest of the 12, in terms of assets.

The Federal Reserve banks act as depositories for federal money and act as payment agents for government transactions. These banks play a role in distributing currency to commercial U.S. banks, make loans to smaller member banks and oversee the regulation of commercial banks in their region.

Fed Operations
The Fed can alter the money supply through open market operations, that is, buying or selling government securities. When the Fed wishes to increase the money supply, it goes into the market and buys bonds from banks; those banks can then lend out that cash. On the flip side, the Fed can sell bonds to these banks and drain money from the market.

Second, the Fed can change the reserve requirements for banks. As previously mentioned, the money supply is tied directly to the percent of deposits that banks hold as reserves. If the reserve rate is increased, the money supply decreases, and vice versa. Banks do not always loan out the maximum amount that they are allowed to, and alterations to the reserve requirement can create instability in the banking sector, to say nothing of taking some time to go into effect. Consequently, this is not an especially commonly used method by the Federal Reserve.

Lastly, the Federal Reserve can impact the money supply through interest rates. The Fed does not directly determine what an individual borrower pays for a mortgage or new car loan, but interest rates, by and large, flow from whatever the Fed charges. Consequently, if the Fed raises rates, those rates typically work down through all levels of banking and ultimately result in higher lending rates, and less lending activity. (Learn more in How The Federal Reserve Manages Money Supply.)

The Fed is also a lender of last resort within the banking system, a regulator and a data gathering and analysis operation.

Controversies About the Fed System
The validity and utility of the Federal Bank is certainly not universally accepted. There has always been a debate about the constitutionality of a national bank, and the extent to which the federal government plans or controls the economy through that bank. Throughout the bank's history there have also been frequent criticisms of particular Fed policies. Some argue that the Fed's monetary policy is too tight and creating unemployment and others argue that monetary policy is too loose, and stokes inflation and dollar depreciation.

Contrary to the experience of bank panics every decade in the 1800s, throughout most of which the U.S. did not have a central bank, some believe that the Fed cannot adequately manage the monetary policy of the country and actually increases instability. Likewise, while some believe that the Fed is too willing to accommodate political administrations and allows asset bubbles to inflate and continue, others believe the Fed interferes too much in the economy of the United States.

Central Banks Around the World
Despite the controversy around the role, or even the existence, of the Federal Reserve System, most developed countries in the world now have functional central banks. As is the case with the U.S. Federal Reserve, most central banks have responsibility for executing monetary policy and overseeing the banking system.

There are certainly differences from country to country in how the central banks operate and the extent to which they are independent of, or beholden to, the ruling administration. One additional notable difference is that some central banks explicitly target a certain inflation rate and base their policy decisions on that target. While some argue that this approach sacrifices economic growth for stability, it does lend predictability to the interest rate outlooks.

The Banking System: Non-Bank Financial Institutions
Related Articles
  1. Insights

    What's the 1913 Federal Reserve Act?

    The 1913 Federal Reserve Act was a pivotal congressional act that helped establish the Federal Reserve System as it exists today. It is one of the United States financial system’s most influential ...
  2. Investing

    What's the Salary of the Chairman of the Federal Reserve?

    The chairman of the Federal Reserve oversees the U.S. banking system.
  3. Personal Finance

    What's the Federal Funds Rate?

    The federal funds rate is the interest rate banks charge each other for overnight loans to meet their reserve requirements.
  4. Insights

    How The Federal Reserve Manages Money Supply

    Find out how the Fed manages bank reserves and this contributes to a stable economy.
  5. Trading

    Understanding the Federal Open Market Committee

    The Federal Open Market Committee is the branch of the Federal Reserve Board that determines monetary policy.
  6. Insights

    What Do the Federal Reserve Banks Do?

    These 12 regional banks are involved with four general tasks: formulate monetary policy, supervise financial institutions, facilitate government policy and provide payment services.
  7. Investing

    What are the Federal Reserve Chairman's responsibilities?

    Learn about the duties and responsibilities of the chairman of the Federal Reserve Board, including testifying before Congress and as chair of the FOMC.
  8. Insights

    What Does the Federal Reserve Do?

    What is the Federal Reserve System and how does it affect interest rates, inflation and the market?
Frequently Asked Questions
  1. How did the ABX index behave during the 2008 subprime mortgage crisis?

    Read about the disastrous performance of the various ABX indexes in the subprime mortgage crisis of 2008 during the middle ...
  2. How did moral hazard contribute to the 2008 financial crisis?

    Learn about moral hazard, how it can affect outcomes and how it contributed to the conditions that led to the 2008 financial ...
  3. Which mutual funds made money in 2008?

    Read about the only mutual fund that turned a profit in 2008. Learn about risk-averse investment strategies and the financial ...
  4. Were Collateralized Debt Obligations (CDO) Responsible for the 2008 Financial Crisis?

    Collateralized debt obligations are exotic financial instruments that can be difficult to understand, Learn the role they ...
Trading Center