In 1907, the U.S. banking system was brought to its knees by a bank panic—a condition where depositors lose confidence in their bank’s ability to pay back their money and thereby withdraw it. This situation occurred several times throughout U.S. history causing economic mayhem until the panic settled back down and liquidity returned to most banks. The answer to the bank panic problem lay in the development of a central bank to act as a “lender of last resort” that would be able to support struggling banking institutions with liquidity until the panic died out. It didn’t come easily, but finally the solution arrived with the rise of the Federal Reserve System in 1913. Here’s how the Fed is structured and how it functions.
Central Banking in the United States: The first credible effort at forming a central bank took place 1791 when congress granted a charter, signed by President George Washington, to create the First Bank of the United States for a term of twenty years. However, congress refused to renew it in 1811 closing it up. In 1816 the government tried again with the Second Bank of the United States, again for twenty years, and again failing to renew it in 1836. In 1908 in response to the recent bank panic, congress passed the Aldrich-Vreeland Act that provided for emergency currency and a National Monetary Commission to study the problems that led to bank panics. It took five years and much persuasion, but congress finally approved the Federal Reserve Act in December, 1913, creating the Federal Reserve System. From 1913 to 2010 there were no fewer than sixteen additional acts or agreements made to adjust and fine tune the role of the Federal Reserve.
Structure: The Federal Reserve Board of Governors consists of seven members who are responsible for the federal agency that oversees national banks via examinations. The Board also oversees the Twelve District Federal Reserve Banks, sets or modifies monetary policy, and regulates the overall banking system. The members must be nominated for the post by the president and confirmed by the senate. The Federal Reserve is independently funded via revenues from open market operations including interest from securities held and gains/losses from trading securities, financial services, and discount loans. The Board of Governors has accountability to congress in the form of financial filings that are subject to audit by the General Accounting Office. Apart from this, the Board of Governors are exempt from further control or influence by any part of the federal government. The Federal Open Market Committee includes all seven members of the Board of Governors plus five of the twelve regional reserve bank presidents. This internal organization is maintained by the Federal Open Market Committee itself that makes decisions as to which five regional bank presidents are selected and for how long. The FOMC meets usually eight times per year and makes monetary policy decisions such as determining Fed Funds target rates and interest on Reserve Balances that can impact the economy. The remaining reserve bank presidents that are not FOMC members are still in the loop on decision making as they usually meet with the FOMC by conference call eight times per year. There are twelve Regional Reserve Banks located from coast to coast covering all regions as per the population distribution of the U.S. in 1913. Each bank has a president and is responsible for the member banks in the region. The member banks also elect six out of nine members of each regional reserve bank’s board of directors. Each regional reserve bank is a privately-held corporation by itself and is tax-exempt although it must remit profits back to the federal government in excess of what it pays to member banks in the form of dividends. This gives each of the twelve reserve banks a unique corporate makeup that includes elements of an ordinary corporation as well as some of a government agency.
The member banks themselves are all publicly or privately owned financial institutions. They own the stock in the regional reserve banks equal to 3% of their own capital and surplus. By law all national banks must be members of the Federal Reserve System, and state banks may join under certain circumstances. The stock of the reserve bank is not transferable, and it pays an annual dividend of about 6% to the member banks.
Tools: Fed Funds are the interest that member banks charge each other for overnight loans of federal funds that constitute the reserves held by regional reserve banks. The Fed Funds rate is determinable by the marketplace and not an arbitrarily determined rate made by the FOMC. The actions the FOMC takes with regards to modifying the Fed Funds rate is to adjust the Interest on Reserve Balances rate to align with the target rate the FOMC chooses for Fed Funds. The Interest on Reserve Balances rate is the interest the Fed pays to member banks for their reserve balances maintained at the regional reserve banks. This rate is arbitrarily determinable by the FOMC and constitutes the Fed’s main monetary policy tool. Raising the Fed Funds target rate provides a trickle-up effect on prime rates which in turn push higher corporate bond rates, mortgages, consumer loan rates, and virtually all other rates. Other tools include the Overnight Reverse Purchase by which the Fed receives funds from nonbank financial companies for deposit and earning interest. This rate augments the Fed’s efforts in reaching Fed Funds targets. The Fed also maintains a Discount Window for overnight loans directly to member banks. Open market operations refer directly to the sale or purchase of short-term Treasury Bills that impact the overall amount of reserves, to insure that monetary reserves in the system are adequate for the economy’s needs. Quantitative easing involves the Fed’s purchase of longer-term instruments such as U.S. Treasury bonds, corporate bonds, mortgage-backed securities, and others. By purchasing these securities, the Fed is providing money to the financial institution that sells them those securities, in effect increasing the money supply in the economy. There are other tools that are either expired or are dormant that the Fed could revive and use if the economic situation required it.
Responsibilities: Prior to the establishment of The Federal Reserve System, the only fallback to prevent or deter a bank panic would be for larger retail banks to lend money to smaller banks to provide liquidity and keep the bank from closing owing to excessive depositor withdrawals. As there was no mandate for this interbank lending to take place, depositor withdrawals could shutter certain banks unable to obtain loans. This condition could multiply itself throughout the banking system pushing it potentially to a total collapse. As liquidity was needed in the banks, the Federal Reserve became a lender of last resort to those banks in the Federal Reserve System struggling to stay open. Another responsibility for the Federal Reserve was to establish a check clearing system to insure that checks and bank drafts would be cleared—a major part of the Panic of 1907 occurred when banks and clearing houses refused to clear checks on certain banks deemed to be in financial trouble. This also provided an elasticity to the currency enabling it to expand or contract in quantity to meet economic conditions. Bank regulation is to a certain degree also the responsibility of the Federal Reserve, as is the national payments system.
Conclusions: The banking history of this country dates back to the Continental Congress who tried to go to a paper-based currency in 1775. That system did not succeed, but the amazing thing about this saga is how long it took for a central bank to emerge. It was 138 years later after a terrible civil war and many bank failures when the system employed today came about. What got in the way? Why, politics, of course.
Sources: Wikipedia, Federal Reserve.