Federal Reserve System

The Federal Reserve System — also known as the Federal Reserve or simply as the Fed — is the central banking system of the United States. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, largely in response to a series of financial panics, particularly a severe panic in 1907. Over time, the roles and responsibilities of the Federal Reserve System have expanded, and its structure has evolved. Events such as the Great Depression in the 1930s were major factors leading to changes in the system. The U.S. Congress established three key objectives for monetary policy in the Federal Reserve Act: maximizing employment, stabilizing prices, and moderating long-term interest rates. The first two objectives are sometimes referred to as the Federal Reserve's dual mandate.[12] Its duties have expanded over the years, and as of 2009 also include supervising and regulating banks, maintaining the stability of the financial system and providing financial services to depository institutions, the U.S. government, and foreign official institutions.[13] The Fed conducts research into the economy and releases numerous publications, such as the Beige Book.The Federal Reserve System's structure is composed of the presidentially appointed Board of Governors or Federal Reserve Board (FRB), partially presidentially appointed Federal Open Market Committee (FOMC), twelve regional Federal Reserve Banks located in major cities throughout the nation, numerous privately owned U.S. member banks, and various advisory councils. The federal government sets the salaries of the Board's seven governors. Nationally chartered commercial banks are required to hold stock in the Federal Reserve Bank of their region, which entitles them to elect some of their board members. The FOMC sets monetary policy and consists of all seven members of the Board of Governors and the twelve regional bank presidents, though only five bank presidents vote at any given time: the president of the New York Fed and four others who rotate through one-year terms. Thus, the Federal Reserve System has both private and public components to serve the interests of the public and private banks. The structure is considered unique among central banks. It is also unusual in that the United States Department of the Treasury, an entity outside of the central bank, creates the currency used.[21] The Federal Reserve System considers itself "an independent central bank because its monetary policy decisions do not have to be approved by the President or anyone else in the executive or legislative branches of government, it does not receive funding appropriated by the Congress, and the terms of the members of the Board of Governors span multiple presidential and congressional terms." The U.S. Government receives all the system's annual profits, after a statutory dividend of 6% on member banks' capital investment is paid, and an account surplus is maintained. In 2015, the Federal Reserve made a profit of $100.2 billion and transferred $97.7 billion to the U.S. Treasury.

Purpose

The Eccles Building in Washington, D.C., which serves as the Federal Reserve System's headquarters

The primary motivation for creating the Federal Reserve System was to address banking panics. Other purposes are stated in theFederal Reserve Act, such as "to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes". Before the founding of the Federal Reserve System, the United States underwent several financial crises. A particularly severe crisis in 1907 led Congress to enact the Federal Reserve Act in 1913. Today the Federal Reserve System has responsibilities in addition to ensuring the stability of the financial system.

Current functions of the Federal Reserve System include:

To address the problem of banking panics To serve as the central bank for the United States To strike a balance between private interests of banks and

the centralized responsibility of government To supervise and regulate banking institutions To protect the credit rights of consumers

To manage the nation's money supply through monetary policy to achieve the sometimes-conflicting goals of maximum employment stable prices, including prevention of

either inflation or deflation[26]

moderate long-term interest rates To maintain the stability of the financial system and

contain systemic risk in financial markets To provide financial services to depository institutions, the

U.S. government, and foreign official institutions, including playing a major role in operating the nation's payments system To facilitate the exchange of payments among regions To respond to local liquidity needs

To strengthen U.S. standing in the world economy

The Federal Reserve: Duties

The Fed's mandate is "to promote sustainable growth, high levels of employment, stability of prices to help preserve the purchasing power of the dollar and moderate long-term interest rates."

In other words, the Fed's job is to foster a sound banking system and a healthy economy. To accomplish its mission, the Fed serves as the banker's bank, the government's bank, the regulator of financial institutions and as the nation's money manager. 

Banker's Bank : Each of the 12 Fed Banks provide services to financial institutions in the same way that regular banks provide services to individuals. This helps to assure the safety and efficiency of the nation's payments system. For example, when you cash a check or have money electronically transferred, there is a good chance that a Fed Bank will handle the transfer of money from one bank to another. 

The Government's Bank : The biggest customer of the Federal Reserve is one of the largest spenders in the world - the U.S. government. Similar to how you have a checking account at your local bank, the U.S. Treasury has a checking account with the Federal Reserve. All revenue generated by taxes and all outgoing government payments are handled through this account. Included in this service, the Fed sells and redeems government securities such as savings bonds and Treasury bills, notes and bonds. 

The Fed also issues all coin and paper currency. The U.S. Treasury actually produces the cash, but the Fed Banks distributes it to financial institutions. It's also the Fed's responsibility to check bills for wear and tear and to take damaged currency out of circulation.

