How the Federal Reserve Works: Functions and Structure

Book: Financial Markets and Institutions, 11th Edition Author: Jeff Madura Publisher: Cengage Learning, 2015 ISBN: 978-1-133-94788-2

The Federal Reserve is the most powerful financial institution in the United States. Chapter 4 explains how it is organized, how it controls the money supply, and what it did during the 2008 credit crisis. If you want to understand why interest rates change, you need to understand the Fed.

A Brief History

The U.S. had several banking panics in the late 1800s and early 1900s. The big one in 1907 finally convinced Congress that the country needed a central bank. In 1913, the Federal Reserve Act was passed. It established reserve requirements for member banks and created 12 Federal Reserve districts across the country.

Initially, each district bank could influence the money supply independently. Over time, the system became more centralized. Today, monetary policy decisions are made by a specific group rather than spread across 12 banks.

How the Fed Is Structured

The Fed has five main components.

Federal Reserve District Banks

There are 12 district banks, each serving a geographic region. The New York district bank is the most important because that is where the big banks are. Each district bank has nine directors and handles operations like clearing checks, replacing old currency, and providing emergency loans to banks.

Member Banks

About 35% of all banks are Fed members, but they hold about 70% of all deposits. All nationally chartered banks must be members. State-chartered banks can choose.

Board of Governors

Seven people appointed by the President, each serving 14-year non-renewable terms. The long terms are designed to insulate governors from political pressure. One governor serves as chairman for a four-year term. Paul Volcker, Alan Greenspan, and Ben Bernanke are named in the book as especially influential chairmen.

The Financial Reform Act of 2010 added a Vice Chairman for Supervision role, responsible for developing policy on regulating the Board of Governors.

Federal Open Market Committee (FOMC)

This is where the action happens. The FOMC is the group that actually sets monetary policy. It consists of the 7 Board of Governors members plus 5 Fed district bank presidents (the New York president is always included, plus 4 others on rotation).

The FOMC meets eight times a year. Before each meeting, members receive the Beige Book, a report on economic conditions from all 12 districts. Staff economists present data on wages, prices, unemployment, GDP, and other indicators.

After reviewing all the data, FOMC members recommend whether to raise, lower, or hold the federal funds rate target. Most decisions are unanimous, though dissents are not unusual.

Advisory Committees

Three committees provide input: the Federal Advisory Council (banking industry), the Consumer Advisory Council (financial institutions and consumers), and the Thrift Institutions Advisory Council (savings banks, S&Ls, and credit unions).

How the Fed Controls Money Supply

The Fed has three main tools.

Open Market Operations

This is the primary tool. When the FOMC wants to lower interest rates, the Fed’s Trading Desk at the New York Fed buys Treasury securities from dealers. The dealers’ bank accounts increase, adding funds to the banking system. More funds means more supply of loanable money, which pushes rates down.

When the FOMC wants to raise rates, the Trading Desk sells Treasury securities. Dealers pay for them, their bank balances drop, and money gets pulled out of the system.

The important point: when the Fed buys securities, it creates new money in the system. When any other investor buys securities, the money just moves from one account to another. The Fed’s purchases are uniquely powerful.

Reserve Requirement Ratio

Banks must hold a percentage of their deposits as reserves. If the Fed lowers this ratio, banks can lend out more money, and the money supply grows. If it raises the ratio, banks lend less.

The book walks through the money multiplier with a clear example. If the reserve requirement is 10% and the Fed injects $100 million into the system, that money multiplies as banks lend and re-deposit. The theoretical maximum increase is $100 million x (1/0.10) = $1 billion.

In practice, the actual multiplier is smaller because people hold cash and banks keep excess reserves. The Fed rarely adjusts the reserve requirement because it can cause erratic swings in the money supply. The ratio has sat at 10% for transactions accounts since 1992.

The Lending Rate

The Fed offers short-term loans to banks through the discount window. Since 2003, this rate (the primary credit lending rate) is set slightly above the federal funds rate. Banks use it as a backup, not a primary funding source.

The Fed During the Credit Crisis

This is where the chapter gets really interesting. During the 2008 crisis, the Fed went far beyond its normal playbook.

Bear Stearns rescue. In March 2008, the Fed provided a loan through J.P. Morgan Chase to keep Bear Stearns alive. Bear Stearns was not a bank, so it normally could not borrow from the Fed. But it handled clearing operations for massive amounts of financial transactions. If it collapsed, those transactions could freeze.

Mortgage-backed securities purchases. The Fed started buying mortgage-backed securities, something it had never done before. The market for these securities had frozen because investors were terrified of defaults. The Fed stepped in as a buyer to restore some functioning.

Commercial paper purchases. After Lehman Brothers failed and defaulted on its commercial paper, investors panicked and stopped buying commercial paper from anyone. The Fed started purchasing it directly to keep that market alive.

Long-term Treasury purchases. Normally the Fed focuses on short-term securities. In 2010, it shifted to buying long-term Treasuries to push down long-term interest rates. The idea was to make mortgages and business loans cheaper.

TALF. The Term Asset-Backed Securities Loan Facility provided financing to institutions buying bonds backed by consumer loans, credit card loans, and auto loans. That market had also frozen, which was cutting off credit to consumers.

Not Everyone Agreed

The book notes that opinions about the Fed’s crisis response were mixed. Supporters said the Fed was necessary to prevent a complete financial collapse and keep credit flowing. Critics argued the interventions mainly helped Wall Street institutions and their highly paid employees, not regular people.

The Fed would counter that letting Lehman Brothers fail (which it did) showed it was not bailing out everyone. And restoring debt market liquidity helped all borrowers, not just financial institutions.

Global Monetary Policy

The chapter closes with a look at central banking globally. Most industrialized countries have central banks with similar goals: price stability and economic growth. They use similar tools: open market operations, reserve requirements, and lending rates.

The European Central Bank (ECB) is especially interesting because it sets monetary policy for all countries using the euro. This means individual countries like Greece or Spain cannot use their own monetary policy to fix local problems. When the eurozone economies weakened in 2008-2009, this created serious tensions. Countries that needed aggressive stimulus were stuck with the same policy as countries that did not.

My Take

The Fed chapter is one of those topics where the more you learn, the more you realize how much power one institution has. Eight meetings a year, and the decisions made in that boardroom affect mortgage rates, business loans, stock prices, and employment levels across the country.

The crisis interventions section is the highlight. The Fed basically rewrote its own rulebook in real time. Buying mortgage-backed securities, commercial paper, lending to non-banks. None of this was standard procedure. Whether you agree with the decisions or not, the speed and scale of the response was something.

The European section is a good warning about the limits of shared monetary policy. One size does not fit all, and that tension still creates problems.

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