Banking and the Federal Reserve
Banks are businesses that make money by borrowing money at one rate and loaning it at a higher rate. They provide an important economic function because they effectively channel money from those who have money to loan (surpluses) to those who wish to borrow. In other words, banks act as middlemen, matching borrowers with lenders.
Because banks are middlemen, they are often called financial intermediaries. Banks issue debts (Certificates of Deposit or other instruments) to entice you to deposit money with them. After they accumulate a sizable number of assets, they loan that money to others at a higher interest rate thus profiting on the difference. The ability for people and business to borrow helps businesses expand trade and improves the economy.
For example, you may wish to buy a new car today but do not have the money. You could choose to do without the car or, instead, get a loan from your bank, which you will pay back over several years plus interest. Where does the bank get the money? It finds someone who doesn’t need the money today and is willing to loan it in exchange for the return of that money plus interest. The interest is their reward for letting you have the money today.
At this point, you’re probably starting to see an important connection with interest rates. If the rate is too high, you may decide the car is not worth buying today. If so, you would decide to save your money, earn the interest, and buy the car in the future. By saving your money in the bank though, you have become a lender. Therefore, if the interest rate is too high, there are too many savers (too much money available for loan) and not enough people willing to borrow. In other words, if the “price” of borrowing is too high, the law of supply tells us many investors will be willing to loan money while the law of demand tells us that few people will be willing to borrow.
On the flip side, if the interest rate is too low, the lender may feel it is not worth loaning the money and would rather spend the money today. Too low of a rate does not mean that he will not have any savings. Rather, it means that if he perceives the rate as too low, he will not have as much in savings; he will choose to put much of the money elsewhere. If the “price” of lending is too low, the law of supply tells us that few people will be willing to lend money while the law of demand tells us there will be a lot of people willing to borrow.
So if the interest rate is too high there are too many lenders. If the rate is too high, there are too many savers. But if the interest rate is between these two extremes, it means that all those willing to borrow money are able to do so. The interest rate is the price that clears the market between borrowers and lenders. Banks act as the middlemen and simply match lenders with borrowers.
By providing this matching function, banks allow the economy to expand more efficiently. For example, if you wanted to buy the car and banks were not been present, you would need to exchange goods or services immediately with the car dealer, which is called a barter system. However, if your products or services are something the car dealer does not necessarily want, he will require a lot of those goods in exchange; in other words, a very high price.
For instance, say you work for a recording company and have just produced a new album, which sells for $15 and you want to purchase a $30,000 car. While the car dealer may like to have one of your CDs, he probably does not want 2,000 of them. Now your car dealer may think he can make money selling them, but he is not in that business. However, as we learned in the previous section, you can create supply if the bid price is raised. If you raise the price high enough, the dealer will eventually agree. In this case, you may need to exchange 3,000 CDs for the car, which your car dealer feels he could easily sell for $10 each and get his $30,000.
Notice that you are far better off by borrowing $30,000 from a bank and then selling 2,000 CDs yourself in the market. In addition, the banks have the expertise in assessing credit worthiness and collecting loans. They are also assuming the credit risk of their loans. You are better at selling CDs. Had it not been for the bank, you would either not have the car (bad for you and the car dealer) or would have paid a very high price by exchanging many more CDs (bad for you and exposes the car dealership to risks they are not experts in handling). The efficient channeling of funds from lenders to borrowers is the basic economic function of the banking system.
We just learned that banks entice savers by offering an incentive – an interest rate – to place deposits with them which they in turn, loan to others. You might think that banks therefore can make loans totaling the number of dollars they have on deposit. It turns out that banks can loan out much more money than that. To understand why, you must understand the fractional reserve banking system.
Fractional Reserve Banking
If you deposit money in your bank, it is an asset to the bank (since they can loan it out) and a liability (since they must give it back to you upon demand). In fact, the deposits you place with a bank are called “demand deposits” for that very reason. Although it is theoretically possible that all customers may demand their deposits at the same time, banks quickly learned that most of their deposits just sat in the vaults collecting cobwebs. Although these vault deposits were liabilities, they were rarely redeemed. In addition, new funds would come in daily, which could be used to meet new demands of withdrawals. Because banks make money by making loans, they caught on to the fact that some of the money sitting in the vault could be loaned as well. Doing so created more liabilities than assets, but it didn't seem to be a concern since all depositors never wanted all of their money at the same time. The notion of the banks lending more money than they have in assets is known as fractional reserve banking.
For example, if you deposit $100 into your account, under the old way of thinking, banks must keep the entire $100 in their vault in case you wanted to withdraw it. With fractional reserve banking, the bank may take your $100 deposits and then loan out $80 of it, thus keeping $20 in the vault for you to withdraw. Does this mean you can't get your $100 upon demand? No, you can always get your $100 as the bank can just pull it from another depositor. Remember, banks do not keep separate vaults for each depositor. Rather the keep one big vault and then keep track of who has what in their records. As long as the vast majority of depositors do not want all of their money at the same time, the bank will always be able to give you back your $100 upon demand.
