Download The Federal Reserve System: History and Structure

In Plain English
The Federal Reserve
System
 Who’s in charge of ensuring that banks
maintain enough reserves?
 Who decides how large the monetary base
will be?
 The Federal Reserve (“the Fed”)
 Central bank that is an institution that oversees
and regulates the banking system and controls
the monetary base
st
21
Overview of
Century
American Banking System
 Federal Reserve System was created in 1913 as a
response to lessons learned in the Panic of 1907
 From 1864 to 1913, American banking was dominated by
a federally regulated system of national banks
 They were alone allowed to issue currency, and the
currency notes they issued were printed by the federal
government with uniform size and design
 Problem: money supply was not sufficiently responsive
– it was difficult to shift currency around the country to
respond quickly to local economic changes
 Rumors of one bank not having enough funds to satisfy
demands would begin a bank run
Overview of 21st Century
American Banking System
 The cause of the Panic of 1907 was different than any
previous crisis
 Began in NYC and then spread to the rest of the country
 Originated in trusts – bank like institutions that
accepted deposits but were originally intended to
manage only inheritances and estates for wealthy clients
 Panic of 1907 began with the failure of the
Knickerbocker Trust that failed when it suffered massive
losses in unsuccessful stock market speculation
 Other trusts came under pressure and people began to line
up to withdraw their money
 Over a dozen major trusts went under in 2 days
Overview of 21st Century
American Banking System
 J.P. Morgan, John D. Rockefeller and U.S Secretary
of the Treasury shored up reserves and gave people
trust back in the banks
 Panic lasted for one week , the stock market
collapse from the trusts failing decimated the
economy and a four year recession ensured with
production falling 11% and unemployment rising
from 3% to 8%
Overview of 21st Century
American Banking System
 1913 the national banking system was eliminated
and the Federal Reserve System was created as a
way to compel all deposit-taking institutions to hold
adequate reserves and to open their accounts to
inspections by regulators
The Structure of the Fed
 The legal status of the Fed is unusual
 Not part of the U.S. government but not a private
institution either
 Consists of two parts: Board of Governors and the
12 regional Federal Reserve Banks
 Board of Governors is located in Washington, D.C.
 Constituted like a government agency, its seven
members are appointed by the president and must be
approved by the Senate
 Appointed for 14 year terms
 Chair is appointed every 4 years
The Structure of the Fed
 12 Federal Reserve Banks each serve a region of the
country, the Federal Reserve District
 Provides various banking and supervisory services
 One of their jobs is to audit the books of privatesector banks to ensure their financial health
 Each bank is run by a board of directors chosen
from the local banking and business community
 Federal Reserve Bank of New York has a special role
– carries out open-market operations
The Structure of the Fed
 Federal Open Market Committee consists of
the Board of Governors plus five of the
regional bank presidents
 Make decisions about monetary policy
 President of the Fed in NY is always on the
committee
The Structure of the Fed
 The effect of this structure is to create an
institution that is ultimately accountable to the
voting public because of the Board of Governors is
chosen by the president and confirmed by the
Senate
The Effectiveness of the
Federal Reserve System
 The Fed system does not eliminate the potential for
bank runs because banks reserves were still less
than the total value of their deposits
 Reality during the Great Depression
 The Great Depression sparked widespread bank
runs in the early 1930s, which greatly worsened and
lengthened the depth of the Depression.
 Federal deposit insurance was created, and the
government recapitalized banks by lending to them
and by buying shares of banks.
The Effectiveness of the
Federal Reserve System
 By 1933, banks had been separated into two
categories: commercial (covered by deposit
insurance) and investment (not covered).
 Public acceptance of deposit insurance finally
stopped the bank runs of the Great Depression.
Savings & Loan Crisis of
the 1980s
 The savings and loan (thrift) crisis of the 1980s arose
because insufficiently regulated S&Ls engaged in overly
risky speculation and incurred huge losses.
 Depositors in failed S&Ls were compensated with
taxpayer funds because they were covered by deposit
insurance.
 1986-1995 – federal government closed over 1,000 failed S &
L’s, costing taxpayers over $124 billion dollars
 1989 Congress empowered Fannie Mae and Freddie Mac to
take over much of the home mortgage lending previously
done by S&Ls
 The crisis caused steep losses in the financial and real
estate sectors, resulting in a recession in the early 1990s.
The Financial Crisis of 2008:
Causes of…..
 During the mid-1990s, the hedge fund LTCM (Long-Term Capital
Management) used huge amounts of leverage (financing its investments
with borrowed funds) to speculate in global financial markets, incurred
massive losses, and collapsed.
 LTCM was so large that, in selling assets to cover its losses, it caused
balance sheet effects (reduction in a firm’s net worth from falling asset
prices) for firms around the world, leading to the prospect of a vicious
cycle of deleveraging

Vicious cycle of deleveraging takes place when asset sales to cover losses
produce negative balance sheet effects on other firms and force creditors to
call in their loans, forcing sales of more assets and causing further declines in
asset prices
 As a result, credit markets around the world froze.
 The New York Fed coordinated a private bailout of LTCM and revived
world credit markets

