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The Federal Reserve system.

Editor's Note: We've had several questions about the Federal Reserve System - how it works - how do the regional banks operate. Here is the first article in a series designed to address these questions.

To many people, the operations of the U.S. Federal Reserve System are more than confusing, they can be downright mysterious. Sure, our politicians and newscasters can often be heard referring to "the Fed," but how many of us really understand this complex part of the American government and economy?

The Federal Reserve System was founded by Congress in 1913 and today remains the central bank of the United States. The Fed provides the nation with a safer, more flexible, and more stable monetary and financial system; over the past 80 years, its role in banking and the economy has changed and expanded.

Today, the Federal Reserve's duties fall into four general areas:

* Conducting the nation's monetary policy by influencing the money and credit conditions in the economy in pursuit of full employment and stable prices;

* Supervising and regulating banking institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers;

* Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets;

* Providing certain financial services to the U.S. government, to the public, to financial institutions, and to foreign official institutions, including playing a major role in operating the nation's payments system.

The Fed is not unique in the global marketplace; most developed countries have a central bank whose functions are similar to those of the Federal Reserve. The Bank of England has served as a central bank since the end of the 17th century. Napoleon I established the Banque de France in 1800, and the Bank of Canada was founded in 1935. The German central bank was dismantled, then reestablished after WW II and is loosely modeled on the Federal Reserve.


One of the driving forces creating the need for a central bank in any country is the problem of financial crises and resulting panic. Before Congress created the Federal Reserve System, financial panics had plagued the nation. Such panics contribute to bank failures, business bankruptcies, and general economic downturns. A particularly severe crisis hit in 1907 and prompted Congress to establish the National Monetary Commission, which proposed to create a national institution that would deter such crises. After considerable debate, Congress passed the Federal Reserve Act, which President Woodrow Wilson signed into law on December 23, 1913. According to the act, the Fed's purposes are, "to provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes."

Shortly after the Fed was created, Congress realized that the act had broader implications for national economic and financial policy. Subsequent legislation has clarified and amended the Fed's original outlined purposes. Key laws affecting the Federal Reserve include the Banking Act of 1935; the Employment Act of 1946; the 1970 amendments to the Bank Holding Company Act; the International Banking Act of 1978; the Full Employment and Balanced Growth Act of 1978; the Depository Institutions Deregulation and Monetary Control Act of 1980; the Financial Institutions Reform, Recovery, and Enforcement Act of 1989; and the Federal Deposit Insurance Corporation Improvement Act of 1991.

The Employment Act of 1946 and the Full Employment and Balanced Growth Act of 1978 (the latter sometimes called the Humphrey-Hawkins Act after its original sponsors) were passed by Congress to define and clarify the objectives of national economic policy. These objectives include economic growth in line with the economy's potential to expand; a high level of employment; stable prices; and moderate long-term interest rates.

The Federal Reserve System is considered an independent central bank because its decisions are not ratified by the president or anyone else in the executive branch of government. Rather, Congress is responsible for oversight of the Fed because the Constitution empowers Congress to coin money and set its value - a power that, in the 1913 act, Congress delegated to the Federal Reserve. The Fed is by no means truly independent, however. It must work within the guidelines and objectives of economic and financial policy established by the government.

Structure of the System

The Fed's structure gives it a broad perspective on the economy in all parts of the country. It is a Federal system, composed of a central governmental agency - the Board of Governors - located in Washington, D.C., and 12 regional Federal Reserve Banks, located in major cities throughout the U.S. Together, these components:

* supervise and regulate certain financial institutions and activities;

* provide banking services to depository institutions and to the federal government;

* and ensure that consumers receive information and fair treatment in dealing with the banking system.

One major component of the system is the Federal Open Market Committee (FOMC), which comprises the Board of Governors, the president of the Federal Reserve Bank of New York, and presidents of four other Federal Reserve Banks, who serve on a rotating basis. The FOMC oversees open market operations, which is the main tool used by the Federal Reserve to influence money market conditions and the growth of money and credit.

