Download 1. Briefly explain why the US financial system is referred to as a dual

CHAPTER 25: The US Financial System
FOCUS OF THE CHAPTER
This chapter presents an overview of the financial system of the United States. Its
evolution, important pieces of legislation, basic features, important institutions, and
their functions are described, highlighting important similarities and differences between
the US and Canadian financial systems.
Learning Objectives:
 Discuss why the financial systems of Canada and the United States differ
 Explain how the US financial system of today can be traced to the history and tension
between centralization and regionalism
 Describe how the US financial system is structured and recent reforms that were
legislated
 Determine how the US central bank, the Federal Reserve, began, how it operates and
why it is autonomous
 Explore the principle tools of US monetary policy
SECTION SUMMARIES
Historical Background
Dual control (federal and state control) of the structure and organization of financial
institutions and central banking is a distinct feature of the US financial system. The
strength of the US financial system resulted from the political pressures of centralization
versus regionalism. After the formation of the United States, Congress chartered the first
and second banks of the United States, endowed with the exclusive right to open
branches nationally. They were a failure in many respects. The experience of the Bank of
the US was ill-suited to the ideology of the gold standard. US policy makers did not
accept central banking until 1913, when the Federal Reserve Board (the Fed) was
created. The tension between centralization and regionalism influenced the structure of
the Federal Reserve system, at least until the Great Depression. The result was a virtual
abolition of nationwide banking. The states took over jurisdiction. Some states permitted
only unit banking, while others permitted limited banking or branching throughout the
state. As a result, free banking became the rule in the 19th century US, and scandals and
bank failures were frequent. Approximately one-third of the US banking system was
wiped out in the Great Depression. Deposit insurance was introduced as a policy response
to the problem. The Federal Deposit Insurance Corporation (FDIC) helped stabilize
the system. Some argue that the deposit insurance coverage was too generous. Over the
years, bank regulators have acted on a "too-big-to-fail" doctrine that could lead to the
moral hazard problem.
US Financial Intermediaries:
The four types of depository institutions are listed in order of their relative importance: 1)
Commercial banks (similar to chartered banks in Canada) engage primarily in making
commercial loans and taking chequable and savings deposits. Most are state chartered
and largely state-regulated; 2) Savings and Loan Associations (S&Ls) were originally
restricted to mortgage lending, and resemble Canadian mortgage loan companies; 3)
mutual savings banks are similar to S&Ls, but are owned by their depositors; and 4)
credit unions, similar to Canadian credit unions, are organized by region or type of
employment.
Unlike Canadian banks, US banks must meet reserve requirements. The Fed
retains the authority to impose reserve requirements on all types of deposits.
Financial Regulatory Practice:
Legal restrictions imposed on the US banking system have made it an innovative
financial system in some respects and a laggard in others. The Edge Act (1919) permitted
the federal chartering of banks for the sole purpose of engaging in international banking.
In the 1980s, International Banking Facilities (IBFs) emerged. They were permitted to
accept deposits from foreigners but were not subject to interest rate limitations and
reserve requirements. The McFadden Act (1927), amended in 1933, cleared up the legal
status of branching and effectively barred branching across state lines.
The Great Depression of the 1930s led to sweeping legislative changes such as the
introduction of deposit insurance, the mandate given to the Federal Reserve (the US
central bank) to supervise banks and manage the nation’s financial affairs, and the GlassStegall Act (1933), which prohibited banks from underwriting corporate securities. The
Glass-Stegall Act gave the Federal Reserve the authority to regulate the interest rate on
bank accounts. The result was Regulation Q, which placed a ceiling on deposit rates.
When market interest rates rose above the ceiling in the 1970s, some New England
savings institutions discovered an instrument called negotiable order of withdrawal
(NOW) as a means to circumvent the ceiling. The banks also offered overnight bank
repurchase agreements (repos) to avoid Regulation Q restrictions.
During the 1980s, the number of bank failures rose, and the S&L scandal loomed.
In response, the Depository Institutions Deregulation and Monetary Control Act was
passed to achieve three important objectives: 1) to phase out Regulation Q;
2) to relax restrictions on the types of loans savings banks could offer; and 3) to impose
uniform reserve requirements on all depository institutions and allow them access to
borrow funds from the Federal Reserve system. The Depository Institutions Act (1982)
further relaxed the differences between commercial banks, savings banks, and other
financial institutions. The S&L debacle led to the Financial Institution Reform,
Recovery and Enforcement Act (1989) which was passed to provide funding to close
down insolvent banks and strengthen the regulatory structure. The Office of Thrift
Supervision (OTS) assumed a supervisory function over the savings and loan industry.
The FDIC took over the deposit protection function of the S&Ls. The Resolution Trust
Corporation (RTC) took over the selling of assets and the winding down of the
operation of insolvent S&Ls. The FDIC Improvement Act (1991) limited the scope of
deposit insurance in the case of brokered deposits, and permitted early intervention by the
FDIC. Congress finally approved legislation in 1955 to deregulate the financial system,
permitting widespread branch banking across states and relaxing some of the provisions
of the Glass-Stegall Act.