$3.625 billion dollars
The Financial Crisis of
2008: Causes of…..
 In 2003, U.S. interest rates were at historically low
levels due to the Federal Reserve policy and partly
because of large inflows of capital from other
countries, especially China
 Loan interest rates helped cause a boom in housing
which led the U.S. economy out of recession
 As housing boomed, financial institutions began
taking on growing risks
The Financial Crisis of
2008: Causes of…..
 Subprime lending (lending to home buyers who don’t meet
the usual criteria for being able to afford their payments)
during the U.S. housing bubble of the mid-2000s spread
through the financial system via securitization (pool of loans is
assembled and shares of that pool are sold to investors).
 When the bubble burst (late 2006), massive losses by banks
and nonbank financial institutions led to widespread collapse
in the financial system.
 Large losses suffered by financial firms, severe cycle of
deleveraging, firms found it difficult to borrow, individuals
found home loans unavailable and credit card limits reached
 To prevent another Great Depression, the Fed and the U.S.
Treasury expanded lending to bank and nonbank institutions,
provided capital through the purchase of bank shares, and
purchased private debt.
The Financial Crisis of
2008: Causes of…..
 In August 2007, Federal reserve and the Treasury
Department began to rescue individual firms that were
deemed too crucial to be allowed to fail
 In September 2008, policy makers decided that one
investment bank, Lehman Brothers, could be allowed to
fail
 Bad decision
 Widespread panic ensued
 Because much of the crisis originated in nontraditional
bank institutions, the crisis of 2008 indicated that a
wider safety net and broader regulation are needed in
the financial sector.
The 2008 Crisis and the Fed
 Fed officials believed that this change in standard
operating procedure was necessary to stave off an even
more severe financial crisis.
 Usually, the Fed invests only in U.S. government debt,
which is considered a very safe asset; the same could not
be said of many of the loans made during 2008.
 Normally, the Federal Reserve holds almost no assets
other than U.S. Treasury bills.
 In response to the 2008 financial crisis, however, the Fed
created an alphabet soup of special “facilities” to lend
money to troubled financial institutions, leading to a
dramatic shift in its balance sheet.
Functions of the Federal
Reserve System
 Four functions:
1. Provide Financial Services
2. Supervise and Regulate Banking
Institutions
3. Maintain stability of the Financial System
4. Conduct Monetary Policy
1. Provide Financial
Services
 The 12 regional banks provide financial services to
depository institutions such as banks and other
large institutions including the U.S. government
 “Banker’s Bank” – holds reserves, clears checks,
provides cash, and transfer funds for commercial
banks
 Federal Reserve also acts as the banker and fiscal
agent for the federal government
 U.S. Treasury has it checking account with the Federal
Reserve
2. Supervise and Regulate
Banking Institutions
 Regional Federal Reserve Banks
examine and regulate commercial
banks in their district
3. Maintain Stability of the
Financial System
 The Fed is changed with maintaining the
integrity of the financial system
 Federal Reserve banks provide liquidity to
financial institutions to ensure their safety
and soundness
4. Conduct Monetary
Policy
 The Fed uses the monetary policy to prevent
or address extreme macroeconomic
fluctuations in the economy
What the Fed Does: The
Reserve Requirement
 The fed sets a minimum required reserve
ration (currently 10%) for checkable bank
deposits
 The federal funds market allows banks that
fall short of the reserve requirement to
borrow funds from banks with excess
reserves.
 The federal funds rate is the interest rate
determined in the federal funds market.
What the Fed Does: The
Reserve Requirement
 To alter the money supply, the Fed can change
reserve requirements
 If Fed reduces the required reserve ratio, banks will
lend a larger percentage of their deposits, leading
to more loans and in increase in the money supply
via the money multiplier
 If the Fed increases the required reserve ratio,
banks are forced to reduce their lending, leading a
fall in the money supply via the money multiplier
What the Fed Does: The
Discount Rate
 The discount rate is the rate of interest the Fed
charges on loans to banks.
 Normally the discount rate is set 1 percentage point
above the federal funds rate in order to discourage
banks from turning to the Fed when they are in
need of reserves
Open-Market Operations
 The Federal Reserve has assets and liabilities
 Fed’s assets consist of its holdings of debt issued by
the U.S. government, mainly short-term U.S.
government bonds with a maturity of less than one
year—U.S. Treasury Bills
Open-Market Operations
 Open-market operations by the Fed are the
principal tool of monetary policy: the Fed can
increase or reduce the monetary base by buying
government debt from banks or selling
government debt to banks.
 These are done with commercial banks – banks that
make business loans
 The Fed never buys U.S. Treasury bills directly from
the federal government
An Open-Market Purchase
of $100 Million
An Open-Market Sale of
$100 Million
Who Gets the Interest on
the Fed’s Assets?
 Who gets the profits? U.S. taxpayers do.
 The Fed keeps some of the interest it receives to finance
its operations, but turns most of it over to the U.S.
Treasury.
 For example, in 2007 the Federal Reserve system
received $40.3 billion in interest on its holdings of
Treasury bills, of which $34.6 billion was returned to the
Treasury.
 The Fed decides on the size of the monetary base based
on economic considerations—in particular, the Fed
doesn't’t let the monetary base get too large, because
that can cause inflation.