Chapter 4 Federal Reserve System © 2003 John Wiley and Sons

2 Chapter Outcomes n Identify three weaknesses of the national banking system before the establishment of the Federal Reserve System n Describe Federal Reserve membership in terms of who must join and who may join n Describe the composition of the Fed Board of Governors

3 Chapter Outcomes (Continued) n Discuss how the Fed uses reserve requirements to carry out monetary policy n Discuss how discount rate policy is employed by the Fed n Describe the Fed’s use of open- market operations to alter bank reserves

4 Chapter Outcomes (Continued) n Describe the ways in which the Reserve Banks accommodate the clearance and collection of checks n Discuss structural characteristics of central banks located in selected foreign countries

5 U.S. Banking System Prior to the Fed n NATIONAL BANKING SYSTEM: Established when National Banking Acts were passed in 1963 and 1964 n WEAKNESSES OF THE SYSTEM: -Inefficient payments system -Money supply “inelastic” or “inflexible” to demand changes -Liquidity problems due to inefficient lending/borrowing mechanism

6 Two Important Definitions n CENTRAL BANK: Federal government agency that facilitates operation of the financial system and regulates money supply growth n FEDERAL RESERVE SYSTEM (Fed): U.S. central bank that sets monetary policy and regulates banking system

7 Structure of the Federal Reserve System n FEDERAL RESERVE ACT OF 1913: Provided for establishment of twelve Federal Reserve districts with each district served by a Federal Reserve Bank n Board of Governors n Federal Reserve Banks n Federal Open Market Committee

8 Fed Board of Governors n Sets reserve requirements and approves discount rates as part of monetary policy n Supervises and regulates member banks and bank holding companies n Establishes and administers protective regulations and consumer finance n Oversees Federal Reserve Banks

9 Federal Reserve Banks n Propose discount rates n Hold reserve balances for depository institutions and lend to them at the discount window n Furnish currency n Collect and clear checks and transfer funds for depository institutions n Handle U.S. government debt and cash balances

10 Federal Open Market Committee n Comprised of the Fed Board of Governors and 5 Reserve Bank Presidents n Directs open market operations (buying and selling of U.S. government securities), which are the primary instruments of monetary policy

11 Federal Reserve Membership n All national banks must be members n State-chartered banks are permitted to join the system n All member banks must purchase capital stock of the Reserve Bank of their district up to a maximum of 6% n Approximately 40% of commercial banks are members of the Fed n Member banks hold about 80% of the deposits of all commercial banks

12 Federal Reserve Banks: Directors and Officers n CLASS A DIRECTORS: Represent member banks of the district n CLASS B DIRECTORS: Represent nonbanking interests (commerce, agriculture, & industry) n CLASS C DIRECTORS: Appointed by the Fed Board of Governors (may not be in banking)

13 Recent Chairs of the Fed Board of Governors n Paul Volcker (Chair, ) -Under his guidance, a restrictive Fed policy was successful in bringing down the double-digit inflation of the 1970s and beginning of the 1980s

14 Recent Chairs of the Fed Board of Governors (Continued) n Alan Greenspan (Chair, 1987-current) -Under his guidance, the U.S. has had low inflation, real economic growth, relatively low interest rates, and record high stock prices

15 Monetary Policy Functions and Instruments n Reserve Requirements -Fed sets reserve requirements for depository institutions n Discount Rate Policy -Fed sets interest rate at which it will lend to depository institutions n Open-Market Operations -Fed buys/sells government securities to change bank reserves

16 Reserve Requirements: Basic Concepts n FRACTIONAL RESERVE SYSTEM: Reserves held with Fed that equal a certain percentage of bank deposits n BANK RESERVES: Vault cash and deposits held at Federal Reserve Banks n REQUIRED RESERVES: Minimum amount of total reserves a depository institution must hold

17 Reserve Requirements: Basic Concepts (Continued) n REQUIRED RESERVES RATIO: Percentage of deposits that must be held as reserves n EXCESS RESERVES: Amount of that total reserves are greater than required reserves

18 Discount Rate Policy n DISCOUNT RATE: Interest rate that a bank must pay to borrow from its regional Federal Reserve Bank n FORMS OF BORROWING: Borrowing institution may receive an “advance” (loan) or may “discount” (sell) to the Reserve Bank its “eligible paper”

19 Open-market Operations n OPEN-MARKET OPERATIONS: n OPEN-MARKET OPERATIONS: Buying and selling of securities in the “open market” by the Fed to alter bank reserves n FED’S ASSETS: n FED’S ASSETS: Primarily held as U.S. government and government agency securities n ORIGINAL FEDERAL RESERVE ACT: n ORIGINAL FEDERAL RESERVE ACT: Did not provide for open-market operations

20 Fed Supervisory Function n On-site examination of commercial banks n Function shared with: -Office of the Comptroller of the Currency (OCC) -Federal Deposit Insurance Corporation (FDIC) -state regulatory agencies

21 Supervision and Regulation of Non-Commercial Banks n CREDIT UNIONS: Regulated by the National Credit Union Administration (NCUA) n SAVINGS & LOANS AND OTHER SAVINGS INSTITUTIONS: Regulated by the Office of Thrift Supervision (OTS)

22 Fed Regulatory Responsibilities nCnConsumer Credit Protection Act of 1968 Act requires clear explanation of consumer credit costs and prohibits overly high-priced credit transactions nRnRegulation Z Enacts Truth in Lending section of the Consumer Credit Protection Act with intent to make consumers able to compare costs of alternate forms of credit

23 Central Banks in Other Countries n UNITED KINGDOM: Bank of England (BOE)--created prior to the Fed n JAPAN: Bank of Japan (BOJ)--created in 1947 n GERMANY: Deutsche Bundesbank--created in 1957 [note: Germany is now part of the European Union EU)]