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 ( )  Second Bank of the United States ( )  Prior to the creation of the Federal Reserve System, nationally chartered banks were regulated by provisions of the National Banking Act of  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  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.