Federal Reserve System

CHAPTER 4

L E A R N I N G O B J E C T I V E S

After studying this chapter, you should be able to do the following: LO 4.1 Discuss how the Federal Reserve System (Fed) responded to the recent fi nancial

crisis and Great Recession.

LO 4.2 Identify three weaknesses of the national banking system that existed before the Federal Reserve System was created.

LO 4.3 Describe the Federal Reserve System and identify the fi ve major components into which it is organized.

LO 4.4 Identify and describe the policy instruments used by the Fed to carry out monetary policy.

LO 4.5 Discuss the Fed’s supervisory and regulatory functions. LO 4.6 Identify important Fed service functions. LO 4.7 Identify specifi c examples of foreign countries that use central banking systems to

regulate money supply and implement monetary policy.

W H E R E W E H A V E B E E N . . . In Chapter 3 we discussed the types and roles of fi nancial institutions that have evolved in

the United States to meet the needs of individuals and businesses and help the fi nancial sys-

tem operate effi ciently. We also described the traditional diff erences between commercial

banking and investment banking, followed by coverage of the functions of banks (all depos-

itory institutions) and the banking system. By now you also should have an understanding of

the structure and chartering of commercial banks, the availability of branch banking, and the

use of bank holding companies. You also should now have a basic understanding of the bank

balance sheet and how the bank management process is carried out in terms of liquidity and

capital management. Selected information also was provided on international banking and

several foreign banking systems.

W H E R E W E A R E G O I N G . . . The last two chapters in Part 1 address the role of policy makers in the fi nancial system and

how international trade and fi nance infl uence the U.S. fi nancial system. In Chapter 5 you will

have the opportunity to review economic objectives that direct policy-making activities. We

4.1 U.S. Central Bank Response to the Financial Crisis and Great Recession 77

then briefl y review fi scal policy and how it is administered through taxation and expenditure

plans. This is followed by a discussion of the policy instruments employed by the U.S.

Treasury and how the Treasury carries out its debt management activities. You will then see

how the money supply is changed by the banking system, as well as develop an understand-

ing of the factors that aff ect bank reserves. The monetary base and the money multiplier also

will be described and discussed. Chapter 6 focuses on how currency exchange rates are

determined and how international trade is fi nanced.

H O W T H I S C H A P T E R A P P L I E S T O M E . . .

Actions taken by the Fed impact your ability to borrow money and the cost of, or interest

rate on, that money. When the Fed is taking an easy monetary stance, money becomes

more easily available, which in turn leads to a lower cost. Such an action, in turn, will

likely result in lower interest rates on your credit card, your new automobile loan, and

possibly your interest rate on a new mortgage loan. Actions by the Fed also infl uence eco-

nomic activity and the type and kind of job opportunities that may be available to you. For

example, a tightening of monetary policy in an eff ort to control infl ation may lead to an

economic slowdown.

While many individuals know that the Federal Reserve System is the central bank of the

United States, what the Fed does and how it operates are less clear. Stephen H. Axilrod

comments,

There must be almost as many images of the Fed as an institution and of the wellsprings of its actions as there are viewers. Mine, born of a particular experience, is a generally benign one. It is of an unbiased, honest, straightforward institution that quite seriously and carefully carries out its congressionally given mandates. . . . It is of course through the window of monetary policy that the public chiefl y sees and judges the Fed.1

This chapter focuses on understanding the structure and functions of the Fed. Chapter 5 describes

how the Fed administers monetary policy in cooperation with fi scal policy and Treasury

operations to carry out the nation’s economic objectives.

4.1 U.S. Central Bank Response to the Financial Crisis and Great Recession CRISIS As previously noted, the 2007–2008 fi nancial crisis and the 2008–2009 Great Reces-

sion combined to create a “perfect fi nancial storm.” Many government offi cials, politicians,

fi nancial institution executives, and business professionals felt during the midst of the

fi nancial storm that both the U.S. and world fi nancial systems were on the verge of collapse

in 2008. The Federal Reserve System (Fed), the central bank of the United States, is responsible for setting monetary policy and regulating the banking system. Direct actions

and involvement by the Fed were critical in government and related institutional eff orts to

avoid fi nancial collapse.

