Chapter 5: The Federal Reserve System of the United States
The U.S. dollar has become the leading reserve currency of the world.
Any discussion of financial and monetary system, especially regarding the LARIBA system as compared to the RIBA system, should be based on a clear understanding of how the U.S. Dollar monetary policies are handled.
It is a known fact that most world currencies are either directly pegged to the U.S. dollar or are dependent on the U.S. dollar.
This chapter is a must for everyone who has the dream of building a LARIBA banking system.
In an effort to stabilize the U.S. monetary element of the economy and to systemize the process of money and credit creation, the U.S. developed one of the most sophisticated central bank systems in the world.
The system is considered to be one of the most important pillars upon which the U.S. as whole is built.
The following is a summary of how the system was developed, where it derives its power from and how it operates.
MONEY CREATION IN THE U.S.
THE FEDERAL RESERVE SYSTEM
AMERICAN CURRENCY PROBLEMS BEFORE CREATION OF THE FEDERAL RESERVE
The small quantity of paper currency that circulated in the United States' early years consisted of the notes issued by the First (1791) and Second (1816) Banks of the United States--two precursors of the Federal Reserve.
After the Second Bank of the United States closed in 1836, the dominant form of currency became private bank notes issued by state-chartered commercial banks (normally redeemable on demand for gold or silver).
The U.S. did not have a uniform national currency, and the system of state-bank issues of notes was confusing and inefficient.
By the 1860s, as many as 8,000 different issues of state bank notes were circulating in the United Sates.
Banks rarely accepted at face value notes issued by banks unknown to them.
During the Civil War national bank notes were issued, and until 1913 these formed the bulk of the nation's paper currency.
National bank notes were currency the government gave to nationally chartered commercial banks for them to issue as their own.
National bank notes grew out of the government's need to raise money to finance the Union army.
Faced with a depleted treasury and reluctant to raise taxes on northern industry, President Lincoln reluctantly agreed to a plan formulated by his Secretary of Treasury, Salmon Chase.
Under Chase's plan, the federal government would offer a new type of banking license--a federal, or national, charter.
A bank with a national charter would have the power to issue a new form of currency; national bank notes.
However, for each note issued, the bank would have to hold a somewhat larger dollar value of government securities as collateral (a "backing" requirement).
The banks could purchase the government securities directly from the Treasury for gold and silver; a universally accepted money at that time.
In effect, the government would receive money assets (gold and silver) in return for its liabilities (government securities).
Chase's plan was embodied in the National Banking Act of 1863.
To enhance the prospect that national bank notes would be successful and to eliminate the competition from notes issued by state banks, Chase also developed a tax that Congress gradually increased until the state bank practice of issuing currency ended.
Because national bank notes had to be fully collateralized government securities, the nation's supply of paper currency effectively depended on the government's debt.
The supply of currency expanded and contracted in direct response to changes in the value of government securities in the nation's bond markets and not in response to the needs of the economy.
When the government began repaying its Civil War debt, redeeming and retiring securities issued in earlier years, the supply of collateral available in the banking system for note issuance shrank.
Currency was inelastic (incapable of adjusting to the public's changing needs and demands), and this led to the money panics (episodes of irrational public hoarding and runs on banks) that periodically plagued the economy of U.S.A.
THE PYRAMID OF BANK RESERVES
The National Banking Act of 1863 specified three tiers of reserve requirements for national banks.
Small "country" banks could keep some of their reserves in cash but were required to deposit most of their reserves with the larger "Reserve City" banks (those in the nation's major cities).
Reserve City banks had to deposit most of their own reserves in still larger "Central Reserve City" banks (those in the nation's money centers of New York, Chicago, and St. Louis).
The central reserve city banks had to keep all their reserves in vault cash.
The banking system's reserves were thus effectively dispersed throughout the country and could not be quickly transferred to banks in regions that might be under liquidity pressure.
Because the central reserve city banks were the ultimate depositories of the banking systems' reserves, they were particularly susceptible to the accumulation of pressures that often led to bank panics.
A bank panic would generally begin in the Midwest, when small banks found they did not have enough currency on hand to pay out to farmers.
These banks would call on their reserve city correspondents for their reserves.
The reserve city correspondents, in turn, would call on the central reserve city banks for their reserves.
Thus, a few central reserve city banks were often hit by the cumulative shock to liquidity that the needs of thousands of country banks generated.
A fundamental problem was lack of a lender of last resort for the banking system; a source of guaranteed liquidity that all banks could tap when they needed money.
THE FEDERAL RESERVE BOARD OF THE UNITED STATES OF AMERICA
The Federal Reserve power is derived from the U.S. constitution (Article I, Section 8).
