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Formal Structure of the Federal Reserve System
The FRS is comprised of Federal Reserve banks, the Board of Governors of the FRS, the Federal Open Market Committee (FOMC), the Federal Advisory Council and member commercial banks. Figure 1 outlines the relationships of these entities to one another and to the three policy tools of the FED (open market operations, the discount rate, and reserve requirements).
Figure 1
Federal Reserve Banks
A glance at American political history should help you understand the motivations behind the structure of the FED. Before the 20th century, a major characteristic of American politics was the fear of centralized power. This fear and the traditional American distrust of moneyed interest were the reason behind open public hostility towards central banks. The bank panics of 1907 that resulted in widespread bank failures finally convinced detractors that a lender of last resort was necessary to prevent substantial losses. To address the fear of centralized authority, Congress wrote an elaborate system of checks and balance into the Federal Reserve Act of 1913, which created the Federal Reserve System with its 12 regional Federal Reserve banks.
Each of the 12 Federal Reserve districts has one main Federal Reserve bank, which may have branches in other cities in the district. The three largest Federal Reserve banks in terms of assets are those of New York, Chicago and San Francisco. Their combined holding is 50% of the assets of the Federal Reserve System with New York holding about 25%.
Each of the Federal Reserve banks is a quasi-public institution owned by the private commercial banks in the district who are members of the Federal Reserve System. These member banks have purchased stock in their district Federal Reserve bank (a requirement of membership), and the dividends paid by that stock are limited by law to 6% annually. The member banks elect six directors for each district bank; three more are appointed by the Board of Governors. Together, these nine directors appoint the president of the bank (subject to the approval of the Board of Governors).
The directors of a district bank are classified into A, B and C categories. The three A directors are professional bankers, B directors are prominent leaders from industry, labor, agriculture, or the consumer sector, and C directors are appointed by the Board of Governors to represent the public interest. The design for choosing directors is intended to ensure that al constituencies of the American public are represented.
Member Banks
All national banks are required to be members of the Federal Reserve System. Before 1980, only member banks were required to keep reserves as deposits at the Federal Reserve banks. Nonmember banks were subject to reserve requirements determined by their states. Because no interest is paid on reserves deposited at the Federal Reserve banks, it was costly to be a member of the system, and as interest rates rose, the relative cost of membership rose, resulting in declining membership.
To prevent this declining membership, the Depository Institutions Deregulation and Monetary Control Act of 1980 stated that all depository institutions are subject to the same requirements to keep deposits at the Fed. This legislation put member and nonmember banks on equal footing in terms of reserve requirements.
Board of Governors of the Federal Reserve System
The seven-member Board of Governors leads the Federal Reserve System. To limit the president’s control over the Fed and insulate the Fed from other political pressures, the governors serve one nonrenewable 14-year term, with one governor’s term expiring every other year. The governors are required to come from different Federal Reserve districts to prevent the interest of one region of the country from being overrepresented.
Federal Open Market Committee
The FOMC usually meets eight times a year and makes decisions regarding the conduct of open market operations. The committee consists of the seven member of the Board of Governors, the present of FRB New York, and presents of four other Federal Reserve banks. The chairman of the Board of Governors also presides as the chairman of the FOM.
Because open market operations are the most important policy tool that the Fed has for controlling the money supply, the FOMC is necessarily the focal point for policy making in the Federal Reserve System.
Informal Structure of the Federal Reserve System
As envisioned in 1913, the Federal Reserve System was to be a highly decentralized system designed to function as 12 separate, cooperating central banks. In the original plan, the Fed was not responsible for the health of the economy through its control of the money supply and its ability to affect interest rates. Over time, it has acquired the responsibility for promoting a stable economy, and this responsibility has caused the FRS to evolve slowly into a more unified central bank. Figure 2 depicts the informal structure of the FRS.
Figure 2
Refer to Central Banking and the Conduct of Monetary Policy (Mishkin) for a complete review of the FRS. All credits to Mishkin.
Conclusion
This post primarily examined the structure of the Federal Reserve System. In my next post, Conduct of Monetary Policy Tools, I will look into how the three monetary policy tools affect national money supply and the federal funds rate.
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Sanjeet Parab
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