The Banking System: Federal Reserve System
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.
The 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.
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.
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