The Federal Reserve Bank and its monetary policy functions

Federal Reserve Bank

Financial services as an industry has progressed to become one of the widely transforming sectors of the global economy, having significant changes in information transference and processing, innovation in terms of commodities and processes, and rapid competition among the financial institutions -- among themselves and also among their several customers. The industry and its part in the transformations in the economy show that the supervising and regulatory structure also needs to be reevaluated periodically. The aim of bank regulation is mostly the same -- to attain maximum static and dynamic efficiency levels in the midst of a politically and economically permissible framework which is stable and equal. However the profits are always associated with a cost by means of stability and equity. A more stable and equal financial system usually need sacrifices with regard to efficiency. (Saunders, p. 3)

A properly functioning, effective banking system is necessary for the successful functioning of a capitalist economy: banks lead savings to facilities for investment when they choose a portfolio and they are a significant part of the corporate governance system because they supervise firm managers and provide a medium of exchange by means of the issuance of demand deposits and the payments associated and also by means of the clearing systems. (Gorton; Winton, p. 57) The Federal Reserve Bank -- Fed is the central bank of the U.S. And acts as the banker to the banking community as well as the government, besides issuing the national currency, framing monetary policies and contributing significantly to the supervision and regulation of banks and bank holding companies. The Board of Governors holds the primary powers which are important in a several policy matters regarding bank control and supervision and in case of vital facets of monetary control. The board declares the Fed's strategies on monetary and banking issues. Since the Board is not a functional body, majority of the routine implementation of policy decisions is handled by the Fed, stock in which there is ownership by the commercial banks which are members of the Fed. Ownership in this case does not construe control; the Board of Governors and the heads of the Reserve Banks direct their strategies to the public interest instead to the benefit of the private banking system.

With the enactment of the National Bank Act, 1864, the banking system was split into three groups: Central reserve city banks with the first being situated in NY City and Chicago, Illinois, and St. Louis, Missouri, were added to the tally in 1887; Reserve city banks in other 16 large cities, and the third group is the Country banks. It is imperative for the national banks to keep cash reserves; however the country banks could hold a percentage of these deposits in every reserve city banks. At the time when country banks needed further reserves to fulfill their customers' demand for cash they will be demanding their reserves from the reserve city banks, which would in turn demand funds from central reserve city banks. In case a reserve bank had insufficient cash to meet the demand, there will be a system failure leading to a collapse, and the economy would not have sufficient cash to fulfill the requirements of the economy.

At the bottom of the Federal Reserve System lie the commercial banks that are the members. It is obligatory on the part of every national; or federally charted bank to join the system; membership of the state-chartered institutions is not compulsory. Members have been mandated to buy capital stock in their respective district Federal Reserve Bank in the amount of 6% of their net capital leaving aside retained earnings, and achieve the right to vote in favor of 6 out of the 9 directors of that particular district bank. The Monetary Control Act passed in 1980 made it obligatory for maintaining a reserve requirement upon every depository institution, inclusive of non-members of the Fed, but also allows them from the Federal Reserve and utilize the services provided by the Fed, like encashment of checks, electronic funds transfers -- EFT, and safe custody of securities. Through letting Banks to borrow reserves from the Fed the liquidity of the total banking system is enhanced. (Federal Reserve System: Encyclopedia Article)

Various Reporting Formats employed by the Banks:

The FR 2644 takes the data every week on the amount outstanding of selected loans, securities, other assets, and borrowings from a sample of U.S. commercial banks. Information collected from this report, coupled with the information from the Weekly Report of Assets and Liabilities for Large Banks (FR 2416) and the Weekly Report of Assets and Liabilities for Big U.S. Branches and Agencies of Foreign Banks (FR 2069), are applied to make estimates of bank credit and the sources and uses of funds, and a balance sheet for the total banking system. (FR 2644- Weekly Report of Selected Assets)

FR2051a/b:- Money Market Mutual Fund Assets Reports: - The Investment Company Institute -- ICI makes use of the above two forms to collect and provide to the Federal Reserve data on shares and investments of money market mutual funds -- MMMFs. The weekly FR 2051a gives information about a single item, the total shares or net financial assets of MMMFs. The FR 201b is a monthly report providing information on U.S. Treasury securities, other U.S. government securities, repurchase agreements on U.S. governments and federal agency securities, large certificates of deposit, Eurodollar deposits, CP, Bankers acceptances, and other assets. FR 2415:- Report of Repurchase -- RPs on U.S. Govt and Federal Agency Securities with Specified Holders. This report is a source of information on wholesale repurchase agreements -- RPs outstanding. It gathers data on outstanding liabilities emanating from RPs in immediately available funds dealt with non-bank brokers and dealers in securities; individuals, partnerships, and corporations, not-for-profit organizations; non-depository financial institutions, leaving aside money market mutual funds; and state and local governments in the U.S.

