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Chapter 3: Regulators, agencies & financial institutions.


The Federal Reserve System is made up of twelve regional Reserve Banks together with the Board of Governors in Washington, D.C. The "Fed," as the system is commonly called, is an independent governmental entity created by Congress in 1913 to serve as the central bank of the United States. The Fed's primary role is to foster a sound monetary and financial system and a healthy economy. To advance this goal, the Fed helps formulate monetary policy; supervises banks and financial holding companies; helps maintain the stability of the financial system; and provides financial services to banks and other depository institutions and the federal government. In addition, it has important roles in operating the nation's payments systems and protecting consumers' rights in their dealings with banks.


Federal Reserve Board of Governors. The chairman and the six other members of the Board of Governors are appointed by the President of the United States, confirmed by the Senate, and serve staggered 14-year terms. The Board has regulatory and supervisory responsibilities over member banks and other banking organizations that are subject to its jurisdiction; plays a key role in assuring the functioning and development of the nation's payments system; and issues a variety of banking and consumer-credit regulations (e.g., development and administration of regulations implementing the Truth in Lending Act and the Equal Credit Opportunity Act).

The Board approves the discount rate (the interest rate at which Federal Reserve Banks extend short-term loans to depository institutions) that is recommended by the board of directors of each of the twelve Federal Reserve Banks. Its power to set margin requirements, which limit the use of credit for purchasing or carrying securities, provides the Board with a limited role in regulating operations of the stock market. The Board can control the money supply by changing the required reserve ratio, which is the percentage of deposits that banks must maintain on reserve at the Federal Reserve banks. Reserve requirements currently are assessed on the depository institution's net transaction accounts (mostly checking accounts). (Effective December 30, 2010 the reserve requirement for transaction deposits was 0% on amounts $0 to $10.7 million, 3% on amounts over $10.7 million to $58.8 million, and 10% on amounts in excess of $58.8 million. There are no reserves required for time deposits) Raising the reserve ratio requires banks to place more money in reserve thereby reducing the funds available and raising interest rates. However, the Open Market Committee's open-market operation is considered more flexible and, therefore, is used more frequently as an instrument of monetary policy. The Board has a majority (7 out of 12) of the votes on the Federal Open Market Committee (FOMC) and plays a key role in the decisions of this committee.

Federal Open Market Committee (FOMC). The Open Market Committee is the most important monetary policymaking body of the Federal Reserve System. It determines the nation's monetary policy with the objective of promoting economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments. It also makes key decisions regarding the conduct of open market operations (i.e., the purchase and sale of U.S. government and federal agency securities), which affect the provision of reserves to depository institutions and, in turn, the cost and availability of money and credit. The twelve members of the Open Market Committee consist of the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York (the monetary policy of the Open Market Committee is implemented by the New York Fed), and four other Reserve Bank presidents, each of whom serve one-year terms as voting members on a rotating basis. The Chairman of the Board of Governors also serves as Chairman of the Open Market Committee. The Open Market Committee holds regularly scheduled meetings every six weeks.

If the Open Market Committee determines that the supply of money is critical in keeping the economy either expanding or contracting, it will direct the New York Fed to purchase U.S. government securities from banks and brokerage houses, thereby injecting cash into the financial system and expanding the monetary supply. This in turn enables the banks and brokerage houses to lend the money to clients. More money in the economy means money will be less expensive, interest rates will fall, and businesses will borrow the money and use it to create new jobs, goods, and services. Conversely, if the money supply grows too rapidly and inflation becomes a problem, the Open Market Committee will direct that federal securities be sold on the open market. These sales reduce bank reserves and therefore the ability of the banking system to create deposits. This tends to drive up the costs of money, businesses put off borrowing, and the economy cools down. At least, this is the theory. But there can be no doubt that the actions of the Fed have a very direct effect on the stock markets, and much attention is paid to any changes in money policy, particular impending changes in interest rates.

