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Sample Term Paper on Federal Reserve System

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Sample Term Paper on Federal Reserve System

Introduction

The current banking system in the United States is a culmination of centuries of progressive development since the establishment of the first commercial bank in 1782 (Mishkin, 2007). Following previous problems associated with security in the banking industry, the Federal Reserve System was established in 1913 (Mishkin, 2007). The establishment of the Fed, as the Federal Reserve Bank is popularly known, became the first step towards a central banking system in the nation. The sole purpose at its establishment was the promotion of a safer banking system; with the requirement, all national banks become members of the Fed. Additionally, the stipulation for the establishment of the Fed was with the intention of having an independent body that would attend to the nation’s monetary and credit needs absent of undue manipulation from the political sphere (Smale, 2010). Over the years however, the responsibility of the Fed has swollen to include monitoring and regulation of national banks. This expanded role has included a monetary policy, which had aimed at maintaining low interest rates especially at the start of 2000. The recent economic recession has however invited a lot of criticism over the role of the Fed in the crisis, with some blaming its maintenance of lower interest rates as the cause of rising housing prices just before the start of the recession. Even with such criticism, the Fed remains a relevant and vital part of the nation’s financial and banking sector, as well as the entire nation’s economy.

The US banking system established in 1782 had grown with more players getting into the industry after the chartering of the Bank of North America. Growth in the industry led to a number of controversies especially regarding national and state interests on chartering of the banks. Most federalists argued for the establishment of a centralized banking system with the federal government as the sole entity for chartering banks (Mishkin, 2007). While this argument carried the day with the chartering of the Bank of United States in 1791, which had feature of both a private and a central bank (Johnson, 2010), the feat was short-lived following suspicions by the agricultural interests of the dangers of a centralized system, that led to the non-renewal of the bank’s charter in 1811 (Mishkin, 2007).

There was however still need for the establishment of a bank that would protect the interests of consumers, given that regulations in the banking sector were lax and therefore led to loss of money by depositors due to bank fraud and insufficiency in capital by a majority of the banks (Smale, 2010). The result of such laxity and fraud had been financial crises and panics, which not only led to depositors losing their money, but also wrecked havoc in the brittle banking system (Federal Reserve System, 2005). To alleviate such panics therefore, Congress passed the Federal Reserve Act of 1913 that established the Fed, mandated “to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes” (Federal Reserve System, 2005, p. 2). While the Fed was established as an independent entity, it works within government-established framework of both financial and economic policies, with the Congress as an oversight.

The structure of the Fed therefore starts with the Congress as the oversight authority within which the Fed works. The operations of the system are however undertaken by the Board of Governors, a seven-member board selected by the president in consultation and approval by the Senate. Each of these serve a 14-year term staggered into two-year terms (Federal Reserve System, 2005). Part of the reason for longer terms of the member of the board is to ensure that they are free from political influence given that the members serve longer than the presidents who appoint them. Additionally, the staggering and long terms are purposed to ensure consistency and stability in the board.

Two members of the board are designated to be chair and vice chair of the board, with both serving four-year renewable terms, currently Janet L Yellen chairs the board. Members of the board come from one of the twelve Federal Reserve Districts, with their appointment guided by the law. From the Federal Reserve Act, presidential selection of members of the Board should be a “fair representation of the financial, agricultural, industrial, and commercial interests and geographical divisions of the country” (Federal Reserve, 2003). Such conditionality guarantees the representation of both regional and diverse public sectors’ interest in policymaking and regulation.

As the central seat of power of the Fed, the Board of Governors forms a section of a larger board that includes the seven-member governors’ board and an additional 5-member presidential board composed of Reserve Bank presidents. These jointly form the most important part of the Fed system in monetary policymaking known as the Federal Open Market Committee (Federal Reserve, 2003). While the president of the New York Federal Reserve Bank is a permanent member of the FOMC, others are chosen on a one-year rotation from the 12 Reserve districts (Federal Reserve, 2003). 

The FOMC is traditionally chaired by the chair of the board and the vice the president of the New York Reserve Bank (Federal Reserve, 2003). Meetings of the Committee are scheduled at least four times yearly, with a traditional venue at Washington D.C. it is however possible for the scheduling of a special meeting in which members can attend via conference or vote on  a proposed policy via telephone or telegram. Meetings therefore typically discuss the current and future prospective within the economic environment, both in the nation and in the international market and the direction of policy. After each member of the Committee has aired their view of the matter, they reach a consensus, which is then implemented through the New York Reserve Bank, which performs business for the System Open Market Account (Smale, 2010).

The twelve-member Reserve Banks form an important part of the Fed System. The Governors Board traditional plays an administrative role on the operations of each of the Banks as part of the daily running of the Fed system. These members are selected from geographic districts within the nation, with a city designated as the Reserve Bank location.  The Reserve Bank city locations are San Francisco, Dallas, Kansas City, Minneapolis, St. Louis, Chicago, Atlanta, Richmond, Cleveland, Philadelphia, New York and Boston (Federal Reserve System, 2005). These exclude the 25 Reserve Bank branches that the Governors’ Board has established over the years (Smale, 2010).