The federal government has historically played an active role in encouraging home own-

ership by supporting liquid markets for home mortgages. If banks and other lenders originate

home mortgages and then “hold” the mortgages, new mortgage funds are not readily available.

However, when banks and other lenders are able to sell their mortgages in a secondary mortgage

market to other investors, the proceeds from the sales can be used to make new mortgage loans. In

Federal Reserve System (Fed) U.S. central bank that sets monetary

policy and regulates banking

system

1 Stephen H. Axilrod, Inside the Fed, (Cambridge: The MIT Press, 2009), p. 159.

78 C H A P T E R 4 Federal Reserve System

1938, the president and Congress created the Federal National Mortgage Association (Fannie Mae) to support the fi nancial markets by purchasing home mortgages from banks and, thus, freeing-up funds that could be lent to other borrowers. Fannie Mae was converted to a government-

sponsored enterprise (GSE), or “privatized,” in 1968 by making it a public, investor-owned com-

pany. The Government National Mortgage Association (Ginnie Mae) was created in 1968 as a government-owned corporation. Ginnie Mae issues its own debt securities to obtain funds that

are invested in mortgages made to low to moderate income home purchasers. The Federal Home Loan Mortgage Corporation (Freddie Mac) was formed in 1970, also as a government-owned corporation to aid the mortgage markets by purchasing and holding mortgage loans. In 1989,

Freddie Mac also became a GSE when it became a public, investor-owned company.

Ginnie Mae and Fannie Mae issue mortgage-backed securities to fund their mortgage

purchases and holdings. Ginnie Mae purchases Federal Housing Administration (FHA)

and Department of Veterans Aff airs (VA) federally insured mortgages, packages them into

mortgage-backed securities that are sold to investors. Ginnie Mae guarantees the payment

of interest and principal on the mortgages held in the pool. Fannie Mae purchases individual

mortgages or mortgage pools from fi nancial institutions and packages or repackages them into

mortgage-backed securities as ways to aid development of the secondary mortgage markets.

Freddie Mac purchases and holds mortgage loans.

As housing prices continued to increase, these mortgage-support activities by Ginnie

Mae, Fannie Mae, and Freddie Mac aided the government’s goal of increased home own-

ership. However, after the housing price bubble burst in mid-2006 and housing-related jobs

declined sharply, mortgage borrowers found it more diffi cult to meet interest and principal

payments, causing the values of mortgage-backed securities to decline sharply. To make the

housing-related developments worse, Fannie Mae and Freddie Mac held large amounts of low

quality, subprime mortgages that had higher likelihoods of loan defaults. As default rates on

these mortgage loans increased, both Fannie and Freddie suff ered cash and liquidity crises.

To avoid a meltdown, the Federal Reserve provided rescue funds in July 2008, and the U.S.

government assumed control of both fi rms in September 2008.

The Federal Reserve, sometimes with the aid of the U.S. Treasury, helped a number of

fi nancial institutions on the verge of failing, due to the collapse in value of mortgage-backed

securities, to merge with other fi rms. Examples included the Fed’s eff orts in aiding the March

2008 acquisition of Bear Stearns by the JPMorgan Chase bank and the sale of Merrill Lynch

to Bank of America during the latter part of 2008. However, Lehman Brothers, a major invest-

ment bank, was allowed to fail in September 2008. Shortly after the Lehman bankruptcy and

the Merrill sale, American International Group (AIG), the largest insurance fi rm in the United

States, was “bailed out” by the Federal Reserve with the U.S. government receiving an own-

ership interest in the company. Like Merrill, Fannie, and Freddie, AIG was considered “too

large to fail,” due to the potential impact of this on the global fi nancial markets.

In addition to direct intervention, the Fed also engaged in quantitative easing actions to

help avoid a fi nancial system collapse in 2008, and to stimulate economic growth after the

2008–09 recession. We will discuss the Fed’s quantitative easing actions later in the chapter.

DISCUSSION QUESTION 1 Do you support the Fed’s decision to bail out selected fi nancial institutions that were suff ering fi nancial distress in 2008?

