Copyright© 2006 John Wiley & Sons, Inc.1 Power Point Slides for: Financial Institutions, Markets, and Money, 9 th Edition Authors: Kidwell, Blackwell, Whidbee & Peterson Prepared by: Babu G. Baradwaj, Towson University And Lanny R. Martindale, Texas A&M University

CHAPTER 2 THE FEDERAL RESERVE AND ITS POWERS

Copyright© 2006 John Wiley & Sons, Inc.3 Purposes of a Central Bank Supervise nation’s money supply and payments system Regulate other financial institutions, especially depository institutions “Lender of last resort” when financial system has liquidity problems National government’s “fiscal agent” (i.e. depository bank)

Copyright© 2006 John Wiley & Sons, Inc.4 Two early central banking institutions did not survive the politics of their time. Bank of the United States, Brainchild of Alexander Hamilton Federal charter Privately owned Public and private functions banknotes international transactions Second Bank of the United States, Major issue in presidential politics. Andrew Jackson vetoed re-charter bill in 1832

Copyright© 2006 John Wiley & Sons, Inc.5 Weaknesses in the 19 th -Century Banking System Unstable money supply— No standard currency, mostly private banknotes “Hard currency” (gold/silver) hoarded, unevenly distributed No coordinated payments system Banks were state-chartered and unregulated— No deposit insurance or minimum capital requirements No supervision of lending or accounting practices Frequent bank failures Disruptions of business credit from bank failures prolonged and intensified economic downturns Exaggerated business cycle– “boom & bust”

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7 National Banking System Currency Acts & National Banking Acts-1862, 1863, 1864 First federally standardized currency First systematic federal regulation of banking Key Provisions: Federally chartered “National Banks” Periodic bank examinations Minimum capital and reserve requirements Maximum lending limits Standard banknotes- printed by US Treasury secured by U.S. bonds Federal tax on state banknotes

Copyright© 2006 John Wiley & Sons, Inc.8 Early National Banking System failed to address 3 related problems Demand deposits (checking accounts) became highly popular as a result of the tax on state banknotes Pyramiding of reserves was allowed: Banks could count deposits at other banks as reserves, so a “run” on one could cause others to run short as well. Call loans were the conventional form of bank financing. These loans were due when “called in” by the bank. Banks low on reserves called in loans, causing borrowers to withdraw their own deposits or default, causing more bank illiquidity and more “calls”. Panic would spread, dragging the economy into recession.

Copyright© 2006 John Wiley & Sons, Inc.9 Origins of the Federal Reserve System Repeated cycles of panic and recession strengthened political consensus Crash of 1907 shifted debate from whether to have central bank to how to structure one Federal Reserve Act of 1913 embodied several compromises

Copyright© 2006 John Wiley & Sons, Inc.10 Initial Goals the Federal Reserve Act Provide an “elastic” currency— Federal Reserve Notes—standardized currency Ability to adjust money supply to changes in economy 12 regionally autonomous Federal Reserve Banks Serve lender of last resort to keep banks liquid Improve payments system (check clearing) Supervise banks more vigorously

Copyright© 2006 John Wiley & Sons, Inc.11 Geography of the Fed

Copyright© 2006 John Wiley & Sons, Inc.12 Formal Organization of the Fed

Copyright© 2006 John Wiley & Sons, Inc.13 Power Structure of the Fed

Copyright© 2006 John Wiley & Sons, Inc.14 Today’s highly centralized Fed has 4 main organizational elements The 12 Federal Reserve Banks About 3,000 member commercial banks The Board of Governors The Federal Open Market Committee (FOMC)

Copyright© 2006 John Wiley & Sons, Inc.15 The 12 Federal Reserve Banks: Many operational functions, less autonomy Each FRB provides basic services in its district - processing checks and electronic payments issuing Federal Reserve Notes holding reserves of banks and other depository institutions monitoring regional economic conditions advising the Board of Governors helping make monetary policy The Federal Reserve Banks are part of a coordinated national monetary policy

Copyright© 2006 John Wiley & Sons, Inc.16 About 3,000 member commercial banks “own” the Federal Reserve Banks Member banks represent “dual banking” in the US All National Banks must be members of the Fed About 17% of state banks choose to join Some 36% of all US banks are in, representing about 76% of deposits Member banks buy stock in the FRB for their district collect dividends set by the Fed but do not otherwise share profits elect 6 of 9 FRB directors but have no other vote or say Membership is not the distinction it once was. As of 1980 Fed services are available to any depository institution for a fee Reserve requirements apply to all U.S. depository institutions

