The Federal Reserve System

Purposes &
  Functions

F E D E R A L R E S E R V E S Y S T E M P U B L I C AT I O N
The Federal Reserve System

Purposes &
  Functions
 First Edition, May 1939
Second Edition, November 1947
Third Edition, April 1954
Fourth Edition, February 1961
Fifth Edition, December 1963
Sixth Edition, September 1974
Seventh Edition, December 1984
Eighth Edition, December 1994
Ninth Edition, June 2005
Tenth Edition, October 2016

ISSN: 0199-9729
DOI: 10.17016/0199-9729.10

This and other Federal Reserve publications are available online

in the Publications section of the Federal Reserve Board’s
website, www.federalreserve.gov. To order copies of publications
available in print, access the Federal Reserve System Publication
Order Form or contact:

Publications Fulfillment
(e-mail) [email protected]
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Board of Governors of the Federal Reserve System
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Washington, DC 20551

ii The Federal Reserve System Purposes & Functions

Contents
1 Overview of the Federal Reserve System. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vi
The U.S. Approach to Central Banking. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
The Decentralized System Structure and Its Philosophy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
The Reserve Banks: A Blend of Private and Governmental Characteristics. . . . . . . . . . . . . . . . 6

2 The Three Key System Entities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

The Federal Reserve Board: Selection and Function. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
The Federal Reserve Banks: Structure and Function. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
The Federal Open Market Committee: Selection and Function . . . . . . . . . . . . . . . . . . . . . . . . 15
Other Significant Entities Contributing to Federal Reserve Functions. . . . . . . . . . . . . . . . . . . . . 17

3 Conducting Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

The Federal Reserve’s Monetary Policy Mandate and Why It Matters. . . . . . . . . . . . . . . . . . . . 23
How Monetary Policy Affects the Economy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Monetary Policy in Practice. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
Monetary Policy Implementation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

4 Promoting Financial System Stability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54

What Is Financial Stability?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
Monitoring Risk across the Financial System. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
Macroprudential Supervision and Regulation of Large, Complex Financial Institutions. . . . . . . 65
Domestic and International Cooperation and Coordination. . . . . . . . . . . . . . . . . . . . . . . . . . 68

5 Supervising and Regulating Financial Institutions and Activities. . . . . . . . . . . . . . . . . . 72

Regulation versus Supervision. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
Entities the Federal Reserve Oversees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
Oversight Councils. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
How the Federal Reserve Supervises Financial Institutions. . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
Overseeing the Structure of the Banking System. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Regulation: Keeping Pace with Innovation and Evolution . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
Promoting Market Discipline: Public Disclosure and Accounting Policy Requirements. . . . . . . . 116

The Federal Reserve System Purposes & Functions iii

6 Fostering Payment and Settlement System Safety and Efficiency . . . . . . . . . . . . . . . . . 118
Overview of Key Federal Reserve Payment System Functions. . . . . . . . . . . . . . . . . . . . . . . . . . 120
Providing Services to Banks and the Federal Government. . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
The U.S. Payment System Today and Reserve Bank Services. . . . . . . . . . . . . . . . . . . . . . . . . . 122
Regulating and Supervising the Payment System. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
Providing Vital Banking System Liquidity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
Exploring and Implementing Payment System Improvements . . . . . . . . . . . . . . . . . . . . . . . . . 148

7 Promoting Consumer Protection and Community Development . . . . . . . . . . . . . . . . . . 152

Consumer-Focused Supervision and Examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154
Administering Consumer Laws, Drafting Regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
Research and Analysis of Emerging Consumer Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165
Community Economic Development Activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167

iv The Federal Reserve System Purposes & Functions

The Federal Reserve System Purposes & Functions v
Purpose Overview of the Federal
Reserve System
The Federal Reserve performs five key functions
in the public interest to promote the health of
the U.S. economy and the stability of the U.S.
financial system.

1
The U.S. Approach to Central Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

The Decentralized System Structure and Its Philosophy . . . . . . . . . . . . . . . . 4

The Reserve Banks: A Blend of Private and

Governmental Characteristics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

vi Overview of the Federal Reserve System

 T   he Federal Reserve System is the central bank of the United States.
It performs five general functions to promote the effective operation of
the U.S. economy and, more generally, the public interest. The Federal
Reserve
• conducts the nation’s monetary policy to promote maximum
employment, stable prices, and moderate long-term interest rates in
the U.S. economy;
• promotes the stability of the financial system and seeks to
minimize and contain systemic risks through active monitoring and
engagement in the U.S. and abroad;
• promotes the safety and soundness of individual financial
institutions and monitors their impact on the financial system as a
whole;

Figure 1.1. The Federal Reserve System

The Federal Reserve is unique among central banks. By statute, Congress provided for a central banking system with public
and private characteristics. The System performs five functions in the public interest.

