Federal Reserve System, U.S.
Federal Reserve System, U.S.
Of all the central banks in the world, the Federal Reserve System (“the Fed”) has one of the most unusual structures. The historic hostility of the American public to banks and centralized authority (which resulted in the demise in 1811 and 1832 of the first two experiments with central banking, the First and Second Bank of the United States) led the U.S. Congress to write an elaborate system of checks and balances into the Federal Reserve Act of 1913, which created the Federal Reserve System with its twelve regional Federal Reserve banks.
The writers of the Federal Reserve Act wanted to diffuse power along regional lines, between the private sector and the government, and among bankers, business people, and the public. This initial diffusion of power has resulted in the evolution of the Federal Reserve System to include the following entities: the Federal Reserve banks, the Board of Governors of the Federal Reserve System, the Federal Open Market Committee (FOMC), and around 2,800 member commercial banks.
Each of the twelve Federal Reserve districts has one main Federal Reserve bank, which may have branches in other cities in the district. The three largest Federal Reserve banks in terms of assets are those of New York, Chicago, and San Francisco—combined they hold more than 50 percent of the assets (discount loans, securities, and other holdings) of the Federal Reserve System. The New York bank, with around one-quarter of the assets, is the most important of the Federal Reserve banks because it conducts foreign-exchange interventions on behalf of the Federal Reserve System and the U.S. Treasury and also purchases and sells securities for the Federal Reserve System.
Each of the Federal Reserve banks is a quasi-public (part private, part government) institution owned by the private commercial banks in the district that are members of the Federal Reserve System. These member banks have purchased stock in their district Federal Reserve bank (a requirement of membership), and the dividends paid by that stock are limited by law to 6 percent annually. The member banks elect six directors for each district bank; three more are appointed by the Board of Governors. Together, these nine directors appoint the president of the bank (subject to the approval of the Board of Governors).
The directors of a district bank are classified into three categories: A, B, and C. The three A directors (elected by the member banks) are professional bankers, and the three B directors (also elected by the member banks) are prominent leaders from industry, labor, agriculture, or the consumer sector. The three C directors, who are appointed by the Board of Governors to represent the public interest, are not allowed to be officers, employees, or stockholders of banks. This design for choosing directors was intended by the framers of the Federal Reserve Act to ensure that the directors of each Federal Reserve bank would reflect all constituencies of the American public.
The twelve Federal Reserve banks perform the following functions:
- Clear checks;
- Issue new currency;
- Withdraw damaged currency from circulation;
- Administer and make discount loans to banks in their districts;
- Evaluate proposed mergers and applications for banks to expand their activities;
- Act as liaisons between the business community and the Federal Reserve System;
- Examine bank holding companies and state-chartered member banks;
- Collect data on local business conditions; and
- Use their staffs of professional economists to research topics related to the conduct of monetary policy.
The twelve Federal Reserve banks are involved in monetary policy in several ways. Their directors “establish” the discount rate (although the discount rate in each district is reviewed and determined by the Board of Governors) and decide which banks, member and non-member alike, can obtain discount loans from the Federal Reserve bank. Their directors select one commercial banker from each bank’s district to serve on the Federal Advisory Council, which consults with the Board of Governors and provides information that helps in the conduct of monetary policy. Five of the twelve bank presidents each have a vote in the Federal Open Market Committee, which directs open market operations (the purchase and sale of government securities that affect both interest rates and the amount of reserves in the banking system). The president of the New York Fed always has a vote in the FOMC, another reason why it is the most important of the banks; the other four votes allocated to the district banks rotate annually among the remaining eleven presidents.
At the head of the Federal Reserve System is the seven-member Board of Governors, headquartered in Washington, D.C. Each governor is appointed by the president of the United States and confirmed by the Senate. To limit the president’s control over the Fed and insulate the Fed from other political pressures, the governors can serve one full nonrenewable fourteen-year term plus part of another term, with one governor’s term expiring every other January. The governors (many are professional economists) must come from different Federal Reserve districts to prevent the interests of one region of the country from being over-represented. The chairman of the Board of Governors is chosen from among the seven governors and serves a four-year, renewable term. It is expected that once a new chairman is chosen, the old chairman resigns from the Board of Governors, even if there are many years left to his or her term as a governor. The chairman exercises enormous power because he is the spokesperson for the Fed and negotiates with Congress and the president of the United States. He also exercises control by setting the agenda of Board of Governors and FOMC meetings and by supervising the board’s staff of professional economists and advisors.
The Board of Governors is actively involved in decisions concerning the conduct of monetary policy. All seven governors are members of the FOMC and vote on the conduct of open-market operations. Because there are only twelve voting members on this committee (seven governors and five presidents of the district banks), the board has the majority of the votes. The board also sets reserve requirements (within limits imposed by legislation) and effectively controls the discount rate by the “review and determination” process, whereby it approves or disapproves the discount rate “established” by the Federal Reserve banks. The chairman of the board advises the president of the United States on economic policy, testifies in Congress, and speaks for the Federal Reserve System to the media. The chairman and other governors may also represent the United States in negotiations with foreign governments on economic matters. The board has a staff of professional economists (larger than those of individual Federal Reserve banks) which provides economic analysis that the board uses in making its decisions.
Through legislation, the Board of Governors often has been given duties not directly related to the conduct of monetary policy. In the past, for example, the board set the maximum interest rates payable on certain types of deposits under Regulation Q. (After 1986, ceilings on time deposits were eliminated, but there is still a restriction on paying any interest on business demand deposits.) Under the Credit Control Act of 1969 (which expired in 1982) the board had the ability to regulate and control credit once the president of the United States approved. The Board of Governors also sets margin requirements— the fraction of the purchase price of securities that has to be paid for with cash rather than borrowed funds. It also sets the salary of the president and all officers of each Federal Reserve bank and reviews each bank’s budget. Finally, the board has substantial bank regulatory functions: It approves bank mergers and applications for new activities, specifies the permissible activities of bank holding companies, and supervises the activities of foreign banks in the United States.
The FOMC usually meets eight times a year (about every six weeks) and makes decisions regarding the conduct of monetary policy, especially by setting the target for the policy interest rate and the federal funds rate (an overnight rate for loans between banking institutions). In addition, it also makes the decisions about reserve requirements and the discount rate (which play less of a prominent role in the conduct of monetary policy). The FOMC does not actually carry out securities purchases or sales. Instead, it issues directives to the trading desk at the Federal Reserve Bank of New York, where the manager for domestic open-market operations supervises a roomful of people who execute the purchases and sales of the government or agency securities. The manager communicates daily with the FOMC members and their staffs concerning the activities of the trading desk.
SEE ALSO Central Banks; Greenspan, Alan; Policy, Monetary
Board of Governors of the Federal Reserve. 2006. About the Fed. http://www.federalreserve.gov/general.htm.
Mishkin, Frederic S. 2007. The Economics of Money, Banking, and Financial Markets. 8th ed. Boston: Addison-Wesley.
Frederic S. Mishkin