1

Chapter 12

The Federal Reserve System: Its Structure

And Functions

©Thomson/South-Western 2006

2

The Origin Of The Federal Reserve System

Some central banks evolved from private commercial banks over a long period of time. Bank of England (est. 1694) Bank of France (est. 1800)

The Federal Reserve was originally established ( in 1913) solely as a central bank. Preceding U.S. central banks were viewed as too powerful and charters were

not renewed by Congress: First Bank of the United States (1791-1811) Second Bank of the United States (1816-1836)

Prior to the creation of the Federal Reserve System, nationally chartered banks were regulated by provisions of the National Banking Act of 1863. Smaller banks held deposits in larger banks as well as cash . Banks in New York, Chicago, and St. Louis were classified as Central

Reserve City Banks. Banks in approximately 50 other cities were classified as Reserve City Banks. All other banks were Country Banks and they held reserves at Reserve City

Banks. Reserve City Banks held reserves for the Central Reserve City Banks.

3

Problems with the Fractional Reserve Banking System

Lack of flexibility: If a seasonal or panic-induced withdrawal of currency from

banks occurred, pressure would converge on the larger banks as small banks drew down their deposits to obtain cash for their customers.

Major banking and financial market panics occurred in 1857, 1873, 1884, 1893, and 1907.

No lender of last resort stood ready to provide temporary cash reserves to the banking system in times of crisis.

The Fed was created by the Federal Reserve Act, which was signed into law by President Woodrow Wilson in December, 1913.

4

Federal Reserve Act A compromise among diverse forces and interests:

between the government and the private sector; among the various geographic regions of the nation; between rural and urban interests, and among bankers, the non-bank business sector, and the rest of society.

Original Mandate: to serve as a lender of last resort to the banking system; to issue currency; to improve on the check collection process; to serve as banker or fiscal agent for the U.S. Treasury, and to improve the supervision and examination of the nation's banks.

Current Mandate: Economic stabilization, Price stabilization, and Encouraging full employment.

5

The Balance Sheet : Assets

gold and Special Drawing Rights (SDR) certificate accounts

coins loans to depository institutions U.S. government securities cash items in the process of collection assets denominated in foreign currencies other assets

6

The Balance Sheet : Liabilities

Federal Reserve notes, (paper money)

Deposits maintained at the Federal Reserve by Commercial banks and other depository institutions

7

The Balance Sheet: Capital Accounts

The capital accounts of the Federal Reserve System consist of the difference between its total assets and total liabilities.

The Federal Reserve is technically "owned" by the approximately 3,000 commercial banks that are Federal Reserve System members.

Each member bank receives dividends on its shares.

Ownership does not suggest influence over operations or policies.

8

Table 12-1

9

Federal Reserve Earnings and Expenses

10

The Structure Of The Federal Reserve System

7-person Board of Governors: appointed by the president of the United States for one 14-

year term, subject to confirmation by the U.S. Senate Major responsibilities include:

setting the levels of reserve requirements; reviewing and "determining" the level of the discount rates set by

the twelve individual district Federal Reserve banks; establishing bank supervision and examination procedures; evaluating applications for bank mergers and acquisitions; setting margin requirements for the purchase of stocks and

bonds, and serving as voting members on the important Federal Open

Market Committee (FOMC). FOMC formulates the basic posture of monetary policy and buys and

sells securities with a view toward influencing credit availability, short-term interest rates, and monetary conditions throughout the nation.

11

Figure 12-1

12

Federal Open Market Committee (FOMC)

meets eight times annually Attendees:

the seven members of the Board of Governors; Five of the twelve presidents of the district Federal Reserve Banks

(always includes the President of the New York Federal Reserve Bank);

a key advisor to each district Federal Reserve Bank president , and key staff of the Board of Governors and FOMC.

Members debate current economic conditions and the appropriate course of monetary policy.

Staff gives projections of key economic variables. With formal votes, FOMC directives are issued to the

manager of the System Open Market Account. The directive outlines the desired conduct of monetary policy until the

next meeting of the FOMC.

13

Figure 12-2

14

Figure 12-3

15

The District Federal Reserve Banks

Each district Federal Reserve Bank: is an incorporated institution, owned by the

Federal Reserve member banks of the district, and

is governed by a nine-person board of directors, six of whom are elected by commercial bankers and three of whom are appointed by the Board of Governors in Washington. 3 professional bankers 3 prominent business leaders 3 representing areas other than banking and business

sectors

16

The Member Banks

Forty percent of the nation's approximately 7,800 commercial banks are members of the Federal Reserve System.

Membership allows banks to participate in the selection of six of the nine directors of the district Fed bank.

Membership also implies strict supervision and regulation by Federal Reserve authorities.

17

Allocation of Power within the Federal Reserve System

Board of Governors in Washington has more power than the district Federal Reserve banks.

Board of Governors in Washington can veto a districts choice of district Federal Reserve bank president.

Though the discount rate is set by each district Federal Reserve bank, it is subject to "review and determination" by the Board of Governors.

Decisions to purchase government securities are made in Washington by the FOMC.

Federal Reserve Bank of New York is the first among equals.

18

The Question Of Federal Reserve Independence

Relative to many other nations’ central banks, the Federal Reserve System enjoys considerable independence from governmental influence—either the executive or legislative branches.

The Fed's independence was created deliberately by the authors of the Federal Reserve Act.

Indicators of independence: nonrenewable 14-year terms of the members of the Board

of Governors, and the Fed's operating revenues are derived from its portfolio

of securities rather than from Congressional appropriations.

19

Independence of the Federal Reserve May be Overstated

If it wants its voice heard, it must conform to Congressional wishes to some degree.

The Fed is frequently involved in Congressional legislation concerning bank regulation.

The Constitution grants authority to Congress to revoke the authority given to the Federal Reserve.

20

The Case For Federal Reserve Independence

Political control of the Fed would introduce an "easy money" bias

Politicians love to spend money, but hate to levy taxes to pay for the expenditures--running up the deficit.

The Fed guards price level stability.

21

The Case Against Federal Reserve Independence

Those responsible for monetary policy should be accountable to the electorate.

Various elements of national economic policy need to be coordinated rather than be allowed to run at cross purposes.

The Federal Reserve has not used its independence effectively over the years.