1
U.S. The Federal
Central Bank Reserve System

3 Federal 12 Federal Federal

Key Reserve Board Reserve Open Market
Entities of Governors Banks Committee

Helping Fostering Promoting

5 Conducting Supervising
maintain the payment and consumer
the nation’s and regulating
Key monetary
stability of
financial
settlement protection and
Functions the financial system safety community
policy institutions
system and efficiency development

The Federal Reserve System Purposes & Functions 1

• fosters payment and settlement system safety and efficiency
through services to the banking industry and the U.S. government
that facilitate U.S.-dollar transactions and payments; and
• promotes consumer protection and community development
through consumer-focused supervision and examination, research
and analysis of emerging consumer issues and trends, community
economic development activities, and the administration of consumer
laws and regulations. The Federal Reserve
was established to
serve the public
interest.

The U.S. Approach to Central Banking

The framers of the Federal Reserve Act purposely rejected the concept
of a single central bank. Instead, they provided for a central banking
“system” with three salient features: (1) a central governing Board,
(2) a decentralized operating structure of 12 Reserve Banks, and
(3) a combination of public and private characteristics.

Although parts of the Federal Reserve System share some characteristics

with private-sector entities, the Federal Reserve was established to serve
the public interest.

There are three key entities in the Federal Reserve System: the Board of
Governors, the Federal Reserve Banks (Reserve Banks), and the Federal
Open Market Committee (FOMC). The Board of Governors, an agency
of the federal government that reports to and is directly accountable
to Congress (figure 1.2), provides general guidance for the System and
oversees the 12 Reserve Banks.

2 Overview of the Federal Reserve System

Figure 1.2. Three key entities, serving the public interest
The framers of the Federal Reserve Act developed a central banking system that would broadly represent the public interest.

CONGRESS
oversees the Federal Reserve System
and its entities.

FEDERAL OPEN MARKET

COMMITTEE
consists of the members of the Board of FEDERAL RESERVE BANKS
Governors and Reserve Bank presidents. BOARD OF GOVERNORS are the operating arms of the
The Chair of the Board is the is an independent agency of the
Federal Reserve System and are
FOMC Chair. federal government.
supervised by the Board of Governors.

Within the System, certain responsibilities are shared between the Board
of Governors in Washington, D.C., whose members are appointed by
the President with the advice and consent of the Senate, and the Federal
Reserve Banks and Branches, which constitute the System’s operating
presence around the country. While the Federal Reserve has frequent
communication with executive branch and congressional officials, its
decisions are made independently.

The Federal Reserve System Purposes & Functions 3

The Decentralized System
Structure and Its Philosophy
In establishing the Federal Reserve System, the United States was divided
geographically into 12 Districts, each with a separately incorporated
Reserve Bank. District boundaries were based on prevailing trade regions
that existed in 1913 and related economic considerations, so they do not
necessarily coincide with state lines (figure 1.3).

As originally envisioned, each of the 12 Reserve Banks was intended

to operate independently from the other Reserve Banks. Variation was
expected in discount rates—the interest rate that commercial banks

Figure 1.3. Twelve Federal Reserve Districts operate independently but with supervision
Federal Reserve District boundaries are based on economic considerations; the Districts operate independently but under the
supervision of the Federal Reserve Board of Governors.

4 Overview of the Federal Reserve System

 were charged for borrowing funds from a Reserve Bank. The setting of
a separately determined discount rate appropriate to each District was
considered the most important tool of monetary policy at that time.
The concept of national economic policymaking was not well devel-
oped, and the impact of open market operations—purchases and sales
of U.S. government securities—on policymaking was less significant.

Revisions to the As the nation’s economy became more integrated and more complex,

Federal Reserve through advances in technology, communications, transportation, and

financial services, the effective conduct of monetary policy began to re-
Act in 1933 and
quire increased collaboration and coordination throughout the System.
1935 created
This was accomplished in part through revisions to the Federal Reserve
the modern-day Act in 1933 and 1935 that together created the modern-day FOMC.
Federal Open
Market Committee. The Depository Institutions Deregulation and Monetary Control Act
of 1980 (Monetary Control Act) introduced an even greater degree
of coordination among Reserve Banks with respect to the pricing of
financial services offered to depository institutions. There has also been
a trend among Reserve Banks to centralize or consolidate many of their
financial services and support functions and to standardize others. Re-
serve Banks have become more efficient by entering into intra-System
service agreements that allocate responsibilities for services and func-
tions that are national in scope among each of the 12 Reserve Banks.