The management of the 12 Reserve Banks is under a nine-member director’s board stretched under classes A B and C. These directors, on a spread out basis, serve three-year tenures. However, “The three Class A and Class B directors are elected by the member banks in each district. Three Class C directors are appointed by the Board of Governors”(Smale, 2010, p. 4). While Class A directors are a representation of the member banks’ interests, “The remaining six directors represent the general public and are selected with due consideration to the interests of agriculture, commerce, industry, services, labor, and consumers” (Smale, 2010, p. 4).

The structure of the Federal Reserve System allows the Fed to effective perform its functions and responsibility as stipulated by the Act establishing it, which over the years has undergone several amendments to include other functions in light of developments in the domestic and international economic spheres. While the core reason for making the Fed independent was to draw it away from political pressure, and therefore allow it to perform its function independently, critics have recently criticized this autonomy, given that some of the monetary policies churned from the Governors’ Board are blamed for the nation’s dip into the economic recession (Alden, 2011).

Such accusations came on revelation of the Fed’s secret dealings with Goldman Sachs, Royal Bank of Scotland and Credit Suisse, all of which are foreign banks, and received $30 billion each, at a rate of 0.01 percent interest  in the thick of the global financial crisis in 2008 (Alden, 2011). These dealings had been shrouded in secrecy, and their revelations fueled the “accusations that the central bank is a power unto itself, operating according to its own devices and in the interest of major financial institutions — and beyond accountability to taxpayers” (Alden, 2011). Retorts to these accusations have maintained that the Fed has the responsibility of keep certain transactions secret for the greater good of the economy and the financial system. Operating in confidentiality is therefore not a new feature in the Fed’s operations since proceedings of the FOMC meetings have restricted attendance given the classified nature of information under discussion (Federal Reserve System, 2005)

Part of the function of the Fed is the maintenance of the interest rate. In the period before the 2008 to 2009 economic recession, the Fed’s monetary policy had maintained and continues to maintain a low interest rate (Lowrey, 2013). In conjunction with the reserve banks, the Board of Governors has a shared responsibility for the nation’s discount policy rate, as well as the open market operations. In light of the previous economic recession however, the maintenance of a low interest rate has been criticized as the reason for the stagnation of the economy. Critics have specifically indicated, “The zero nominal interest rate is a chronic and systemic inhibitor of economic activity” (Lowrey, 2013). In a rejoinder however, it is important to note that the Fed’s maintenance of a low interest rate is not a perpetual monetary policy. Part of such a low interest rate is in fact the Fed is in essence, working to stimulate job creation, as well as work towards spurring the economy and growth despite the low interest rates (Lowrey, 2013).

The balance between inflation the low interest rates and the prevailing economic conditions is part of the Fed’s Dual Mandate responsibility. In acting to stimulate job creation and maintain stable prices therefore, the Fed is acting within its constitutional mandate. Under the Taylor’s rule where higher interest rates are charged at either inflation or high unemployment rates, and the reduction of the same in converse conditions, the Fed’s current actions are therefore in line with Taylor’s rule, given that the unemployment rate stands at 7.3 percent (Lowrey, 2013). The maintenance of the low interest rate, especially in the early to mid 2000s, which culminated into substantial credit expansion, and consequently the financial crisis, has been one of the downsides of the systemic risk in which there were financial interdependencies, which resulted in the failure of some of the largest financial institutions in the nation.

The Fed remains a relevant and important institution of the US economy and financial system. Its structure ensures that it carries out its mandate without influence from within political factions. The most important function of the Fed remains the formulation of monetary policies for stabilization of the economy and checking on prizes. Additionally, it plays a regulatory role especially on the member banks to ensure the existence of a safe banking environment and that these banks maintain sound business practices. While it has been blamed in part for the deterioration of the economy, the recent financial crisis and operation in secrecy, the Fed remains committed to its mandate and has so far been seen spurring growth in the economy through promotion of job creation programs. Among the steps taken included quantitative easy, in which the Fed buys long-term Treasury, and in so doing creates more resources to the system and stimulates borrowing, all aimed at spurring economic growth. The Fed therefore remains a relevant and an imperative component of the financial system.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

References

Alden, W. (2011, May 26). Federal Reserve Lending Revelations Intensify Criticism of Central Bank’s Secrecy. Huffington Post.

Federal Reserve Board (2003). The Structure of the Federal Reserve System. Federal Reserve Board. 

Federal Reserve System. (2005). Federal Reserve System: Purposes and Functions. Washington, DC: Federal Reserve System

Johnson, R., T. (2010). Historical Beginnings…The Federal Reserve. Boston: Federal Reserve Bank of Boston

Lowrey, A. (2013, November 8). Candid Criticism for Fed that Wasn’t on the Agenda. The New York Times

Mishkin, F. S. (2007). The Economics of Money, Banking and Financial Markets, 8th ed. Pearson Addison Wesley

Smale, P. (2010). Structure and Functions of the Federal Reserve System. Congress Research service

 

 

 

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