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The Federal Reserve

Structure & Functions

Introduction


The Fed's Structure
  The Board of Governors
  Federal Reserve Banks
  Federal Open Market Committee

The Fed's Functions
  Monetary Policy
  Supervision of Banks
  Services to Depository Institutions
  Services to the U.S. Treasury

Conclusion
The Fed's Functions

a man and a woman at work/a man and a woman at homeAs the U.S. central bank, the Federal Reserve carries out a number of functions that affect the nation's economic well-being. Through monetary policy, which influences the availability of money and credit, the Fed plays a major role in keeping inflation in check while promoting economic growth. By supervising and regulating commercial banks, the Fed fosters the U.S. financial system's safety and soundness. And by providing check-clearing and other payment services to depository institutions and the federal government, the Fed helps make commercial transactions more efficient.

Monetary Policy
Aside from market dynamics like consumer spending and business investments, a major influence on a country's economic performance is public policy—particularly fiscal policy and monetary policy. Fiscal policy is determined by the legislative and executive branches of the U.S. government chiefly through decisions about taxation and spending. Monetary policy is carried out by the Federal Reserve.

The objectives of the nation's economic policy are to protect the purchasing power of the U.S. dollar, encourage conditions that sustain economic growth and a high level of employment, and foster a reasonable balance in transactions with other nations over the long run. The Federal Reserve contributes to these objectives through its monetary policy actions, which affect the availability and cost of money and credit.

The Fed, seeking to adjust monetary policy to changing economic conditions, bases its policy decisions on current economic and financial information. For example, the FOMC's policy actions are influenced at least in part by the economic analysis provided by staff economists and analysts at the Reserve Banks and the Board of Governors. Each component of the Fed—the Board of Governors, the Reserve Banks, and the FOMC—plays various roles in formulating and carrying out monetary policy.

Tools of Monetary Policy
To foster economic growth while maintaining stable prices, the Federal Reserve must balance the flow of money and credit with the needs of the economy. The Board of Governors, the Reserve Banks, and the FOMC achieve this balance by influencing the levels of financial institutions' reserves, which in turn affect institutions' ability to make loans or purchase investments. These reserves, required by law of all U.S. depository institutions, must be equal to specified percentages of the institutions' deposits and can be held either as cash on hand or as account balances at Reserve Banks.

The Fed has three policy tools for influencing reserves: open market operations, the discount rate, and reserve requirements.picture of two fingers holding a penny

Open market operations. The most flexible, and therefore most important, of the Fed's monetary policy tools is open market operations—the purchase and sale of government securities in the open market. The Fed's open market operations are directed by the FOMC and carried out through the trading desk of the Federal Reserve Bank of New York.

To increase the availability of money and credit, the Fed buys government securities. These purchases are paid for by crediting the reserve accounts (held at Reserve Banks) of the depository institutions handling the securities dealers' transactions. These larger reserve accounts give the banks more money for lending and investing elsewhere. To tighten money and credit flows the Fed sells securities, thereby restraining the growth in banks' reserve balances and restricting their lending and investing activities.

The discount rate. Depository institutions sometimes borrow money from Reserve Banks to cover temporary deposit drains. The discount rate—the rate of interest charged on these short-term, “discount window” loans—is set by Reserve Banks' boards of directors, subject to approval by the Board of Governors. A change in the discount rate can either inhibit or encourage financial institutions' lending and investment activities by making it more or less expensive for them to obtain funds. Although the discount rate may have little direct effect on market conditions, a change in the discount rate can be an important signal of the Fed's policy direction.

Reserve requirements. Within limits prescribed by law, the Board of Governors can change the percentage of deposits that depository institutions must set aside as reserves. The Federal Reserve changes reserve requirements much less often than it does the discount rate because such changes have a further-reaching impact on the financial industry.

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Supervision of Banks
Commercial banks are governed by a variety of regulations intended to ensure that they serve their depositors and communities well and are operated in accordance with sound banking principles.

a man in line at a bank tellerSeveral federal and state agencies, including the Federal Reserve, share the responsibility for writing these regulations and for examining banks to determine their compliance. The Federal Reserve supervises all bank and financial holding companies as well as state-chartered banks that are members of the Federal Reserve System. The Fed also regulates foreign activities of all U.S. banks and certain U.S. activities of foreign banks.

Bank and financial holding companies and certain banks that wish to acquire or merge with other banks must obtain Federal Reserve approval. Staff at a Reserve Bank analyze the banks and financial markets that will be affected by a proposed merger or acquisition, taking into account the convenience and needs of the community to be served and the financial and managerial resources of the existing and proposed institutions. The Board of Governors approves or disapproves merger and acquisition applications based on Reserve Banks' findings and recommendations.

In addition, Reserve Banks monitor commercial banks' compliance with consumer protection laws relating to credit, such as the Truth in Lending Act. Reserve Bank specialists help banks interpret technical requirements of the laws. They also provide information and assistance to consumers with questions or complaints regarding commercial banks' services.

