PowerPoint Presentation by Charlie Cook Copyright © 2004 South-Western. All rights reserved. Chapter 18 The Federal Reserve and the Financial System

Copyright © 2004 South-Western. All rights reserved.18–2 Fundamental Issues 1.What are the main assets and liabilities of the Fed? 2.In what ways is the Fed the government’s bank? 3.What is the rationale for the Fed’s role as a bank for private banks? 4.Why does the Fed play a supervisory role in the U.S. payment system? 5.In what ways do payment-system risks span national borders,and how do central banks seek to contain these risks?

Copyright © 2004 South-Western. All rights reserved.18–3 The Fed’s Balance Sheet THE FED’S ASSETS  Treasury securities  U.S. agency securities  Discount window loans  Gold certificates.  Special Drawing Right (SDR) certificates  Foreign currency reserves  Cash items in the process of collection LIABILITIES AND EQUITY CAPITAL  Federal Reserve notes  Bank reserve deposits  U.S. Treasury deposits  Foreign official deposits  Deferred availability cash items  Equity capital

Copyright © 2004 South-Western. All rights reserved.18–4 The Fed as the Government’s Bank Government depository:  Treasury tax and loan (TT&L) accounts:  U.S. Treasury checking accounts at private depository institutions. Fiscal agent:  A term describing the Federal Reserve’s role as an agent of the U.S. Treasury Department, on whose behalf the Fed issues, services, and redeems debts.

Copyright © 2004 South-Western. All rights reserved.18–5 Do Banks Need A Central Bank? Externalities:  Spillovers from the interactions of one set of individuals to others who otherwise are not involved in the transactions. Negative externality:  A reduction in the welfare of one individual caused by a transaction between other parties, even though the individual is not directly involved in the transaction.

Copyright © 2004 South-Western. All rights reserved.18–6 Do Banks Need A Central Bank? Lender of last resort:  An institution that is willing and able to lend to any temporarily illiquid but otherwise solvent institution to prevent its illiquid position from leading to a general loss of confidence in that institution or in others.

Copyright © 2004 South-Western. All rights reserved.18–7 The U.S. Payment System Payment system:  A term that refers broadly to the set of mechanisms by which consumers, businesses, governments, and financial institutions exchange payments. Retail payments  Nonelectronic payments  Consumer-oriented electronic payment systems  ATM’s  Automated clearing houses (ACHs)  Electronic benefits transfer (EBT) system  Point-of-sale (POS) systems

Copyright © 2004 South-Western. All rights reserved.18–8 Average Expense Allocations of ATM Fees at Depository Institutions Figure 18–1 SOURCE: Office of the Comptroller of the Currency.

Copyright © 2004 South-Western. All rights reserved.18–9 Figure 10–2 SOURCE: Number of Transactions Per Person Percentage CountryPaper-based Electronic Electronic Payments Switzerland26597% Netherlands Belgium Denmark Japan93178 Germany Sweden Finland United Kingdom75850 France Canada Norway Italy23620 United States Annual Noncash Transactions Per Person in Selected Countries

Copyright © 2004 South-Western. All rights reserved.18–10 Wholesale Payments Large-value wire transfer systems:  Payment systems such as Fedwire and CHIPS that permit the electronic transmission of large dollar sums. Fedwire:  A large-value wire transfer system operated by the Federal Reserve that is open to all depository institutions that legally must maintain required reserves with the Fed.

Copyright © 2004 South-Western. All rights reserved.18–11 Wholesale Payments (cont’d) Clearing House Interbank Payment System (CHIPS):  A large-value wire transfer system that links about ninety depository institutions and permits them to transmit large dollar sums relating primarily to foreign exchange and Eurodollar transactions.

Copyright © 2004 South-Western. All rights reserved.18–12 The World’s Key Large-Value Wire Transfer Systems Table 18–2 Country/Payment SystemTransactions Value (Millions)($Trillions) European Monetary Union TARGET53.7$322.8 Euro Japan Zengin BOJ-NET United Kingdom CHAPS United States Fedwire CHIPS

Copyright © 2004 South-Western. All rights reserved.18–13 Payment-System Risks Liquidity risk:  The risk of loss that may occur if a payment is not received when due. Credit risk:  The risk of loss that might occur if one party to an exchange fails to honor the terms under which the exchange was to take place.

Copyright © 2004 South-Western. All rights reserved.18–14 Payment-System Risks (cont’d) Systemic risk:  The risk that some depository institutions may not be able to meet the terms of their credit agreements because of failures by other institutions to settle transactions that otherwise are not related.

Copyright © 2004 South-Western. All rights reserved.18–15 Sources of Operating Revenues for the Top Twenty- Five U.S.Bank Holding Companies Figure 18–2 SOURCE: Lawrence Radecki,“Banks’ Payment-Driven Revenues,” Federal Reserve Bank of New York Economic Policy Review 5 (2, July 1999): 53–70.

Copyright © 2004 South-Western. All rights reserved.18–16 International Payment Risks Herstatt risk:  The risk of any form of loss due to payment settlement failures that occur across national borders; named after a German bank that collapsed in Free-rider problem:  A situation in which some individuals take advantage of the fact that others are willing to pay for a jointly utilized good, such as a system of multilateral netting of foreign exchange payments.

Copyright © 2004 South-Western. All rights reserved.18–17 Common Payment-System Standards The Lamfalussy standards:  Standards that clarify the essential legal payment responsibilities of any payment intermediary that participates in a large-value wire transfer system operated within a G10 nation.  All large-value wire transfer systems have agreed to operate within the framework of rules established under the Lamfalussy standards.

Copyright © 2004 South-Western. All rights reserved.18–18 Daylight Overdrafts Figure 18–3 SOURCE: Board of Governors of the Federal Reserve System and Diana Hancock and James Wilcox,“Intraday Bank Reserve Management:The Effects of Caps and Fees on Daylight Overdrafts,” Journal of Money, Credit and Banking 28 (2, November 1996):870–908; Board of Governors of the Federal Reserve System. Depository institution reserve account balance ($) Daylight overdrafts (in 1995 $ billions)