The US has an extremely complex web of regulators, including state regulators,
and three other major regulators, the Treasury and its Office of the Comptroller of the
Currency (OCC), the Office of Thrift Supervision (OTS), and the FDIC.
The Financial Services Act of 1999: The Financial Services Act (1999) was a major
piece of legislation which reformed US banking and financial institutions. The
legislation: a) allowed bank holding companies to affiliate with any financial company;
b) allowed banks to underwrite any financial product except insurance and real estate
development; c) removed geographical restrictions on the sale of financial products; d)
increased prudential and soundness requirements; e) imposed limits on the total asset size
of a subsidiary of a particular national bank; f) prevented commercial companies from
operating or owning thrift any longer; g) imposed restrictions on banks in the
underwriting of new insurance products; and h) expanded the collateral that small and
rural banks can pledge to obtain liquidity from the Federal Home Loan Bank System
(FHLBS).
Current Trends: A series of reforms and other actions taken by banks have led to a
tremendous consolidation of the banking sector. The number of small banks has dropped
significantly. As a result, US banks have become once again among the largest in the
world.
The Federal Reserve System:
The Federal Reserve (the US central bank, referred to as the Fed), created in 1913,
consisted of a decentralized system of twelve banks, each with sufficient autonomy to
regulate the financial system in its own district. Each bank issued its own currency, with
the result that interest rates and monetary policy were largely regionally determined. The
Board of Governors in Washington coordinated national monetary and regulatory
policies. After the Great Depression, the Board determined the discount rate, set reserve
requirements, and provided certain kinds of regulation. The Federal Open Market
Committee (FOMC) directs open market operations, and therefore, national monetary
policy. The FOMC issues statements which are influential not only in the US but also in
the rest of the world. The Fed operates a payment system called Fedwire whose members
are the depository institutions that are Fed members. Fedwire carries out transactions and
settlements intraday (in real time).
Unlike many other central banks, the Fed is relatively independent of the
government. Perhaps the most important monetary policy tool is the Federal Funds Rate
(FFR), a rate roughly equivalent to the overnight rate in Canada.
Federal Reserve Operations: The Federal Reserve was not originally created to intervene
in the economy. But, in the face of the Great Depression, the Fed’s structure was
centralized and open market operations were recognized as an important instrument to
control interest rates and inflation. The advent of World War II took away the interest
instrument from the Fed, along with some degree of its independence. But the Fed
regained interest rate control in 1951. Until the 1960s, however, the Fed relied mainly
on the manipulation of reserves in implementing monetary policy. In the 1960s, the
interest rate remained the principal tool of monetary policy. In the 1970s, with the accent
on monetarism, an active policy of monetary targeting was followed. Until 1982,
targeting reserves of the banking system and interest rate control served as instruments of
monetary policy.
The historic approach of the Fed was to change interest rates after the appearance
of economic evidence that required the change. The current chair of the Board of
Governors, Alan Greenspan, made it clear that the Fed must act in advance of what it
believes the future course of the economy will be. This has led to a series of “Preemptive strikes” against expected upsurges in inflation. In order to provide a more
transparent monetary policy, carefully and clearly worded minutes of the FOMC
meetings are released.
The Principal Tools of Monetary Policy
Open Market Operations: The purchase and sale of US government securities (such as
treasury bills) is one of the most important tools of the Fed’s monetary policy. The
purchase (sale) of bonds expands (contracts) the money supply. Occasionally, the Fed
uses open market operations in a defensive manner in order to prevent changes in the
money supply that would otherwise take place. Open market operations are conducted
daily by the New York Federal Reserve Bank, after consulting the Board of Governors.
The New York Fed uses repos and reverse repos as temporary devices of monetary
policy.
The Fed Discount Rate and the Fed Funds Rate: The rate of interest charged by the
Federal Reserve on short-term loans issued to the banking system, referred to as the
“discount window,” is called the Fed discount rate. This is equivalent to the bank rate
in Canada. The interest rate charged on overnight loans of deposits at the Federal Reserve
is called the Fed funds rate (FFR). This is roughly equivalent to the overnight rate in
Canada. The FFR has become one of the most important tools of monetary policy.
MULTIPLE-CHOICE QUESTIONS
1. The dual control of the US financial system refers to
a) control by the US Congress and the US Senate.
b) control by the President and the Congress.
c) federal level and state level control.
d) federal level control and IMF control.
2. In the United States, under unit banking,
a) branching throughout the state was permitted.
b) a limited number of branches in addition to the main office were permitted.
c) no bank branches were permitted.
d) only national level banks were allowed to operate.
