Federal Reserve System (FRS): What It Is and How It Works

In every nation, there’s always a need for a financial system that manages and controls the creation and circulation of money in the country. Hence, the Federal Reserve System (FRS) serves this purpose in the United States.

Since its inception in December 1913, the FRS has been actively functioning as a regulatory entity over the monetary and financial system of the US.

The Federal Reserve System Defined

Also called the Federal Reserve or most commonly the Fed, The Federal Reserve System (FRS) serves as the central bank of the United States and is arguably the most influential financial institution globally, founded to provide the country with a monetary and financial system that is stable, flexible, and safe.

A central bank is a financial institution vested with supervisory and regulatory control over the production and circulation of money and credit for an individual nation or a group. The central bank in modern economies is often tasked with formulating monetary policies and regulating the operations of member banks.

History of The Fed

The creation of the Fed was in response to the financial panic which occurred in 1907 due to remarkable bank runs, suspension of payments and bank failures.

The Fed was created by the Federal Reserve Act, which was signed by President Woodrow Wilson on December 23, 1913.

Prior to the establishment of the Fed, the US was the only major financial power that did not have a central bank. The creation of the central bank was prompted by recurring financial panics that weighed on the US economy over the preceding century, resulting in critical economic disruptions from bank failures and business bankruptcies. Thus, there were calls for an institution that would prevent panics and disruptions.

During these periods, the failure of one bank often led to a corresponding effect on other banks, as customers of other banks would rush to withdraw funds from their own banks even if those banks were not in danger of failing. Banks needed a source of emergency reserves to prevent the panics and resulting runs from driving them out of business. Concerns regarding this led to the establishment of the Federal Reserve System in late 1913.

Over time, research revealed that critical events such as the Great Depression in the 1930s and the Great Recession during the 2000s have acted as a major drive towards the expansion of the roles and responsibilities of the Federal Reserve System.

Apparently, the Fed is vested with the power to act towards ensuring financial stability, and it is the main regulator of member banks. It functions as the lender of last resort to member institutions with no other credit source.

Functions of the FRS

The primary motive or central objective for the establishment of the Fed was to address the issue of financial panics. The Federal Reserve System performs five key functions aimed at promoting the effective operation of the economy of the US as well as serving the interest of the public. These five functions are briefly highlighted as follows:

1. Conducting monetary policy. The Federal Reserve sets monetary policy for the US to engender increased employment and stabilize prices in the economy.

2. Promoting the stability of the financial system. Risks associated with the financial system are monitored by the Fed, which also engages within and outside the U.S. economy to provide a system that promotes a healthy economy for households, businesses and communities in the US.

3. Supervision and regulation of financial institutions and activities. The safety and balanced operations of individual financial institutions are promoted by the Fed, which also monitors the impact of such financial institutions on the entire financial system and takes regulatory actions where necessary.

4. Fostering the safety and efficiency of the payment and settlement system. The Fed acts to ensure that the financial system for transactions in the US dollar is safe, accessible and efficient. This helps to build confidence in the system for both individuals and corporate entities locally and internationally.

5. Promoting consumer protection and community development.  The Fed engages in supervision, research and community reinvestment to better understand the impact/effect of policies of financial services and practices on consumers and communities with a view to providing improvements for increased consumer protection and community development.

Other functions of the Fed include:

• addressing the issue of banking panics;
• acting as the central bank for the US;
• promoting the exchange of payments among regions;
• strengthening the US standing on the global economic map.

The Federal Reserve Structure

The Federal Reserve System (FRS) is composed of The Board of Governors, The Federal Reserve Banks, The Federal Open Market Committee, and the member banks across the country. These four entities work together to promote the stability of the US financial system and the overall interest of the US economy.

• The Board of Governors. The Board of Governors is a seven-member board of governors  that functions in oversight of business with the examination of  national banks.It is tasked with the overseeing of the twelve District Reserve Banks and setting national monetary policy. In addition, it supervises and regulates the banking system of the US in general. Governors of the board are appointed by the President of the United States and are further confirmed by the Senate for 14-year terms. Members of the Board shall continue to serve after the expiration of their terms of office until the appointment and qualification of their successors. The law provides for a member of the board to be removed from office by the president “for cause”. The board is mandated to issue an annual report of operations to the Speaker of the US House of Representatives.
• The Federal Reserve Banks. There are twelve Federal Reserve Banks and each bank is responsible for member banks sited in its district. The Federal Reserve Banks are located in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. The size of each district was set based on the population distribution of the U.S. at the time of the passing of the Federal Reserve Act. The law establishes the charter and organization of each of the 12 Federal Reserve Bank  and they cannot be altered by the member banks. However, six of the nine members of the board of directors of the Federal Reserve Banks are elected by member banks.
• The Federal Open Market Committee (FOMC). The Federal Open Market Committee (FOMC) is composed of twelve members: seven of them are from the board of governors and five are from the regional Federal Reserve Bank presidents. The FOMC performs oversight and policy formulation on open market operations which the main tool of national monetary policy. The FOMC also directs operations carried out by the Federal Reserve in forex markets.
• Member banks. A member bank is a private financial institution. Member banks own stock in the Federal Reserve Bank in their region. All banks which are chartered nationally, hold stock in one of the Federal Reserve Banks. By satisfying certain standards, State chartered banks may also choose to be members and hold stock in their regional Federal Reserve bank.

Monetary Policy

Notably, the main income source of the Fed is interest charges on a range of US government securities which it acquired via its open market operations (OMO). Other income sources include interest earned on foreign currency investments, interest on loans made to depository institutions, and fees for services – like as check clearing and transfers of fund – provided to these institutions. The Fed transfers the rest of its earnings after payment of expenses to the US Treasury.

The Fed does not collect taxes. The Fed is responsible only for monetary policy and oversight on banking system. Federal taxes are approved and exclusively collected  by Congress through the Internal Revenue Service (IRS), a federal agency), which is an instance of fiscal policy. Individual States or municipalities collect state and local taxes.

Bottom Line

The Federal Reserve System (FRS), or The Fed, is the central bank of the United States, created to provide the country with a stable, flexible and safe monetary and financial system. The Federal Reserve System comprises 12 regional Federal Reserve Banks, each of which is responsible for a specific geographic area of the United States.

As the nation’s central bank, the Fed performs five key functions in the public interest to promote the health of the American economy and the stability of the US financial system.