Summary of the Federal Reserve System - Example

Summary of the Federal Reserve System The Federal Reserve System frequently known as the Federal Reserve or just “the Fed”, is the America’s central bank and was formed as an act of Congress to offer the country a safer, more stable and flexible financial and monetary system. The FED was founded on 23rd December 1913 after President Woodrow Wilson assented to the Federal Reserve Act into law. Presently, the FED’s roles fall into 4 general areas; Acts as a supervisor and regulator of banks as well as crucial financial organizations to ensure soundness and safety of the country’s financial and banking system, in addition to protecting consumers’ credit rights. Conducts the country’s monetary policy by controlling credit and money conditions in the country’s economy in quest for complete employment as well as stable prices. Sustains the stability of the nation’s financial system and restraining systematic threat that may occur in financial markets. Offering specific financial services to the government of U.S, foreign institutions and U.S financial institutions together with playing a key task in overseeing and operating the country’s payment systems. History of the Federal Reserve System The Fed is the 3rd central banking system in the history of the US. The first 2 banks of the US; First Bank of the US (1791-1811) as well as the Second Bank of US (1817-1836) were each granted a 20 year charter. The two banks both accepted deposits, bought securities, issued currency, created commercial banks in addition to maintaining several branches and acting as US treasury’s fiscal agents (Wells, 2004). The formation Federal Reserve Bank A severe financial fright in 1907 shook Wall Street forcing numerous banking institutions into liquidation. This fright, nevertheless, failed to prompt a wide range financial collapse. Nevertheless, the simultaneous happenings of common prosperity with a crisis in the country’s financial centers convinced several Americans that their structure of banking was regrettably outdated and needed a major shakeup (Wells, 2004). The congress in 1908 formed the National Monetary Commission which was headed by Nelson W. Aldrich and made up of members of the Senate and the House of Representatives. The plan that resulted demanded for a National Reserve Association; which apparently would have the banking industry dominating it. Nevertheless, this idea was met with great skepticism with very little support from the public (Wells, 2004). The House Banking and Currency Committee, in1912, held hearings so as to study the country’s management of the financial and banking resources. The other key incident that led to America’s financial reform occurred in 1912 when Woodrow Wilson was elected as president. The President together with his secretary resisted any proposal that would give banks a lot of control. The Glass-Willis plan was on 26 December 1912, presented to Woodrow Wilson who had just been elected in office. This proposal by Glass-Willis planned for the formation of 20 0r more regional reserve banks that would be privately controlled. These regional reserve banks would perform central banking roles such as issuing currencies and holding a portion of member banks’ reserves. Whereas Wilson nodded to the plan, he nevertheless stressed upon formation of a central board that would be charged with coordinating and controlling the activities of the regional reserve banks (Wells, 2004). Congressman Carter Glass presented the Federal Reserve Act together with Senator Robert L. Owen integrated adjustments by Wilson and permitted for a regional Federal Reserve System, that would function under a controlling board based in Washington, D.C. This Act was accepted by the Congress and was signed into law on 23rd December 1913.This is the Act that made a provision for the formation of Federal Reserve Banks, so as to provide an elastic currency, furnish means of rediscounting commercial paper, in addition to establishing a more efficient supervision of the US banking system as well as other functions. In addition, the Act also made a provision for a Reserve Bank Organization Committee that would appoint no less than 8 but not exceeding 12 cities to be turned into Federal Reserve cities and then would later divide the country into districts, with every district having one Federal Reserve City(Wells,2004). Structure of the Federal Reserve The FED is made up of 5 parts; The Federal Reserve Board (Board of Governors) that is appointed by the president and is an autonomous federal government agency whose location is Washington D.C. 12 Federal Reserve Banks regional situated in main cities throughout the country, which subdivides the country into 12 Federal Reserve districts. These Federal Reserve Banks serve as fiscal instruments for the treasury. Everyone has its own individual 9 directors serving as members of the board. Several other private member banks in US which have the needed quantities of non-transferable stake in their respective regional Federal Banks. Different advisory councils and The federal Open Committee(FOMC) which consists of the 7 members of the Federal Reserve Board as well as 5 of the 12 presidents of the Federal Reserve Bank ,which supervises open market operations, the key instrument of America’s monetary policy(Grey,2002). The Federal Reserve Board offers leadership for the Federal system and the 7 governors are usually appointed by the president and later confirmed by the senate. The governors have a staggering term of 14 years so as to ensure continuity and stability over time. No one owns the Federal Reserve nor is it a profit making private institution. It is an autonomous body inside the government with both private aspects and public functions (Wells, 2004). Functions of the Federal Reserve System The Federal Reserve System has a critical function as far as the payment system in US is concerned. Thus, the 12 Federal Reserve Banks offer banking services to the federal government and various depository institutions. They maintain accounts as well as offer different payment systems comprising of checks collection, transferring funds electronically, distribution and receipt of coins and currency to the depository institutions. On the other hand, they act as fiscal agents for the Federal government through payment of Treasury checks, electronic payments processing and transferring, redeeming and issuing of government securities. The Federal Reserve is also a system that serves a very crucial role as an intermediary in the clearance and settlement of interbank payments. Thus the Reserve Banks are responsible for settling payment transactions effectively by effecting payments as well as crediting various accounts of depository institutions receiving those payments. In this capacity, the Federal Reserve has a crucial role in both the country’s wholesale and retail payment systems, a wide range of financial services to depository organizations (Grey, 2002). Another critical role of the Federal Reserve is that of making sure that there is adequate cash (coin and currency) circulating to meet the public’s demand. The demand for cash by public is variable and it usually decreases or increases seasonally with the change in the level of a country’s economic activity. Every