Federal Reserve System

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Formed in 1913

Central banking system of the United States

Headquarters- Washington, D.C.

Chairman -- Janet Yellen

Employees (2012) -- 18,300

Annual budget (2012) -- $3.46 billion (Board of Governors budget (2012) -- $497.4 million)

Base borrowing rate- 0%-0.25%

Website- federalreserve.gov

Overview

The Federal Reserve (the “Fed”) is the nation’s central bank. A quasi-public institution founded by the U.S. government, the Fed wields enormous power over the financial system and the economy of the United States. Consisting of a dozen regional banks and led by a presidentially-appointed board, the Fed makes decisions that can raise or lower interest rates, increase or decrease the money supply and regulate the activities of banks and other financial institutions, among other things. Since its founding in the early 20th Century, the Fed has been scrutinized for its many controversial decisions. During its early years, it was faulted for not doing more to prevent the Great Depression of the 1930s. In 2008, the Fed has made several controversial decisions as the nation’s struggles with the greatest threat to the U.S. financial system since the Stock Market crash of 1929. The Fed has moved to prevent certain major financial institutions from going bankrupt, while allowing others to falter and be sold to rivals. Perspectives on the Federal Reserve range from helping it grow even more powerful to abolishing it altogether.

History

The United States’ first paper currency was known as “continentals,” printed to finance the American Revolution. The currency was printed in such quantities that it led to inflation, and the American people soon lost faith in the notes.

At the urging of the federal government’s first Treasury Secretary, Alexander Hamilton, Congress established the First Bank of the United States, headquartered in Philadelphia, in 1791. It was the largest corporation in the country and was dominated by big banking and money interests. Many ordinary Americans were uncomfortable with the idea of a large, powerful central bank, and so were numerous lawmakers. When the bank’s 20-year charter expired in 1811, Congress refused to renew it.

A Second Bank of the United States won approval in Congress five years later, in 1816. But like the first bank, this second bank had its detractors, including President Andrew Jackson, whose opposition helped kill the bank when its charter expired in 1836.

For the next several decades, state-chartered banks and unchartered “free banks” popped up around the country and issued their own bank notes, redeemable in gold or silver. Banks also began offering demand deposits (the forerunner to modern checking accounts) to bolster banking opportunities for citizens.

During the Civil War, the National Banking Act of 1863 was passed, providing for

nationally-chartered banks whose circulating notes had to be backed by U.S.

government securities. An amendment to the act required taxation on state bank

notes but not national bank notes, effectively creating a uniform currency for the

nation. Despite taxation on their notes, state banks continued to flourish due to the

growing popularity of demand deposits.

Although the National Banking Act of 1863 established some measure of currency

stability for the country, bank runs and financial panics plagued the economy. In 1893 a banking panic triggered the worst depression the United States had seen up to that point, and the economy stabilized only after the intervention of financial mogul J.P. Morgan.

In 1907, Wall Street was rocked by a severe bank panic. By this time many Americans were calling for reform of the banking system, including the creation, once again, of a central banking authority. The Aldrich-Vreeland Act of 1908 established the National Monetary Commission to search for a long-term solution to the nation’s banking and financial problems. The commission developed a banker-controlled plan, but many progressives attacked the plan, calling instead for the creation of a central bank under public, not banker, control.

President Woodrow Wilson inherited the banking problem when he was elected in 1912. He turned to Virginia Congressman Carter Glass, chairman of the House Committee on Banking and Finance, and H. Parker Willis, formerly a professor of economics at Washington and Lee University, for help in crafting a solution. Their plan developed into the Federal Reserve Act, which was adopted on December 23, 1913. The law called for establishing a decentralized central bank, but did not specify how this would be done. Instead, the Reserve Bank Organizing Committee, comprised of Treasury Secretary William McAdoo, Secretary of Agriculture David Houston, and Comptroller of the Currency John Skelton Williams, built a working institution by choosing 12 cities to host a regional Reserve Banks.

Under the provisions of the Federal Reserve Act, the Federal Reserve Board was composed of seven members, including five appointed members, the Secretary of the Treasury, who was ex-officio chairman of the board, and the Comptroller of the Currency. The original term of office was ten years, and the five original appointed members had terms of two, four, six, eight, and ten years, respectively. In 1922 the number of appointed members was increased to six, and in 1933 the term of office was increased to twelve years.

Following World War I, Benjamin Strong, head of the New York Federal Reserve Bank, recognized that gold no longer served as the central factor in controlling credit. Strong’s aggressive action to stem a recession in 1923 through a large purchase of government securities gave strong evidence of the power of open market operations to influence the availability of credit in the banking system. During the 1920s the Federal Reserve (a.k.a. the Fed) began using open market operations as a monetary policy tool.

