Federal Reserve System in the United States

Introduction

The Federal Reserve System, the central bank of the United States, administers and formulates the Nation’s credit and monetary policy.

The Federal Reserve System (FRS) was established by the Federal Reserve Act (12 U.S.C. 221), approved December 23, 1913. Its major responsibility is in the execution of monetary policy. It also performs other functions, such as the transfer of funds, handling Government deposits and debt issues, supervising and regulating banks, and acting as lender of last resort.

FRS contributes to the strength and vitality of the U.S. economy. By influencing the lending and investing activities of depository institutions and the cost and availability of money and credit, the FRS promotes the full use of human and capital resources, the growth of productivity, relatively stable prices, and equilibrium in the Nation’s international balance of payments. Through its supervisory and regulatory banking functions, FRS helps maintain a commercial banking system that is responsive to the Nation’s financial needs and objectives.

Origens of the FRS

The National Banking System, which in 1913 contained a total of about 7,500 members, had been organized during the Civil War, the constituent Act being passed in 1863 and modified in the following year. It provided for the creation of independent institutions operating under the general requirements of the National Banking Law, but organized directly at the will of prospective stockholders. The fundamental basis of the law was “free banking,” as reflected in general authority to organize banks provided that the capitalization of each institution should not be less than a specified sum varying with the population of the place in which the proposed bank was to be situated. The minimum of capitalization was $50,000 (changed in 1900 to $25,000).

Currency issued by the national banks was based upon and protected by Government bonds which each bank was required to purchase in a specified amount, not exceeding, however, a sum equal to the capital of the bank. Bond purchase provisions were later modified, but the essential principle remained. When these bonds had been purchased they were deposited with the Treasurer of the United States who thereupon issued circulating notes to the bank. Each bank was required to maintain a specified reserve which amounted to 25% in the case of banks located in three central reserve cities (New York, Chicago and St. Louis), while in reserve cities (eventually nearly 50 in number) the requirement was 12½% cash in vault and 12½% in the form of balances in banks in the central reserve cities. All other banks were required to keep 15% reserve, of which 6% had to be cash in vault and 9% might be in the form of balances in the banks of central reserve cities.

This system had proved inadequate because in time of stress or panic there was no recognized means for relieving hard-pressed banks; also the currency was inelastic, being limited by the amount of bonds available, and being slow in its issue and even slower in redemption. During and shortly after the panic of 1893, an agitation was started in favour of some plan for the issue of “emergency currency” as a means of preventing the development of acute panics; this ultimately grew into a demand for a currency not purely of emergency nature but elastic as required by business needs, and therefore including issues of ordinary bank-notes protected by the joint guarantee of the banks. The only practical outcome of this agitation was seen in certain sections of the Gold Standard Act of 1900. These provided for refunding the outstanding U.S. bonds at a rate (2%) which precluded the growth of a premium while it authorized banks of $25,000 capital in places with less than 3,000 people. Both provisions tended to make the issue of notes easier.

Although numerous bills were urged, especially after 1907, the proposed plan for a really elastic note issue was never seriously considered by Congress because of the unwillingness of the larger banks to guarantee notes issued by a great many small institutions. After the panic of 1907 the so-called Aldrich-Vreeland Act was adopted (May 30 1908). This made provision for the organization of “national currency associations” which would have been allowed to issue notes based upon commercial paper or other securities deposited by constituent banks with the associations in question. At the time, however, the plan did not get into practical operation, partly because the difficulties attendant upon the panic of 1907 had been overcome before the Act was enacted. Contemporaneously with the Aldrich-Vreeland Act, provision was made for the creation of a body called the National Monetary Commission, which continued investigations for several years and eventually proposed a bill for general banking reform, ordinarily described as the Aldrich bill.

This measure contemplated the creation of a central banking organization with branches. The plan still retained the fundamental concept of an emergency currency, but the proposed institution was not equipped with the ordinary powers, duties and responsibilities which had been found necessary in central banking experience abroad. It has been supposed that the Aldrich bill would have been adopted in its original or a modified form if the Republican party, under whose auspices it had been developed, had not been defeated in Nov. 1912. The Democratic party having come into office in the spring of 1913, the duty of enacting banking legislation was necessarily assumed by it and in June of that year a bill embodying what afterward became the Federal Reserve Act was introduced into congress. The measure had been under construction and preparation from about March 1912 onward, and a first draft of it had been presented to President-elect Wilson soon after the election of 1912. It was then approved by the President-elect, and the process of perfecting and improving it went on during the winter of 1912-3 under direction of a House of Representatives Committee. This bill when introduced had thus been under consideration at the hands of the special committee of the House Banking and Currency Committee for about 15 months prior to the date of its introduction, while preliminary studies had been undertaken even earlier. The bill consequently was quickly completed, went through Congress during the middle of 1913 and became law on Dec. 23 of that year.

