Chapter 16: Central Banks and the Federal Reserve System:
Origins of the Federal Reserve System
Federal Reserve System has the most unusual structure and it was created in 1913.
The fear of centralized power inAmerican society was a major source of resistance towards the
creation of the central bank.Another source of this hostility was the traditionalAmerican distrust
for moneyed interests like the central bank for example.
This open hostility towards the existence of a central bank led to the demise of the first two
experiments of central banking whose main function was to police the banking system--The First
Bank of the United States was disbanded in 1811, and the national charter for the Second Bank
of the United States expired in 1836 and its renewal was vetoed by PresidentAndrew Jackson.
(The first two attempts at a central bank in The United States were not total failures, but their
charters were not renewed.)
The termination of the charter for the Second Bank of the United States created a problem for the
financial markets. There was no lender of last resort to provide reserves in order to prevent bank
panics. This led to bank panics between the 19th and early 20th century. Bank panics became
such a regular thing during this time period, occurring every 20 years. The bank panic of 1907
resulted in nationwide spread bank failures and great loss to depositors. It was enough to
convince the public that there was a great need for a central bank.
Hostility of theAmerican public towards banks and the centralized authority led to opposition
towards the creation of a central bank. The fear was that wall street, banks, and corporations
would manipulate such an institution in order to obtain control over the economy and that federal
operation of a bank would result into government intervention in the affairs of private banks.
There were disagreements as to whether the central bank should be a private bank or a
government institution. Acompromise was struck--the greatAmerican tradition, congress wrote
an elaborate system of checks and balances into the Federal ReserveAct of 1913. This act
created a federal reserve system with 12 regional federal reserve banks. (Read Inside the Fed
Structure of the Federal Reserve System:
The Federal Reserve System was formed as a result of diffusion of power. The writers of the
Federal ReserveAct wanted to diffuse the power along regional lines, between the private sector
and the government, among bankers, business people, and the public.
The Fed consists of the following entities:
● Federal Reserve Banks
● Board of Governors (B.O.G) of the Federal Reserve System
● Federal Open Market Committee (FOMC)
● FederalAdvisory Council
● about 2,500 member banks
Federal Reserve Banks 12 federal reserve districts each with one main federal reserve bank, which may have branches in
other cities in the district. The three largest banks in terms of assets are New York, Chicago, and
San Francisco (combined hold more than 50% of Federal Reserve System assets). Assets include
discount loans, securities, and so on. New York bank holds a quarter of the assets and it is the
most important (New York Federal Reserve Bank has a special role).
Each federal reserve bank is a quasi-public institution--a part private, a part government
institution. Each is owned by the private commercial banks in its district that are members of the
Federal Reserve System. The member commercial banks purchase stock in their district federal
reserve bank (membership requirement). the dividends are payable only up to 6% annually by
Member banks elect six directors for each district bank, and the board of directors appoint three
more. the directors of the district banks are categorized intoA, B, and C. Category A consists of
three directors who are elected by the member banks, and are professional bankers. Category B
consists of three directors as well. They are also elected by member banks. They consist of
prominent leaders from industry, labor, agriculture, and consumer sector. Category C consists of
directors appointed by the Board of Governors. They represent public interest and are not
allowed to be officers, employees or stockholders of banks.
Directors oversee the activities of the district banks, but their most important function is to
appoint the president of the bank (subject to approval of B.O.G).
(12 Federal Reserve Banks, 9 directors, 7 governors, and 12 bank presidents)
Open market operations consist of the purchase and sale of government securities that affect
interest rates and the amount of reserves in the banking system.
Before July 2010, all nine directors participated in the appointment of the president, but the
Dodd-Frank legislation was excluded directors in categoryAbecause congress felt that it was
inappropriate for bankers to be involved in appointing a president would be in charge of
supervising the same banks.
Ways in which the Federal Reserve Banks are involved in monetary policy:
● Directors establish the discount rate (it is reviewed and determined by B.O.G)
● Decide which banks (member and nonmember) receive discount loans from the Federal
● Directors select one commercial banker from each bank’s district to serve of Federal
Advisory Council, which consults with the B.O.G, and provides information that helps in
the conduct of monetary policy
● Five of the twelve bank presidents have a vote on the Federal Open Market Committee
(directs open market operations)
The Federal Reserve bank of New York has a special role. This is because the president of the
New York Fed is a permanent member of the FOMC. The president of the New York Fed always
has a vote on the FOMC and this makes it the most important bank. The New York Fed houses
the open market desk, the open market operations are directed through this trading desk. The other four votes are allocated to the district banks, and they rotate amongst the 11 remaining
Other functions of the 12 Federal Reserve Banks are:
● gather data on local business conditions
● clear checks
● issue new currency and withdraw damaged currency from circulation
● act as liaisons between the business community and the Fed
● administer and make discount loans to banks in their districts
● examine bank holding companies and state-chartered member banks
● evaluate proposed mergers and applications for banks to expand their activities.
Commercial banks are chartered by the Office of the Comptroller of the Currency.
National banks are all required to be members of the Federal Reserve System. Commercial
banks chartered by the state are not required to be members, but can choose to join.
Currently, a third of commercial banks in the United States are members of the Federal Reserve
Initially, only member banks were only required to hold reserves as deposits at the Federal
Reserve bank. (this was before 1980). The nonmember banks were subject to reserve
requirements determine by their states. This enabled them to hold their reserves in interest
bearing securities. At the time, interest wasn’t paid deposits held at the Fed, therefore it was
costly to be a member of the Fed. As the interest rates rose, so did the cost of membership and
this led to a decline in membership. The B.O.G were concerned about the decline in Fed
membership, and this is the reason as to why the Fed lessened its control over money
supply. This made it difficult for the Fed to conduct Monetary policy.
Under the Depository Institutions Deregulation and Monetary ControlAct of 1980, all depository
institutions became subject ( by 1987) to the same requirements to keep deposits at the Fed, so
member and nonmember banks would be on an equal footing in terms of reserve requirements.
Depository institutions were given access to the Federal Reserve facilities, such as the discount
window and Fed check clearing, on an equal basis. These provisions ended the decline in Fed
membership and reduced the distinction between member and nonmember banks.
B.O.G of the Federal Reserve System
The Board of Governors of the Fed consists of seven members. They are headquartered in
Washington D.C. Each governor is appointed by the president of the United States and confirmed
by the Senate. In order to limit the president’s influence over the Fed and any other political
pressures, each governor serves a full nonrenewable fourteen-year term plus part of another
term. One governor’s term expires every other January. Governors are required to come from
different Federal Reserve districts to prevent the interests of one region being over represented.
The Chairman of the B.O.G is chosen from among the 7 governors and serves a four-year
renewable term. Once a new chairman is chosen, the former chairman is required to resign from
the B.O.G even if many years are left on the governor term. B.O.G is actively involved in the conduct of the monetary policy through the following ways:
● all seven governors are members of the FOMC, therefore they vote on the conduct of
open market operations. (The FOMC consists of 12 members, that is 7 governors and five
bank presidents). B.O.G therefore has majority of the vote.
● sets the reserve requirement within the limits set by legislation
● controls the discount rate by review and determination process (approves or disapproves
the discount rate set by the Federal Reserve Banks).
● chairman of the Board advises the President of the United States on economic policy,