Regulator and Supervisor 

The Federal Reserve Board has regulatory and supervisory responsibilities over banks. This includes monitoring banks that are members of the system, the international banking facilities in the U.S., the foreign activities of member banks and the U.S. activities of foreign-owned banks. The Fed also helps to ensure that banks act in the public's interest by helping to develop federal laws governing consumer credit. Examples are the Truth in Lending Act, the Equal Credit Opportunity Act, the Home Mortgage Disclosure Act and the Truth in Savings Act. In short, the Federal Reserve Board acts as the policeman for banking activities within the U.S. and abroad. 

The FRB also sets margin requirements for investors. This limits the amount of money that an investor can borrow to purchase securities. Currently, the requirement is set at 50%, meaning that with $500, you have the opportunity to purchase up to $1000 worth of securities.

Money Manager While all the previously mentioned duties are important, the primary responsibility of the Fed is devising and implementing monetary policy. This function is so important, in fact, that we'll talk about it in detail in the next section.

Structure

Main article: Structure of the Federal Reserve System

Organization of the Federal Reserve System

The Federal Reserve System has a "unique structure that is both public and private"[45] and is described as "independent within the government" rather than "independent of government".[46] The System does not require public funding, and derives its authority and purpose from the Federal Reserve Act, which was passed by Congress in 1913 and is subject to Congressional modification or repeal.[47] The four main components of the Federal Reserve System are (1) the Board of Governors, (2) the Federal Open Market Committee, (3) the twelve regional Federal Reserve Banks, and (4) the member banks throughout the country.

Board of Governors[edit]Main article: Federal Reserve Board of Governors

The seven-member Board of Governors is a federal agency. It is charged with the overseeing of the 12 District Reserve Banks and setting national monetary policy. It also supervises and regulates the U.S. banking system in general.[48]Governors are appointed by the President of the United States and confirmed by the Senate for staggered 14-year terms.[30]One term begins every two years, on February 1 of even-numbered years, and members serving a full term cannot be renominated for a second term.[49] "[U]pon the expiration of their terms of office, members of the Board shall continue to serve until

their successors are appointed and have qualified." The law provides for the removal of a member of the Board by the President "for cause".[50] The Board is required to make an annual report of operations to the Speaker of the U.S. House of Representatives.

The Chair and Vice Chair of the Board of Governors are appointed by the President from among the sitting Governors. They both serve a four-year term and they can be renominated as many times as the President chooses, until their terms on the Board of Governors expire.[51]

Nominations, confirmations and resignations[edit]

In late December 2011, President Barack Obama nominated Jeremy C. Stein, a Harvard University finance professor and a Democrat, and Jerome H. Powell, formerly of Dillon Read, Bankers Trust] and The Carlyle Group and a Republican. Both candidates also have Treasury Department experience in the Obama and George H. W. Bushadministrations respectively.

"Obama administration officials [had] regrouped to identify Fed candidates after Peter Diamond, a Nobel Prize-winning economist, withdrew his nomination to the board in June [2011] in the face of Republican opposition. Richard Clarida, a potential nominee who was a Treasury official under George W. Bush, pulled out of consideration in August [2011]", one account of the December nominations noted.[56] The two other Obama nominees in 2011, Yellen and Raskin,[57] were confirmed in September.[58] One of the vacancies was created in 2011 with the resignation of Kevin Warsh, who took office in 2006 to fill the unexpired term ending January 31, 2018, and resigned his position effective March 31, 2011.[59][60] In March 2012, U.S. Senator David Vitter (R, LA) said he would oppose Obama's Stein and Powell nominations, dampening near-term hopes for approval.[61]However Senate leaders reached a deal, paving the way for affirmative votes on the two nominees in May 2012 and bringing the board to full strength for the first time since 2006[62] with Duke's service after term end. Later, on January 6, 2014, the United States Senate confirmed Yellen's nomination to be Chair of the Federal Reserve Board of Governors; she is slated to be the first woman to hold the position and will become Chair on February 1, 2014.[63] Subsequently, President Obama nominated Stanley Fischer to replace Yellen as the Vice Chair.[64]

In April 2014, Stein announced he was leaving to return to Harvard May 28 with four years remaining on his term. At the time of the announcement, the FOMC "already is down three members as it awaits the Senate confirmation of ... Fischer and Lael Brainard, and as [President] Obama has yet to name a replacement for ... Duke. ... Powell is still serving as he awaits his confirmation for a second term."[65]

Allan R. Landon, 65, former president and CEO of the Bank of Hawaii, was nominated in early 2015 by President Barack Obama to the Board.[66]

