Chapter 10.2 Function of the Fed
10.2 Function of the Fed
Learning Objectives
By the end of this section, you will be able to:
- List the four functions of the Federal Reserve (the Fed)
- Understand how the Fed maintains the stability of the nation’s banking system
- Explain how deposit insurance protects against bank runs
Functions of The Fed
The Federal Reserve, like most central banks, is designed to perform four important functions:
- To conduct monetary policy
- Administrative functions such as clearing interbank payments
- To promote stability of the financial system by imposing rules and regulations
- To serve as the lender of last resort
Conducting monetary policy is the most important function and will be discussed in Chapter 12.3.
Administrative Services to Commercial Banks
The Federal Reserve provides many of the same services to banks as banks provide to their customers. For example, all commercial banks have an account at the Fed where they deposit reserves. Similarly, banks can obtain loans from the Fed through the “discount window” facility, which we will discuss in more detail later. The Fed is also responsible for check processing. When you write a check, for example, to buy groceries, the grocery store deposits the check in its bank account. Then, the grocery store’s bank returns the physical check (or an image of that actual check) to your bank, after which it transfers funds from your bank account to the grocery store’s account. The Fed is responsible for each of these transactions.
In addition, the Federal Reserve ensures that enough currency are circulating through the financial system to meet public demands. For example, each year the Fed increases the amount of currency available in banks around the Christmas shopping season and reduces it again in January.
Finally, the Fed is responsible for assuring that banks are in compliance with a wide variety of consumer protection laws. For example, banks are forbidden from discriminating on the basis of age, race, sex, or marital status. Banks are also required to disclose publicly information about the loans they make for buying houses and how they distribute the loans geographically, as well as by sex and race of the loan applicants.
Imposing Rules and Regulations
A safe and stable national financial system is a critical concern of the Federal Reserve. The goal is not only to protect individuals’ savings, but to protect the integrity of the financial system itself. This important task came into view during the 2008–2009 financial crisis, when for a brief period of time, critical parts of the financial system failed, and firms became unable to obtain financing for ordinary parts of their business. Imagine if suddenly you were unable to access the money in your bank accounts because your checks were not accepted for payment and your debit cards were declined. This gives you an idea of a failure of the payments/financial system.
Bank regulation is intended to maintain banks’ solvency by avoiding excessive risk. Bank regulations falls into three categories, (1) reserve requirements, (2) capital requirements, and (3) restrictions on the types of investments banks may make. In chapter11-3 (Banking System), we learned that the reserve required ratio is the percent of all deposits that banks must keep “on hand” as reserves. “On hand” very often means that a portion of bank reserves are held as cash in the bank, while the majority are held in the bank’s account at the Federal Reserve, and their purpose is to cover desired withdrawals by depositors. Setting the reserve requirement ratio, is a major function of the Fed. Not only the fed ensures that banks have enough cash available for customer withdrawals, but, they control the increase of money supply through the reserve ratio. For example, a lower reserve ratio, means that banks need to keep less cash as reserves and more money available for loans, thus a higher increase in money supply.
Another part of bank regulation is restrictions on the types of investments banks are allowed to make. Banks are permitted to make loans to businesses, individuals, and other banks. They can purchase U.S. Treasury securities but, to protect depositors, they are not permitted to invest in the stock market or other assets that are perceived as too risky.
Bank capital is the difference between a bank’s assets and its liabilities. In other words, it is a bank’s net worth. A bank must have positive net worth; otherwise, it is insolvent or bankrupt, meaning it would not have enough assets to pay back its liabilities. Regulation requires that banks maintain a minimum net worth, usually expressed as a percent of their assets, to protect their depositors and other creditors.
Lender of Last Resort
The Federal Reserve Bank has the discretionary power to lend money to banks and other depository institutions. Every day at the end of the day, banks must deposit overnight at the Fed the reserve requirement. Reserve requirement is the percent of all deposit’s banks must keep aside as cash, deposit at the Fed and not lend to their own customers. If a bank is unable to come up with the reserve requirement, they can borrow from other banks. However, as a “lender of last resort” the Fed stands ready to lend to banks and other financial institutions when they cannot obtain funds from anywhere else.
In addition, as a lender of last resort, the Fed can prevent a bank from failing. For example, during a financial crisis. During the 1987 stock market crash panic, when U.S. stock values fell by 25% in a single day, the Federal Reserve made a number of short-term emergency loans so that the financial system could keep functioning. An example of this would be how during the 2008-2009 recession, the Fed adopted “quantitative easing” policies (discussed next unit) in order to make short-term credit available as needed in a time when the banking and financial system was under stress.
Bank Runs
Back in the nineteenth century and during the first few decades of the twentieth century (around and during the Great Depression), putting your money in a bank could be nerve-wracking. Imagine that the net worth of your bank became negative, so that the bank’s assets were not enough to cover its liabilities. In this situation, whoever withdrew their deposits first received all of their money, and those who did not rush to the bank quickly enough, lost their money. We call depositors racing to the bank to withdraw their deposits, as Figure 12.3 shows a bank run. In the movie It’s a Wonderful Life, the bank manager, played by Jimmy Stewart, faces a mob of worried bank depositors who want to withdraw their money, but manages to allay their fears by allowing some of them to withdraw a portion of their deposits—using the money from his own pocket that was supposed to pay for his honeymoon.
Figure 10.3 A Run on the Bank Bank runs during the Great Depression only served to worsen the economic situation. (Credit: “Depression: “Runs on Banks” by National Archives and Records Administration, Public Domain)
The risk of bank runs created instability in the banking system. Even a rumor that a bank might experience negative net worth could trigger a bank run and, in a bank run, even healthy banks could be destroyed. Because a bank loans out most of the money it receives, and because it keeps only limited reserves on hand, a bank run of any size would quickly drain any of the bank’s available cash. When the bank had no cash remaining, it only intensified the fears of remaining depositors that they could lose their money. Moreover, a bank run at one bank often triggered a chain reaction of runs on other banks. In the late nineteenth and early twentieth century, bank runs were typically not the original cause of a recession—but they could make a recession much worse.
Deposit Insurance
To protect against bank runs, Congress has put two strategies into place: deposit insurance and the lender of last resort. Deposit insurance is an insurance system that makes sure depositors in a bank do not lose their money, even if the bank goes bankrupt. About 70 countries around the world, including all of the major economies, have deposit insurance programs. In the United States, the Federal Deposit Insurance Corporation (FDIC) is responsible for deposit insurance. Banks pay an insurance premium to the FDIC. The insurance premium is based on the bank’s level of deposits, and then adjusted according to the riskiness of a bank’s financial situation. In 2009, for example, a fairly safe bank with a high net worth might have paid 10–20 cents in insurance premiums for every $100 in bank deposits, while a risky bank with very low net worth might have paid 50–60 cents for every $100 in bank deposits.
Bank examiners from the FDIC evaluate the banks’ balance sheets, looking at the asset and liability values to determine the risk level. The FDIC provides deposit insurance for about 4,914 banks (as of the third quarter of 2021). Even if a bank fails, the government guarantees that depositors will receive up to $250,000 of their money in each account, which is enough for almost all individuals, although not sufficient for many businesses. Since the United States enacted deposit insurance in the 1930s, no one has lost any of their insured deposits. Bank runs no longer happen at insured banks.
This chapter is a revised version of the chapter 15.2 Bank Regulation in Principles of Macroeconomics 3e by OpenStax, published under a Creative Commons Attribution 4.0 International License. Other additions and modifications have been made in accord with the style, structure, and audience of this guide.
