Download Organizational Structure of the System

Chapter 4
The Overseer: The Federal
Reserve System
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
Organizational Structure of
the System
• The Federal Reserve System was created
by Congress in 1913
– created as a central bank that could lend
funds to commercial banks during
emergencies to help them avoid insolvency
and bankruptcy
• lender of last resort
2
Organizational Structure of
the System
• In the midst of the Great Depression, it
was clear that the Federal Reserve was
not able to handle bank failures
– in the Banking Reform Acts of 1933 and 1935,
Congress provided many of the additional
policy tools and regulation the Fed needed
• the most significant change involved the Fed’s
purpose and objectives
3
Organizational Structure of
the System
• The Fed’s new responsibilities involved
efforts to attain the nation’s economic an
financial goals
– foster a smooth-running, efficient, competitive
financial system
– promote the overall health and stability of the
economy through its ability to influence the
availability and cost of money and credit
4
Organizational Structure of
the System
• The core of the Federal Reserve System
in the Board of Governors
– 7 members appointed by the President with
the consent of the U.S. Senate
– the full term of a member is 14 years
• arranged so that 1 expires every 2 years
– 1 member is appointed as chair and 1 is
appointed as vice-chair
• term is 4 years
• chair is the “official spokesperson” for the Fed
5
Organizational Structure of
the System
• The nation is divided into 12 districts
– each district is served by a Reserve Bank
• the 3 largest are New York, Chicago, and San
Francisco
• the 12 Reserve Banks have a total of 26 branches
– member commercial banks within a district
elect 6 of the 9 directors of the Reserve Bank
• the other 3 are appointed by the Board of
Governors
6
Organizational Structure of
the System
7
Organizational Structure of
the System
• The Federal Open Market Committee
(FOMC) is the principal policy-making
body within the Federal Reserve System
– formulates policy and oversees its
implementation
– 12 members
• 7 members of the Board of Governors
• 5 of the 12 District Bank presidents (1 is always
the president of the New York District Bank)
– by tradition, the chair has been the Fed chair
8
Organizational Structure of
the System
• The FOMC meets in Washington 8 times
per year (approximately every 6 weeks)
– issue a policy directive which sets forth the
operating instructions to the Federal Reserve
Bank of New York regarding the conduct of
monetary policy
• the Fed uses the New York District Bank because
New York is the center of the U.S. financial system
• economists, financial investors, and portfolio
managers follow the operations of the New York
District Bank closely
9
The Organizational Structure of
the Federal Reserve System
Board of Governors
Seven members appointed by the president of the United States and confirmed by
the Senate for 14-year terms.
One of the seven governors is appointed chair by the President of the United States
and confirmed by the Senate for a 4-year term.
The Board of Governors appoints three of the nine directors to each Reserve Bank.
Twelve Federal Reserve Banks
Each with nine directors who appoint the Reserve Bank president and other officers
of the Reserve Banks.
Federal Open Market Committee (FOMC)
Seven members of the Board of Governors plus the president of the New York Fed
and presidents of four other Reserve Banks.
Nearly 5,000 Member Commercial Banks
Elect six of the nine directors to each Reserve Bank.