Once the $80 is loaned to another customer, that person may deposit it the same bank (or other). Once the bank records the transaction, it can then loan a fraction of the $80 deposit to yet another customer and so on. This practice creates an “expansionary” or “multiplier” effect and creates more money in the banking system than the banks actually have on hand. It works because the banks only hold a fraction of the initial deposit, thus the term “fractional reserve” banking. But there is a tenuous assumption that goes along with it. It also works on the assumption that all customers will not demand all of their money at the same time. However, history has proven that’s not always the case.
Run On the Bank
Starting in the late 1800s, banks encountered several periods of financial panic. For one reason or another (most of them unsubstantiated) people would suddenly fear that they wouldn't be able to get their money out of their bank and rushed down to withdraw their funds before the doors even opened. Other people would see the lines forming outside and join the line out of the ominous fear it created.
Because banks used fractional reserves, they couldn't pay all of the depositors their money and many failed. This was known as a run on the bank. Once one bank failed, other depositors feared their banks would be next and would rush to get their money. This mindset, of course, created a vicious circle of bank failures for no reason other than a failed belief in the banking system. Fractional reserve banking has its merits, but it is not without risk.
You may remember from the Frank Capra classic Christmas film “It’s a Wonderful Life” that it was a run on the bank that left the Building and Loan in serious danger of going under. The film takes place just after World War II, which was a time when banks were certainly vulnerable to falling victim to the risks of fractional reserve banking.
Creation of the Federal Reserve Bank
In 1907 there was a major financial panic, which spurred the creation of the Federal Reserve Bank, also called "The Fed," under the Federal Reserve Act of 1913. President Woodrow Wilson signed the bill on December 23, 1913 and the Federal Reserve System was born. The Fed is a central bank or bankers' bank. It is a place where banks can go for loans, just as you can go to a local bank if you need to borrow money. In the event of financial panic, the Fed can simply issue Federal Reserve Notes, a type of IOU that was backed by the "full faith and credit of the United States." In fact, if you look at a dollar bill (or any other denomination), you will see the words "Federal Reserve Note" at the top.
Technically, you could redeem these notes for gold but because the government has the ability to print money, the money was accepted with confidence without the public wanting to convert the currency in times of panic.
In many countries, especially in Europe, their central banks are part of the government. In the United States, however, member banks technically own the Fed. You may have noticed that some banks have the letters "F.A." after their name. These are "Federal Association" banks, which are state-chartered and not required to be a member of the Federal Reserve, although most of them are. Banks with the letters "N.A." are "National Association" banks, which are federally chartered and are required to be member banks of the Fed. Regardless of whether a bank is a member of the Fed or not, all banks are subject to the Fed's control. The member banks have few privileges. They receive a nominal interest rate on their funds deposited at the Fed and that's about it. The U.S. President appoints the Board of Governors of the Federal Reserve and the member banks have no say-so in the matter. Also, nearly all of the profits go to the government and not the member banks. So while member banks own the Fed, it actually operates like an agency of the U.S. government. You can find out more about the Federal Reserve by going to their website at www.FederalReserve.gov.
The Federal Reserve is composed of twelve regional banks located in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco as shown in Figure 1:
Figure 1:
The twelve regional banks (and 25 additional branches) are run by the Board of Governors of the Federal Reserve. The Board of Governors consists of seven members appointed by the president and confirmed by the Senate. The chairman (currently Ben Bernanke) and Vice Chairman (currently Donald L. Kohn.) are also selected by the president and confirmed by the Senate from these seven members. The Fed governors are elected for a 14-year term and cannot be reelected nor removed. This is done so there is no political pressure on them to get reelected or to make errant decisions to avoid being fired. In a similar sense, the chairman serves a four-year term that does not coincide with presidential elections. This is to reduce conflicts of interests between presidents and governors.
The Federal Open Market Committee (FOMC) is comprised of the seven governors plus five of the bank presidents from the twelve regional banks. This seven to five split ensures that the Fed's decisions cannot be overridden. It's an alarming thought when you realize that 12 out of 19 people of the Federal Reserve are doing the major financial decisions for the entire U.S.!
Today the Federal Reserve's duties fall into four general areas: (1) conducting the nation's monetary policy; (2) supervising and regulating banking institutions and protecting the credit rights of consumers; (3) maintaining the stability of the financial system; and (4) providing certain financial services to the U.S. government, the public, financial institutions, and foreign official institutions.
It is primarily the conducting of monetary policy that we will be concerned with, which is the attempt of the Fed to control economic activity by controlling the amount of money and credit available.