Central Banking and the Federal Reserve System Flashcards
The origins of US central banking began in 1781 when Robert Morris obtained a charter to open the Bank of _____________.
North America. Morris wanted to open a central bank modeled on the British Empire’s Bank of England. It did not rise to become a central bank because at that time, US financial markets were decentralized and it was very small compared to other central banks.
The second attempt by the US at creating a central bank came in 1791 when the nation’s first Secretary of the Treasury, __________________, was granted a twenty-one year charter by Congress to open the First Bank of the United States.
Alexander Hamilton. He wanted to create a central bank to rival the Bank of England and so it was modeled along those lines. Branches were opened across the country. It was stable and profitable, but the charter was not renewed for fear that too many foreigners had acquired shares in the bank and it would become powerful enough to affect the affairs of other banks.
The Second Bank of the United States operated only from 1816 to 1836, after which followed a period of ____-banking.
Free. This was a period where there was no central bank or federal regulation of state banks. Each state had their own rules. It lasted throughout the Civil War period.
The Federal Reserve Act of ____ created the Federal Reserve System (FED) of central banking institutions which were supervised by the Federal Reserve Board.
1913.
The FED was restructured in 1935 by the Banking Act as a consequence of the ________________.
Great Depression. This event led to many banking collapses which the FED decided not to prevent. This in turn caused an economic and financial collapse in the US. The banking system had become illiquid when the FED was meant to provide liquidity. Thus, reform was essential.
The 1935 Act introduced the new _____-member Board of Governors of the FED as the main policy-making unit in the FED.
Seven. These 7 members (or governors) are appointed by the President and confirmed by the Senate for 14 year terms.
The 1935 Act also introduced the Federal ___________ Committee comprising of the seven governors and five district FED bank Presidents.
Open Market. The FOMC determines the FED’s open market operations. Thus, many of the day-to-day policy decisions are taken by this group.
The President of the Federal Reserve Bank of New York serves as the permanent _____________ of the FOMC and is always a voting member because this bank implements the FED’s open market operations and foreign exchange trading.
Vice Chairman. The FOMC has 12 voting members–the seven members of the Board of Governors and five Reserve Bank presidents. The Chairman of the Board of Governors serves as the permanent Chairman of the FOMC, and the President of the Federal Reserve Bank of New York serves as the permanent Vice Chairman.
The FED board supervises ______ district Federal Reserve banks.
Twelve. This is the structure of the FED. The 12 district banks supervise and regulate the member banks.
The FED board is led by its chairperson, currently ______________, who was originally chosen by the President for a four year term.
Alan Greenspan. This is the current chairperson of the FED and he has held this role since 1987. (NOTE: Actually, as of Feb 2006, Ben Bernake has taken this position. However, the textbooks that were used in the development of the Money and Banking exam probably still reference Alan Greenspan as the FED chairperson)
Member banks of the FED purchase stock in their district FED bank and can vote in six of the ____ directors of the district bank.
Nine. This is the limit set by law. The stocks they purchase earn them a fixed 6% return. The remaining three directors are selected by the FED Board.
The three main activities of the FED are supervising and regulating banks, providing banking services to depository institutions and the Treasury, and determining ________ policy.
Monetary. Determining monetary policy is one of the roles of the FED. So, for example, the reserve rates determined by the FED are a tool of monetary policy.
The FED is the US Treasury Department’s ______ agent.
Fiscal. The Federal Reserve System (FED) issues, services, and redeems debts on behalf of the Treasury Department.
The FED acts as a depository institution for the Treasury Department, and also manages their Treasury ____________ accounts deposited at private depository institutions.
Tax and Loan. Treasury Tax and Loan (TT&L) accounts are special checking accounts the Treasury Department has with private depository institutions. Most Treasury payments to people and businesses originate from Federal Reserve banks, not private banks.