10
The Functions of the Fed
FUNCTIONS
OF THE FED
Formulates Monetary
Policy
Facilitates the
Payments
Mechanisms
Supervises and
Regulates
the Financial System
Acts as Federal Agent
for
the U.S. Government
Actions taken to
improve the health of
the economy
Actions taken to
ensure the safety and
soundness of the
financial system
Actions taken to
ensure the safe and
efficient transfer of
funds including check
clearing and providing
sufficient currency and
coin
Maintains the
Treasury’s
transactions account
11
Formation and Implementation
of Monetary Policy
• 2 objectives
– to ensure that sufficient money and credit are
available to allow the economy to expand
along its long-term potential growth trend with
little or no inflation
– to minimize the fluctuations around the longrun trend
12
Formation and Implementation
of Monetary Policy
• The Fed takes actions to affect the cost
and availability of funds in the financial
system
• Its decisions may, in turn, affect the
spending, producing, borrowing, lending,
pricing, and hiring decisions made in the
rest of the economy
13
Supervision and Regulation
of the Financial System
• Promoting the safety and soundness of
depository institutions
– forming specific rules that govern banking
behavior
– ensuring that banks are operated prudently and
in accordance with statutes and regulations
•
•
•
•
Truth in Lending Act
Fair Credit Billing Act
Equal Credit Opportunity Act
Community Reinvestment Act
14
Facilitation of the Payments
Mechanism
• Developing and maintaining safe and
efficient means for transferring funds
– providing currency and coin
– clearing checks
15
The Check-Clearing System
Mary writes
check to Dad
check
check canceled
Dad receives
and deposits
check
check deposited
Mary’s bank
Dad’s bank
check forwarded
Federal Reserve
Bank
16
Operation as Fiscal Agent for
the Government
• Furnishes banking services to the
government
– maintains the U.S. Treasury transactions
account
– clears Treasury checks
– issues and redeems government securities
– acts as the fiscal agent of the government in
financial transactions with foreign
governments and foreign central banks
17
The Fed’s Major Policy Tools
• Open Market Operations
• The Discount Rate
• Reserve Requirements
18
Open Market Operations
• The most important monetary policy tool
available to the Fed
• These involve the buying and selling of
U.S. government securities by the Fed
– when the Fed buys securities, reserves rise
– when the Fed sells securities, reserves fall
• changes in reserves affect the ability of depository
institutions to make loans and to extend credit
• thus, changes in reserves also affect the money
supply
19
The Discount Rate
• The Fed operates a discount window
through which depository institutions can
borrow reserves from the Fed
– in January 2003, a new policy was
implemented that established three credit
programs for discount window borrowing
• primary
• secondary
• seasonal
20
The Primary Credit Program
• Loans are made to depository institutions
that are in a healthy and sound financial
condition for a very short time
– usually overnight
– the primary credit rate is set 1 percent above
another key short-term interest rate on which
the Fed exerts a great deal of influence
• When we refer to the “discount rate”, we
are generally talking about the primary
credit rate
21
The Secondary Credit Program
• Short-term loans are made to depository
institutions that are having financial
difficulties
– the secondary credit rate is generally set ½
percent higher than the primary credit rate
22
The Seasonal Credit Program
• Seasonal credit is extended to a small
number of depository institutions that have
recurring seasonal funding needs
– banks in agricultural or seasonal resort
communities
– the seasonal credit rate is an average of
various market rates
23
The Discount Rate
• Prior to 2003, changes in the discount rate
often lagged changes in other interest
rates
• Now the discount rate automatically
changes in response to changes in other
short-term rates
24
The Discount Rate
• Changes in the discount rate can have
several possible effects on depository
institution behavior and the economy
– alters the cost of borrowing reserves from the
Fed
• The Fed urges depository institutions to
borrow from the Fed only when other
alternatives are not available
– should be temporary and not persistent
25
The Discount Rate
• In cases where the safety and solvency of
the institution exist, the Fed stands ready
to serve as lender of last resort
– its main concern is to minimize the risk to the
public interest and the financial system
• wants to preserve the public’s confidence in the
safety and soundness of the country’s depository
institutions
26
Reserve Requirements
• The Fed requires depository institutions to
hold required reserves equal to a
proportion of checkable deposit liabilities
– if the Fed wants to encourage bank lending, it
could lower the required reserve ratio
• can have a powerful effect on the supply of money
and the cost and availability of credit
• The Fed does not change the required
reserve ratio very often
27
Division of Responsibility within
the Federal Reserve System
28
The Independence of the Fed
• Congress established the Fed as an
independent agency to shield it from the
political process
– 14-year terms of the members of the board
ensure that they do not have to defend their
policies to Congress or the President
– the Fed does not depend on Congress for its
funding
– the Fed is exempt from many of the
provisions of the Freedom of Information Act
29
The Independence of the Fed
• The Fed is not completely outside of
government
– in the short run, the Fed does not take orders
from anyone in the executive or legislative
branch of government
– in the long run, Congress can pass new laws
that the Fed must obey
30
The Independence of the Fed
• Ever since the Fed was created, there has
