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

Overview of 21st 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 private-sector 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.

The Federal Reserve: Monetary Policy

Functions of the Federal Reserve System Four functions: Provide Financial Services Supervise and Regulate Banking Institutions Maintain stability of the Financial System 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.

The Federal Reserve System: History and Structure