Federal Reserve Banks. Each of the twelve Federal Reserve Banks is headed by a president appointed by the bank's nine-member board of directors. Three of the board of directors represent the commercial banks in the bank's region that are members of the Federal Reserve System. The other six directors are selected to represent the public with due consideration to the interest of agriculture, commerce, industry, services, labor, and consumers. Three of these six directors are elected by member banks and the other three are chosen by the Board of Governors. Each Federal Reserve Bank supervises and regulates both bank holding companies and state chartered banks that are members of the Federal Reserve System; provides services to depository institutions; and functions as a fiscal agent of the U.S. government.

Federal Advisory Council. The Federal Advisory Council, composed of a representative from each of the twelve Federal Reserve Districts, confers periodically with the Board of Governors of the Federal Reserve System on business conditions and issues related to the banking industry. It also makes recommendations regarding system policies. Representatives are selected annually by the board of directors of each reserve bank.

Federal Funds Rate. When banks have more funds then needed to meet their reserve requirements they can make overnight deposits of these funds in a Federal Reserve Bank. Other banks can then borrow these funds in order to meet their own short-term reserve requirements. The rate charged between banks on this overnight borrowing is known as the federal funds rate. This practice has benefits for the both the lending bank, which earns | interest on otherwise idle funds, and the borrowing bank, which is able to increase its reserves in order to make more loans. A rise in the federal funds rate typically signals a withdrawal of reserves through the Fed's open market operations that will cause interest rates to increase (see page 52). In contrast, a lowering of the federal funds rate signals an easing of the Fed's monetary policy and a lowering of interest rates. Investors closely watch the federal funds rate as an indicator of Federal Reserve monetary policy and movements in the rate can have a strong effect on stock prices. However, these rates tend to experience sharp daily fluctuations that can compromise their significance.

Keeping Current

The federal funds rate is given daily under the Money Rates table of The Wall Street Journal.

The Money Supply. The term money supply refers to the amount of money freely circulating in the economy that is available for individuals to spend. Control of the money supply by the Federal Reserve Bank is accomplished in one of three ways: buying and selling government securities; increasing or decreasing the required reserve ratios that banks must maintain with a Federal Reserve bank; and raising or lowering the discount rate (i.e., the interest rate banks pay on money borrowed from the Federal Reserve). See discussion of the discount rate below. The following designations, also called money aggregates, are used to keep track of the money supply according to the degree of liquidity, with M1 being the most liquid:

M1 includes cash, traveler's checks, and other demand deposit or checking accounts from which money can be withdrawn on demand (i.e., it is money that can be spent immediately). M1 is sometimes referred to as "narrow money."

M2 includes M1 plus savings and time deposits of $100,000 and under such as CDs, money market accounts, and money market mutual funds (i.e., assets that are invested for the short term). M2 is sometimes referred to as "broad money." For many years the M2 monetary aggregate maintained a stable, predictable relationship with output and inflation, allowing it to serve as a primary indicator of monetary policy. Although this relationship appeared to break down during the early 1990s, caused in part by a blurring of the distinctions between M1 and M2, M2 may have begun to regain its value as a policy indicator. It remains one of the ten components of the leading economic indicators, an index that is regarded as a barometer of economic activity (see description on page 59).

M3 includes M2 plus savings deposits of more than $100,000, institutional money-market funds, and agreements among banks (i.e., big deposits). M3 is sometimes referred to as "broadest money."

L includes M3 plus commercial paper and private holdings of government securities, such as savings bonds and treasury notes. Economists do not agree on the actual effects changes in the money supply have on the economy. Keynesians maintain that increases in the money supply will lead to increased employment and output, whereas monetarists maintain that an increase in the money supply only results in price increases and inflation, without an increase in output.

Keeping Current

The latest M1, M2, and M3 figures can be obtained at: releases/h6/hist/h6hist1.txt.

Discount Rate. This is the rate charged by the twelve Federal Reserve banks for short-term loans made to member banks. Typically this acts as a benchmark for the rate used for consumer borrowing from banks. The stock market generally views a rise in the discount rate as bearish since rising interest rates tend to indicate a fall in stock prices. Conversely, a fall in interest rates is viewed as bullish.

Keeping Current

Both the discount rate and the prime rate are given daily under the Money Rates table of The Wall Street Journal.