FR 2910a Annual Report of Total Deposits and Reservable Liabilities: The report is filed yearly by depository institutions which are excluded from reserve requirements under the Garn-St. Germain Depository Institutions Act of 1982 -- Regulation D. It deals with the measurements of total deposits, total transaction accounts, and reservable liabilities for the report date of June 30. FR 2915: The Report of Foreign or Non-U.S. Currency Deposits: Through this report the weekly average amount outstanding of deposits denominated in foreign or non-U.S. currencies, maintained at U.S. offices of depository institutions which are included in the Report of Transaction Accounts, Other Deposits and Vault Cash (FR 2900). These deposits are reported in terms of U.S. dollars. FR 2930: Allocation of Low Reserve Tranche and Reservable Liabilities Exemption for the U.S. Branches and Agencies for Foreign Banks and Edge and Agreement Corporations. This report gives information on the allocating the low reserve tranche and the reservable liabilities exemption for depository institutions having their branches in more than one state or Federal Reserve District. (The Federal Reserve Board)

FR 2900 (Commercial Banks) Report of Transaction Accounts, Other Deposits and Vault Cash: This report gains knowledge on transaction accounts, time and savings deposits, vault cash and other reservable compulsions from depository institutions. These data constitutes the basic source of information for calculation of required reserves and for arriving at the monetary and reserves aggregates, utilized by the Board and the Federal Open Market Committee in the devising of monetary policy. The deposit reports were devised to fulfill the obligations of the Monetary Control Act of 1980 -- MCA and the Garn-St. Germain Depository Institution Act of 1982. The MCA made it compulsory regarding the reserve requirements on every depository institutions which keep a record of the transaction accounts or non-personal time deposits; earlier only member banks were needed to report deposits and maintain reserves. The Garn -St. Germain Act forced a zero percentage reserve requirement on the initial $2 mn of reservable liabilities, as a result waiving from the reserve requirements all depository institutions having a net reserve liabilities of an amount less than or equal to the exemption amount.

The exemption amount is ranked every year. From 1980 there have been amendments to accommodate banking trends and modifications to Regulation D. Lagged Reserve Requirements -- LRR were modified to Contemporaneous Reserve Requirements -- CRR in 1984, needing for necessary reserves against transaction liabilities to be recorded nearly contemporaneously. During 1994 the single deposit cutoff relevant to nonexempt as well as fully exempt institutions were replaced by two different cutoffs. During 1998, the Federal Reserve necessitated that every depository institution maintained just one "master" account with the Federal Reserve System, and it returned to a system of LRR. The frequency of the respondents submits daily data for a Tuesday through Monday reporting week. Quarterly respondents report daily data for the week starting with the third Tuesday and which continues through the following Monday in March, June, September, and December. (FR 2900 Commercial Banks)

Maintenance of Necessary Reserves:

A depository institution, a U.S. branch or an agency of a foreign bank, and an Edge or Agreement shall be required to maintain reserves against deposits and also liabilities relating to Eurocurrencies in keeping with the methods stipulated in Section 204.3 -- Computation and maintenance and 204.4 and the ratios prescribed in Sec. 204.9. Reserve deficiency charges shall be reviewed for shortfalls in required reserves and as per the provisions contained in 204.7.

The various reporting requirements are (i) A foreign bank's U.S. branches and agencies functioning within the same state and coming within the ambit of the same Federal Reserve District shall make a file and report of deposits on a tallied basis. (ii) U.S. branches and agencies of the same foreign bank, if probably, allocate the low reserve tranche on transaction accounts (Sec. 204.9(a)) to a single office or several offices filing a single report of deposits in a totaled basis. In case the low reserve tranche is not able to be used completely utilized by a single office or several offices filing a single report of deposits, the unutilized part of the tranche might be allocated to other offices of the same overseas bank till the amount of the tranche is finished. The overseas bank shall determine this assignment on the condition that in case a portion of the tranche is assigned to an office in a specific State, any unutilized portion must first of all be allocated to other offices situated in the same State and within the same Federal Reserve District, which means to other offices which are included on the same totaled report of deposits. If needed, to evade underutilization of the low reserve tranche, the allocation might be altered at the start of a calendar month.