The Federal Reserve System Purposes & Functions 5

The Reserve Banks: A Blend of Private
and Governmental Characteristics
Pursuant to the Federal Reserve Act, each of the 12 Reserve Banks is
separately incorporated and has a nine-member board of directors. Is Reserve Bank stock like
regular corporate stock?
The 12 regional Federal
Commercial banks that are members of the Federal Reserve System
Reserve Banks issue shares
hold stock in their District’s Reserve Bank and elect six of the Reserve of stock to member banks.
Bank’s directors; three remaining directors are appointed by the Board Owning Reserve Bank stock
is, however, quite different
of Governors. Most Reserve Banks have at least one Branch, and each
from owning stock in a pri-
Branch has its own board of directors. Branch directors are appointed vate company. The Reserve
by either the Reserve Bank or the Board of Governors. Banks are not operated for
profit, and ownership of
a certain amount of stock
Directors serve as a link between the Federal Reserve and the private is, by law, a condition of
sector. As a group, directors bring to their duties a wide variety of ex- membership in the System.
The stock may not be sold,
periences in the private sector, which gives them invaluable insight into
traded, or pledged as secu-
the economic conditions of their respective Federal Reserve Districts. rity for a loan, and dividends
Reserve Bank head-office and Branch directors contribute to the Sys- are, by law, paid to member
banks at a maximum rate of
tem’s overall understanding of the economy.
6 percent, determined in part
by each member bank’s total
The Federal Reserve is not funded by congressional appropriations. assets.

Its operations are financed primarily from the interest earned on the
­securities it owns—securities acquired in the course of the Federal
Reserve’s open market operations. The fees received for priced ­services
provided to depository institutions—such as check clearing, funds
transfers, and automated clearinghouse operations—are ­another
source of income; this income is used to cover the cost of those ser-
vices. After payment of expenses and transfers to surplus (limited to an
aggregate of $10 billion), all the net earnings of the Federal Reserve
Banks are transferred to the U.S. Treasury (figure 1.4).

6 Overview of the Federal Reserve System

 Despite the need for coordination and consistency throughout the
Federal Reserve System, geographic distinctions remain important.
Effective monetary policymaking requires knowledge and input about
regional differences. For example, two directors from the same indus-
try may have different opinions regarding the strength or weakness of
that sector, depending on their regional perspectives. The decentralized
structure of the System and its blend of private and public characteris-
tics, envisioned by the System’s creators, therefore, remain important
features today.

Figure 1.4. Federal Reserve net earnings are paid to the U.S. Treasury
The Federal Reserve transfers its net earnings to the U.S. Treasury.

Billions of
dollars
$100
$96.9 $97.8*

$88.4
$80
$79.3 $79.6
$75.4

$60

$47.4
$40
$34.6
$31.7
$29.1
$20 $22.9 $21.5
$18.1

0
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

* Does not include $19.3 billion also transferred to the U.S. Treasury from Reserve Bank capital surplus per the Fixing
America’s Surface Transportation Act.
Source: Federal Reserve Board news release, January 10, 2013 (available in the News & Events section of the Federal Reserve
Board’s website, www.federalreserve.gov).

The Federal Reserve System Purposes & Functions 7

Purpose The Three Key System
Entities
The Board of Governors, the Federal Reserve
Banks, and the Federal Open Market Committee
work together to promote the health of the U.S.
economy and the stability of the U.S. financial
system.

2
The Federal Reserve Board: Selection and Function . . . . . . . . . . . . . . . . . 10

The Federal Reserve Banks: Structure and Function . . . . . . . . . . . . . . . . . 12

The Federal Open Market Committee: Selection and Function . . . . . . 15

Other Significant Entities Contributing to

Federal Reserve Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

8 The Three Key System Entities

 T   hree key Federal Reserve entities—the Federal Reserve Board of Gov-
ernors (Board of Governors), the Federal Reserve Banks (Reserve Banks),
and the Federal Open Market Committee (FOMC)—make decisions that
help promote the health of the U.S. economy and the stability of the
U.S. financial system.

Figure 2.1. How the Federal Reserve operates within the U.S. government framework
A statutory framework established by the U.S. Congress guides the operation of the Federal Reserve System.

THE FEDERAL RESERVE ACT

creates the Federal Reserve System and
specifies how Board members and Reserve
Bank presidents are chosen.

PRESIDENT SENATE
nominates members of the Board of confirms Board members appointed by the
Governors, the chief governing President to staggered 14-year terms, and
body of the Federal Reserve System, confirms the nominations of Board members
and nominates one Board member to be to be either Chair or Vice Chair.
Chair and one to be Vice Chair.

FEDERAL OPEN MARKET

BOARD OF GOVERNORS FEDERAL RESERVE BANKS COMMITTEE
Seven Board members guide all 12 Reserve Banks examine and Seven Board members and five
aspects of the operation of the Federal supervise financial institutions, act as Reserve Bank presidents direct open
Reserve System and its five key functions. lenders of last resort, and provide U.S. market operations that sets U.S. monetary
payment system services, among policy to promote maximum employment,
other things. stable prices, and moderate long-term
interest rates in the U.S. economy.

The Federal Reserve System Purposes & Functions 9

The Federal Reserve Board:
Selection and Function
The Board of Governors—located in Washington, D.C.—is the govern-
ing body of the Federal Reserve System. It is run by seven members, or
“governors,” who are nominated by the President of the United States
and confirmed in their positions by the U.S. Senate. The Board of Gov-
ernors guides the operation of the Federal Reserve System to promote
the goals and fulfill the responsibilities given to the Federal Reserve by
the Federal Reserve Act.