The article states: "Congress shall have power ... to coin money (and) regulate the value thereof...." The Federal Reserve Act of 1913 established the Federal Reserve to realize the following objectives:
Furnish an elastic currency which responds to the economic meeds of the nation. Serve as a last resort to defend against any run on the banking system of the nations Establish a more effective and responsive system to supervise banks Improve the efficiency of the national payment mechanism
The 1946 Employment Act established the following national goals:
Full employment. Price stability. Economic growth. These goals were expanded in 1978 when the congress passed the Full Employment and Balanced Growth Act.
These are the expanded goals:
Increased real income.(net of inflation)
Balanced economic growth.
Balanced federal budget.
Growth in productivity.
Improved balance of trade.
The Act also required the Federal Reserve to report to the Congress twice a year on its monetary policies as they relate to the goals outlined in the 1978 Full Employment and Balanced Growth Acts.
FUNCTIONS OF THE FEDERAL RESERVE
The three basic functions of the Federal Reserve are:
1. Implementation of Monetary Policy:
This is done through the use of three primary control devices which are:
1.1.Setting the reserve requirements of the banks. 1.2.Setting the discount rate at which the Federal Reserve lends the banks.
1.3. Setting the monetary growth or contraction through the activities of the Federal Open Market Committee (FOMC).
The monetary expansion or contraction is done through the purchase or selling of Government securities respectively.
2. Providing Payment Services for the Depositories:
Like loans, check collections, currency insurance, wire transfers, and account settlements.
3. Serving As a Bank for the Federal Government:
3.1.Responsible for supervising and regulating banks. 3.2.Keeps U.S. Federal Government checking account.
3.3.Sells and redeems interest payment on U.S. Government securities.
3.4.Establishes relations with foreign central banks and foreign exchange trading world-wide.
The Federal Reserve was made as an independent branch of the politics of governing. The U.S. monetary policy, which includes adjusting interest rate and money supply, is designed and implemented without any political interference from the President or the Congress.
In such a unique set up the monetary policy would be implemented for the interest of the nation and not to promote a certain political party, the Congress or the President.
On the other hand, the President of the United States and the Congress decide on the fiscal policy of the Government which includes the federal budget, taxes and government spending.
The Federal Reserve structure as an independent central bank is unique among the world's central banks.
This adds to the power of the Federal Reserve to influence the U.S. economy and to bring creditability to he U.S. Dollar world-wide.
Structure of the Federal Reserve
The structure of the Federal Reserve is unique among the worlds central banks.
It consist of:
A presidentially appointed Board of Governors with general responsibilities for oversight, Twelve regional Federal Reserve banks that are private institutions nominally owned by their stockholders (commercial banks that are members of the Federal Reserve System), and The Federal Open Market Committee (FOMC). The committee is composed of a 12 member policy making committee of the Federal Reserve. The 12 members consist of the 7 governors appointed by the President and 5 regional reserve bank presidents.
The nations monetary policy is decided at the monthly meetings of the FOMC.
The Federal Reserve banks are directed by nine member boards of directors.
Congress again stipulated a unique structure for those boards to insure that the selection process does not favor bankers and allow them to become a majority on any given Federal Reserve bank board.
The Congress, in doing so, wanted to ensure that the views and concerns of all economic interest groups would be expressed and heard during the development of monetary policy.
The nine member board of directors of a Federal Reserve bank is elected as follows:
1.Member commercial banks elect 3 members from the banking community and 3 members from agricultural, commercial, industrial, services, labor, and consumer communities.
2.The Federal Reserve Board of Governors appoints three directors on its own. It also appoints the Reserve banks' presidents.
For a detailed description of the operation of Federal Reserve and the process used to adjust and manage interest rates please read David H. Fridman, Essential of Banking, American Banking Associations 1989.
The above discussion clearly indicates that interest rates especially related to the U.S. dollar are reflections of the way the Federal Reserve Board manages its monetary policy in response to many other factors.
Hence; the real intention of this section.
It is hoped that those who translate LARIBA banking as interest free banking would understand that LARIBA banking is much deeper in goal and fundamentally different at heart from just waiving the word "interest" away.
CREATION OF CREDIT AND THE MONEY MULTIPLIER OF THE U.S BANKING SYSTEM
"T" ACCOUNT TRACKING OF ONE LOAN MADE BY A BANK AND THE MULTIPLE DEPOSITS IT GENERATES
"T" accounts are abstracts of a bank's balance sheet that show only the changes in the bank's assets and liabilities.