Under other situations, the low reserve tranche might be reallocated during the beginning of a calendar month. (iii) Allocation of waiver from reserve obligations: While determining the reserve requirements of a depository institution, the waiver stipulated in Sec 204.9 (a) shall be applicable in the rank of priorities given hereunder. Firstly to net transaction accounts that are initially sanctioned by the federal law in any state subsequent to 1 April, 1980 and second to other total transaction accounts. (iv) Calculation of required reserves for institutions who report on a weekly basis:- (1) Necessary reserves are computed on the basis of daily average balances of deposits and Eurocurrency liabilities during a period of 14 days culminating on every second Monday which is the calculation period. Reserve necessities are calculated through the application of the ratios in accordance with Sec 204.9 to the categories of deposits and Eurocurrency liabilities of the deposit institution. While calculating the reserve balance which is needed to be maintained with the Federal Reserve, the average daily vault cash held at the time of the calculation period is subtracted from the amount of the institution's necessary reserves. (2) The reserve balance which is necessary to be kept which begins on the third Thursday subsequent to the expiration of a given computational time frame. (3) While determining the reserve balance which is needed to be maintained with the Federal Reserve, the daily average vault cash held at the time of the calculation period which culminated 3 days ahead to the beginning of the maintenance period is subtracted from the amount of the institution necessary reserves.

Submission of Reports:

(i) It is mandatory upon each and every depository institution that keeps transaction reports or non-personal time deposit to file its reports of deposits or any other stipulated form or statement directly with the Federal Reserve Bank or its District, irrespective of the manner it prefers to maintain the necessary reserve balances. (ii) The Federal Reserve Bank upon receiving such reports will give a notice to the reporting depository institution of its reserve needs. In case where there is a pass through system, the Reserve Bank will also take it to the notice of the correspondent passing respondent reserve balances through to the Federal Reserve of its respondent's needed reserve balances. (3) A correspondent cannot be held responsible by the Federal Reserve for assuring the correctness of the report of deposits submitted by its respondents before their local Federal Reserve banks. (Regulation D. Sec 204.3 Computations and Maintenance)

The Federal Reserve Board on 6th October, 2004, declared the yearly indexing of the low reserve tranche and of the reserve needs exemption amount for the year 2005. These amounts are needed in the computation of reserve needs of depository institutions. It was also declared by the Board regarding the yearly indexing of the non-exempt deposit cut-off level and the curtailed reporting restriction which will be implemented to determine reporting panels from September 2005. Every depository institution should hold a percentage of certain types of deposits as reserves in the shape of vault cash, as a deposit in a Federal Reserve Bank, or as a deposit in a pass-through account at a corresponding institution. Reserve requirements presently are evaluated on the depository institution's total transaction accounts for checking accounts on most of the occasions. Depository institutions should even on a regular basis submit deposit reports of their deposits and other reservable liabilities. (Jarvis, 8)

Every depository institution in the U.S., similar to other countries of the world are under compulsion of reserve requirments on the deposit of their customers. Commercial banks and thrift institutions like mutual saavings banks, savings and loan associations and credi unions-whose checkable deposits are more than a fixed size are stipulated to maintain cash reserves, equal to a stipulated fraction of those deposits. The majority of the commercial banks share of checkable deposits is shown by member banks of the Federal Reserve Bank. Reserve needs are structured so that not much load fall on the smaller depository institutions. At all depository institutions, checkable deposits till a certain level and adjusted every year to show the growth in the banking system either are waived or carry comparatively low needs. Depository institutions maintain necessary reserves either as cash kept in their vaults or in the form if deposits at their District Federal Reserve Banks. In order to give banks and thrifts with the flexibility in fulfilling their needs, the Federal Reserve permits them to maintain an average amount of reserve over two-week reserve maintainence period ending on alternate Wednesdays instead of specific amount on every day. (Monetary Stress and Reserve Management)

Bigger banks use up the complete vault cash for meeting requirements and as their needed reserves become more compared to their vaultcash. However, several small banks and other thrift insitutions hold increased vault cash compared to their required reserves as they require more cash compared to their necessary reserves since they require more cash to fulfill customer deemands than do to fulfill reserve requirements. In their pursuit towards managing reserve positions, depository institutions try to maintain an equilibrium the two contrasting considerations. Being enterprises looking for profits, they attempt to keep their reserves, that fail to produce any income, nearer to the required minimum levels. Nevertheless, they must avoid reserve defeciencies, that have a punishment charge on the shortfall at a rate which is 2% point more than the discount rate.