All of the members of the Board serve on the FOMC, which is the body
within the Federal Reserve that sets monetary policy (see “The Federal
Open Market Committee: Selection and Function” on page 15). Each
member of the Board of Governors is appointed for a 14-year term;
the terms are staggered so that one term expires on January 31 of each
even-numbered year. After serving a full 14-year term, a Board member
may not be reappointed. If a Board member leaves the Board before
his or her term expires, however, the person nominated and confirmed
to serve the remainder of the term may later be appointed to a full 14-
year term (figure 2.2).

The Chair and Vice Chair of the Board are also appointed by the Presi-
dent and confirmed by the Senate, but serve only four-year terms. They
may be reappointed to additional four-year terms. The nominees to
these posts must already be members of the Board or must be simulta-
neously appointed to the Board.

The Board oversees the operations of the 12 Reserve Banks and shares
with them the responsibility for supervising and regulating certain
financial institutions and activities (see section 5, “Supervising and
Regulating Financial Institutions and Activities,” on page 72). The
Board also provides general guidance, direction, and oversight when
the Reserve Banks lend to depository institutions and when the Reserve

10 The Three Key System Entities

Figure 2.2. Serving on the Board of Governors
The Federal Reserve’s governors serve staggered 14-year terms and may not be reappointed; all governors—including the
Chair and Vice Chair—are appointed by the President and confirmed by the Senate.

A Board member The member The member’s term ends

is appointed and serves a on January 31, and he or
confirmed. 14-year term. she cannot be reappointed.

The member The newly appointed member serves the

leaves before his He or she remainder of his or her predecessor’s
or her term has is replaced. term and may be appointed to a full
expired. 14-year term.

The member is nominated to be Chair or Vice Chair

by the President and confirmed by the Senate.
He or she may be reappointed as Chair or Vice
Chair for one or more additional four-year terms.

Banks provide financial services to depository institutions and the fed-

eral government. The Board also has broad oversight responsibility for
the operations and activities of the Federal Reserve Banks (see section
6, “Fostering Payment and Settlement System Safety and Efficiency,”
on page 118). This authority includes oversight of the Reserve Banks’
services to depository institutions, and to the U.S. Treasury, and of the
Reserve Banks’ examination and supervision of various financial insti-
tutions. As part of this oversight, the Board reviews and approves the
budgets of each of the Reserve Banks.

The Board also helps to ensure that the voices and concerns of con-
sumers and communities are heard at the central bank by conduct-
ing consumer-focused supervision, research, and policy analysis, and,
more generally, by promoting a fair and transparent consumer financial
services market (see section 7, “Promoting Consumer Protection and
Community Development,” on page 152).

The Federal Reserve System Purposes & Functions 11

The Federal Reserve Banks:
Structure and Function
The 12 Federal Reserve Banks and their 24 Branches are the operating
arms of the Federal Reserve System. Each Reserve Bank operates within
its own particular geographic area, or district, of the United States.

Each Reserve Bank gathers data and other information about the busi-
nesses and the needs of local communities in its region. That informa-
tion is then factored into monetary policy decisions by the FOMC and
other decisions made by the Board of Governors.

Figure 2.3. Composition of Federal Reserve Bank boards of directors and selection of
Reserve Bank presidents
The boards of directors of the Reserve Banks represent a cross-section of banking, commercial, agricultural, and industrial
interests. Six of the nine members of each board of directors are chosen to represent the public interest; those six board
directors nominate their Bank’s president.

Federal Reserve member banks Federal Reserve

elect three Class A directors and Board of Governors appoints
three Class B directors. three Class C directors.

Class A directors Class B directors Class C directors

represent District represent the public. represent the public.
member banks. Chair and deputy chair
are designated by the
Board of Governors
from among Class C
directors.

Reserve Bank presidents are nominated

by Class B and C directors and approved
by the Board of Governors.

12 The Three Key System Entities

 Reserve Bank Leadership
As set forth in the Federal Reserve Act, each Reserve Bank is subject to

Want to learn more

“the supervision and control of a board of directors.” Much like the
about Reserve Bank boards of directors of private corporations, Reserve Bank boards are
directors? responsible for overseeing their Bank’s administration and governance,
Reserve Bank and Branch reviewing the Bank’s budget and overall performance, overseeing the
directors play a number of
roles at their Banks. To
Bank’s audit process, and developing broad strategic goals and direc-
learn more about director tions. However, unlike private corporations, Reserve Banks are not oper-
responsibilities and ated in the interest of shareholders, but rather in the public interest.
requirements, see Roles
and Responsibilities of
Federal Reserve Directors in Each year, the Board of Governors designates one chair and one deputy
the About the Fed section chair for each Reserve Bank board from among its Class C directors.
of the Board’s website,
www.federalreserve.gov/
The Federal Reserve Act requires that the chair of a Reserve Bank’s
aboutthefed/directors/about. board be a person of “tested banking experience,” a term which has
htm. been interpreted as requiring familiarity with banking or financial
­services.

