The Federal Reserve System

Background

Financial panics plagued the nation throughout much of the 19th century.  Many bank failures, business bankruptcies, and economic downturns could be traced to a poorly regulated banking system and the lack of a flexible money supply.  A particularly severe crisis in 1907 finally led Congress to establish the National Monetary Commission to propose an institution that could deal with those problems. 

After considerable debate, Congress passed the Federal Reserve Act which Woodrow Wilson signed into law on Dec 23, 1913.  The act stated that its purposes were to "provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes."

Over the years, deficiencies in the original act have been addressed in further legislation.  The International Banking Act of 1978, sometimes known as the Humphrey-Hawkins Act, included an update of the objectives of the Federal Reserve, namely to achieve economic growth in line with the economy’s potential to expand; a high level of employment; stable prices (meaning stability in the purchasing power of the dollar); and moderate long-term interest rates.

Basic Duties

The Federal Reserve comprises the Board of Governors in Washington D.C., and twelve regional Federal Reserve Banks. Their responsibilities are to:

  o  Conduct the nation’s monetary policy by influencing the money and credit conditions in the economy. 

  o  Supervise and regulate banking institutions to ensure safety and soundness of the nation’s banking and financial system.

  o  Maintain the stability of the financial system.

  o  Provide certain financial services to the U.S. government, financial institutions, the public, and foreign official institutions, including a major role in operating the nation’s payments system.

Board of Governors

The Board of Governors was established as a federal agency.  It is made up of seven members appointed by the President and confirmed by the Senate.  The full term of a member is fourteen years with appointments staggered so that one term expires on January 31 of each even-numbered year. 

The Chairman of the Board is appointed for a four year term starting midway through each Presidential term.  Besides carefully monitoring domestic and international financial and economic developments, the Board supervises and regulates the operations of the Federal Reserve Banks.  The Board is supported by a Washington staff of about 1700.

The Board is audited annually by a major public accounting firm and is also subject to audit by the General Accounting Office, an arm of Congress. Monetary policy, which is exempt from audit by the GAO, is monitored directly by Congress through written reports prepared by the Board. 

Monetary Policy

The Federal Reserve conducts monetary policy using three major tools: (1) open market operations to control the level of reserves in the depository system. (2) setting reserve requirements for depository institutions, and (3) setting the discount rate for lending reserves.

Policy regarding open market operations is the responsibility of the Federal Open Market Committee (FOMC) comprising the seven members of the Board, the president of the New York Federal Reserve Bank, and the presidents of four other reserve banks on a rotating basis.  However, the Board has sole authority over changes in reserve requirements and the discount rate.

Federal Reserve Banks

Each Reserve Bank has its own board of nine directors chosen from outside the Bank.  Three, designated Class A, represent commercial banks that are members of the Federal Reserve System. Three Class B and three Class C represent the public.  The member commercial banks in each district elect the Class A and B directors.  The Board of Governors appoints the Class C directors, one of whom it selects as chairman.  No Class B or Class C director may be an officer, director, or employee of a bank or a bank holding company.  The directors in turn nominate a president of the Reserve Bank, whose selection is subject to approval of the Board of Governors.

Reserve Bank Services

The twelve Federal Reserve Banks provide banking services to depository institutions within their district, and to the federal government.  For depository institutions they maintain reserve and clearing accounts and provide various payment services.  These include collecting checks, electronically transferring funds, and distributing and receiving currency and coin.  For the federal government they act as fiscal agents.  As such they maintain the Treasury Department's transaction account; pay Treasury checks; process electronic payments; and issue, transfer, and redeem U.S. government securities.

Income of the Federal Reserve

The income of the Federal Reserve System is derived primarily from the interest on U.S. government securities that it has acquired through open market operations.  Other important sources of income are the interest on foreign currency investments held by the System, interest on loans to depository institutions, and fees for services provided to depository institutions such as check clearing, fund transfers, and automated clearing house operations.

After it pays its expenses, the Federal Reserve turns the rest of its earnings over to the U.S. Treasury.  About 95% of net earnings have been paid into the Treasury since inception in 1914.  The Board of Governors audits the Reserve Banks every year.  The Reserve Banks, like the Board, are subject to audit by the GAO, but certain functions such as transactions with foreign central banks and open market operations are excluded from audit. 

Member Banks

The nation's banks can be divided into three types according to which governmental body charters them and whether or not they are members of the Federal Reserve System.  Those chartered by the federal government (through the Office of the Comptroller of the Currency in the Department of the Treasury) are national banks, and by law are members of the System. 

Banks chartered by the states are divided into those that are members of the System and those that are not. State-chartered banks are not required to join the System, but they may elect to become members if they meet the standards.  As of June 30, 2006, there were a total of 7,480 commercial banks nationwide, of which 2,548 were members of the System.  The Federal Deposit Insurance Corporation is responsible for supervising non-member banks.

Member banks must subscribe to stock in their regional Federal Reserve Bank in an amount equal to 6 percent of their capital and surplus.  They receive a 6 percent annual dividend on their stock and may vote for Class A and Class B directors of the Reserve Bank.  However the stock does not carry with it the control and financial interest that is normal for the common stock of a for-profit organization.  It offers no opportunity for capital gain and may not be sold or pledged as collateral for loans.  The stock is merely a legal obligation that goes along with membership. 

Independence of the Fed

The Federal Reserve System is considered to be an independent central bank.  It is, but only in the sense that its decisions do not have to be ratified by the President or anyone else in the executive branch of government.  However the entire system is subject to the oversight of Congress because the Constitution gives to Congress the power to coin money and set its value. 

In 1913 Congress delegated that power to the Fed, and could reclaim it at any time.  The Fed must act within the framework of the overall objectives of economic and financial policy established by Congress. Thus the description of the System as "independent within the government" is more accurate.