one of the 12 Reserve Bank is mandated by the Federal Reserve System to issue currency with the Treasury Department mandated to give out coins. The federal banks also serve as America’s fiscal agents and they operate as government’s bank, performing a wide array of services for the US treasury, government agencies, international organizations and other enterprises sponsored by the government. Thus the fiscal agent roles carried out by these Reserve Banks offer are alike to the services that are provided by the Reserve system to the commercial banks. One of the exceptional roles provided by the Reserve Banks to the Treasury is a plan through which the Treasury monies are invested by the Reserve Banks until when required to fund operations of the government. Normally, the treasury gets money from 2 key sources which comprise of borrowings and tax receipts (Grey, 2002). The other critical role of the Federal Reserve is that of provision of international services. The Federal Reserve being the Central Bank of US undertakes various services for international organizations like the IMF and International Bank of Reconstruction and Development. Some of the services provided to these organizations include securities safekeeping accounts, maintenance of non-interest bearing deposit accounts as well as gold safekeeping accounts. Monetary tools for implementation of monetary policy The objectives of the monetary policy comprise of promotion of maximum employment, stabilizing prices as well as moderating long-term interest rates. The Fed can sustain stable prices through implementing efficient monetary policy. This will support conditions for maximum employment and long-term economic growth. The following are tools that are used by the Federal Reserve to implement monetary policy; open market operations, reserve requirements and discount rate (Grey, 2002). Open market operation-this operation comprises of buying as well as selling government securities. As the term implies it means that these are operations that are carried out by the Fed in the open market. Thus the Fed may be involved in buying and selling government securities in the open market. When the Fed for instance wants the rate for the funds to fall, it buys government securities from various banks. It then pays for such securities by raising the reserves in those banks. Consequently, the banks now have more reserves than they need, implying that the banks can lend out those unwanted reserves to other financial institutions trading in the federal funds market. As a result, the purchasing of the Fed in the open market raises the supply of reserves to the banking system, leading to the falling of federal funds rate. The moment the Fed wants rate of the funds to rise, it executes the reverse, meaning that it will start selling government securities. The banks pays the Fed using reserves which lowering the supply of reserves held by the banks and the fund rate effectively rises (Grey, 2002). Discount rate Discount rate can be described as the interest rate that is charged by Federal Reserve Banks to depository institutions on loans taken for a short-term. Banks have “discount windows” through which they can directly borrow from the Federal Reserve Banks. The discount rate normally is the rate at which banks that are financially sound must pay for this kind of credit. The discount rate is normally set at a higher rate than the funds rate so as to discourage banks from using this window before exhausting other cheap alternatives (Grey, 2002). Reserve requirement Reserve requirements normally are the portions of deposits that are maintained by banks either as a deposit at a Federal Reserve Bank or in their vaults. Thus banks are obligated to set aside a certain amount of reserves so as to meet unanticipated outflows .Typically, they may even hold over what is needed of them so as to restock ATMS, clear overnight checks and meet other payment obligations(Grey, 2002). The impact of Fed Policy before, during and after the Great Recession The 2007-09 financial crisis is broadly seen as the worst financial distraction ever since the 1929-33 Great Depression. The 2007-09 crisis reflected fear in general funding markets leaving banks incapable of rolling over short term debts. The 2007-09 crisis was basically a banking crisis just like several other crises that had preceded it. The crisis started in December 2007 and ended in mid 2009.Financial, fiscal and monetary policies are broadly attributed for reducing the impact of the 2007-09 financial crisis on the general economy. The Board of Governors of the Federal Reserve System, chairman, Ben Bernanke, has been praised for assisting in preventing an economic freefall. Bernanke also talked of “aggressive” policies aimed at shielding the global economy from the financial catastrophe. Originally, the Fed’s focus was on availing funds to banks together with other financial institutions. Nevertheless, the Fed made use of open market operations to avoid lending to individual institutions from raising total monetary base or banking system reserves (Wheelock, 2010). With the intensification of the crisis, the Fed invoked on authority given during the depression to offer emergency loans particularly to distressed non-banking institutions. In addition, the Fed reduced its target for the federal monies rate successfully to zero and finally bought huge amounts of US Treasury as well as agency debt together with mortgage-backed securities. Though the crisis reduced in October 2007, it reappeared again in November. The Federal Reserve further on 12th December declared the formation of swap lines (reciprocal currency agreements) with Swiss national Bank and the European Central Bank to offer a source of dollars in funding European Central Bank. The Fed would establish swap lines over the following 10 months with 14 central banks. In addition, the Fed instituted the formation of the Term Auction Facility (TAF) on December 12 to loan money directly to commercial banks for a fixed period (Wheelock, 2010). The efforts of the Fed to ease the financial crisis and therefore rouse the economy by directing credit to particular institutions and markets were not effective, and merely a policy whose aim was to increase the monetary base. Observers point to a reduction in growth of money stock in mid-2008 as proof that the recession would not have been that severe if the Fed had increased the monetary base earlier. Some other observers argued that Fed’s lending to particular firms in addition to supporting specific markets may have severe prolonged consequences. Thus, for example, such kind of lending may have destabilized creditors’ incentives to penalize and monitor extreme risk-taking by institutions thought to be “too big to fail”. Targeted lending also affects the political independence of the Fed, which is important to practicing a stable monetary policy(Wheelock, 2010). Works cited David, Wheelock. "Lessons Learned?Comparing the Federal Reserves Responses to the Crises of 1929-1933 and 2007-2009." Federal Reserve Bank of St.Louis Review (2010): 89-102. Donald, Wells. The Federal Reserve System:A History. New York: McFarland, 2004. George, Grey. Federal Reserve System:Background,Analyses and Bibliography. New York: Nova Science Publishers, 2002. Read More