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Home  >  Fundamental analysis  >  Central banks  >  Federal Reserve System (Fed)

Federal Reserve System (Fed)

The Federal Reserve System (Fed) is the United States' central bank.

The founding fathers established the Bank of the United States in 1791, the first central bank of the United States. Alexander Hamilton, the first Secretary of the Treasury, was also a chief proponent of this central bank. This First Bank of the United States was just what the fledgling country needed to get its financial house in order. And it worked... for a while. Its charter, however, expired in 1811 and was not renewed.

Motivated by the same desire to have central banking oversight that motivated the first bank, a Second Bank of the United States was formed in 1816. The Second Bank of the United States experienced a great deal of controversy during its brief existence. In 1832, its demise was sealed when President Andrew Jackson, a major critic of federally controlled central banking, vetoed a bill renewing the charter of the second bank. The charter officially expired and the bank ceased to operate in 1836.

From 1836 to 1913, the United States had NO federally sanctioned central bank. This eight-decade period was also marked by perpetual economic turmoil. Just coincidence? Probably not. During this period, economic downturns were typically termed "bank panics," rather than business-cycle recessions. Banking instability was, more often than not, the cause of economic problems.

Banking instability often led to economic downturns because the lack of central bank regulatory oversight encouraged some banks played fast and loose with deposits and loans. With no central bank providing emergency reserves, banks that played it too fast or too loose, often came up short of reserves and were forced to shut down. When these banks closed down any deposits evaporated and so too did financial wealth and part of the money supply.

Such bank failures were seldom isolated events. The failure of one bank often caused a chain reaction throughout the banking system, causing other banks to fail as well. Much like a tiny spark igniting a raging fire, pre-Fed panics often spread rapidly throughout the economy, causing banks to close and the money supply to shrink. Without money, production went unsold and resources were unemployed.

The Second National Bank developed a powerful and effective system of monetary regulation under the leadership of Nicholas Biddle (1786-1844), its president from 1823 to 1839. Biddle hoped to expand the bank's role in America's economy, but as the bank became more powerful, many citizens feared it was a threat and menace to democracy. President Andrew Jackson distrusted the central bank's authority, believing it was an instrument of the rich and powerful. The 1832 bill to recharter the bank passed both houses of Congress, but Jackson vetoed the bill. Nicholas Biddle resigned as president in 1839 and the bank finally ceased operations in 1841.

In the absence of a central bank authority, the state-chartered banks once again filled the gap with a patchwork system subject to violent fluctuations in the monetary system. The United States Treasury assumed some central banking responsibilities such as open market securities purchases. Clearinghouse associations also performed some responsibilities normally under the jurisdiction of a central authority. The associations issued clearinghouse loan certificates, which became a important type of "emergency currency" for banks during financial panics. Regulatory activities, such as controlling member banks' interest rates on deposits and conducting member bank examinations, were also carried out by the associations.

The National Banking Act (formerly the National Currency Act) of 1863 instituted a system of nationally chartered banks subject to strict capital requirements. Three types of national banks were recognized: country banks, reserve city banks, and central reserve city banks. The country banks were required to keep a portion of their reserves in vault cash and the remainder with a national bank in a reserve or central reserve city in the form of vault cash. Reserve city banks had to keep a portion of their reserves as vault cash and the remaining portion as a deposit in a national bank at a central reserve city. The central reserve city banks in New York, Chicago, and St. Louis were required to keep all their reserves as vault cash.

Under this system circulating bank notes had to be backed by the holdings of United States government securities. State bank notes eventually ceased circulating, but state banks continued to thrive. Checking accounts rather than bank notes provided the revenue these banks required to operate.

The primary weaknesses of the national banking system were an inelastic supply of currency and the immobile reserves. The currency supply did not expand and contract as appropriate with the cycle of business, and the pyramid structure of country, reserve city, and central reserve city banks meant reserves were not readily available when needed. As a result the economy suffered wild cycles of boom and bust.

Congress passed the Aldrich-Vreeland Act of 1908 after the financial panic of 1907. One of the most important provisions of the act was the creation of the National Monetary Commission. Under the direction of its chairman, Senator Nelson W. Aldrich of Rhode Island, the commission studied the nation's financial system over three years. The final report, known as the Aldrich Plan, recommended the creation of a central banking system.

The 12 Federal Reserve Bank districts are headquartered in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. The 25 branch banks in each district are shown in Table 1 (the Boston bank has no branches). The stock of each Federal Reserve Bank is owned by the respective district member banks as required by the membership guidelines. However, stock ownership does not confer the privileges of financial or controlling interest as does common stock ownership.

The system consists of the Board of Governors, the Federal Open Market Committee (FOMC), 12 Federal Reserve Banks, 25 branches, member financial institutions, and advisory committees.

1. The Board Of Governors is composed of seven members. Their appointments are made by the President of the United States and confirmed by the Senate. Members are appointed for terms of fourteen years, so arranged that one term expires every two years. The Board's responsibilities lie in the field of money and banking. Their object in a broad sense is to maintain sound banking conditions and an adequate supply of credit at reasonable cost for use in commerce, industry, and agriculture. The Board supervises the operations of the twelve Federal Reserve Banks. Its offices are in Washington, D. C.

2. Each Federal Reserve Bank serves a district comprising several states or parts of states.

3. The Federal Open Market Committee comprises the seven members of the Board of Governors and five representatives of the Federal Reserve Banks.

4. The Federal Advisory Council consists of twelve members, one selected annually by each Federal Reserve Bank through its board of directors.

5. Member banks include all national banks in the continental United States, and such State banks and trust companies as apply for membership, meet the requirements, and are admitted.

The Fed does not conduct commercial banking activities. Fed's goal is to attain stable economic growth in the nation, and through its actions, influence the flow of money and credit in the economy. Specifically, the Fed is responsible for:

  • formulating monetary policy;
  • acting as lender of last resort for the nation's banks and depository institutions;
  • facilitating the collection and clearance of checks;
  • regulating and supervising banks and other financial institutions;
  • acting as fiscal agent for the United States Treasury;
  • distributing coin and currency to the public through depository institutions;
  • implementing certain regulations of consumer credit legislation.
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