Chapter 4 Federal Reserve System © 2000 John Wiley & Sons, Inc.

2 Chapter Outcomes n Identify three weaknesses of the national banking system before the establishment of the Federal Reserve System n Describe Federal Reserve membership in terms of who must join and who may join n Describe the composition of the Fed Board of Governors

3 Chapter Outcomes (Continued) n Discuss how the Fed uses reserve requirements to carry out monetary policy n Discuss how discount rate policy is employed by the Fed n Describe the Fed’s use of open- market operations to alter bank reserves

4 U.S. Banking System Prior to the Fed n NATIONAL BANKING SYSTEM: Established when National Banking Acts were passed in 1963 and 1964 n WEAKNESSES OF THE SYSTEM: -Inefficient payments system -Money supply “inelastic” or “inflexible” to demand changes -Liquidity problems due to inefficient lending/borrowing mechanism

5 Two Important Definitions n CENTRAL BANK: Federal government agency that facilitates operation of the financial system and regulates money supply growth n FEDERAL RESERVE SYSTEM (Fed): U.S. central bank that sets monetary policy and regulates banking system

6 Structure of the Federal Reserve System n FEDERAL RESERVE ACT OF 1913: Provided for establishment of twelve Federal Reserve districts with each district served by a Federal Reserve Bank n Board of Governors n Federal Reserve Banks n Federal Open Market Committee

7 Fed Board of Governors n Sets reserve requirements and approves discount rates as part of monetary policy n Supervises and regulates member banks and bank holding companies n Establishes and administers protective regulations and consumer finance n Oversees Federal Reserve Banks

8 Federal Reserve Banks n Propose discount rates n Hold reserve balances for depository institutions and lend to them at the discount window n Furnish currency n Collect and clear checks and transfer funds for depository institutions n Handle U.S. government debt and cash balances

9 Federal Open Market Committee n Comprised of the Fed Board of Governors and 5 Reserve Bank Presidents n Directs open market operations (buying and selling of U.S. government securities), which are the primary instruments of monetary policy

10 Federal Reserve Membership n All national banks must be members n State-chartered banks are permitted to join the system n All member banks must purchase capital stock of the Reserve Bank of their district up to a maximum of 6% n Approximately 40% of commercial banks are members of the Fed n Member banks hold about 82% of the deposits of all commercial banks

11 Federal Reserve Banks: Directors and Officers n CLASS A DIRECTORS: Represent member banks of the district n CLASS B DIRECTORS: Represent nonbanking interests (commerce, agriculture, & industry) n CLASS C DIRECTORS: Appointed by the Fed Board of Governors (may not be in banking)

12 Recent Chairs of the Fed Board of Governors n Paul Volcker (Chair, ) -Under his guidance, a restrictive Fed policy was successful in bringing down the double-digit inflation of the 1970s and beginning of the 1980s

13 Recent Chairs of the Fed Board of Governors (Continued) n Alan Greenspan (Chair, 1987-current) -Under his guidance, the U.S. has had low inflation, real economic growth, relatively low interest rates, and record high stock prices

14 Monetary Policy Functions and Instruments n Reserve Requirements -Fed sets reserve requirements for depository institutions n Discount Rate Policy -Fed sets interest rate at which it will lend to depository institutions n Open-Market Operations -Fed buys/sells government securities to change bank reserves

15 Reserve Requirements: Basic Concepts n FRACTIONAL RESERVE SYSTEM: Reserves held with Fed that equal a certain percentage of bank deposits n BANK RESERVES: Vault cash and deposits held at Federal Reserve Banks n REQUIRED RESERVES: Minimum amount of total reserves a depository institution must hold

16 Reserve Requirements: Basic Concepts (Continued) n REQUIRED RESERVES RATIO: Percentage of deposits that must be held as reserves n EXCESS RESERVES: Amount of that total reserves are greater than required reserves

17 Discount Rate Policy n DISCOUNT RATE: Interest rate that a bank must pay to borrow from its regional Federal Reserve Bank n FORMS OF BORROWING: Borrowing institution may receive an “advance” (loan) or may “discount” (sell) to the Reserve Bank its “eligible paper”

18 Open-market Operations n OPEN-MARKET OPERATIONS: n OPEN-MARKET OPERATIONS: Buying and selling of securities in the “open market” by the Fed to alter bank reserves n FED’S ASSETS: n FED’S ASSETS: Primarily held as U.S. government and government agency securities n ORIGINAL FEDERAL RESERVE ACT: n ORIGINAL FEDERAL RESERVE ACT: Did not provide for open-market operations

19 Fed Supervisory Function n On-site examination of commercial banks n Function shared with: -Office of the Comptroller of the Currency (OCC) -Federal Deposit Insurance Corporation (FDIC) -state regulatory agencies

20 Supervision and Regulation of Non-Commercial Banks n CREDIT UNIONS: Regulated by the National Credit Union Administration (NCUA) n SAVINGS & LOANS AND OTHER SAVINGS INSTITUTIONS: Regulated by the Office of Thrift Supervision (OTS)

21 Central Banks in Other Countries n UNITED KINGDOM: Bank of England (BOE)--created prior to the Fed n JAPAN: Bank of Japan (BOJ)--created in 1947 n GERMANY: Deutsche Bundesbank--created in 1957 [note: Germany is now part of the European Economic Union]