3. In the United States, free banking meant
a) no bank service charges.
b) only minimal restrictions on creating new banks.
c) that deposits earned no interest.
d) the same as unit banking
4. Which of the following financial institutions in the US can be likened to Canadian
chartered banks?
a) Mutual savings banks
b) Credit unions
c) Federal Reserve Banks
d) Commercial banks
5. Regulation Q
a) imposed ceilings on reserve requirements for deposits of all banks in the US.
b) prevented commercial banks from underwriting corporate securities.
c) imposed a ceiling on deposit interest rates.
d) imposed a floor on the lending rates of commercial banks.
6. Regulation Q was one of the regulations imposed by
a) The Glass-Stegall Act (1933)
b) The Financial Services Act (1999)
c) The Financial Institution Reform, Recovery and Enforcement Act (1989)
d) The Depository Institutions Deregulation and Monetary Control Act (1980)
7. Which of the following acts might be regarded as the most comprehensive piece of
reform legislation in the US after the Great Depression?
a) The Glass-Stegall Act (1933)
b) The Financial Services Act (1999)
c) The Financial Institution Reform, Recovery and Enforcement Act (1989)
d) The Depository Institutions Deregulation and Monetary Control Act (1980)
8. Which of the following was a significant development in the US financial system in
the 1980s?
a) The creation of a central bank in the US
b) The unprecedented number of bank failures in the US history
c) The tremendous growth in the number of banks
d) The consolidation of the banking sector
9. The central bank in the US is
a) the Federal Bank of the United States.
b) the State Bank of the United States.
c) the Bank of America.
d) the Federal Reserve.
10. In the United States, the agency responsible for monetary policy is
a) the Federal Reserve.
b) the Federal Open Market Committee.
c) the Office of the Comptroller of the Currency.
d) the Office of Thrift Supervision.
11. Fedwire
a) is the telephone communication network among the Federal Reserve Banks.
b) is the payments system operated by the Federal Reserve.
c) is a network of investment dealers operating at the federal level in the US.
d) is another name for the Federal Reserve System.
12. Which two of the following are key monetary policy instruments in the United
States?
a) Open market operations and the Fed funds rate
b) The Fed funds rate and the Fed discount rate
c) Repos and reverse repos
d) Reserve requirements and open market operations
13. Which of the following is roughly equivalent to the overnight lending rate in Canada?
a) The Fed discount rate
b) The Fed funds rate
c) The US T-bill rate
d) The US bank rate
PROBLEMS
1. Briefly explain why the US financial system is referred to as a dual banking system.
2. Briefly describe:
a) the Fed.
b) the Federal Open Market Committee.
3. Explain how open market operations can be implemented in a defensive manner.
4. Why do many believe that the Federal Reserve is relatively independent of the
government?
ANSWER SECTION
Answers to multiple-choice questions:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
c
c
b
d
c
a
b
d
d
b
b
a
b
(see page 505)
(see page 506)
(see page 506)
(see page 507)
(see page 508)
(see page 508)
(see pages 510-511)
(see pages 508-510)
(see page 512)
(see page 512)
(see page 513)
(see pages 515-516)
(see page 515,516)
Answers to problems:
1. The US financial system is referred to as a dual banking system mainly for the
following reasons: a) some US banks are regulated at the federal level, while others
are regulated at the state level; b) some banks are members of the Federal Reserve
System while others are not; c) banks which are not members of the Federal Reserve
System have no direct access to the lender of last resort (the Fed); d) the number of
bank branches permitted is varied and limited across states according to existing state
regulations; and e) nationwide banking is not yet allowed by federal legislation.
2. a) The Fed: The Federal Reserve, known as the Fed, is the central bank in the United
States, created in 1913. It consisted of a decentralized system of twelve banks, each
with sufficient autonomy to regulate the financial system in its own district. Each
bank issued its own currency so that interest rates and monetary policy were largely
regionally determined. The Board of Governors in Washington coordinated national
monetary and regulatory policies.
b) The Federal Open Market Committee (FOMC) is the principal decision-making
body of the US Federal Reserve. It sets interest rates and directs open market
operations, and therefore, is responsible for national monetary policy. The FOMC
issues statements which are influential not only in the US but also in the rest of the
world.
3. Suppose that the US Treasury engages in the sale of treasury bills that may lead to a
decrease in the money supply. If the Federal Reserve believes such a decrease is not
appropriate or necessary, an open market operation of purchasing government bonds
may be implemented to counteract a possible decrease in the money supply. In the
case of the likelihood of an unwanted increase in the money supply, the Fed may
implement an open market operation of selling government bonds to counteract this
eventuality.
4. The Fed is considered to be relatively independent of the government, mainly for the
following reasons: 1) the members of its board of governors have rotating terms that
do not overlap with the term of the presidency; 2) it operates on its own profits and
does not receive appropriations from Congress; and 3) the Fed conducts its operations
in secrecy. Also, the past practice of the Fed has displayed a relatively high level of
independence.