Worksheet Mailing: FRB Structure & Functions Brochure
Federal Reserve Structure & Functions
Like most industrialized nations, the United States has a central bank to meet certain needs of its complex economy and financial system. Unlike most central banks, however, the U.S. Federal Reserve System--often called the Fed--is, in a sense, a "decentralized" central bank. It consists of a Board of Governors in Washington, D.C., 12 regional Federal Reserve Banks and their branches, and the Federal Open Market Committee.
Established in December 1913 by the Federal Reserve Act, the Federal Reserve System was designed to address the conditions underlying the money panics that had plagued the country for many years. The act has been amended several times to enhance the Fed's ability to foster a sound financial system and a healthy economy.
The Federal Reserve System advances this goal in several ways. Its monetary policy decisions affect the flow of money and credit in the economy. It contributes to the safety and soundness of the nation's financial system by establishing regulations and acting as a commercial bank supervisor. And, by serving as a bank for depository institutions and the federal government, the Fed helps ensure that the system of paying for all kinds of transactions works efficiently. In carrying out these three functions, the Fed also helps to stabilize the financial system and to contain systemic risk that may arise in financial markets.
The Fed's Structure
To safeguard the Federal Reserve from short-term political pressures, the Fed was set up to be "independent" within the government. The Fed operates on its own earnings rather than on congressional appropriations, and the members of its Board of Governors are appointed for long, staggered terms, limiting the influence of day-to-day political considerations.
But the Federal Reserve works within the government in the sense that it formulates monetary policy to achieve overall goals set by Congress and the president. Although the Federal Reserve's specific decisions do not have to be approved by the president or the executive branch, the Fed must report to Congress, which created it. Congress has the power to alter or even abolish the Federal Reserve at any time.
The Fed's unique structure also provides internal checks and balances, ensuring that its decisions and operations are not dominated by any one part of the system.
The Board of Governors
The Board of Governors, located in Washington, D.C., is a federal government agency. It consists of seven members appointed by the president and confirmed by the Senate for staggered 14-year terms. The chairman and vice chairman are designated by the president, with Senate approval, for four-year terms (renewable during their board-member terms).
The Board of Governors regularly reports to Congress, giving an annual report on operations and semiannual reports on the state of the economy and the Fed's objectives for the growth of money and credit. The chairman meets regularly with the president and the secretary of the Treasury. Board
frequently before congressional committees and meet frequently with the president's Council of Economic Advisers and other key economic officials.
Board members participate in formulating monetary policy, along with Reserve Bank presidents, through the Federal Open Market Committee (see below). The Board has sole responsibility for setting reserve requirements for depository institutions and approves discount rate changes proposed by Reserve Bank directors.
The Board establishes and administers financial safety and soundness and consumer protection regulations and administers regulations regarding bank consolidation. The Board also oversees Reserve Banks' services to depository institutions, bank supervision functions, and accounting procedures and approves Reserve Banks' budgets.
Federal Reserve Banks
Federal Reserve Banks are the decentralized element of the U.S. central bank. The 12 Reserve Banks are located in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. Branches are located in 25 other cities, and all but two Reserve Banks have at least one branch.
Each Federal Reserve Bank is separately incorporated, with a board of nine directors. Reserve Banks generate their own income, which comes mainly from interest on government securities acquired through open market operations. Each year, Reserve Banks turn over to the U.S. Treasury earnings in excess of the amount they need to pay expenses and dividends to member banks, to maintain a surplus equal to paid-in capital, and to pay operating expenses.
Reserve Bank directors, under the Board of Governors' supervision, oversee their bank's operations and appoint and recommend salaries of the bank's president and first vice president. Of the nine directors, six--three class A, representing the banking industry, and three class B--are elected by member banks, including all nationally chartered banks and state-chartered banks that meet certain requirements. Three class C directors, including the chairman and deputy chairman, are appointed by the Board of Governors. Class B and C directors represent agriculture, commerce, industry, labor, and services in the Federal Reserve District; they cannot be officers, directors, or employees of a bank, and class C directors cannot be bank stockholders.
Advisory committees at the individual Reserve Banks advise the banks on these and other interests at the regional level.
Branch banks' boards have five or seven directors; the majority are appointed by head-office directors and the rest by the Board of Governors.
Reserve Banks monitor national and international economic conditions and provide information on their districts that is used in formulating monetary policy. Reserve Banks hold reserve balances for and serve as "lender of last resort" to depository institutions. Directors establish the discount rate charged on such loans, subject to approval by the Board of Governors.
Reserve Banks also examine and supervise certain types of depository institutions and provide payment services to depository institutions and the U.S. Treasury.
Federal Open Market Committee
The Federal Open Market Committee (FOMC) directs open market operations, the most important tool of monetary policy. The committee meets in Washington, D.C., eight times a year and holds additional meetings or telephone consultations as needed.
The FOMC comprises 12 members--the seven members of the Board of Governors and five Reserve Bank presidents, one of whom is the president of the Federal Reserve Bank of New York. Other presidents serve one-year terms on a rotating basis, and all presidents participate in each meeting.
The Fed's Functions
As 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.
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.
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.
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.
Several 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.
Services 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.
When 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.
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.
Like the federal government, the Federal Reserve System was designed to be a compromise between national and regional powers. Its regional base--the 12 Reserve Banks--makes the Fed more flexible and innovative and ensures that its decisions and actions are broadly based. The Board of Governors, acting as general overseer of the Reserve Banks, helps coordinate the Fed's operations. And the Federal Reserve's most important function--formulating and implementing monetary policy--is carried out in light of both regional and national concerns by the Board of Governors, the Reserve Banks, and the FOMC.
The Federal Reserve's major functions account for its structure and for its unique position in the public policy arena. Accountable to the government but working independently within it, the Fed is able to pursue its monetary policy goals without undue pressures from short-term political considerations.
Since its founding in 1913, the Federal Reserve System has evolved to meet the needs of a changing financial system and a growing economy. Its unique structure, however, remains its most outstanding feature and its greatest strength.