Transcript The Federal Reserve System: Purposes and Functions Kristin A. Van Gaasbeck California State University, Sacramento Student Economics Association December 11, 2006

The Federal Reserve System:
Purposes and Functions
Kristin A. Van Gaasbeck
California State University, Sacramento
Student Economics Association
December 11, 2006
Background

The Federal Reserve
System (“the Fed”) is the
central bank of the United
States.


Founded by Congress in 1913
to provide the nation with a
safer, more flexible and more
stable monetary and financial
system.
Congress designed the
structure of the Fed to give it
a broad perspective on the
economy.
Structure of the Federal Reserve


Board of Governors in Washington, D.C. (since 1935)
Twelve Federal Reserve Banks
Since February
2006, Ben Bernanke
has served as
Chairman of the
Board of Governors.
Alan Greenspan had
served as chairman
since 1987.
Overview of the San Francisco Fed

The 12th District is the largest Federal Reserve
district in terms of geographic area and population.
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1.3 million square miles, or 36% of the nation’s area.
60.3 million people accounted for 20% of the U.S.
population in 2005.
25.6 million workers in 2005

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19% of the nation’s total nonfarm employment
21% of the nation’s total personal income.
22% of the nation's exports of manufactured goods in
2005.
Janet Yellen is the President of the 12th district
Reserve Bank.
Purposes and Functions

Over time, the Federal Reserve’s role in banking
and policy has expanded.

The Federal Reserve’s duties fall into four general
areas:

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Conducting the nation’s monetary policy.
Supervising and regulating banking institutions.
Providing financial services to depository institutions and
the federal government.
Maintaining stability of the financial system.
Conduct of Monetary Policy

The “textbook” monetary policy tools are:

Open Market Operations
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Primary Credit (Discount Loans)
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Federal Reserve Bank of New York buys/sells U.S. Treasury
securities with securities dealers (“primary dealers”)
The proceeds from these transactions are deposited into, or
withdrawn from, the banking system
Private banks may borrow from Reserve Banks at an interest
rate set by the Board of Governors (primary credit rate)
Allows the Federal Reserve to act as a lender of last resort
Reserve requirement


The fraction of deposits banks may not lend out.
These must be held in reserves (vault cash or with the Fed)
Conduct of Monetary Policy

In practice, the Fed relies on open market
operations to implement monetary policy.

Federal Open Market Committee (FOMC) is the
policy-making group within the Federal Reserve
System.

Membership includes 12 voting members:
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Board of Governors (seven members)
President of the Federal Reserve Bank of New York
Four other Reserve Bank presidents (rotating, one-year terms)
President Yellen is a voting member of the FOMC.
Committee meets eight times each year. Next meeting?
Conduct of Monetary Policy

FOMC communicates to the public through interest rates

Federal funds rate target

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Interbank lending rate
Market-determined rate manipulated through open market operations.
Current target is 5.25% (last changed on June 29, 2006, up from 5%)
Primary credit rate (“Discount rate”)

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Interest rate on Federal Reserve loans to banks.
Loans are approved and issued by Federal Reserve Banks.
(“Discount window”)
Primary credit rate by the Board of Governors, but historically only
changes when FOMC changes the federal funds rate target.
Currently, the Board of Governors simply sets the primary credit rate
as 100 basis points above the FOMC federal funds rate target.
Supervision and Regulation of Banks

The Federal Reserve is responsible for the following
sectors in the banking industry:
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Bank holding companies – own one or more banks
State-chartered banks that are members of the Federal Reserve
System (state member banks)
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Membership in the Federal Reserve System means the bank owns equity
shares in the Federal Reserve Bank in its district.
All banks with a federal charter are members of the system
State banks have the option to be members.
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Foreign branches of member banks
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Edge and agreement corporations
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U.S. banks may conduct international banking activities through these
U.S. state-licensed branches of foreign banks
Nonbanking activities of foreign banks
Supervision and Regulation of Banks
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As of March 31, 2006, in the 12th District, there were:
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47 state member banks
116 national banks
461 state-chartered non-member banks
77 U.S. branches, agencies, and representative offices
of foreign banks and eight Edge Act agreement
corporations.
Supervision and Regulation of Banks

Other regulators of the banking industry include
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Office of the Comptroller of the Currency (OCC) – national banks
Federal Deposit Insurance Corporation (FDIC) – nonmember
state banks, mutual savings banks
Office of Thrift Supervision (OTS) – thrifts, savings & loans, and
mutual savings banks
Regulators use the CAMELS rating system:
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C – capital adequacy
A – asset quality
M – management and administration
E – earnings
L – liquidity
S – sensitivity to market risk
Supervision and Regulation of Banks
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Why does a bank’s CAMELS rating matter?
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Poor ratings indicates banks are taking on excessive risk,
threatening the stability of the banking system.
Why do banks need to be regulated?