4.2 The U.S. Banking System Prior to the Fed In Chapter 1, when we discussed the characteristics of an eff ective fi nancial system, we

said that one basic requirement was a monetary system that effi ciently carried out the fi n-

ancial functions of creating and transferring money. While we have an effi cient monetary

system today, this was not always the case. To understand the importance of the Federal

Reserve System, it is useful to review briefl y the weaknesses of the banking system that gave

rise to the establishment of the Fed. The National Banking Acts passed in 1863 and 1864

provided for a national banking system. Banks could receive national charters, capital and

reserve requirements on deposits and banknotes were established, and banknotes could be

Federal National Mortgage Association (Fannie Mae) created to support the fi nancial markets by

purchasing home mortgages from

banks so that the proceeds could be

lent to other borrowers

Government National Mortgage Association (Ginnie Mae) created to issue its own debt securities to

obtain funds that are invested in

mortgages made to low to moderate

income home purchasers

Federal Home Loan Mortgage Corporation (Freddie Mac) formed to support mortgage

markets by purchasing and holding

mortgage loans

4.2 The U.S. Banking System Prior to the Fed 79

issued only against U.S. government securities owned by the banks but held with the U.S.

Treasury Department. These banknotes, backed by government securities, were supposed to

provide citizens with a safe and stable national currency. Improved bank supervision also was

provided for with the establishment of the Offi ce of the Comptroller of the Currency under

the control of the U.S. Treasury.

Weaknesses of the National Banking System Although the national banking system overcame many of the weaknesses of the prior systems

involving state banks, it lacked the ability to carry out other central banking system activities

that are essential to a well-operating fi nancial system. Three essential requirements include

(1) an effi cient national payments system, (2) an elastic or fl exible money supply that can

respond to changes in the demand for money, and (3) a lending/borrowing mechanism to help

alleviate liquidity problems when they arise. The fi rst two requirements relate directly to the

transferring and creating money functions. The third requirement relates to the need to main-

tain adequate bank liquidity. Recall from Chapter 3 that we referred to bank liquidity as the

ability to meet depositor withdrawals and to pay other liabilities as they come due. All three

of these required elements were defi cient until the Federal Reserve System was established.

The payments system under the National Banking Acts was based on an extensive net-

work of banks with correspondent banking relationships. It was costly to transfer funds from

region to region, and the check clearing and collection process sometimes was quite long.

Checks written on little-known banks located in out-of-the-way places often were discoun-

ted or were redeemed at less than face value. For example, let’s assume that a check written

on an account at a little-known bank in the western region of the United States was sent to

pay a bill owed to a fi rm in the eastern region. When the fi rm presented the check to its local

bank, the bank might record an amount less than the check’s face value in the fi rm’s checking

account. The amount of the discount was to cover the cost of getting the check cleared and

presented for collection to the bank located in the western region. Today, checks are processed

or cleared quickly and with little cost throughout the U.S. banking system. Recall from Chapter 3

that the current U.S. payments system allows checks to be processed either directly or indirectly.

The indirect clearing process can involve the use of bank clearinghouses as discussed in Chapter 3

or a Federal Reserve Bank. The role of the Fed in processing checks is discussed in this chapter.

A second weakness of the banking system under the National Banking Acts was that the

money supply could not be easily expanded or contracted to meet changing seasonal needs

and/or changes in economic activity. As noted, banknotes could be issued only to the extent

that they were backed by U.S. government securities. Note issues were limited to 90 percent

of the par value, as stated on the face of the bond, or the market value of the bonds, whichever

was lower. When bonds sold at prices considerably above their par value, the advantage of

purchasing bonds as a basis to issue notes was eliminated. 2

For example, if a $1,000 par value bond was available for purchase at a price of $1,100,

the banks would not be inclined to make such a purchase since a maximum of $900 in notes

could be issued against the bond, in this case 90 percent of par value. The interest that the

bank could earn from the use of the $900 in notes would not be great enough to off set the high

price of the bond. When government bonds sold at par or at a discount, on the other hand,

the potential earning power of the note issues would be quite attractive and banks would be

encouraged to purchase bonds for note issue purposes. The volume of national bank notes,

thus the money supply, therefore depended on the government bond market rather than on the

seasonal, or cyclical, needs of the nation for currency.

A third weakness of the national banking system involved the arrangement for holding

reserves and the lack of a central authority that could lend to banks experiencing temporary

liquidity problems. A large part of the reserve balances of banks was held as deposits with

large city banks, in particular with large New York City banks. Banks outside of the large

cities were permitted to keep part of their reserves with their correspondent large city banks.