Prime Rate. This is the rate that large commercial banks charge their best corporate customers. Again, a rising prime rate is considered bearish, whereas a falling prime rate is considered bullish.


Federal Deposit Insurance Corporation (FDIC). The FDIC directly examines and supervises about 5,160 banks and savings banks, more than half of the institutions in the banking system. The FDIC also protects depositors against loss if a bank experiences financial difficulties. The insurance provided extends up to $100,000 (temporarily increased to $250,000) per depositor in virtually all United States banks and savings associations (also called savings and loan associations or S&Ls). It does not regulate banks, that is the job of the Federal Reserve and state agencies. However, the FDIC is the primary federal regulator of the state-chartered "nonmember" banks (commercial and savings banks that are not members of the Federal Reserve System). Savings, checking and other deposit accounts, when combined, are generally insured to $250,000 per depositor in each bank or thrift the FDIC insures. The standard insurance amount of $250,000 per depositor is in effect through December 31, 2013. On January 1, 2014, the standard insurance amount will return to $100,000 per depositor for all account categories except IRAs and other certain retirement accounts, which will remain at $250,000 per depositor.

Securities Investor Protection Corporation (SIPC). When a brokerage firm is closed due to bankruptcy or other financial difficulties, the SIPC, within limits, steps in and works to return an investor's cash, stock and other securities. However, insurance for investment fraud does not exist in the U.S. The risk-based investment marketplace is quite different from the world of banking and it is important to understand that in the world of securities the SIPC is not the equivalent of the Federal Deposit Insurance Corporation (FDIC). Protection only extends to customers of SIPC members and, even then, it is not the purpose of the SIPC to compensate all victims in the event of loss due to investment fraud. That said, the SPIC's track record is quite impressive. The SIPC estimates that no fewer than 99% of eligible investors have been made whole through the efforts of the SIPC.

Securities And Exchange Commissions (SEC). The SEC is the primary overseer and regulator of the U.S. securities markets. Critical to its mission is to protect investors and maintain the integrity of the securities markets by assuring a steady flow of timely, comprehensive and accurate information. So that people can make sound investment decisions the SEC requires public companies to disclose meaningful financial and other information to the public. The SEC also oversees other key participants in the securities world, including stock exchanges, broker-dealers, investment advisors, mutual funds, and public utility holding companies. In exercising its enforcement authority, the SEC brings civil enforcement actions against individuals and companies that break the securities laws. Typical infractions include insider trading, accounting fraud, and providing false or misleading information about securities and the companies that issue them.

Financial Industry Regulatory Authority (FINRA). Created in July 2007 through the consolidation of the NASD and the member regulation, enforcement, and arbitration functions of the New York Stock Exchange, FINRA oversees nearly 4,580 brokerage firms, about 162,850 branch offices, and 630,695 registered securities representatives. FINRA touches virtually every aspect of the securities business--from registering and educating industry participants to examining securities firms; writing rules; enforcing those rules and the federal securities laws; informing and educating the investing public; providing trade reporting and other industry utilities; and administering the largest dispute resolution forum for investors and registered firms.


Commercial Banks. Of all deposit-type financial institutions commercial banks are the largest and most visible. They offer a full range of financial products and services, including checking accounts, savings accounts, credit cards, consumer and business loans, trust services, safe deposit boxes, traveler's checks, ATM services, check cashing privileges, overdraft protection, savings accounts with check writing privileges, foreign exchange services, and financial counseling. Until the mid-1970s, the full-service nature of commercial banks afforded them a substantial competitive edge over other financial institutions. (Interestingly, the term "Full Service Bank" is a registered trademark of the American Bankers Association.) However, the deregulation of the financial market in the 1980s has in many ways blurred the differences between commercial banks and other deposit-type institutions. In 1999, the playing field was further leveled by legislative changes that enabled commercial banks to act as broker/dealers, meaning they can now sell securities, mutual funds, and variable annuities. Deposits up to $100,000 (temporarily increased to $250,000, see page 55) are federally insured through the Federal Deposit Insurance Corporation (FDIC). Certain retirement accounts, such as IRAs and Keoghs, are insured up to $250,000.