Asymmetric information problems:
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With deposit insurance, depositors have no incentive to
provide oversight for banks’ activities.
Bank managers have different incentives than their
shareholders
Bank managers know that regulators have an incentive to
keep larger banks afloat to avoid paying out deposit
insurance claims (“Too Big to Fail”)
Supervision and Regulation of Banks

What do the banks care about CAMELS?

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Qualification for primary, secondary credit loans
Deposit insurance premiums based on CAMELS
Poor ratings lead to increased monitoring and
examinations by regulators. This attracts unwanted
attention to the bank, potentially reducing share prices.
Reserve Requirement
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Board of Governors sets the reserve requirement.
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A percentage of deposits that must be held in reserves.
Since 1990s, a percentage of transactions deposits
Banks verify this requirement when reporting balance sheet
information to the Federal Reserve Banks (every two weeks).
Supervision and Regulation of Banks
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Banks satisfy the reserve requirement through:
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Vault cash (currency in its vault)
Balances held at a Federal Reserve Bank
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Banks use their balances with Reserve Banks to satisfy the
reserve requirement and to clear financial transactions.
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Given the volume and unpredictability of transactions that clear
throughout the day, banks seek to hold an end-of-day balance to
protect against unexpected debits that would leave their accounts
overdrawn (and subject to charge).
These positive balances, held above the reserve requirement are
known as contractual clearing balances.
Beginning in 2016, the Fed will pay interest on bank balances
held at Reserve Banks.
Financial Services: Government

Federal Reserve Banks provide banking services to
several groups.
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Federal Reserve Banks act as fiscal agents for the federal
government.
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Pay Treasury checks
Process electronic payments
Issue, transfer, and redeem U.S. Treasury securities
Reserve Banks provide services to other central banks and
international agencies, including maintaining:
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non-interest-bearing accounts (in U.S. dollars)
securities safekeeping accounts
accounts for safekeeping gold
Financial Services: Depository Institutions
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Distribute and receive currency and coin
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When Congress established the Federal Reserve System,
it recognized that the public’s demand for currency is
variable.
Each of the 12 Reserve Banks is authorized to issue paper
currency (the U.S. Treasury issues coin).
About 45% of all paper currency printed is $1 bills.
Of the total U.S. currency in worldwide circulation, up to
two-thirds is held outside of the country.
The Federal Reserve Bank of San Francisco is the home
of the American Currency Exhibit.
Financial Services: Depository Institutions
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When currency is worn or damaged, the Reserve Bank
destroys it and replaces it with new paper currency.
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The Fed’s Cash Services department processes currency
high speed computer controlled machines that each verify
currency at a rate of approximately 1,250 notes per minute.
The average life span of bills is as follows: $1 (22 months),
$20 (25 months), $100 (60 months)
In 2005, the Fed spent $479 million to destroy damaged
currency and to print and transport new currency.
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Suspected counterfeit currency is removed from circulation
and reported to the U.S. Secret Service.
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In 2005, the 12th district processed 19.1 billion currency
notes, or about 76 million pieces a day.
Financial Services: Depository Institutions
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Check processing
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The Federal Reserve Banks clear checks for the banking
system.
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In 2003, Reserve Banks cleared 58% of interbank checks
Depository institutions cleared the remainder through private
arrangements among themselves.
In 2003, the Reserve Banks collected 16,271 million checks
worth $15.8 trillion. They also paid $267 million in Treasury
checks and $198 million in postal money orders.
In 2005, the San Francisco Federal Reserve Bank
processed 1.3 billion commercial checks.
Financial Services: Depository Institutions
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Electronic payments
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Automated Clearinghouse (ACH)
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Developed jointly by the Fed and the private sector in the
1970s as a more efficient alternative to checks.
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Currently, a nationwide mechanism for processing credit and
debit transfers electronically.
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Payments are sent by banks and processed by the Reserve
Banks in batches. There is a private-sector competitor (Electronic
Payments Network).
Dramatic increase in these payments:
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1975: 6 million transactions worth $92.9 billion.
2003: 6.5 billion transactions worth $16.8 trillion
Financial Services: Depository Institutions
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Electronic payments
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Fedwire Funds Service
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Provides real-time gross settlement system in which more
than 9,500 participants (banks) are able to initiate immediate
electronic funds transfers.
All banks are maintain an account with a Federal Reserve
Bank are eligible to participate.
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Participants use Fedwire to handle large-value, time-critical
payments, such as payments to settle interbank purchases,
trades of financial securities, or to disburse or repay large loans.
Reserve Banks secure transfer of funds once received.
National Settlements Service

Automated mechanism for submitting settlement information
to the Reserve Banks.
Stability of the Financial System
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The Federal Reserve maintains financial system
stability through the aforementioned broad duties.
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Conduct of monetary policy designed to promote economic
stability (e.g., low inflation, stable output growth, and low
unemployment).
Regulation and supervision of banking system critical for
stability and long-run economic growth.
Financial services promote financial system efficiency.