During the 1920s, Congressman Glass warned that stock market speculation would lead to dire consequences. In October 1929 his predictions came true when the stock market crashed, and the nation fell into the worst depression in its history. From 1930 to 1933, nearly 10,000 banks failed. Many people blamed the Federal Reserve for failing to stem speculative lending that led to the crash, and some also argued that inadequate understanding of monetary economics kept the Federal Reserve from pursuing policies that could have lessened the depth of the Depression.

In March 1933, President Franklin Roosevelt declared a bank holiday. In reaction to the crisis, Congress passed the Banking Act of 1933, better known as the Glass-Steagall Act, calling for the separation of commercial and investment banking and requiring use of government securities as collateral for Federal Reserve notes. The act also established the Federal Deposit Insurance Corporation (FDIC), placed open market operations under the Federal Reserve, and required bank holding companies to be examined by the Federal Reserve. Also, Roosevelt recalled all gold and silver certificates, effectively ending gold and any other metallic standards that backed currency.

The Banking Act of 1935 called for further changes in the Federal Reserve’s structure, including changing the name of the Federal Reserve Board to the Board of Governors of the Federal Reserve System and creating the Federal Open Market Committee (FOMC) as a separate legal entity. The act also removed the Treasury Secretary and the Comptroller of the Currency from the Fed’s governing board, which would now have seven members, and set the terms of board members 14 years. The terms of the chairman and vice chairman of the board were set at four years.

Following World War II, the Employment Act added the goal of promoting maximum employment to the list of the Fed’s responsibilities. In 1956 the Bank Holding Company Act named the Fed as the regulator for bank holding companies owning more than one bank, and in 1978 the Humphrey-Hawkins Act required the Fed chairman to report to Congress twice annually on monetary policy goals and objectives.

The 1970s saw inflation skyrocket, as producer and consumer prices rose, oil prices soared and the federal deficit more than doubled. The Monetary Control Act of 1980 required the Fed to price its financial services competitively against private sector providers and to establish reserve requirements for all eligible financial institutions. The act marked the beginning of a period of modern banking industry reforms. Following its passage, interstate banking proliferated, and banks began offering interest-paying accounts and instruments to attract customers from brokerage firms.

Two months after Alan Greenspan took office as Fed chairman, the stock market crashed on October 19, 1987. In response, he ordered the Fed to issue a one-sentence statement before the start of trading on October 20 to help calm fears: “The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.”

Throughout the 1990s, the Fed used monetary policy on a number of occasions, including the credit crunch of the early 1990s and the Russian default on government bonds, to keep potential financial problems from adversely affecting the economy. The decade was marked by generally declining inflation and the longest peacetime economic expansion in the country’s history.

In 1999 the Gramm-Leach-Bliley Act was passed, which essentially overturned the Glass-Steagall Act of 1933 and allowed banks to offer a menu of financial services, including investment banking and insurance sales. At the time of the scrapping of Glass-Steagall, Sen. Byron Dorgan (D-North Dakota) voiced a prescient warning: “I think we will look back in 10 years’ time and say we should not have done this.”

The 10-year economic expansion of the 1990s came to a close in March 2001 and was followed by a short, shallow recession ending in November 2001. In response to the bursting of the 1990s stock market bubble, the Fed lowered interest rates rapidly.

The effectiveness of the Federal Reserve as a central bank was put to the test on September 11, 2001, when the terrorist attacks in New York, Washington, and Pennsylvania disrupted US financial markets. The Fed issued a short statement reminiscent of its announcement in 1987: “The Federal Reserve System is open and operating. The discount window is available to meet liquidity needs.” In the days that followed, the Fed lowered interest rates and loaned more than $45 billion to financial institutions in order to provide stability to the U.S. economy. By the end

of September, Fed lending had returned to pre-September 11 levels and a potential liquidity crunch had been averted.

In 2008, the Fed faced its biggest financial crisis since the Great Depression, as Senator Dorgan’s earlier pronouncement came true. After years of giving out mortgages with variable rates and to individuals with limited resources, numerous banks and other financial institutions faced the risk of collapsing. Venerable entities like Fannie Mae and Freddie Mac and insurance giant AIG had to be rescued by the federal government, in part with help from the Federal Reserve. Officials in the Bush administration and, subsequently, the Obama administration negotiated with Congress to enact the largest bailout of financial institutions in U.S. history.

What it Does

The Federal Reserve is a government-created banking system that wields enormous power over the financial system and economy of the United States. Sometimes thought of as a central or “national bank” (due to previous government-created institutions that held such a name), the Federal Reserve (or “Fed”) makes important decisions involving government securities and interest rates that affect private banks as well as other financial institutions on Wall Street. By affecting interest rates, the Fed can manipulate billions of dollars in business profits or losses and millions in worker employment and stock, bond or bank account values.

