On October 9th President Obama nominated Janet Yellen to lead the Federal Reserve. Yellen is well qualified for the job and, when confirmed by the Senate, she will be the first woman to lead the Fed. As Yellen is about to start meeting with senators to discuss her nomination it is time to reflect on the Fed, its history, purpose, structure and operations.
I picked this topic for the article because I feel that while there is a plenty of information about the Fed, it is often overlooked not only by regular people but also by many finance professionals. An average finance textbook devotes a page to this important topic so, unless you took a class in macroeconomics from Wharton’s own Professor Abel and carefully read the Macroeconomics textbook that he coauthored with the current Fed chairman Ben Bernanke, this article should be of interest.
The history: The first effort to create a central bank in the US was made with charter of the Bank of the United States in 1791. The Bank’s charter expired in 1811. The second effort was made in 1816 when the Second Bank of the United States was chartered for 20 years. Because there was a general distrust towards the central banking system at that time, the charter wasn’t renewed in 1836. Both buildings, the Bank of the United States and the Second Bank of the United States are still standing in Philadelphia and are open to visitors. In spite of the lack of the central banking system, the economy had done remarkably well for the following 80 years, until the Panic of 1907 that bankrupted many state and local banks. During the Panic of 1907, J.P Morgan realized that all banks were in danger of bankruptcy and that the country could fall into economic chaos. To save the banks and the economy, J.P. Morgan intervened by convincing bankers to unite in providing support to the banking system. The wisdom and leadership of J.P. Morgan convinced other bankers to pledge their financial support and thus further financial collapse was averted.
The purpose: After the Panic of 1907, the need for the lender of last resort with unlimited lending capability was evident and bankers began a lobbying campaign. The main purpose of creating a central bank was to provide the nation with a safer, more flexible, and more stable monetary and financial system. Today, the Fed’s responsibilities fall into four areas.
- Conducting the nation’s monetary policy
- Supervising/regulating financial institutions
- Maintaining the stability of the financial system and containing systemic risk
- Providing certain financial services to the U.S. government, financial institutions, foreign official institutions, and playing a major role in operating and overseeing the nation’s payments systems.
The structure: To overcome the opposition to central banking, creators were careful when drafting the bill that became the basis for the Federal Reserve Act of 1913. The entity would be called the Federal Reserve rather than a central bank. It would be an independent, decentralized bank to better ensure that monetary policy would be based on a broad economic perspective from all regions of the country. Today, the Federal Reserve consists of the following:
1) Federal Reserve Board – a federal agency consisting of the seven members of the Board of Governors who are appointed by the President and confirmed by the U.S. Senate. The seven members include the Chair who leads the Fed (Currently Ben Bernanke). The seven members are required to report to Congress on the Board’s activities, Board’s decisions are not required to be approved by either the President or Congress.
2) 12 Reserve Banks – these are not federal agencies but each is governed by the board of directors representing the public and the member banks in its districts. Reserve Banks are subject to the general supervision of the Federal Reserve Board.
3) Federal Open Market Committee (FOMC) – the main group that decides on US monetary policy as it sets the Federal Funds Rate and the Discount Rate. There are twelve members that include: the seven members of the Board of Governors with Chairman of the board also serving as the Chairman of FOMC, the President of the Federal Reserve Bank of New York (FRBNY) serves as a permanent member and as a Vice Chairman of the FOMC, and four other Reserve Bank presidents serving on a rotating basis for one year each. The FOMC directs the open market operations to influence the total amount of money and credit available in the economy. The FRBNY carries out the FOMC directives on open market operations. Based on this structure, the FRBNY is the dominant player in executing Fed policies and its president is a key figure in central banking. The FRBNY president is elected by FRBNY’s board of directors which consists of Class A, B and C. Class A and B directors are elected by the member commercial banks of the Second District. Class C directors are appointed by the Board of Governors.
The operations: The Federal Reserve Act of 1913 transferred the right to print currency from the U.S. Government to the Fed. It is the banker’s bank. It sets interest rates, processes banking transactions, acts as government’s banker and buys and sells government securities. It has no reserves as it can create money electronically. The total amount of actual paper money in circulation is about 3% of the total money supply; the rest is all electronic money. When the Fed needs to increase monetary supply it purchases US securities through the private market (and not directly from the U.S. Treasury), when it needs to decrease monetary supply it sells the security, done through electronic deposits and withdrawals. The fed creates money whenever it needs to. The operations of the Fed have never been fully audited. The most recent audit was performed in 2011 as part of the Dodd-Frank legislation. The audit examined the emergency actions taken by the Fed from December 1 2007 through July 21 2010. The audit report lists multiple recommendations and sites $16 trillion worth of loans at .01% interest (in comparison, the current-dollar GDP in 2010 was $14.66 trillion) to prevent bankruptcy and insolvency of the large financial institutions such as Bank of America, Citigroup, Royal Bank of Scotland, Barclays, UBS AG, etc. This was a very significant amount of loans in addition to the assistance provided through the Troubled Assets Relief Program (TARP) and the Temporary Liquidity Guarantee Program (TLGP). This additional assistance and loans were distributed through more than a dozen of additional emergency programs. Under some of the programs, the determination of whether an emergency existed was not required.
The purpose of the Fed, established back in 1913 has proven to be effective in saving financial institutions from the collapse and bankruptcy as evident from its lending activities during the Recession of 2007-2009. Still, after Yellen is confirmed to become Chair, she will face a tough road ahead with the bond purchase program and weaker projected global growth. Too big to fail institutions are making this road even more challenging.