In July 2015, President Obama nominated University of Michigan economist Kathryn M. Dominguez to fill the second vacancy on the Board. The Senate had not yet acted on Landon's confirmation by the time of the second nomination.[67]

Federal Open Market Committee

The Federal Open Market Committee (FOMC) consists of 12 members, seven from the Board of Governors and 5 of the regional Federal Reserve Bank presidents. The FOMC oversees and sets policy on open market operations, the principal tool of national monetary policy. These operations affect the amount of Federal Reserve balances available to depository institutions, thereby influencing overall monetary and credit conditions. The FOMC also directs operations undertaken by the Federal Reserve in foreign exchange markets. The FOMC must reach consensus on all decisions. The president of the Federal Reserve Bank of New York is a permanent member of the FOMC; the presidents of the other banks rotate membership at two- and three-year intervals. All Regional Reserve Bank presidents contribute to the committee's assessment of the economy and of policy options, but only the five presidents who are then members of the FOMC vote on policy decisions. The FOMC determines its own internal organization and, by tradition, elects the Chair of the Board of Governors as its chair and the president of the Federal Reserve Bank of New York as its vice chair. Formal meetings typically are held eight times each year in Washington, D.C. Nonvoting Reserve Bank presidents also participate in Committee deliberations and discussion. The FOMC generally meets eight times a year in telephone consultations and other meetings are held when needed.[68]

Federal Advisory Council

The Federal Advisory Council, composed of twelve representatives of the banking industry, advises the Board on all matters within its jurisdiction.

Federal Reserve Banks

Map of the twelve Federal Reserve Districts, with the twelve Federal Reserve Banks marked as black squares, and all Branches within each district (24 total) marked as red circles. The Washington DC Headquarters is marked with a star. (Also, a 25th branch in Buffalo, NY had been closed in 2008.)

The twelve Reserve Banks buildings in 1936

There are 12 Federal Reserve Banks and they are located in Boston, New York, Philadelphia, Cleveland,Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. Each reserve Bank is responsible for member banks located in its district. The size of each district was set based upon the population distribution of the United States when the Federal Reserve Act was passed. Each regional Bank has a president, who is the chief executive officer of their Bank. Each regional Reserve Bank's president is nominated by their Bank's board of directors, but the nomination is contingent upon approval by the Board of Governors. Presidents serve five-year terms and may be reappointed.[69]

Each regional Bank's board consists of nine members. Members are broken down into three classes: A, B, and C. There are three board members in each class. Class A members are chosen by the regional Bank's shareholders, and are intended to represent member banks' interests. Member banks are divided into three categories: large, medium, and small. Each category elects one of the three class A board members. Class B board members are also nominated by the region's member banks, but class B board members are supposed to represent the interests of the public. Lastly, class C board members are nominated by the Board of Governors, and are also intended to represent the interests of the public.[70]

A member bank is a private institution and owns stock in its regional Federal Reserve Bank. All nationally chartered banks hold stock in one of the Federal Reserve Banks. State chartered banks may choose to be members (and hold stock in their regional Federal Reserve bank), upon meeting certain standards. About 38% of U.S. banks are members of their regional Federal Reserve Bank.[71] The amount of stock a member bank must own is equal to 3% of its combined capital and surplus.[72][73] However, holding stock in a Federal Reserve bank is not like owning stock in a publicly traded company. These stocks cannot be sold or traded, and member banks do not control the Federal Reserve Bank as a result of owning this stock. The charter and organization of each Federal Reserve Bank is established by law and cannot be altered by the member banks. Member banks, do however, elect six of the nine members of the Federal Reserve Banks' boards of directors.[30][74] From the profits of the Regional Bank of which it is a member, a member bank receives a dividend equal to 6% of their purchased stock.[17] The remainder of the regional Federal Reserve Banks' profits is given over to the United States Treasury Department. In 2009, the Federal Reserve Banks distributed $1.4 billion in dividends to member banks and returned $47 billion to the U.S. Treasury.[75]

Legal status of regional Federal Reserve Banks[edit]

The Federal Reserve Banks have an intermediate legal status, with some features of private corporations and some features of public federal agencies. The United States has an interest in the Federal Reserve Banks as tax-exempt federally created instrumentalities whose profits belong to the federal government, but this interest is not proprietary.[76] In Lewis v. United States,[77] the United States Court of Appeals for the Ninth Circuit stated that: "The Reserve Banks are not federal instrumentalities for purposes of the FTCA [the Federal Tort Claims Act], but are independent, privately owned and locally controlled corporations." The opinion went on to say, however, that: "The Reserve Banks have properly been held to be federal instrumentalities for some purposes." Another relevant decision is Scott v. Federal Reserve Bank of Kansas City,[76] in which the distinction is made between Federal Reserve Banks, which are federally created instrumentalities, and the Board of Governors, which is a federal agency.

