The Federal Reserve is the central bank of the United States. However, when people first learn about it, they seem to believe it is just one entity, as in one bank in New York. Well, there is one in New York, but the Federal reserve is actually a system of reserve banks in different regions of the United States. This system as a whole is responsible for creating and implementing the nation’s monetary policy. Through talking to people I know and also going to a couple conferences and presentations, I have found that there are extreme holes in people’s (including my own) understanding of the Federal Reserve and how it operates. So, this post is the first of many that are aimed to remedy that deficit, and we will naturally start with an overview of the Federal Reserve System as a whole.
5 functions of the Federal Reserve
- Conduct national monetary policy with the aim to maximize employment and price stability
As stated above, the Federal Reserve system (from here on called “the Fed”), conducts national monetary policy, where monetary policy is influencing interest rates and the money supply. I say influencing because a lot of the Fed’s actions are just expectations policy, and we will go into the nuance of how money is created, how the interest rates work on a macro scale and others in future posts.
- Promote stability of the financial system and try to minimize systemic risks by actively monitoring and engaging in the U.S. and abroad
This function is a little more self-explanatory. The Fed does not like disorder, that includes disorder in financial markets. When you are dealing with something as complex and omnipresent as the financial system, not just the level of a certain indicator, but the speed and volatility of its movement can also have a drastic impact in the real economy. In future posts, I will allow my perspective (bias by definition) to show a little bit as we dive more into nuance, but I will keep that separate from the educational piece. I say this because it is of my opinion when you see “actively monitor and engage in the U.S. and abroad” there should be alarm bells going off everywhere in your head. Maybe it’s my inner-free-market-capitalist, but just an initial thought of mine.
- Promote safety and soundness of individual financial institutions and monitor their influence on the entire financial system
This one should be 100% self-explanatory and I won’t comment much on it… *cough**cough* 2008.
- Promote consumer protection and community development
The Fed verbalizes that they aim to aid the consumer instead of only the whales of the financial world. This function will probably get heavily opinionated and go rather in depth, so we will save further comments for another day. Essentially, the Fed conducts research and analyzes consumer issues as well as engages in community economic development activities.
- Foster payment and settlement system safety and efficiency
As the central bank of the United States, the Fed is responsible for maintaining the currency. They provide services in the banking industry and the U.S. government to aid U.S dollar transactions. I say the central bank “of the United States” with a sort of smirk, as it is arguable that the Fed isn’t really central to the U.S., but the dollar itself. I’d also like to refer to Eurodollar University for further reading if you are interested.
https://alhambrapartners.com/tag/eurodollar-university/
Central Banking in the United States
The Federal Reserve is not meant to be a single entity, it is actually an entire system of 12 regional banks, a central governing board called the Board of Governors, and the Federal Open Market Committee (FOMC). It is also not entirely a public entity, as it is supposed to mix both public and private characteristics.
For the public aspect of the system, the Board of Governors is an agency of the Federal Government that reports to and is accountable to congress. This board is responsible for guiding the 12 reserve banks. Also, the members of the board are appointed by the President and confirmed by the senate. A full term for a board member is fourteen years, and they cannot be reappointed if they complete a full term. One of the members of the board can be named chairman or vice chairman if they are named by the president from among the other board members and confirmed by the senate. Chairman and vice chairman terms are four years and do not affect their term as a board member.
The regional reserve banks are the operating entities of the Federal Reserve system. They are supervised by the board of governors and are responsible for carrying out policy implementations. Lastly, the Federal Open Market Committee (FOMC) consists of the members of the board of governors and the presidents of the regional banks. The chairman of the board is also the chairman of the FOMC. The FOMC is responsible for inducing open market activities which we will go into more in depth below.
Structure
Below is a map of the United States with the boundaries of each of the Federal Reserve districts. As you can notice, they do not always follow state lines. This is because the district boundaries are based off of the prevailing trade regions that existed in 1913 when the Federal Reserve act was drafted. Each region has their own reserve bank that is supposed to operate independently of the others. This includes each region having different discount rates, at least in the beginning. Each region having different discount rates that acted independently of the other regions was considered one of the most important tools of monetary policy. However, this was before monetary policy became more centralized and a national policy which is where we are today.
Also, the FOMC was not in the original Federal Reserve act in 1913. It was created later with revisions to the piece of legislation in 1933 and 1935 with the intention of increasing the coordination throughout the entire system. Keep in mind that the reserve banks are still banks, so they provide financial services as well, they have to pay their employees somehow, and it’s not through funding from congress. So, The Depository Institutions Deregulation and Monetary Control Act of 1980 (aka the Monetary Control Act) amended the Federal Reserve act again to require all Federal and State banks, credit unions, and thrift institutions to submit periodic reports to the Board of Governors, at the discretion of the Board, for it to control monetary and assets owned by the institutions. This was done under the guise of increasing coordination across the system. Also, the reserve banks now have intra-system service agreements that distribute responsibilities in order to better carry out functions that are of national scope.
More on the Reserve banks
Let’s go down another layer and talk more about the reserve banks themselves. Each reserve bank has its own Board of Directors with nine members. Commercial banks who hold stock in their district’s reserve banks elect six of those directors with the other three being appointed by the Board of Governors. Also, the reserve banks have at least one branch each, and each branch gets its own Board of Directors that are appointed by either the reserve banks or the Board of Directors. These directors of the reserve banks are how the Federal Reserve system is tied into the private sector. Each director normally has a background in the private sector that pertains to their respective region. Remember that the district boundaries themselves are based off of trade regions of the early 20th century, so each reserve bank specializes in the industries that are prominent in their region.
A bit more on the funding of the Federal Reserve. The Fed does not receive funding from congress, so they have to make money from their open market operations (interest on bonds, fees from financial services, etc.). By not receiving government funding, they are supposed to be incentivized to make policy decisions that are independent of the fiscal policy congress proposes. This is just one cross-current, so this is not the only defining factor of the relationship between the Fed and Congress. Also, after the Fed’s expenses and transfers to surplus are paid, their net earnings are sent to the U.S. Treasury.
Final words
I have noticed that not many people truly understand how the banking system works (I include myself in this assessment). So, I want to fix this problem. Not only to deepen my understand of the banking system, but that of others as well. Too many financial mishaps are chalked up to being a “black swan” event (an event that no one could ever have foreseen), but when I go through old interviews and podcasts, there were actually a few people who did foresee them. It seems to me that it is in the deeps of the financial and banking systems that these black swans lurk, and I want to find their nest. I may never find it, but at least I will have a much deeper understanding of how the system works, and hopefully I can help you understand it better as well. I have absolutely no clue what I will find, but I am sure excited to find out.
To your wealth and future,
James Forsythe
For more on the founding of our national banking system
https://jamesdforsythe.com/national-banking-act-of-1863/
For more on the Banking System in general
https://jamesdforsythe.com/category/finance/banking-system/