Discount Window Loans
Reserve Banks also help maintain a sound banking system by acting as the lender of last resort for depository institutions. Institutions that find themselves temporarily short of reserves because of unexpected credit demands, deposit drains, or seasonal economic factors may be eligible to borrow from a Reserve Bank. The availability of credit from the Federal Reserve is intended to stabilize individual depository institutions as well as the banking and financial system as a whole. Depository institutions are expected to seek funds first from reasonably available alternative sources and to rely on the Federal Reserve discount window only in exceptional circumstances.

Generally, discount window loans are made for a day or two to help the borrowers adjust their reserve position. Discount window credit is subject to governing statutes and is administered according to Federal Reserve policy guidelines by lending officers at the individual Reserve Banks.

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a man and a woman at work at the FedServices to Depository Institutions
As part of the nation's central bank, Reserve Banks are actively involved in the nation's payment system to help it operate as efficiently and safely as possible. Unlike private providers of payment services, Federal Reserve Banks do not offer these services to make a profit—their service fees must closely match and not exceed their costs.

Since the passage of the Depository Institutions Deregulation and Monetary Control Act of 1980, Reserve Banks' financial services have been available not just to banks that are members of the Federal Reserve System but also to nonmember commercial banks, savings and loan associations, credit unions, and mutual savings banks.

In some ways Federal Reserve Banks' services to depository institutions are similar to depository institutions' services to their customers—transferring funds, providing cash, and accepting and safeguarding deposits.

Payment System Services
Most of the nation's spending money is held in checking accounts, and checks are one of the most commonly used methods of disbursing funds from these accounts. But check usage has declined steadily since its peak in the mid-1990s while the popularity of electronic payments has soared. By 2003, for the first time in U.S. history, the number of electronic payments of all types—including debit cards, credit cards, and ACH payments—exceeded the number of check payments.

Check collection. Many checks are cashed or deposited at depository institutions far from the institutions on which they are drawn. More than half of such “interbank” checks are collected through the Federal Reserve Banks' check collection system. (Another large portion is handled within banking organizations or their correspondent banks. The remainder are processed by commercial banks or other private-sector check processors.) High-speed, computer-controlled machines at Reserve Banks sort checks, total the amounts, credit the depositing institution, and charge the institution on which they are drawn. The checks are then sent, either in paper or electronic form, to the latter depository institution.

Electronic payments and funds transfers. Reserve Banks and one other private-sector operator provide nationwide processing of automated clearinghouse (ACH) electronic payments. ACH payments, which are cheaper to process than checks, are used for direct deposit of payroll and corporate payments to vendors, and consumers use ACH transfers to pay insurance premiums, mortgages, loans, and other bills.

Reserve Banks also provide an electronic funds transfer (EFT) system that depository institutions can use to make large-value, time-critical payments for interbank purchases, sales of securities, disbursing or repaying loans, or settling real estate transactions.

Cash services. Although checks and electronic payments account for most of the dollar volume of spending, cash is still an important medium of exchange.

New coins and notes are shipped from the U.S. Treasury to the Federal Reserve Banks, where the cash is stored until needed to fill orders from depository institutions. Depository institutions, of course, furnish cash to businesses and the public.

image of treasury securities noteWhen depository institutions have excess cash on hand, they may return it to the Reserve Banks, where the amount is verified and worn-out notes are destroyed. Counterfeits are removed and sent to the Secret Service. Worn, bent, and foreign coins, too, are culled. Reusable coins and notes are stored until needed. When depository institutions order cash, the Reserve Banks fill the orders from their stocks of new and used coins and notes.

Safekeeping and Transfer of Securities
Depository institutions may request a Reserve Bank to hold securities either for safekeeping or as collateral for loans from the Federal Reserve. These securities are held in the form of electronic records in custody accounts. Reserve Banks also perform such services as transferring securities between accounts and processing associated payments.

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Services to the U.S. Treasury
Reserve Banks provide a number of banking and financial services to the U.S. Treasury, including two major services.

The Treasury's Checking Account
Incoming federal government revenues are credited to the U.S. Treasury's accounts at Reserve Banks. Most of these revenues come from transfers of funds from depository institutions in which the Treasury initially deposited its receipts from taxes and the sale of securities. The transfers are accomplished by debiting the depository institutions' reserve balances with the Federal Reserve and crediting the Treasury's account with the Fed. Reserve Banks disburse money from the Treasury's account through EFT or ACH payments or, to a limited extent, by check.

The Treasury's Fiscal Agent
When its current expenses run ahead of its current cash resources, the Treasury borrows, mostly by auctioning government securities to investors. The auctions are held by the Federal Reserve Banks, acting as the Treasury's fiscal (financial) agents. The Fed also inscribes and delivers U.S. savings bonds sold through depository institutions and other issuing agents.