Although it is often referred to as being a single entity, the Federal Reserve is really made up of 12 Federal Reserve Districts with offices in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis,Kansas City, Dallas and San Francisco. Overseeing these 12 district banks is the Federal Reserve’s seven-member Board of Governors, all of whom are appointed by the President and confirmed by the Senate and serve 14-year terms.

Federal Open Market Committee

The most important policy-making body of the Federal Reserve System is the Federal Open Market Committee (FOMC). It is composed of the Fed’s seven governors, the president of the Federal Reserve Bank of New York, and four other Reserve Bank presidents, who serve on a rotating basis. By statute, the FOMC determines its own organization, and by tradition it elects the chairman of the Board of Governors as its chairman and the president of the New York Bank as its vice chairman.

The FOMC can affect monetary policy through the buying and selling of U.S. government securities, altering reserve requirements (the amount of funds that commercial banks must hold in reserve against deposits) and adjusting the discount rate (the interest rate charged to commercial banks). These tools can be used to tighten or expand the money supply. For example, if the FOMC wanted to control inflation, it could restrict the nation’s money supply by selling government securities and raising the amount of money that banks need to set aside for reserve requirements. Both of these actions would take money out of circulation. In theory, a smaller supply of money would lead to less spending, which would lead to lower prices.

The FOMC can also raise interest rates to help control inflation. By making money more expensive to borrow, consumers would be more likely to save money rather than spend it. This could also lead to lower prices.

In recent times, when the economy has appeared headed toward a recession, the Fed has lowered interest rates in the hope that it will spur investors to lend more money and thus produce more business activity and potentially more jobs in the economy. For instance, from September 2007 until June 2008, the Federal Reserve cut its federal funds rate (what banks charge each other for overnight loans) from 5.25% to 2%. Manipulating interest rates comes with risks, however, including the danger of causing inflation. It was this concern that caused Federal Reserve officials to end their rate cuts in June 2008.

Board of Governors

The seven members of the Board of Governors may serve only one full term, but a member who has been appointed to complete an unexpired term may be reappointed to a full term. The President designates, and the Senate confirms, two board members to be chairman and vice chairman for four-year terms. Only one member of the board may be selected from any one of the 12 Federal Reserve Districts. In making appointments, the President is directed by law to select a “fair representation of the financial, agricultural, industrial, and commercial interests and geographical divisions of the country.” These aspects of selection are intended to ensure representation of regional interests and the interests of various sectors of the public.

The board sets reserve requirements and shares the responsibility with the Reserve Banks for discount rate policy. These two functions, along with open market operations, constitute the monetary policy tools of the Federal Reserve System.

In addition to monetary policy responsibilities, the Federal Reserve Board has regulatory and supervisory responsibilities over banks that are members of the system, bank holding companies, international banking facilities in the United States, Edge Act and agreement corporations, foreign activities of member banks, and the U.S. activities of foreign-owned banks. The board also sets margin requirements, which limit the use of credit for purchasing or carrying securities.

In addition, the board is supposed to assure the “smooth functioning” and development of the nation’s payments system. Important details of this responsibility are included in Fedwire and the board’s Payment System Risk Policy.

Another area of board responsibility is the development and administration of regulations that implement major federal laws governing consumer credit, such as the Truth in Lending Act, the Equal Credit Opportunity Act, the Home Mortgage Disclosure Act and the Truth in Savings Act. More information on this regulatory function is made available through the Fed’s Consumer Information and Community Development sections.

The Fed also makes available a considerable amount of Economic Research and Data for consumers or researchers who want to delve into the micro and macro aspects of the monetary system.

Where Does the Money Go?

Neither the Federal Reserve nor its Board of Governors provides information to the federal web site, USAspending.gov, regarding contractors for goods or services. The banking system does contract out, however, for help.

For instance, Unisys, Oracle, and Dutch-based Clear2Pay won a major contract in 2007 to help streamline the Federal Reserve Banks’ transition from paper checks to electronic check transactions. The contract was the largest ever for Clear2Pay, a company that employs 300 people worldwide.

Clear2Pay will deliver most of the products and the core technology for the new settlement system to the 12 Federal Reserve Banks, an order valued at 5 million euros. The changeover by the Federal Reserve is expected to generate more business for the companies, as private banks will have to adapt their existing interfaces with the Federal Reserve.

In 2001, the Federal Reserve Bank of Chicago hired the design firm SmithGroup to design and engineer a new $65-million bank branch in the Forest Park area, near Detroit, MI.

Data on Federal Reserve System

Graph source: Wikimedia Commons. Note: currency is usually printed around the Christmas season so that holiday shoppers can make withdrawals at banks, and then removed from circulation after the holiday season is over.