Federal Reserve System

What It Is

The Federal Reserve System (FRS) is the U.S.'s central bank. The Federal Reserve manages the economy's money supply, regulates the banking industry, acts as a clearinghouse for checks and other payments conducted through the banking system, operates the U.S. Mint and provides banking services to the U.S. government.

The Federal Reserve was created by the Federal Reserve Act of 1913 after years of national financial crises caused massive deposit withdrawals by bank customers and widespread bank failures. Several subsequent pieces of legislation clarified and added to the Federal Reserve's responsibilities.

Not all banks are members of the Federal Reserve system, but the Monetary Control Act of 1980 made the difference between members and nonmembers nominal: all depository institutions must maintain reserves within the Federal Reserve system and may use certain Federal Reserve payment services.

How It Works

The Federal Reserve system is composed of three parts: the Board of Governors, the Federal Open Market Committee, and 12 regional reserve banks.

The Board of Governors

The Board of Governors is the decision-making body at the Federal Reserve. There are seven members on the Board of Governors, and each is appointed to a 14-year term by the president of the United States with the advice and consent of the Senate. The president designates the chair and the vice chair of the Federal Reserve Board. Three committees advise the Board of Governors: the Federal Advisory Council, the Consumer Advisory Council and the Thrift Institutions Advisory Council.

The Board of Governors sets reserve requirements and regulates the asset holdings of banks. The Board of Governors shares several banking supervision responsibilities with the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation.

The chairman of the Federal Reserve is an alternate U.S. member of the Board of Governors of the International Monetary Fund and the National Advisory Council on International Monetary and Financial Policies.

The Federal Open Market Committee

The Federal Open Market Committee (FOMC) is composed of the Board of Governors, the president of the New York District Federal Reserve Bank and four other Federal Reserve District bank presidents. The chair of the Board of Governors is also the chair of the FOMC. The FOMC's primary responsibility is to purchase or sell U.S. Treasuries in the open market at the direction of the Board of Governors. This is done as part of the Federal Reserve's ongoing efforts to regulate the nation's money supply.

Federal Reserve Banks

The Federal Reserve's 12 district banks are located in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas and San Francisco. There are also 25 Federal Reserve bank branches. Federal Reserve banks have many responsibilities: they operate their local mints and handle a large portion of the country's check-clearing services, as well as monitor and lend to the banks in their regions. The Federal Reserve banks also act as depositories for member banks.

Federal Reserve Banks are nonprofit institutions owned by the member banks in their districts, although their earnings belong to the U.S. Treasury. Member banks must purchase stock in the Federal Reserve Bank in an amount equal to 3% of their capital and surplus. Member banks may not sell or collateralize their ownership, but they receive a 6% dividend per year and can vote for directors.

Why It Matters

The overall purpose of the Federal Reserve system is to maintain long-term economic prosperity through the execution of monetary policy and preservation of the public's faith in the U.S. banking system. The Federal Reserve uses three methods to conduct monetary policy: altering bank reserve requirements, buying and selling U.S. government securities in the open market and changing the Federal Reserve Discount Rate.

The Federal Reserve system exerts substantial influence on many economic factors because its decisions and actions are at the center of U.S. monetary policy. Thus, the anticipated actions of the Federal Reserve are the subject of considerable speculation.

It is important to note that monetary policy is not the same thing as fiscal policy, which is formulated and executed by the U.S. Treasury and other members of the president's administration. Although Congress oversees the Federal Reserve System, the Federal Reserve has legal authority to execute monetary policy free from political pressure, and its decisions do not need approval from the executive branch of the government. However, the Board of Governors has regular contact with the president's Council of Economic Advisors, and the policies of the Treasury and the Federal Reserve are often similar.

Source: Investing Answers