LeoGlossary: Federal Reserve System (The Fed)

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The monetary authority of the United States. It is known as the Central Bank, responsible for implementing monetary policy, overseeing the largest banks, and providing financial services.

According to what was set down by the US Congress, the Fed has 3 primary areas of focus:

The Fed is the most powerful of all central banks, with it taking on a role outside the borders of the United States.

List of Federal Reserve Banks

  • Boston
  • New York
  • Philadelphia
  • Cleveland
  • Richmond
  • Atlanta
  • Chicago
  • St. Louis
  • Minneapolis
  • Kansas City
  • Dallas
  • San Francisco

The Fed was established on December 29, 1913 with the passing of The Federal Reserve Act in an effort to alleviate banking panics.

Central Bank

The United States Federal Reserve operates as a central bank. This means it serves roles for both the government and the commercial banking system.

This is where the US Government has its bank account. The Treasury Government Account (TGA) is where all the money that comes in from taxes or the selling of securities is kept. This is run by the U.S. Treasury. All government payments are made out of this account. It can be thought of at the U.S. Government's checking account.

Banknotes and physical coins are produced by the US Treasury and sold to the Fed. The cash is priced at the printing charge while coins are at face value.

For the commercial banks, the Fed is the primary regulator. At the same time, it maintains a payment system where the banks can transfer central bank money (reserves) amongst each other. This is how banks settle the interbank debits and credits.

The system is a public/private system.

While the Federal Reserve banks are privately owned, the Fed is overseen by the U.S. Congress. The Fed Governors are privately elected whereas the Fed Chair and Vice Chair are selected by the President and confirmed by the Senate.

The Board of Governors along with the Federal Reserve banks can also be audited by the Government Accountability Office (GAO).

Structure

Board of Governors

The Board's primary role is to oversee the different district banks. This is a 7 person Board and the Governors are appointed by the President with the Senate confirming. Each term is 14 years. There is a new term kicking off Feb 1st of every even numbered year. A Governor cannot serve a second term.

Chair and Vice-Chair: Selected from the sitting Governors. These positions are chosen by the President who then get confirmed by the Senate. There is no limit to the number of terms a Chari or Vice Chair can serve. They are granted a 4 year term and can get reappointed.

Alan Greenspan is an example of a Fed Chair who served a number of terms, spanning different Presidencies.

Federal Open Market Committee (FOMC)

This is a 12 member committee made up of the 7 Board members along with 5 of the Regional Bank Presidents. The FOMC is what sets monetary policy, mostly through the primary tool of open market operations.

The President of the Federal Reserve Bank of NY is a permanent member of the FOMC. The other 4 positions are filled by the others on a rotational basis. These members serve 2 and 3 years terms. All Presidents can comment on conditions and monetary policy but only the 5 on the FOMC have voting rights.

By tradition, the Chair of the Board of Governors serves as Chair of the FOMC. The Federal Bank of NY President is the Vice-Chair.

The committee meets 8 times a year to discuss monetary policy and vote on actions to take.

Member Banks

A member bank is one who holds stock in any one of the Federal Reserve Banks. All nationally chartered banks hold stock in at least one of the Reserve Banks. They are able to hold shares in more than one, with many of the largest commercial banks having a stake in all of them.

State charted banks have the option of holding stock in the applicable regional bank.

Holding requirements are 3% of the total of combined capital and surplus. In return for this, the banks that are under $10 billion in assets will receive 6% of the profits of the bank. Member banks with over $10 billion in assets will receive the lesser of 6% or the current 10-year Treasury auction rate.

After the dividends are paid, the excess is handed over the the US Treasury.

Unlike public stock, shares in the different Regional Banks cannot be bought or sold. This is private ownership based upon size of asset holdings.

Monetary Policy

Interbank Lending

One of the main areas the Fed handles is the setting of the rate the banks use to lend to each other. This is known as the Fed Funds Rate. It is the rate used on the lending of excess reserves.

There are a number of tools the Fed uses:

  • Open Market Operations - the purchasing of Treasury and federal agency securities
  • Discount rate - the rate the Fed charges commercial banks and other financial institutions on loans made through the discount window
  • Reserve requirements - the amount of reserves the banks have to hold in relation to their deposit liabilities

Central Bank Money

Under the fractional reserve banking system, the central bank is responsible for the issuance of some money. With the Fed, this is banknotes, i.e. physical USD. It is also responsible for the distribution of the coins.

The Fed also creates reserves. This is a ledger entry on the asset side of the balance sheet of commercial banks. It is also a liability to the Fed. Unlike commercial bank money, this is not legal tender. Thus, it does not directly enter the economy since only institutions with master accounts at the Fed can hold it.

This differs from commercial bank money which can be thought of as "digital dollars".

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