The rise of the central banking system in the United States of American is one of the most significant economic developments; this is the Federal Reserve System. The bank has a most significant influence on the nation’s financial direction since its main purpose is to ensure the stability of the nation’s economy through the stabilization of the national currency, maintaining reasonably high levels of employment, and carrying out transactions with foreign countries.
History of Central Banking in the United States
The need for central banking in the United States was triggered by the rapidly changing population; it was growing in size, increasing its mobility and diversifying; and increasing the volume of their trade.
At the time, many banks operated under state charter or by private parties; each of the banks issued its own banknotes. The chaos in this industry precipitated the first attempts to create central banking in the United States.
The First Bank, created in 1791 thus became the first bank with the representation of the US treasury. The bank in 1811 ceased operations. There lasted a period with no central banking between then and 1816 when the Second Bank was opened.
The Federal Reserve System was formally created in 1913 through the signing of the Federal Reserve act by the then-American president Woodrow Wilson. The institution, created through an act of congress aimed at creating a system of banking and money that was flexible and safer.
Over time, however, the status of the system has evolved and its scope widened into broader financial and economic objectives; linked closely to the smooth running of the national economy (Feinman, 1993).
The federal reserve system administrative organisation
The Federal Reserve Board of Governors is the supreme authority in the Federal Reserve administrative hierarchy. Additionally, there are twelve Federal Reserve districts covering the whole of the United States. Each of the Federal Reserve banks is governed by a board of directors under the leadership of a bank president.
The Board of Governors
The authority to appoint the board of governors rests with the president of the united state, however, all the appointments have to be confirmed by Senate. The board consists of seven members each serving a 14-year term. The 14-year term is aimed at shielding the members from the political fluctuations associated with the inevitable changes of regimes. An appointed member can only serve one term; however, exceptions can be made; for example, a member can be reappointed to serve a full term if initially s/he had been appointed to complete an unfinished term. The president also has the prerogative of appointing both the chairman and the vice-chairman of the board but with the confirmation of the Senate; these two serve four-year terms.
There is only one representative in the seven-man board from the twelve Federal Reserve districts. Fair representation of the various sectors of the economy and of the society in the board is essential during appointments of its members by the president.
The seven members of the board constitute the majority of the federal open market committee [The Board of Governors].
The board and the reserve banks work together to regulate the functions of the open market. The drafting of the discount policy is the responsibility of the board, and so is the setting of the reserve requirements. The monetary policy is therefore constituted by the open market functions, the reserve requirement, and the discount policy.
In addition to this, the Federal Reserve Board also has regulation and supervision responsibilities. Banks that are members of the system, their foreign activities, and activities of foreign banks in the US, bank holding companies, international banking facilities, and agreement corporations are all under the watchful eye of the board. The board sets the margin requirement; this effectively limits the use of credit for carrying out securities or for purchasing. The supervision of the functions of the vast payment system in the US to ensure its smooth running is a responsibility of the board [The Board of Governors].
The drafting of various federal legislation governing consumer credit is done by the board; the board also enforces these legislations, for example, the Truth in Savings act and others.
The board meets several times a week; some of the meetings are open to the attendance of the public; however, the board can lock out the public if matters of confidential financial information are being discussed. The board also consults widely with members of Congress, the banking industry representatives, officials of other agencies of the government, and officials of central banks of other countries.
Despite the fact that the Board is appointed by the federal administration, it is not part of it; the board is an independent agency of the federal government. The Board is not unsupervised; Congress, through legislation, has the authority through legislation to adjust the duties and clout of the board. Washington DC is the city that hosts the board and serves as its center for operations and meetings (Feinman, 1993).
The Federal Open Market Committee
This twelve-member committee draws its population from various sectors. Seven of its members are drawn from the Federal Reserve board of governors. The other five members are Reserve Bank representatives. The president of the New York reserve bank has a permanent seat on the committee. The other representatives serve a one-year term on a rotation basis shared among all the other banks. Customarily, the President of the New York federal bank is the automatic committee’s vice chairman: the chairman of the board of governors of the Federal Reserve is, by the same mechanism, the chairman. The cost and availability of money are determined by this committee; also the amount of credit in the economy. The committee meets in Washington DC about every six weeks (Feinman, 1993).
The Federal Reserve Districts
There are twelve of these in the United States; each of which has a District Federal Reserve Bank. Each of the banks is run by a board of directors, and there is a president of the bank. The banks are privately owned and are located in major American cities.
These banks have several important functions; among the most important is the supply of currency to the private banks in the district. They in addition collect and clear checks, and make loans to these institutions within the district. The banks handle the US government debt and the cash balances. Each of the District Federal Reserve bank’s depository financial institutions has to deposit a reserve balance with the bank.
The district banks also have another responsibility; they advise the federal reserve board regarding the amount of interest rate to be charged to financial institutions that the reserve lends money to; thus the Discount rate.
The purpose of the federal reserve system
The Federal Reserve System was originally designed to stabilize the market and the banking system.
The formation of the Federal Reserve was motivated by various financial crises that had plagued the American economy; of most significance is the bank panics; especially the financial crisis of 1907 that spurred Congress to enact the Federal Reserve act in 1913. Since then the purpose of the bank has evolved and grown.