Credit Unions. Credit unions are essentially cooperatives providing financial products and services to a group of individuals who share the same employer or some other common interest or characteristic. Only members may save at or borrow from a credit union. They offer many different forms of savings accounts, including interest paying checking accounts, called share draft accounts. As mutual associations, they pay dividends, rather than interest, on savings accounts. Because they are nonprofit, the savings rates tend to be somewhat higher than those offered by commercial banks. Likewise, their loans rates tend to be lower. A variety of loans are typically offered, including auto loans, home equity loans, secured and unsecured loans, and both single payment and installment loans. Deposits up to $100,000 (temporarily increased to |250,000, see page 55) are insured by the National Credit Union Share Insurance Fund (NCUSIF), which is administered by the National Credit Union Administration and backed by the "full faith and credit" of the U.S. Government. Certain retirement accounts, such as IRAs and Keoghs are insured up to $250,000.

Savings And Loan Associations (S&Ls). Second only to commercial banks in the size of their savings deposits and assets, savings and loan associations are organized as either mutual associations owned by their depositors, or as corporations owned by their stockholders. Since deregulation, except for demand deposits (i.e., checking accounts), they tend to offer the same products and services as commercial banks. However, their savings accounts generally pay somewhat higher rates than those available at commercial banks. Most savings and loan associations are federally insured through the Federal Deposit Insurance Corporation (FDIC) for deposits up to $100,000 (temporarily increased to $250,000, see page 55). Certain retirement accounts, such as IRAs and Keoghs, are insured up to $250,000. (The Federal Savings and Loan Insurance Corporation (FSLIC) has been abolished and its functions transferred to the FDIC.) In New England, S&Ls are often known as cooperative banks.

Mutual Savings Banks. Mutual savings banks are found primarily on the east coast. They are mutual associations owned by their depositors, and are very similar to savings and loan associations. The deposits in most mutual savings banks are federally insured through the FDIC.

Brokerage Services. Both "full-service brokers" and "discount brokers" offer these services. Discount brokers generally execute trades for substantially less than the amount charged by full-service brokers. However, the full-service broker often provides clients with a wide variety of services such as research reports, newsletters, advice on security selection, and financial planning. Both full-service and discount brokers now offer extensive online services.

NASDAQ. This is the acronym for the National Association of Securities Dealers Automatic Quotation System. It is a computerized system linking brokers and dealers in providing price quotations for both over-the-counter and some New York Stock Exchange listed securities. Traditionally the home of emerging companies, telecommunications, and high-tech stocks, securities traded on the NASDAQ must meet specific listing criteria regarding both market capitalization and trading activity. The NASDAQ is considered a very active and highly volatile market. In the United States it is owned and operated by NASDAQ OMX Group, Inc.

Over-The-Counter Market. Also referred to as the OTC market, this is a decentralized market comprised of geographically dispersed dealers who are linked via electronic communications and telephones. Securities are bought and sold by dealers, who in turn sell them to and buy them from investors. In contrast to the organized exchanges where prices are set by auction, the OTC market sets prices by negotiation. Securities purchased OTC are often referred to as OTC instruments, whereas securities purchased on organized exchanges are referred to as exchange-traded contracts. In addition to bonds and other fixed income securities, derivatives and small capitalization stocks are traded OTC.

Keeping Current

To learn more about the over-the-counter market go to: www.

Exchanges. This is the place where securities, commodities, options, and futures are traded, generally using an auction or open outcry system. The principal United States exchanges are the New York Stock Exchange (NYSE) and the National Association of Securities Dealers Automatic Quotation System (NASDAQ). The NYSE is often referred to as "The Exchange," or the "Big Board." The exchange formerly known as the American Stock Exchange (AMEX) was acquired in 2008 by NYSE Euronext, renamed NYSE Alternext US, and then again renamed NYSE AmexEquities.
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Author:Cady, Donald F.
Publication:Field Guide to Financial Planning
Date:Jan 1, 2011
Previous Article:Chapter 2: Investment concepts & principles.
Next Article:Chapter 4: Measuring economic health & market performance.

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