Federal reserve system and its impact on banking industry

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The Federal Reserve System (Fed) is the central bank of the United States. As a central bank, the Fed is a bank for other banks and a bank for the federal government. It was created to provide the nation with a safer, more flexible and more stable monetary and financial system. Over the years, its role in banking and the economy has expanded. The Federal Reserve System is a network of twelve Federal Reserve Banks and a number of branches under the general oversight of the Board of Governors. The Reserve Banks are the operating arms of the central bank

Federal Reserve System


During the nineteenth century and the early twentieth century financial panics lead to bank failures and business bankruptcies that severely disrupted the economy. This was mostly due to unavailable short term credit to troubled depository institutions. To prevent such a downfall of the economy, Congress passed the Federal Reserve Act on December 23, 1913 to provide an elastic currency and supervise the Banking Industry in the U.S. with the creation of the Federal Reserve System.


Federal Reserve System, also known as Federal Reserve, or The Fed, is the central bank of the United States, founded by Congress to provide the nation with a safer, flexible, and stable financial system. Over the years, the Federal Reserve System has expanded its role in banking and the economy.


The Federal Reserve's role in banking and the economy fall into four general categories:


supervising and regulating banking institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers (Fed, 2009)

maintaining the stability of the financial system and containing systemic risk that may arise in financial markets (Fed, 2009)

providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation's payments system (Fed, 2009)


The Federal Reserve System plays a very important role in the banking industry and the economy. It sets the nation's monetary policy to promote the objectives of maximum employment, stable prices, and moderate long-term interest rates. It has supervisory and regulatory authority over the financial institutions and their activities to ensure the soundness of the financial institutions, fair treatment of their consumers and stability in the financial markets. As the U.S. central bank, it has well-established relationships with the central banks, and can coordinate with them to when managing international financial crises and supervising institutions with a substantial international presence. It also conducts research on the U.S. and regional economies and distributes information about the economy through speeches, publications, seminars and web sites.


The Federal Reserve System comprises of a central, governmental agency-the Board of Governors-in Washington, D.C., and twelve regional Federal Reserve Banks.

The Board of Governors is made up of seven members appointed by the President and confirmed by the Senate. The full term of a member is fourteen years. The President also appoints the Chairman of the board for a four year term.

The twelve Federal Reserve Banks provide banking services to the government and the depository institutions within their district for payment processing, check clearance and managing currency and securities.

The Federal Reserve System is considered to be an independent central bank. Its decisions are independent of the President and the executive branch of the government, but subject to oversight by the Congress and must work within the policies established by the government.

Banking Industry

Banking is the business of accepting deposits and lending them out to earn an interest. Banks earn profits by providing financial services and functioning as financial intermediaries. The banks in the U.S. can be classified into three types based on which government body has chartered them. Those chartered by the federal government are national banks, they are members of the Federal Reserve System. Banks chartered by states are either members of the Federal Reserve System once they meet the standards set by the Board of Governors and are called Member banks, or they are not members of the the Federal Reserve System and are called Nonmember banks.

Based on the bank's activities they can be divided into retail banking, providing services to individuals and small business; business banking, providing services to mid-market business; corporate banking, providing services to large corporations; private banking, providing wealth management services to high net-worth individuals; and investment banking, relating to activities on the financial market. Most banks are for-profit private companies, some are government owned as mentioned above and or are non-profit organizations like the Credit Unions. Big banks that provide a wide range of the above activities and include insurance and other services are termed as Universal banks.

Impact of Federal Reserve System on Banking Industry

To meet its objectives, the Federal Reserve requires the depository institutions to maintain balances and at a desired price which is the federal funds rate. The Federal Reserve balances has three components: required reserve balances, contractual clearing balances, and excess reserve balances.

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Clearing house


Reserve Requirements

The Federal Reserve requires the depository institutions to maintain a fraction of certain liabilities in reserve. The Federal Reserve can adjust this reserve requirements by changing the reserve ratio, the liabilities or both. By changing the reserve requirements, Federal Reserve has a predictable demand for the Federal Reserve balances and provides a greater ability to control the federal funds rate and facilitates the conduct of open market operations. However, the adjustments in the reserve requirements are costly to administer, do not earn interest and have a huge impact on the depository institutions and therefore are not adjusted frequently.

Contractual Clearing Balance


Performance and Effectiveness of Federal Reserve System