Certain percentages of deposits had to be retained in their own vaults. These were the only

2 A bond’s price will diff er from its stated or face value if the interest rate required in the marketplace is diff erent from

the interest rate stated on the bond certifi cate. Bond valuation calculations are discussed in Chapter 10.

80 C H A P T E R 4 Federal Reserve System

alternatives for holding reserve balances. During periods of economic stress, the position of

these large city banks was precarious because they had to meet the demand for deposit with-

drawals by their own customers as well as by the smaller banks. The frequent inability of the

large banks to meet such deposit withdrawal demands resulted in extreme hardship for the

smaller banks whose reserves they held. A mechanism for providing loans to banks to help

them weather short-term liquidity problems is crucial to a well-functioning banking system.

The Movement to Central Banking A central bank is a government-established organization responsible for supervising and regulating the banking system and for creating and regulating the money supply. While central

bank activities may diff er somewhat from country to country, central banks typically play an

important role in a country’s payments system. It is also common for a central bank to lend

money to its member banks, hold its own reserves, and be responsible for creating money.

Even though the shortcomings of the national banking system in terms of the payments

system, infl exible money supply, and illiquidity were known, opposition to a strong central

banking system still existed in the United States during the late 1800s. The vast western fron-

tiers and the local independence of the southern areas during this period created distrust of

centralized fi nancial control. This distrust deepened when many of the predatory practices of

large corporate combinations were being made public by legislative commissions and invest-

igations around the turn of the century.

The United States was one of the last major industrial nations to adopt a permanent sys-

tem of central banking. However, many fi nancial and political leaders had long recognized the

advantages of such a system. These supporters of central banking were given a big boost by

the fi nancial panic of 1907. The central banking system adopted by the United States under the

Federal Reserve Act of 1913 was, in fact, a compromise between the system of independently

owned banks in this country and the single central bank systems of such countries as Canada,

Great Britain, and Germany. This compromise took the form of a series of central banks, each

representing a specifi c region of the United States. The assumption was that each central bank

would be more responsive to the particular fi nancial problems of its region.

4.3 Structure of the Federal Reserve System The Federal Reserve System is the central bank of the United States and is responsible for

setting monetary policy and regulating the banking system. It is important to understand that

the Fed did not replace the system that existed under the National Banking Acts of 1863 and

1864 but, rather, it was superimposed on the national banking system created by these acts.

Certain provisions of the National Banking Acts, however, were modifi ed to permit greater

fl exibility of operations.

The Fed system consists of fi ve components:

Member banks

Federal Reserve District Banks

Board of Governors

Federal Open Market Committee

Advisory committees

These fi ve components are depicted in Figure 4.1.

Member Banks The Federal Reserve Act provided that all national banks were to become members of the

Fed. In addition, state-chartered banks were permitted to join the system if they could show

central bank federal government agency that facilitates the operation

of the fi nancial system and

regulates the money supply

4.3 Structure of the Federal Reserve System 81

evidence of a satisfactory fi nancial condition. The Federal Reserve Act also required that all

member banks purchase capital stock of the Reserve Bank of their district up to a maximum

of 6 percent of their paid-in capital and surplus. In practice, however, member banks have had

to pay only 3 percent; the remainder is subject to call at the discretion of the Fed. Member

banks are limited to a maximum of 6 percent dividends on the stock of the Reserve Bank that

they hold. The Reserve Banks, therefore, are private institutions owned by the many member

banks of the Fed.

State-chartered banks are permitted to withdraw from membership with the Fed six

months after written notice has been submitted to the Reserve Bank of their district. In such

cases, the stock originally purchased by the withdrawing member is canceled and a refund is

made for all money paid in.

Exercises

General

Supervision

Compose

BOARD OF GOVERNORS

(7 Appointed Members)

Consumer Advisory

Council

Federal Advisory

Council

Thrift Institutions

Advisory Council

approves discount rates as part

of monetary policy

companies

consumer finance

Banks

FEDERAL RESERVE BANKS

(12 Districts)

depository institutions and lend

to them at the discount window

transfer funds for depository

institutions

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