The FED operates systems for the Treasury to sell new securities and make principal and interest payments on outstanding securities. Therefore, as the fiscal agent, depository institution, and manager of TT & L accounts, the FED could be said to be the __________’s bank.
Government. The Federal Reserve System performs all these functions for the US Treasury Department, so it would be accurate to say that the FED acts as a bank for the government.
The key monetary policy tool of the ________ banks is the discount rate.
District. The discount rate is the rate the FED charges to depository institutions when they borrow from the FED. The district banks propose this rate to the FED board, and they accept or reject it. This rate is usually lower than the money market rate.
Notice that we’ve discussed two main tools the FED uses to influence monetary policy–setting the reserve requirements for banks, and setting the discount rate. The third main tool the FED uses, which we’ve briefly alluded to, is where the FED constantly buys and sells U.S. government securities in the financial market, which in turn influences the level of ________ in the banking system.
Reserves. Influencing the level of reserves affects the federal funds rate - the interest rate at which banks borrow reserves from each other.
All banks are subject to reserve requirements, but frequently fall below requirements in the carrying out of day-to-day business. To meet requirements they have to borrow from each other’s reserves.
The more the banks are borrowing from each other, the more of a market it creates for reserve funds, which means it raises the federal funds interest rate. This is how the Fed can increase or decrease the federal funds rate, which will impact (over time) every other interest rate charged by U.S. banks.
This can get kind of confusing, so to boil it down–the Fed buys and sells U.S. government securities to influence the level of reserves in the banking system, which in turn affects the federal funds rate (the interest rate at which banks borrow reserve funds from each other), which in turn affects every other interest rate charged by banks.
The FED has three programs to provide depository institutions with borrowed funds - extended credit for exceptional circumstances, extended credit for ________ needs, and adjustment credit.
Seasonal. This is usually for smaller institutions that face large seasonal needs that they cannot supply without disrupting their normal portfolio.
Note that these three programs for providing banks with borrowed funds are called discount window programs, because the banks borrow from the FED at the discount rate.
Adjustment credit refers to loans advanced for a maximum of __ days to aid institutions by meeting needs that cannot be reasonably satisfied from market sources.
- This is the cap applied by the FED and this loan is intended to meet unexpected or temporary liquidity needs.
The FED views ___________ as a privilege, not a right, and hence the following are considered unacceptable reasons for borrowing: to support loan or investment expansion, to benefit from the differential between market and discount rates, to substitute for normal fund sources, and to substitute capital.
Discounting. The bank should have adequate capital without having to borrow from the FED.
Research has shown that when the spread between the discount rate and the federal funds rate is _____, then borrowing from the FED tends to go up and this could be construed as evidence of the profit incentive to borrow from the FED.
Large. Generally, only large banks borrow directly from the Fed and get the benefit of borrowing at the lower discount rate. Since the large banks lend to the small banks at the federal funds rate, that means that when the spread between the discount rate and funds rate grows, the profit for the large banks grow. Therefore, banks have a better profit margin when borrowing from the FED.
So, even though banks aren’t technically allowed to borrow from the FED to benefit from this spread, it is arguable that some profit based discounting takes place.
When the FED informs everyone that the ________ rate is changed, an announcement effect occurs.
Discount. On the day after the discount rate changes, the market rates move in the same direction as the discount rate, albeit temporarily, as a signal of FED monetary policy. This is called an “announcement effect.”
The main supervisory functions of the Federal Reserve Banks include currency distribution, processing _________ of payments, funds transfer between depository institutions, research on economic conditions, and issuance and redemption of federal debt.
Clearings. This is one of their tasks - to process clearings of electronic and non-electronic payments. This includes clearing checks.
The FED supervises the US payments system because of considerable risk of negative _____________ or systemic risk, as these systems are extremely complicated.
Externalities. Systemic risk is the risk that some depository institutions may not be able to meet their credit agreement terms because of a failure by other institutions to settle transactions that may or may not be related.