been a debate concerning the desirability
of its independence
– the degree to which the Fed should alter its
policy in response to “suggestions” from
Congress or the President
• the more responsive the Fed is, the less
independent it will be
31
The Independence of the Fed
• Those who support independence do so
on the grounds that anything less will
inject politics into monetary policy
operations
– politicians may be short-run maximizers, only
interested in getting elected and reelected
32
The Independence of the Fed
• Those who do not support independence
argue that the independence of the Fed is
inconsistent with democracy
– the President and Congress are held
accountable for economic conditions
• they should have all policy tools available to them
• monetary policy should be controlled by people
directly responsible to the electorate
33
The Independence of the Fed
• Opponents of the Fed’s independence
would like to see reforms
– a change in the status of Reserve Bank
presidents on the FOMC
• bank presidents represent the interests of the
banking community and not the public at large
– a broadening of the authority of the General
Accounting Office (GAO) to audit the Fed
• the deliberations regarding monetary policy, the
transactions directed by the FOMC, and the
transactions involving foreign exchange operations
34
The Independence of the Fed
• In response to concerns about too much
Fed autonomy, the Fed has become more
open in recent years
– releases edited minutes of its deliberations a
few weeks after the FOMC meets
– several policy changes are announced
immediately after FOMC meetings
35
Summary of Major Points
• The Federal Reserve System was
established by an act of Congress in 1913
– the original Federal Reserve Act was modified
and strengthened in 1933 and 1935 following
the economic and financial collapse of the
Great Depression
36
Summary of Major Points
• The Fed is charged with regulating and
supervising the operation of the financial
system so as to promote a smoothrunning, efficient, competitive financial
system and with promoting the overall
health and stability of the economy
through its ability to influence the
availability and cost of money and credit
37
Summary of Major Points
• The Board of Governors, located in
Washington, D.C., is the core of the
Federal Reserve System
– it is composed of seven members appointed
by the president, with the approval of the
Senate, for 14-year terms
• the terms are staggered so that one expires every
two years
– the President appoints one of the governors
as chair for a four-year term
38
Summary of Major Points
• The country is divided into 12 districts
– each district is served by a Reserve Bank
located in a large city within the district
– the framers of the original Federal Reserve
Act hoped to decentralize policy-making
authority within the Fed through the creation
of Reserve Banks
39
Summary of Major Points
• The Federal Open Market Committee
(FOMC) is the chief policy-making body
within the Fed
– it is composed of 12 members
• the 7 members of the Board of Governors
• 5 of the 12 presidents of the Reserve Banks
– the president of the New York Federal Reserve Bank is a
permanent voting member
– the other four slots rotate yearly among the remaining 11
Reserve Bank presidents
40
Summary of Major Points
• The Fed’s functions can be classified into
four main areas
– formulating and implementing monetary policy
– supervising and regulating the financial
system
– facilitating the payments mechanism
– acting as a fiscal agent for the government
41
Summary of Major Points
• The FOMC directs open market operations,
the major tool for implementing monetary
policy
– these operations involve the buying or selling
of government securities
– these operations affect the volume of reserves
in the banking system as well as interest rates
• when the Fed buys securities, bank reserves rise
• this encourages bankers to expand loans and the
money supply
42
Summary of Major Points
• The FOMC meets eight times each year in
closed meetings in Washington
– policy changes are announced immediately
after the meetings
– the minutes of the meetings are released to the
public immediately after the next FOMC
meeting
• they contain the policy directive, which is the set of
instructions regarding the conduct of open market
operations
43
Summary of Major Points
• The New York Fed, located at the center of
the nation’s financial markets, executes
open market operations on behalf of the
FOMC and the entire Federal Reserve
System
44
Summary of Major Points
• In January 2003, the Fed established
primary, secondary, and seasonal credit
rates for discount window borrowing of
reserves from the Fed
– the primary credit rate is for short-term
borrowing by healthy financial institutions
– the secondary credit rate is the rate charged
for borrowing reserves by troubled depository
institutions
45
Summary of Major Points
• In exceptional circumstances, the Fed is
prepared to serve as a lender of last resort
– to preserve the public’s confidence in the
safety and soundness of the financial system,
the Fed will lend for an extended period to an
institution experiencing severe difficulties
46
Summary of Major Points
• The Fed requires depository institutions to
hold reserve assets equal to a proportion of
each dollar of its deposit liabilities
– the Fed’s required reserve ratio specifies the
proportion
47
Summary of Major Points
• There is an ongoing debate as to whether
the Fed should continue to operate as an
independent government agency
– the Fed and others argue that independence is
essential to the pursuit of economic stability
– opponents argue that such independence is
inconsistent with our democratic form of
government
– others observe that Congress and the
President find the Fed a convenient scapegoat
48
when the economy deteriorates