Copyright© 2006 John Wiley & Sons, Inc.17 The Board of Governors runs the Fed 7 Governors appointed by President, confirmed by Senate No 2 Governors from same Federal Reserve District Governors have 14-year terms, expiring every 2 years. Governors’ terms are nonrenewable One Governor serves as Chairman Chairman has 4-year term and may be reappointed When new Chairman is named, old one traditionally leaves (regardless of time left in underlying appointment as Governor)

Copyright© 2006 John Wiley & Sons, Inc.18 FOMC sets monetary policy under Board of Governors’ control FOMC has 12 members - 8 permanent, 4 rotating 7 Governors are permanent members President of FRB of New York has permanent seat New York Fed operationally executes FOMC directives Presidents of 4 other FRBs rotate through 1-year terms FOMC’s actions substantially influence 2 major financial sector variables - size of the money supply level of short-term interest rates

Copyright© 2006 John Wiley & Sons, Inc.19 Significant powers are concentrated in today’s centralized Fed Chairman is powerful figure Board regulates key aspects of banking and finance beyond monetary policy Independence enhances power

Copyright© 2006 John Wiley & Sons, Inc.20 Chairman is powerful figure in monetary policy sets agenda and chairs meetings of both Board of Governors and FOMC public face and voice of the Fed

Copyright© 2006 John Wiley & Sons, Inc.21 Board regulates key aspects of banking and finance beyond monetary policy

Copyright© 2006 John Wiley & Sons, Inc.22 Fed’s independence enhances its power No direct channels of political or fiscal pressure Fed is creature of Congress, but not directly under its authority Board is appointed by but not answerable to President No fiscal pressure; Fed funds itself— income exceeds expenses by about $20 billion/year Congress thus has no “power of the purse” over Fed Ultimately independent within, not of government What Congress creates, Congress can modify or destroy. Fed remains independent because most politicians want it that way- mostly agree that monetary policy is not partisan issue independent Fed can absorb some blame if economy falters independent Fed can take necessary but unpopular steps

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Copyright© 2006 John Wiley & Sons, Inc.24 Fed’s balance sheet reflects its relationship to money supply and financial system Main operating assets— Loans at Discount Window US Government Securities “CIPC”—Cash Items in Process of Collection Main operating liabilities— Federal Reserve Notes in Circulation Depository Institution Reserves “DACI”—Deferred Availability Cash Items

Copyright© 2006 John Wiley & Sons, Inc.25 Fed's Balance Sheet, 12/31/03 Source: Board of Governors, Federal Reserve System.

Copyright© 2006 John Wiley & Sons, Inc.26 Fed has 3 major “Tools of Monetary Policy” Open Market Operations Discount Rate Reserve Requirements Fed’s use of these tools is discussed in detail in Chapter 3

Copyright© 2006 John Wiley & Sons, Inc.27 Open market operations: most useful—and thus most important— tool Fed directly changes money supply by buying or selling US government securities on open secondary market— Pays for “buys” by crediting new reserves to special bank accounts of selected dealers Collects for sales by taking existing reserves back Only the central bank can unilaterally create or retire money in this way

Copyright© 2006 John Wiley & Sons, Inc.28 Effects of Open Market Operations Money supply changes immediately and dollar for dollar, making Open Market Ops flexible and precise Short-term interest rates are pressured upward when Fed sells and downward when it buys

Copyright© 2006 John Wiley & Sons, Inc.29 Control of Open Market Operations FOMC decides whether, when, and how much to buy or sell FOMC meets 8 times a year The FOMC issues policy directives to Open Market Desk at FRB of New York

Copyright© 2006 John Wiley & Sons, Inc.30 Discount Rate: Interest rate at which Fed lends to depository institutions As Fed lends “at The Window”, money supply increases Changes in Discount Rate theoretically affect incentives to borrow Banks in early 20th century relied on Window; now they have other choices for managing liquidity, are wary of “Discount Window scrutiny” Today, Discount Rate is more signal than direct control— Increase means Fed wants smaller money supply and higher rates Decrease means Fed wants larger money supply and lower rates

Copyright© 2006 John Wiley & Sons, Inc.31 Reserve Requirements: least-used tool of monetary policy Depository institutions must reserve set percentage of certain types of deposits Most reserves are held at FRB for that District Reserves may also be held as vault cash Monetary Control Act of 1980 – subjects all US depository institutions to uniform reserve requirements sets limits within which Fed is to specify required reserve ratio Reserve requirements are a structural control Changes in reserve requirements have dramatic effects. Reserve requirements are not useful for “fine-tuning”

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