Each Reserve Bank board delegates responsibility for day-to-day opera-

tions to the president of that Reserve Bank and his or her staff. Reserve
Bank presidents act as chief executive officers of their respective Banks
and also serve, in rotation, as voting members of the FOMC. Presidents
are nominated by a Bank’s Class B and C directors and approved by the
Board of Governors for five-year terms.

Reserve Bank Branches also have boards of directors. Pursuant to policy

established by the Board of Governors, Branch boards must have either
five or seven members. All Branch directors are appointed: the majority
of directors on a Branch board are appointed by the Reserve Bank, and
the remaining directors on the board are appointed by the Board of
Governors. Each Branch board selects a chair from among those direc-
tors appointed by the Board of Governors. Unlike Reserve Bank direc-
tors, Branch directors are not divided into different classes. However,
Branch directors must meet different eligibility requirements, depending
on whether they are appointed by the Reserve Bank or the Board of
Governors.

The Federal Reserve System Purposes & Functions 13

Reserve Bank and Branch directors are elected or appointed for stag-
gered three-year terms. When a director does not serve a full term, his
or her successor is elected or appointed to serve the unexpired portion
of that term.

Reserve Bank Responsibilities

The Reserve Banks carry out Federal Reserve core functions by
1. supervising and examining state member banks (state-chartered
banks that have chosen to become members of the Federal Reserve
System), bank and thrift holding companies, and nonbank financial
institutions that have been designated as systemically important
under authority delegated to them by the Board;
2. lending to depository institutions to ensure liquidity in the finan-
cial system;
3. providing key financial services that undergird the nation’s pay-
ment system, including distributing the nation’s currency and coin to
depository institutions, clearing checks, operating the FedWire and
automated clearinghouse (ACH) systems, and serving as a bank for the
U.S. Treasury; and
4. examining certain financial institutions to ensure and enforce
compliance with federal consumer protection and fair lending laws,
while also promoting local community development.

In its role providing key financial services, the Reserve Bank acts, essen-
tially, as a financial institution for the banks, thrifts, and credit unions
in its District—that is, each Reserve Bank acts as a “bank for banks.”
In that capacity, it offers (and charges for) services to these depository
institutions similar to those that ordinary banks provide their individual
and business customers: the equivalent of checking accounts; loans;
coin and currency; safekeeping services; and payment services (such as
the processing of checks and the making of recurring and nonrecurring
small- and large-dollar payments) that help banks, and ultimately their
customers, buy and sell goods, services, and securities.

14 The Three Key System Entities

 In addition, through their leaders and their connections to, and interac-
tions with, members of their local communities, Federal Reserve Banks
provide the Federal Reserve System with a wealth of information on
conditions in virtually every part of the nation—information that is vital
to formulating a national monetary policy that will help to maintain the
health of the economy and the stability of the nation’s financial system.

Certain information gathered by the Reserve Banks from Reserve Bank

directors and other sources is also shared with the public prior to each
FOMC meeting in a report commonly known as the Beige Book. In ad-
dition, every two weeks, the board of each Reserve Bank recommends
discount rates (interest rates to be charged for loans to depository
institutions made through that Bank’s discount window); these interest
rate recommendations are subject to review and determination by the
Board of Governors.

The Federal Open Market Committee:

Selection and Function
The FOMC is the body of the Federal Reserve System that sets national
monetary policy (figure 2.4). The FOMC makes all decisions regarding
the conduct of open market operations, which affect the federal funds
rate (the rate at which depository institutions lend to each other), the
size and composition of the Federal Reserve’s asset holdings, and com-
munications with the public about the likely future course of monetary
policy. Congress enacted legislation that created the FOMC as part of
the Federal Reserve System in 1933 and 1935.

FOMC Membership
The FOMC consists of 12 voting members—the 7 members of the
Board of Governors; the president of the Federal Reserve Bank of New
York; and 4 of the remaining 11 Reserve Bank presidents, who serve
one-year terms on a rotating basis.

The Federal Reserve System Purposes & Functions 15

Figure 2.4. Composition of the Federal Open Market Committee
The Federal Open Market Committee’s (FOMC) structure promotes the consideration of broad U.S. economic perspectives and
the public interest in key monetary policy decisions made by the U.S. central bank.

Board of Governors Federal Reserve Bank Reserve Bank presidents

(permanent FOMC of New York president (serve one-year terms
participants) (permanent FOMC on a rotating basis)
participant)

All 12 of the Reserve Bank presidents attend FOMC meetings and par-
ticipate in FOMC discussions, but only the presidents who are Commit-
tee members at the time may vote on policy decisions.