History of the Operation of the System

The operation of the Federal Reserve System may be divided into several distinct periods:

the first from Nov. 2 1914 to the declaration of war by the United States April 6 1917;
the second extending from the latter date to a period some time after the conclusion of the Armistice of Nov. 11 1918 (the date most aptly chosen for the close of this period probably being Nov. 4 1919); and
the third period extended from the latter date to the close of the year 1920. There are some other periods.

During the first or pre-war period the functions of the system were concerned largely with the organization of its own constituent units and the modification of banking practice in the United States and with the establishment of methods suited to the initiation of the new plan. These functions naturally fell into two main groups:

in the internal organization of the Federal Reserve banks, and
in the establishment of satisfactory relationships between them and their members.

In the latter category should be placed the work done in perfecting coöperation between the banks and the clearing houses of the different communities and in developing methods of collection, in working out plans for rediscounting with the least possible delay and friction, and other matters of equal importance. In the same group of functions must also be placed the work done by the Federal Reserve System in developing a new standard for commercial paper.

The Federal Reserve Act had given to the Federal Reserve Board the duty of defining commercial paper. Consequently, one of the first undertakings of the board was the establishment of regulations designed to cover the different classes of commercial paper and the processes to be pursued by reserve banks in discounting such paper. These regulations did not have the force of law since they merely amounted to a statement of the standards with which commercial paper must comply in order to be “eligible,” that is to say, to be rediscountable at the Federable Reserve banks. Nevertheless, the growing power of the Federal Reserve banks was such that these standards of eligibility rapidly came to be recognized through the whole of the banking community. Progress was made in the matter of securing nearly identical methods of preparing financial statements to be used for the purpose of testing the credit position of firms who were presenting paper for discount. An outstanding element in the work of the Federal Reserve Board during this first period was the national and district clearance and collection system.

The Federal Reserve Act had authorized the board to act as a clearing house for the several reserve banks, and early in 1915 the board took action by establishing the so-called Gold Settlement Fund at Washington. Each bank contributed originally a sum of $1,000,000 in gold, the entire amount being stored in the Treasury or the sub-treasuries. Claims accumulated by reserve banks upon one another were each week telegraphed as an aggregate to the board at Washington and offset against one another, the net debit or credit balances in the fund being registered in a set of books created for that purpose. The size of the fund grew rapidly and eventually reached a maximum of about $500,000,000. A second section of the fund was established to provide for clearances growing out of the accounts of Federal Reserve Agents as distinct from the bank to which they were accredited.

The Gold Settlement Fund probably would not have been successful alone had it not been supported by some plan for the collection of items originating within the several districts. Such a plan was, however, worked out and put into effect in practically final form beginning about July 1 1916. This was the so-called “intradistrict” collection system. It provided for the depositing of cheques (at first only on member banks but finally on any other bank or any banker) by members or holders of clearing accounts with Federal Reserve banks. These cheques were sent to the banks upon which they were drawn, the latter being required to remit the proceeds in cash or acceptable exchange or to authorize the charging off of these remittances upon the books of the reserve banks.

Member banks, of course, habitually followed the latter plan, while non-members who had no account with the reserve bank were obliged to furnish exchange or send coin. Although there was opposition from the banks which had previously made a profit out of this kind of exchange business, the opposition gradually lessened. Possibly the most vigorous form which it assumed was seen in the amendment to the Federal Reserve Act adopted in 1917, in which exchange charges made by member banks were recognized but which, on the other hand, practically neutralized such charges by providing that the Federal Reserve banks should not be permitted to pay exchange.

The matter was promptly tested in the courts, and as a result of favourable decisions and of the evidently beneficial character of the system, the number of banks which agreed to clear at par was extended until in 1920 it included more than 29,000 institutions — practically all the banks of the United States. The total operations of the Federal Reserve intradistrict clearing system were at the rate of $13,124,000,000 per month during the year 1920.

Improvements in the years 1917 to 1921

The Federal Reserve System between its organization at the end of 1914 and the close of the year 1921 passed through a remarkable development which not only vastly increased its resources as compared with any figures they would have been likely to reach had it not been for the war, but also necessitated active participation on the part of reserve banks in many types of financial transactions from which they might otherwise have abstained. The results of this activity were both good and bad — good in increasing the activity of the system and in affording an opportunity to be of direct and material usefulness; bad in bringing about a mushroom growth which prevented or curtailed the development of methods and practices upon a scientific basis.