For the sake of simplicity, assume, in this T-account example, that
All the deposits created by banks stay in the banking system. Demand deposits are the only form in which newly created funds are held. Banks lend out every available dollar. These assumptions do not by any means reflect reality.
Some deposits created by banks leak out of the banking system into non-bank financial institutions and money market instruments.
Consumers and businesses typically convert some newly acquired demand deposits into cash.
Banks do not usually lend (or invest) every available dollar not because they do not want to, but because the pace with which deposits flow in and out of banks on any given day is often so rapid and the volume so large, and the net effect of check collections so uncertain, that only at the end of the day do banks know just how much net funds they have to support new loans.
Nonetheless, these assumptions, abstract as they maybe, do not distort the fundamental process by which banks create deposits, which takes place in the following sequence of steps:
1. Assume that bank A receives a cash deposit of $10,000 from a customer for credit to the customer's transaction account.
Under Federal Reserve requirements, the bank must hold an amount of reserves--vault cash or deposit balances at a Federal Reserve bank--equal to a fixed percentage of its deposits; assume 10 percent.
Thus, Bank A must hold $1,000 in required reserves against its new $10,000 deposit and has $9,000 in excess reserves.
These excess reserves can support a new $9,000 loan and the creation of $9,000 in demand deposits entailed by such a loan.
Cash Assets $10,000* Demand Deposits $10,000
New Loans $9,000 borrowing $ 9,000
* Required reserves $1,000 (10% of deposits)
2. When Bank A makes the loan, both its assets and its liabilities will temporarily increase to $19,000, reflecting the addition of the loan to its earning assets portfolio and the addition of the newly created demand deposit to its total liabilities.
However, as soon as the borrower uses the newly created funds, Bank A's assets and liabilities will decline to their pre-loan level as an inevitable result of the check collection process.
3. Assume that the borrower writes a check for the loan amount to a manufacturing company that has an account at Bank B.
When the borrower's $9,000 check clears, bank A will have to transfer $9,000 of its cash assets in payment for the check to the presenting bank (Bank B).
Bank A will also strike the $9,000 demand deposit liability carried for the borrower from its books.
Thus, after check clearance, Bank A has $10,000 in assets and $10,000 in liabilities.
Note, however, that the composition of its assets has changed.
Before the loan, it had $10,000 in cash assets, now it has $1,000 in cash assets and $9,000 in loan assets.
The $1,000 in cash assets meets the assumed 10 percent reserve requirement ratio against transaction account liabilities
BANK A BANK B
Assets Liabilities Assets Liabilities
Cash Demand Cash Demand
Assets $1,000 deposit $10,000 assets $9,000a deposit $9,000
a. Required reserves$ 900
Excess reserves $8,100
4. The $9,000 in deposit created by Bank A is now a demand deposit on the books of bank B, increasing that bank's liabilities.
However, Bank B also received a transfer of $9,000 in cash assets when it received payment for the check deposited by the manufacturing company.
Bank B, subject to the same 10 percent reserve requirement as Bank A, must keep $900 against the deposit but can use the remaining $8,100 to support a new loan and the creation of a new $8,100 deposit.
5. When Bank B makes the $8,100 loan its assets and liabilities will increase initially and then decline to their pre-loan level in response to the collection of the borrower's check.
Assume that the borrower writes a check for the loan amount to pay for a corporate service and that the corporation deposits the check in its account in Bank C.
Bank B's newly created $8,1000 will now reside as a liability in Bank C, together with the $8,100 in cash assets Bank B had to transfer in payment for the check.
BANK B BANK C
Assets Liabilities Assets Liabilities
Cash Demand Cash Demand
Assets $ 900 deposit $9,000 assets $8,100a deposit $8,100
a. Required reserves$ 810
Excess reserves $7,290
6. Bank C, in turn, will now be able to create demand deposits equal to 90 percent of its new cash assets.
If it does so it will give still another bank the ability to create new deposits.
In theory, this process of bank deposit creation can continue through hundreds of banks, generating, in this example, a total amount of deposits on all banks' books 10 times grater than the $10,000 in cash deposits that started the process.
The "multiplier," or expansion coefficient, is the reciprocal of the reserve requirement ratio.
In this example, because the reserve requirement ratio is 10 percent, the multiplier is 10.
This simple multiplier is valid only in the context of this example.
In the real world of banking there are separate reserve requirements for different types and amounts of liabilities.
This multiple expansion of bank-created deposits is characteristic of banking systems but not of individual banks.
No bank can create deposits in any amount greater than its excess reserves.
If it did, it would find itself in a reserve deficiency as soon as the borrower's check cleared.
This act violates the Federal Reserve rules and the bank will be subject to severel federal stipulations, controls and penalties.