By law, the FOMC determines its own internal organization and, by Want to learn more about
the FOMC?
tradition, the FOMC elects the Chair of the Board of Governors as its
For more information
chair and the president of the Federal Reserve Bank of New York as its
about the FOMC, visit the
vice chair. FOMC meetings are typically held eight times each year in About the Fed section of
Washington, D.C., and at other times as needed. the Board’s website,
www.federalreserve.gov/
aboutthefed/structure-
FOMC Responsibilities federal-open-market-
committee.htm.
The FOMC is charged with overseeing “open market operations,” the
principal tool by which the Federal Reserve executes U.S. monetary
policy. These operations affect the federal funds rate, which in turn in-
fluence overall monetary and credit conditions, aggregate demand, and

16 The Three Key System Entities

 the entire economy (see section 3, “Conducting Monetary Policy,” on
page 20). The FOMC also directs operations undertaken by the Federal
Reserve in foreign exchange markets and, in recent years, has autho-
rized currency swap programs with foreign central banks.

Other Significant Entities Contributing

to Federal Reserve Functions
Two other groups play important roles in the Federal Reserve System’s
core functions: (1) depository institutions—banks, thrifts, and credit
unions; and (2) Federal Reserve System advisory committees, which
make recommendations to the Board of Governors and to the Reserve
Banks regarding the System’s responsibilities.

Depository Institutions
Depository institutions offer transaction, or checking, accounts to the
public and may maintain accounts of their own at their local Federal
Reserve Banks. Depository institutions are required to meet reserve re-
quirements—that is, to keep a certain amount of cash on hand or in an
account at a Reserve Bank based on the total balances in the checking
accounts they hold.

Depository institutions that have higher balances in their Reserve Bank

accounts than they need to meet reserve requirements may lend to
other depository institutions that need those funds to satisfy their own
reserve requirements. This rate influences interest rates, asset prices
and wealth, exchange rates, and, thereby, aggregate demand in the
economy. The FOMC sets a target for the federal funds rate at its meet-
ings and authorizes actions called open market operations to achieve
that target (see section 3, “Conducting Monetary Policy,” on page 20
for more information about the conduct of monetary policy).

The Federal Reserve System Purposes & Functions 17

Advisory Councils
Four advisory committees assist and advise the Board on matters of
public policy.
1. Federal Advisory Council (FAC). This council, established by the
Federal Reserve Act, comprises 12 representatives of the banking
More on Federal Reserve
industry. The FAC ordinarily meets with the Board four times a year,
Advisory Councils
as required by law. Annually, each Reserve Bank chooses one person
For a current roster of Fed-
to represent its District on the FAC. FAC members customarily serve eral Reserve advisory council
three one-year terms and elect their own officers. members, visit the About the
Fed section of the Federal
2. Community Depository Institutions Advisory Council (CDIAC). Reserve Board public website
The CDIAC was originally established by the Board of Governors to at www.federalreserve.gov/
aboutthefed/advisorydefault.
obtain information and views from thrift institutions (savings and
htm.
loan institutions and mutual savings banks) and credit unions. More
recently, its membership has expanded to include community banks.
Like the FAC, the CDIAC provides the Board of Governors with
firsthand insight and information about the economy, lending condi-
tions, and other issues.
3. Model Validation Council. This council was established by the
Board of Governors in 2012 to provide expert and independent
advice on its process to rigorously assess the models used in stress
tests of banking institutions. Stress tests are required under the
Dodd-Frank Wall Street Reform and Consumer Protection Act. The
council is intended to improve the quality of stress tests and thereby
strengthen confidence in the stress-testing program. (For more infor-
mation about stress tests, see “Capital Planning, Stress Testing, and
Capital Distributions” on page 112.)
4. Community Advisory Council (CAC). This council was formed by
the Federal Reserve Board in 2015 to offer diverse perspectives on
the economic circumstances and financial services needs of consum-
ers and communities, with a particular focus on the concerns of
low- and moderate-income populations. The CAC complements the
FAC and CDIAC, whose members represent depository institutions.

18 The Three Key System Entities

 The CAC meets semiannually with members of the Board of Gov-
ernors. The 15 CAC members serve staggered three-year terms and
are selected by the Board through a public nomination process.

Federal Reserve Banks also have their own advisory committees. Per-
haps the most important of these are committees that advise the Banks
on agricultural, small business, and labor matters. The Federal Reserve
Board solicits the views of each of these committees biannually.

The Federal Reserve System Purposes & Functions 19

Function Conducting Monetary
Policy
The Federal Open Market Committee sets
U.S. monetary policy in accordance with its
mandate from Congress: to promote maximum
employment, stable prices, and moderate long-
term interest rates in the U.S. economy.

3
The Federal Reserve’s Monetary Policy Mandate
and Why It Matters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

How Monetary Policy Affects the Economy . . . . . . . . . . . . . . . . . . . . . . . . 27

Monetary Policy in Practice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

Monetary Policy Implementation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

20 Purposes and Functions of the Federal Reserve System

 W hat is monetary policy? It is the Federal Reserve’s actions, as a
central bank, to achieve three goals specified by Congress: maximum
employment, stable prices, and moderate long-term interest rates in
the United States (figure 3.1).

