CHAPTER IV

WHY WAS THE FEDERAL RESERVE ACT PASSED?

71. What is a central bank?
A central bank has two essential functions. One is to serve as a bankers’ bank, i.e., a bank which gives credit to the commercial banks and also holds their official reserves. The other is to adjust the money supply through the power to create reserves or to regulate the commercial banking system’s ability to manufacture money. A bank which performs these and other related functions is called a “central bank.” The Federal Reserve is a central bank.

72. How does the Federal Reserve System differ from other central banks?
First, it is a system of 12 separate regional banks. Second, membership in the System is not compulsory for private commercial banks, except for national banks.

73. Was the Federal Reserve the first central bank in the United States?
No. Both the First and Second Banks of the United States were chartered to combine central and commercial banking. After 1836, however, when Andrew Jackson refused to extend the Second Bank’s charter, the United States was without a central bank.

74. In what ways did American banking experience during this period lead to passage of the Federal Reserve Act?
During the 19th century, the fractional reserve system, operating without central bank supervision led to money panics, bank crises, and depressions. Furthermore, the monetary system proved unable to provide the money necessary for the country s growing volume of industry and trade on a rational basis. National banks could create deposit money and notes, but were limited by their gold reserves. This meant that the total money supply was unresponsive to the needs of trade. Moreover, since it was customary for country banks to keep their reserves in New York, there were nationwide shortages of money periodically, as at harvest time. And at all times, the New York banks used the pyramided funds in the stock market in New York. As a result, between the end of the Civil War and passage of the Federal Reserve Act, the country suffered from four major money panics: 1873,1884,1893, and 1907.

75. In what specific ways did the panic of 1907 lead to central banking in America?
Public indignation at the banking manipulations which led to the panic stirred Congress to authorize a National Monetary Commission, headed by former Senator Nelson Aldrich. The results of the commission’s study were published in 20 volumes, and in 1912, a bill was introduced in Congress embodying reforms, of which the most important was the proposed establishment of a central bank with powers to regulate banking.

76. Was the Aldrich Commission alone in suggesting a central bank?
No. The House of Representatives had begun the famous “Pujo Committee” hearings which gave the public a picture of the “money trust,” a network of holding companies and other interlocking relationships which gave a small group of Wall Street tycoons control, not only of all the big banks of New York City, but of most of the financial power of the whole country.

77. What were the main purposes of the Federal Reserve Act?
First, it was intended to mobilize reserves—to strengthen the fractional reserve system—and thus increase public confidence in the banking system. Second, it was designed to provide an “elastic currency” responsive to the needs of local business and trade. Third, it was to provide central bank supervision, to insure sound banking practices, and to safeguard against insolvency and loss of depositors’ money. Fourth, it was to provide a system by which the banks could clear checks promptly and uniformly throughout the Nation.

78. Was the Federal Reserve System established as a private or public agency?
The Federal Reserve was established as a public agency. But private banks were given control of the 12 regional Federal Reserve banks that is, they were given the privilege of electing six directors of each bank, and these directors—a 2/3 majority—in turn, selected the presidents and other chief officers of the bank.

79. Did the powers given to the Federal Reserve include discretionary control over the quantity of money?
No. It was expected that increases and decreases in the money supply would be ‘automatic.” Private banks would continue to increase—and extinguish—money by making loans to business in their locality, under safeguards prescribed by the law. The “automatic” feature was that the regional Federal Reserve banks were now available to increase reserves for member banks when and as these needed more lending power to finance the short-term needs of farmers and businessmen in bringing their goods to market.

80. What other powers were given to the Federal Reserve?
The Federal Reserve was given the right to discount “eligible paper” for member banks, that is lend money to the banks on the basis of the commercial paper arising from loan transactions with their customers. The minimum amount of reserves which member banks were required to keep on deposit with the Federal Reserve, however, was prescribed by law.

81. Were any powers given the Federal Reserve Board in Washington?
Yes. The most important was the right to review and determine the discount rate—the interest rate charged by the regional banks when they loaned the commercial banks money on eligible paper. Other powers included formulating new rules to safeguard the banks against dangerous practices.

82. Who must join the Federal Reserve System?
State-chartered banks are not compelled to become members of the System. All National banks, however, must join as a matter of law. Membership in the System requires meeting certain minimum standards prescribed by the Board of Governors of the Federal Reserve.

83. In what ways was the Federal Reserve System an improvement upon the Preceding monetary system?

1. It permitted mobilizing reserves where they were needed in times of difficult and eliminated the pyramiding of reserves in New York.
2. The Federal Reserve, although a central bank, was also in part decentralized, operating in 12 regions throughout the country.
3. The Federal Reserve Act provided virtually uniform regulation for all the banks of the Nation. (Although almost half of the banks of the Nation are not members, banks accounting for 85 percent of all commercial bank deposits are members)
4. The Federal Reserve System was designed to provide an adequate money supply, one which expanded and contracted with the needs of trade.

84. How is the Federal Reserve System organized?
The Federal Reserve System is composed of the Board of Governors, the 12 Federal Reserve banks. Approximately, 6,100 private commercial banks are members of the System. The most important Policy making group is the Federal Open Market Committee.

85. How many members of the Board of Governors are there?
There are seven members of the Board of Governors. They are appointed by the President for terms of 14 Years, with one term expiring each 2 years.

86. Where are the 12 Federal Reserve banks located?
In Boston, New York, Philadelphia, Richmond, Atlanta, Cleveland, Chicago, St. Louts, Dallas, Kansas City, Minneapolis, and San Francisco.

87. Who are the members of the Federal Open Market Committee?
The Federal Open Market Committee consists of 12 members, 7 members of the Board of Governors plus 5 of the 12 presidents of the Federal Reserve banks. These are the voting members. But all of the regional bank presidents participate in policy discussions of the Committee. In that sense it is a 19 member Committee.

88. What are some of the routine operations of the Federal Reserve System?
Check clearing, furnishing currency, acting as fiscal agent for the U.S. Government (by issuing all notes and bonds of the Federal Government).

90. What are the important policy operations of the Federal Reserve System?
The Federal Reserve has the power to determine the money supply and thus strongly influence the level of economic activity and the general level of interest rates. It controls the money supply through its control over the, within limits, percentage in reserves member banks are required to hold behind their deposit liabilities and by controlling the amount of reserves actually available to member banks. The most important tool for controlling the amount of member bank reserves is in the hands of the Federal Open Market Committee.

91. What are the sources of revenue of the Federal Reserve?
By far the largest is interest on its holdings of U.S. Government securities. This accounts for almost 99 percent of Federal Reserve income.

92. How much of the Federal Reserve earnings must be returned to the Treasury?
No law or regulation specifies how much of the Federal Reserve’s earnings must be returned to the Treasury, but in practice the Federal Reserve spends all of the income it cares to spend, pays dividends to member banks on their “stock” and sets aside a large amount as “surplus.” The remainder is then returned to the Treasury. It usually returns an amount several times the amount of its expenses.