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FEDERAL RESERVE SYSTEM

To promote the development of a sound economy and a reliable banking system, Congress passed, and President Woodrow Wilson signed, the Federal Reserve Act on December 23, 1913. The act was a response to the recurring bank failures and financial panics that had plagued the nation.

After much disagreement and eventual compromise, all parties to the discussions—the government, banks, other financial institutions, and a few business and labor leaders—agreed that a central U.S. bank was essential for the economic health of the country. Starting with the goal of stabilizing the nation's monetary and financial system, the Federal Reserve System (commonly called the Fed) has undertaken a number of responsibilities.

STRUCTURE OF THE SYSTEM

Designed by Congress and subject to congressional authority, the Fed is a politically independent and financially self-sufficient federal agency. It consists of the following components:

1. A central bank, sometimes called the government's bank, located in Washington, D.C.
2. Twelve regional Reserve Banks, located in Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas City, Minneapolis, New York, Philadelphia, Richmond, San Francisco, and St. Louis. Each Reserve Bank relies on advisory groups for information and suggestions. Some of the more important ones concern operations, small business and agriculture, and thrift institutions (savings banks, savings and loan associations, and credit unions). Reserve Bank officials also meet periodically to discuss mutual problems. These groups include the Conference of Presidents, the Conference of First Vice Presidents, the Conference of Chairmen, and the Financial Services Policy Committee.
3. Twenty-five branch banks, located within defined areas of the Reserve Banks. For example, branch banks within the San Francisco Reserve Bank area are located in Los Angeles, Portland (Oregon), Salt Lake City, and Seattle.
4. Member banks, located throughout the country. Some are national banks (all of which are commercial banks) chartered by the federal government and, by law, are members of the Fed. Others are state commercial banks that have chosen to be members. Of the more than 9,000 commercial banks in the country, more than 3,700 are members of the Fed. Other depository institutions, including nonmember commercial banks and thrift institutions, are subject to many of the Fed's rules and regulations. A member bank is required to purchase stock from its Reserve Bank in an amount equal to 3 percent of its combined capital and surplus. However, this investment does not represent control of or a financial interest in the Reserve Bank. In return for its investment, however, a member bank receives a 6 percent annual dividend and the right to vote in elections of directors of its Reserve Bank.

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GOVERNANCE OF THE SYSTEM

These are three basic components in the governance structure of the Fed:

1. The Fed's primary policy-making group is the seven-member Board of Governors. Appointed by the president and confirmed by the Senate, members serve for one fourteen-year term only. A member who is appointed to fill an unexpired term may be appointed for an additional full term. From among the seven members, the Board's chairman and vice chairman are also appointed and confirmed by the president and the Senate for four-year terms.
2. There are three advisory groups that aid the Board of Governors:
   1. Federal Advisory Council, consisting of one member from each Reserve Bank. Its major concerns involve banking and economic issues.
   2. Consumer Advisory Council, consisting of thirty specialists in consumer and financial matters.
   3. Thrift Institutions Advisory Council, consisting of people representing thrift institutions. This Council is concerned with issues affecting those institutions.
3. The Federal Open Market Committee (FOMC) consists of the seven-member Board of Governors, the New York Federal Reserve Bank president, and an additional four Reserve Bank presidents who serve on a one-year rotating basis. By tradition, the Committee elects the Board of Governors chairperson as its chairperson and the New York Reserve Bank president as its vice chairperson. Although all twelve Reserve Bank presidents attend the FOMC's eight-times-a-year formal meetings, only the Board, the New York Reserve Bank president, and the four rotating presidents are voting members.

ACTIVITIES AND RESPONSIBILITIES OF THE FEDERAL RESERVE SYSTEM

In conjunction with the FOMC and the twelve Reserve Banks, the Board of Governors' main concern is the development of monetary policy, which it carries out through three means:

1. The establishment of reserve-level rates (amounts that member banks must set aside to be reserved against deposits). These amounts depend on the nation's economic activity status, with emphasis placed on price levels and the volume of business and consumer expenditures. By the lowering of the required reserve-level rate, banks can increase the proportion of funds they are able to lend to customers. By raising the required reserve-level rate, the opposite effect takes place. Thus, the Fed can influence such factors as economic activities, the money supply, interest rates, credit availability, and prices. However, a change in a reserve-level rate usually causes banks to change their strategic plans. In addition, a reserve-level rate increase is costly to banks. Consequently, changes in reserve-level rates are uncommon.
2. The approval of discount rates (interest rates at which member banks may borrow short-term funds from their Reserve Bank). When inflation threatens, a discount-rate increase tends to dampen economic activity because then banks charge higher interest rates to borrowers. On the other hand, a discount-rate decrease is designed to stimulate business activity. The term discount window is often used when describing a Reserve Bank facility that extends credit to a member bank.
3. Another rate, the federal funds rate, is an important factor affecting day-to-day bank operations. This is the rate charged by one depository institution to another for the overnight loan of funds. This happens when one bank is short of funds while another has a surplus. The rate is not fixed; it may change from day to day and from bank to bank.
4. Open-market operations (the purchase and sale of U.S. government securities in the open market). These activities are conducted by the FOMC, of which the Board of Governors comprises the majority. The Fed buys and sells U.S. government securities such as Treasury bills from banks and others several times a week. As a result, the amounts banks have available to lend to borrowers are affected. For example, when the Fed buys securities, banks have more funds, so interest rates tend to drop. The opposite occurs when the Fed sells its securities. By and large, open-market operations comprise the most powerful tool the Fed has to influence monetary policy.

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Other activities and responsibilities of the Federal Reserve System include the following:

1. Supervision of the twelve Reserve Banks and their branches. With regard to the latter, the Board of Governors, through the Reserve Banks, uses both on- and off-site examinations to maintain awareness of each member bank's activities. These activities include the quality of loans, capital levels, and the availability of cash.
2. Cooperative efforts of the U.S. Treasury and the Fed. For example, the Fed acts as the Treasury's fiscal agent by putting paper money and coins into circulation, handling Treasury securities, and maintaining a checking account for the Treasury's receipts and payments.
3. Oversight of banking organizations, such as bank holding companies (companies that own or control one or more banks).
4. Provision of an efficient payments system such as check collections and electronic transactions. With billions of checks in circulation each year, the Fed plays a major role in assuring their efficient processing. By arrangements among the Reserve Banks, member banks and nonmember banks, checks are credited or debited (added to or subtracted from) to depositors' accounts speedily and accurately. Electronic methods are being used increasingly to transfer funds (and securities, too). One such method, involving very large sums, is called Fedwire. Another is the Automated Clearinghouse (ACH), which is used by the government, businesses, and individuals for the receipt or payment of recurring items, such as Social Security.
5. Enforcement of consumer credit protection laws. These laws include the Community Reinvestment Act, which promotes community credit needs; the Equal Credit Opportunity Act, which prohibits discrimination in credit transactions on the basis of marital status, race, sex, and so forth; the Fair Credit Reporting Act, which allows consumers access to their credit records for the purpose of correcting errors; and the Truth in Lending Act, which enables consumers to determine the true amount they are paying for credit.
6. Establishment of banking rules and regulations.
7. Determination of margin requirements (the amount of credit granted investors for the purchase of securities, such as shares of stock). The borrowed funds are usually secured from a bank or a brokerage firm (a company that sells stocks and/or bonds). Margin requirements that are too liberal can damage the stock market and the economy.
8. Approval or disapproval of applications for bank mergers (two or more banks joining together to form one new bank). The Fed also acts if the new bank is to become a state member bank of the Federal Reserve System.
9. Approval and supervision of the Edge Act (named for Senator Walter Edge of New Jersey) and agreement corporations. Both cases involve corporations that are chartered to engage in international banking. Edge Act corporations are chartered by the Fed, while agreement corporations secure their charters from the states. The latter are so named because they must agree to conform to activities permitted to Edge Act corporations. The Fed is also responsible for approving and regulating foreign branches of member banks and for developing policies regarding foreign lending by member banks.
10. Issuance and redemption of U.S. savings bonds. Regardless of how the bonds are purchased—for example, through an employer savings plan or a bank—it is the Fed that processes the applications and sends the bonds.

SUMMARY

Since it holds substantial U.S. government securities, the Federal Reserve System earns sufficient interest to operate without government appropriations. Consequently, it is both a financially self-sufficient and politically independent agency that exerts great influence on the nation's economy. It bolsters domestic consumer confidence and is a major player in global economic activities.

SEE ALSO Financial Institutions

BIBLIOGRAPHY

Board of Governors of the Federal Reserve System. (2002) The Federal Reserve System: Purposes and Functions. Washington, DC: Books for Business.

Federal Reserve System (2003). "The Structure of the Federal Reserve System". Retrieved October 18, 2005, from http://www.federalreserve.gov.

Feinman, Joshua N. (1993, June). "Reserve Requirements: History, Current Practice, and Potential Reform." Federal Reserve Bulletin, 569-589.

Melvin Morgenstein