The Federal Reserve conducts the nation’s monetary policy by managing

the level of short-term interest rates and influencing the availability and
cost of credit in the economy. Monetary policy directly affects interest
rates; it indirectly affects stock prices, wealth, and currency exchange
rates. Through these channels, monetary policy influences spend-
ing, investment, production, employment, and inflation in the United
States. Effective monetary policy complements fiscal policy to support
economic growth.

While the Federal Reserve’s monetary policy goals have not changed for
many years, its tools and approach to implementing policy have evolved

Figure 3.1. The Federal Reserve’s statutory mandate

The Federal Reserve conducts monetary policy in pursuit of three goals set for it by Congress. The three mandated goals are
considered essential to a well-functioning economy for consumers and businesses.

Mandate
1. Maximum employment
2. Stable prices
3. Moderate long-term
interest rates

Traditional Nontraditional
monetary policy monetary policy

Open market Reserve Discount Forward Large-scale

operations requirements window lending guidance asset purchases
Influence Influence Influences supply Helps the public Provide additional
supply of demand for of balances in the better understand stimulus to interest-
balances in the balances in the federal funds policymakers’ sensitive spending,
federal funds federal funds market, supply of intentions about the affect the economy
market, supply of market, supply of money and credit future course of through the same
money and credit money and credit in the economy monetary policy channels as traditional
in the economy in the economy monetary policy

The Federal Reserve System Purposes & Functions 21

“Congress has entrusted the Federal Reserve with great responsibilities. Its decisions affect the well-being of every
American and the strength and prosperity of our nation. That prosperity depends most, of course, on the produc-
tiveness and enterprise of the American people, but the Federal Reserve plays a role too, promoting conditions that
foster maximum employment, low and stable inflation, and a safe and sound financial system.”
— Chair Janet Yellen, Nov. 14, 2013

over time. Prior to the financial crisis that began in 2007, the Federal
Reserve bought or sold securities issued or backed by the U.S. govern-
ment in the open market on most business days in order to keep a key
short-term money market interest rate, called the federal funds rate, at
or near a target set by the Federal Open Market Committee, or FOMC
(figure 3.2). (The FOMC is the monetary policymaking arm of the Fed-
eral Reserve.) Changes in that target, and in investors’ expectations of
what that target would be in the future, generated changes in a wide
range of interest rates paid by borrowers and earned by savers.

To support the economy during the financial crisis that began in 2007
and during the ensuing recession, the FOMC lowered its target for the
federal funds rate to near zero at the end of 2008. It then began to
use less traditional approaches to implementing policy, including buy-
ing very large amounts of longer-term government securities to apply
downward pressure on longer-term interest rates. In addition, the Fed-
eral Reserve’s communication of its assessment of the outlook for the
economy and its intentions regarding the federal funds rate became
a more important policy tool. In the fall of 2014, with the economy
having made substantial progress toward maximum employment, the
FOMC announced key elements of its plans for normalizing monetary
policy when appropriate. In December 2015, the FOMC decided that
economic conditions and the economic outlook warranted starting
the process of policy normalization and voted to raise its target for the
federal funds rate.

22 Conducting Monetary Policy

 The Federal Reserve’s Monetary
Policy Mandate and Why It Matters
The Federal Reserve was created by Congress in 1913 to provide the
nation with a safer, more flexible, and more stable monetary and finan-
cial system. The Federal Reserve Act states that the Board of Governors
and the FOMC should conduct monetary policy “so as to promote
effectively the goals of maximum employment, stable prices, and mod-
erate long-term interest rates.” This statutory mandate ties monetary
policy to the broader goal of fostering a productive and stable U.S.
economy.

The statutory mandate is achieved when most people looking

for work are gainfully employed, and when prices for goods and
services are, on average, relatively stable. Stable prices for goods

Figure 3.2. The federal funds rate over time

The effective federal funds rate is the interest rate at which depository institutions—banks, savings institutions (thrifts), and
credit unions—and government-sponsored enterprises borrow from and lend to each other overnight to meet short-term
business needs. The target for the federal funds rate—which is set by the Federal Open Market Committee—has varied widely
over the years in response to prevailing economic conditions.

Percent
7.0
6.5
6.0 Effective federal funds rate
5.5 Target federal funds rate
5.0 Target federal funds range
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
.5
0

1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

The Federal Reserve System Purposes & Functions 23

and services contribute importantly to achieving three economic
outcomes: (1) maximum sustainable economic growth, (2) maximum
sustainable employment, and (3) moderate long-term interest rates.

When the average of prices of a broad collection of goods and ser-

vices is stable and believed likely to remain so, changes in the prices
of individual goods and services serve as clear guides for efficient
resource allocation in the U.S. economy. This then contributes to
higher standards of living for U.S. citizens.