The system as a whole, especially those features which were at first thought to be of doubtful practicability, had definitely found its place and established its effectiveness. There had been improvement in methods of business financing, in the type of commercial papers, and in the use of modern instruments in connexion with the conduct of foreign trade. There had also been a large advance in economy, promptness and effectiveness, in domestic exchange, and in the collection of cheques. Priceless service was rendered to the U.S. Treasury during the war and through it to the world at large, since without the aid of the Federal Reserve System the financing of the war would probably have been impossible. On the other hand, the Federal Reserve System was the instrument through which an inflation of credit and prices occurred in the United States. The post-war attempt to curtail such inflation was not begun at a sufficiently early date, but was steadily working during 1921.

Structure and Functions

The Federal Reserve System comprises:

the Board of Governors;
the 12 Federal Reserve Banks and their 25 branches and other facilities;
the Federal Open Market Committee;
the Federal Advisory Council;
the Consumer Advisory Council;
the Thrift Institutions Advisory Council; and
the Nation’s financial institutions, including commercial banks, savings and loan associations, mutual savings banks, and credit unions.

Board of Governors

The Board comprises seven members appointed by the President with the advice and consent of the Senate. The Chairman of the Board of Governors is a member of the National Advisory Council on International Monetary and Financial Policies. The Board determines general monetary, credit, and operating policies for the System as a whole and formulates the rules and regulations necessary to carry out the purposes of the Federal Reserve Act. The Board’s principal duties consist of monitoring credit conditions; supervising the Federa Reserve Banks, member banks, and bank holding companies; and regulating the implementation of certain consumer credit protection laws.

The Board has the power, within statutory limitations, to fix the requirements for reserves to be maintained by depository institutions on transaction accounts or nonpersonal time deposits. The Board reviews and determines the discount rate charged by the Federal Reserve Banks. For the purpose of preventing excessive use of credit for the purchase or carrying of securities, the Board is authorized to regulate the amount of credit that may be initially extended and subsequently maintained on any security (with certain exceptions).

Supervision of Federal Reserve Banks

The Board is authorized:

to make examinations of the Federal Reserve Banks,
to require statements and reports from such Banks,
to supervise the issueand retirement of Federal Reserve notes,
to require the establishment or discontinuance of branches of Reserve Banks, and
to exercise supervision over all relationships and transactions of those Banks with foreign branches.

Supervision of Bank Holding Companies regulates bank holding companies. Its objective is:

to maintain the separation between banking and commerce by controlling the expansion of bank holding companies,
preventing the formation of banking monopolies,
restraining certain trade practices in banking, and
limiting the nonbanking activities of bank holding companies.

A company that seeks to become a bank holding company must obtain the prior approval of the Federal Reserve. Any company that qualifies as a bank holding company must register and file reports with the FRS.

Aldrich Plan (1910)

Following the near catastrophic financial disaster of 1907, the movement for banking reform picked up steam among Wall Street bankers, Republicans, and a few eastern Democrats. However, much of the country was still distrustful of bankers and of banking in general, especially after 1907. See more about the Aldrich Plan and the Federal Reserve Act here.

Federal Reserve Act (1913)

What eventually emerged was the Federal Reserve Act, also known at the time as the Currency Bill, or the Owen-Glass Act. The bill called for a system of eight to twelve mostly autonomous regional Reserve Banks that would be owned by commerical banks and whose actions would be coordinated by a committee appointed by the President. The Federal Reserve System would then become a privately owned banking system that was operated in the public interest.

Legal Materials

For legal materials about the Federal Reserve System, click here.

Federal Reserve System in the U.S. Legal History

Summary

The central banking system of the United States, established with passage of the Federal Reserve Act of 1913, charged with the responsibility of managing the country’s money supply through such means as lowering or raising interest rates. A presidentially appointed board of seven members (the Federal Reserve Board) oversees the twelve regional banks of the Federal Reserve System.

Federal Reserve System (Banking Law)

This section introduces, discusses and describes the basics of federal reserve system. Then, cross references and a brief overview about Banking Lawin relation to federal reserve system is provided. Note that a list of bibliography resources and other aids appears at the end of this entry.

Finding the law: Federal Reserve System in the U.S. Code

A collection of general and permanent laws relating to federal reserve system, passed by the United States Congress, are organized by subject matter arrangements in the United States Code (U.S.C.; this label examines federal reserve system topics), to make them easy to use (usually, organized by legal areas into Titles, Chapters and Sections). The platform provides introductory material to the U.S. Code, and cross references to case law. View the U.S. Code’s table of contents here.