Regarding the structural relationship between the twelve Federal Reserve banks and the various commercial (member) banks, political science professor Michael D. Reagan has written that:[78]

... the "ownership" of the Reserve Banks by the commercial banks is symbolic; they do not exercise the proprietary control associated with the concept of ownership nor share, beyond the statutory dividend, in Reserve Bank "profits." ... Bank ownership and election at the base are therefore devoid of substantive significance, despite the superficial appearance of private bank control that the formal arrangement creates.

Member banks

According to the website for the Federal Reserve Bank of Richmond, "[m]ore than one-third of U.S. commercial banks are members of the Federal Reserve System. National banks must be members; state chartered banks may join by meeting certain requirements."[79]

Accountability

The GAO and an outside auditor regularly audit the Board of Governors, the Federal Reserve banks, and individual member banks. Audits do not cover "most of the Fed's monetary policy actions or decisions, including discount window lending (direct loans to financial institutions), open-market operations and any other transactions made under the direction of the Federal Open Market Committee" ...[nor may the GAO audit] "dealings with foreign governments and other central banks."[80] Various statutory changes, including the Federal Reserve Transparency Act, have been proposed to broaden the scope of the audits.[citation needed]

As of August 27, 2012, the Federal Reserve Board has been publishing unaudited financial reports for the Federal Reserve banks every quarter.[81] This is an expansion of prior financial reporting practices. Greater transparency is offered with more frequent disclosure and more detail.

November 7, 2008, Bloomberg L.P. News brought a lawsuit against the Board of Governors of the Federal Reserve System to force the Board to reveal the identities of firms for which it has provided guarantees during the Late-2000s financial crisis.[82] Bloomberg, L.P. won at the trial court[83] and the Fed's appeals were rejected at both the United States Court of Appeals for the Second Circuit and the U.S. Supreme Court. The data was released on March 31, 2011.[84][85]

The Federal Reserve: Monetary PolicyThe term monetary policy refers to the actions that the Federal Reserve undertakes to influence the amount of money and credit in the U.S. economy. Changes to the amount of money and credit affect interest rates (the cost of credit) and the performance of the U.S. economy. To state this concept simply, if the cost of credit is reduced, more people and firms will borrow money and the economy will heat up. 

The Fed has three main tools at its disposal to influence monetary policy:

Open-Market Operations - The Fed constantly buys and sells U.S. government securities in the financial markets, which in turn influences the level of reserves in the banking system. These decisions also affect the volume and the price of credit (interest rates). The term open market means that the Fed doesn't independently decide which securities dealers it will do business with on a particular day. Rather, the choice emerges from an open market where the various primary securities dealers compete. Open market operations are the most frequently employed tool of monetary policy.

Setting the Discount Rate - This is the interest rate that banks pay on short-term loans from a Federal Reserve Bank. The discount rate is usually lower than the federal funds rate, although they are closely related. The discount rate is important because it is a visible announcement of change in the Fed's monetary policy and it gives the rest of the market insight into the Fed's plans.

Setting Reserve Requirements - This is the amount of physical funds that depository institutions are required to hold in reserve against deposits in bank accounts. It determines how much money banks can create through loans and investments. Set by the Board of Governors, the

reserve requirement is usually around 10%. This means that although a bank might hold $10 billion in deposits for all of its customers, the bank lends most of this money out and, therefore, doesn't have that $10 billion on hand. Furthermore, it would be too costly to hold $10 billion in coin and bills within the bank. Excess reserves are, therefore, held either as vault cash or in accounts with the district Federal Reserve Bank Therefore, the reserve requirements ensure that depository institutions maintain a minimum amount of physical funds in their reserves. 

The Federal Funds Rate The use of open-market operations is the most important tool that used to manipulate monetary policy. The Fed's goal in trading the securities is to affect the federal funds rate - the rate at which banks borrow reserves from each other. The Federal Open Market Committee (FOMC) sets a target for this rate, but not the actual rate itself (because it is determined by the open market). This is what news reports are referring to when they talk about the Fed lowering or raising interest rates. All banks are subject to reserve requirements, but they frequently fall below requirements in carrying out of day-to-day business. To meet requirements they have to borrow from each other's reserves. This creates a market in reserve funds, with banks borrowing and lending as needed at the federal funds rate. Therefore, the federal funds rate is important because by increasing or decreasing it, over time, the Fed can impact practically every other interest rate charged by U.S. banks.

Remember, the end goals of monetary policy are sustainable economic growth, full employment and stable prices. Through monetary policy, therefore, the Fed attempts to tweak the economy to the right levels.