There are two other groups integral to the workings of the Fed: depository institutions, through which the tools of monetary policy operate, and advisory committees, which make recommendations to the Board of Governors and to the Reserve Banks regarding the System's responsibilities.

The Board of Governors is a Federal agency and has seven members who are appointed by the President of the United States and confirmed by the U.S. Senate. The full term of a board member is 14 years and members may not be reappointed. The chairman and the vice chairman of the board are also appointed by the president and confirmed by the Senate. The nominees to these posts must already be members of the board or must be simultaneously appointed to the board. The terms for these positions are four years.

The Board of Governors in Washington, D.C. employs a staff of about 1,700 who are responsible for thorough analysis of domestic and international financial and economic developments. The Board also supervises and regulates the operations of the Federal Reserve Banks and their branches and the activities of various banking organizations, exercises broad responsibility in the nation's payments system, and administers most of the nation's laws regarding consumer credit protection.

The Federal Reserve System uses three major tools:

* Open market operations - the buying and selling of U.S. government securities in the open market to influence the level of reserves in the depository system;

* Reserve requirements - requirements regarding the amount of funds that commercial banks must hold in reserve against deposits;

* The discount rate - the interest rate charged commercial banks and other depository institutions when they borrow reserves from a regional Federal Reserve Bank.

The Federal Reserve also plays a major role in supervising and regulating the U.S. banking system. Banking supervision - the examination of institutions for safety and soundness and for compliance with law - is shared with the Office of the Comptroller of the Currency, which supervises national banks, and the Federal Deposit Insurance Corporation, which supervises state banks that are not members of the Federal Reserve System. The Board supervises the roughly 1,000 state banks that are members of the Federal Reserve System, all bank holding companies, the foreign activities of member banks, and the U.S. activities of foreign banks.

The Board can pass regulations affecting the entire banking industry or rules that apply only to member banks, that is, state banks that have chosen to join the Federal Reserve System and national banks, which by law are automatically members of the System. The Board also issues regulations to carry out major federal laws governing consumer credit protection, such as Truth in Lending, Equal Credit Opportunity, and Home Mortgage Disclosure; many of these regulations apply to various lenders outside the banking industry as well as to banks.

Members of the Board of Governors are in continual contact with policymakers in government and frequently testify before congressional committees on the economy, monetary policy, banking supervision and regulation, consumer credit protection, financial markets, and other matters. The Board of Governors is also responsible for submitting a report on the economy and the conduct of monetary policy to Congress by February 20 and July 20 of each year.

Banks and Branches

A network of 12 Federal Reserve Banks and their 25 branches carries out a variety of Fed functions, including operating a nationwide payments system, distributing the nation's currency and coin, supervising and regulating member banks and bank holding companies, and serving as banker for the U.S. Treasury. Each Reserve District is identified by a letter and a number. All U.S. currency carries the letter and number designation of the Reserve Bank that first puts it into circulation. Besides carrying out functions for the System as a whole, such as administering nationwide banking and credit policies, each Reserve Bank acts as a depository for the banks in its own district and fulfills other district responsibilities.

In addition to the central Board of Governors office in Washington, D.C., there are 12 reserve banks in various cities. Those cities are: Boston, New York, Philadelphia, Cleveland, Richmond, Va., Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Mo., Dallas, and San Francisco. The Board of Governors exercises broad authority over the operations and activities of these branches, including oversight of the Reserve Banks' services to banks and other depository institutions and of their examination and supervision of various banking institutions. Each Federal Reserve Bank must submit its annual budget to the Board of Governors for approval.

Although the individual branches operate independently of one another in their regions, they are all linked by the policy decisions made at the top. The Federal Reserve is considered an independent government body, but it is important to note that the branches and the Fed itself actually operate "independently within the government".
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Title Annotation:part 1
Publication:Business Credit
Date:Jul 1, 1995
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