In the United States of America, central banking services are provided by the federal reserves. The US government keeps a check-off account with the bank; all the incoming money from government revenues and all the outgoing payments are routed through the bank. The bank issues the legal tender of the nation and redeems all the government securities [Chicago Fed].
Regulation of the banking industry in the US
All the private banks in the country and their activities are under the direct regulation and supervision of the board of directors of the Federal Reserve. However, the board also delegates the supervision of the roughly 900 state banks and other similar bodies. The main purpose of this is the protection of the consumer.
The Lender of Last Resort
Cases may arise leading to a severe financial crisis whereby the failure to get credit would lead to a severe economic downturn. In this scenario, reserve banks would have to step in and offer short-term liquidity to banks to enable them to achieve their credit obligations. The Fed thus acts as a buffer against the fluctuations of the economy offering stability to financial institutions during unexpected downturns or bank runs. The banks are required to pay interest on the loans they acquire from the reserve; this is known as the Primary Credit.
Maintaining an elastic currency
The Federal Reserve Act gives the board the power to manipulate the supply of money in the economy. By either contracting or expanding the volume of the money circulating in the market, the banks seek to respond to the changes in the economy and ensuring an optimum supply of money.
The Federal Reserve maintains a federal fund whereby private banks can lend money to one another. Since the banks charge interest for all the loans that they lend, the amount charged has to be regulated to ensure a sustainable system; the proportion of the interest is stipulated in the Federal Reserve monetary policy.
The Federal Reserve System is charged with the responsibility of strengthening the US economy in comparison to other countries. It also has the capability of addressing the issue of bank panics. The balance between the centralized responsibility of the government and the private interests of the bank is maintained by the efforts of the system.
The federal reserve monetary policy
Measures that are undertaken by the Federal Reserve to manipulate the availability and the cost of the money and credit in the economy constitute the monetary policy of the US. There are three ways that the reserve can enforce this influence:
- The operations of the open market: the government can supply or deplete money from the banking system by the buying and selling of IOUs from and to banks. These government securities are sold and bought in an open market with the various institutions openly bidding for them.
- The Reserve requirement: is the amount of money that the Federal Reserve requires a depository institution to deposit with the federal reserve banks and is set by the board of governors [Fin-Web].
- The Federal Fund Rate: is the quantity of interest the banks, as a part of inter-bank lending activities, charge each other for overnight loans for the purposes of depositing the funds with the federal fund. The federal system attempts to influence this rate by manipulating the amount of money in the banking system.
The Federal Reserve System funds itself; a large section of the money is derived from operations of the open market. Every year, the board prepares a report for congress; these are comprehensive and detailed; and are posted on the Board of Governor’s official website for public access [FRB: Annual report, 2008].
The Federal Reserve balance sheet; is published every week. It has two installments namely; the consolidated statement of all Federal Reserve banks (one for each of the twelve banks) and the consolidated statement of all the federal banks together [FRB, website]. These regularly updated financial reports analyze the various holdings of the reserve at estimated and true value, and a net value of the Federal Reserve is released.
Criticisms of the Federal Reserve System
The influence of New York City on the system has been a source of complaints about the federal system. This influence is further confirmed by the fact that the president of the New York Federal Reserve Bank has a permanent seat on the FOMC while the other president has to have a rotation system since only four other positions are available. A major influence has been demonstrated in the drafting of legislation [FBA, working paper, 2003]. The federal system has also been blamed for causing the great depression by over-supplying money in the banking system while the correct step would have to reduce the amount.
The bank has been blamed for not stopping inflation and its effects on the workforce of the country. The wages of the working class have been struggling to keep up with the inflation [FBM, 1997].
Since some of the meetings are held behind closed doors, the system has been criticized for having excessive secrecy. A lag of five years has been placed on some of the transcripts of the meetings. This secrecy has been blamed for the market volatility since only speculations can be made.
The centralized control of the amount of credit and money in the country has been seen by some as tantamount to communism where the direction of the country’s economy can be controlled from a central location.
The Federal Reserve system in the United States is a vast and complex subject where both facts and opinions call to the scholar’s attention. While questions have been asked about the relevance and effectiveness of the system, the greatest folly that could happen to it is the loss of dynamism. In today’s fast-changing world, old and proven ideas don’t always work in new scenarios.
One of the recommendations that I would make is to improve the accessibility of the operations of the system to a bigger range of financial analysts in order to forestall a financial disaster in the future.
Federal Reserve Bank of Atlanta. Working paper 2003-42: New York and the Politics of Central Banks, 1781 to the Federal Reserve Act.
Federal Reserve Bank of Minneapolis, (1997): The Great Wave: Price Revolutions and the Rhythm of History. Web.
Joshua N. Feinman. Reserve Requirements: History, Current Practice, and Potential Reform. Federal Reserve bulletin. 1993. Web.
The Board of Governors, Federal Reserve system (2008); Annual report; Budget review. Web.
The Structure of the Federal Reserve System; Federal Reserves Board; official website: www.federalreserve.gov.
The Federal Reserve System; Part 1: Purpose and Organization; Financial web; Independent Financial Portal. 2009. Web.
The Federal Reserve System; Part 2: How the Reserve Regulates Money and the Economy; Financial web; Independent Financial Portal. 2009. Web.