Moreover, stable prices encourage saving and capital formation

because when the risks of erosion of asset values resulting from
inflation—and the need to guard against such losses—are mini-
mized, households are encouraged to save more and businesses are
encouraged to invest more.

The Federal Reserve’s other responsibilities—promoting financial system

stability (section 4), supervising and regulating financial institutions
and activities (section 5), fostering payment and settlement system
safety and efficiency (section 6), and promoting consumer protection
and community development (section 7)—contribute to the nation’s
economic well-being by supporting a smoothly functioning financial
system.

To promote public understanding of how the Federal Reserve interprets

its statutory mandate, the FOMC released its “Statement on Longer-
Run Goals and Monetary Policy Strategy” in January 2012. This state-
ment explains the FOMC’s longer-run goals and its strategy for setting
monetary policy to achieve them. In the statement, the FOMC also
established a numerical longer-run goal for inflation: In the Commit-
tee’s judgment, an annual rate of increase of 2 percent in the price
index for personal consumption expenditures—an important price mea-
sure for consumer spending on goods and services—is most consistent,
over the longer run, with meeting the Federal Reserve’s statutory man-
date to promote both maximum employment and price stability. The
FOMC reaffirms its goals statement at its January meeting each year.

24 Conducting Monetary Policy

 Low and stable inflation. Because the nation’s inflation rate over
the longer run is primarily determined by monetary policy, the Fed-
eral Reserve can work directly to ensure that the U.S. economy ben-
efits from low and stable inflation. Low and stable inflation helps the
economy operate efficiently. When inflation is low and stable, individu-
als can hold money without having to worry that high inflation will
rapidly erode its purchasing power. Moreover, households and busi-
nesses can make more accurate longer-run financial decisions about
borrowing and lending and about saving and investment. Longer-term
interest rates are also more likely to be moderate when inflation is low
and stable.

In contrast, deflation—which occurs when the prices of goods and ser-

vices are falling, on average—would increase the burden of household
and business debts after adjusting for the decline in prices. Moreover, if
inflation persisted near zero, short-term interest rates would likely also
be quite low and monetary policymakers might not be able to reduce
interest rates enough to support the economy when it is at risk of slid-
ing into recession. (Note that the terms “policymakers,” “monetary
policymakers,” and “FOMC policymakers” are used interchangeably in
this section.) As a result, monetary policy that aims to keep inflation at
2 percent over the longer run helps to maintain a productive and well-
functioning economy, leading to increases in employment and to higher
standards of living for U.S. citizens. In this way, the goal of achieving
maximum employment in the economy is closely linked with the goal
of 2 percent inflation.

Maximum employment. The goal of maximum employment stands

on an equal footing with price stability as an objective of monetary pol-
icy. However, policymakers recognize that factors other than monetary
policy largely determine the maximum level of employment that can
be sustained without leading to higher inflation. These factors include
trends in the size and makeup of the population, changes in the types
of jobs and skills needed in the workforce, and other policies such as
those affecting education and training. Consequently, it would not be
appropriate for the FOMC to specify a fixed goal for employment.

The Federal Reserve System Purposes & Functions 25

Policymakers consider a range of indicators in making their assessments
of labor market conditions consistent with maximum employment, Longer-run views aid
monetary policy
recognizing that those assessments are necessarily uncertain and may
FOMC participants present
change. All FOMC participants present their views on the longer-run
their views on the longer-
outlook for economic activity and unemployment four times each year, run outlook for economic
in their Summary of Economic Projections. In those projections, partici- activity and unemployment
four times each year in
pants report the unemployment rate they expect over the longer run.
their Summary of Economic
For example, in the projections released in March 2016, FOMC partici- Projections, available on
pants’ estimates of the longer-run normal unemployment rate ranged the Federal Reserve Board’s
website at
from 4.7 to 5.8 percent, with a median estimate of 4.8 percent.
www.federalreserve.gov/
monetarypolicy/
The Federal Reserve’s goals for maximum employment and 2 percent fomccalendars.htm.

inflation are generally complementary. For example, when inflation

is below 2 percent and the FOMC judges that conditions in the labor
market are not as strong as those that the Committee views as con-
sistent with maximum employment, the FOMC can keep interest rates
temporarily low to promote higher employment and return inflation to
2 percent. Of course, the FOMC may, at times, face situations in which
its goals are not complementary; for example, inflation might be above
2 percent even as employment is below its maximum level. The FOMC
has indicated in its “Statement on Longer-Run Goals and Monetary
Policy Strategy” that, in such a situation, it would follow a balanced
approach to achieving its goals, taking into account how close or far
employment is from its maximum level and how close or far inflation is
from 2 percent. (The “Statement on Longer-Run Goals and Monetary
Policy Strategy” is available on the Federal Reserve Board’s website at
www.federalreserve.gov/monetarypolicy.)

Because monetary policy actions influence inflation and employment

with a lag, the FOMC’s decisions are based on its assessments of the
medium-term outlook for the economy and the potentially different
time horizons over which employment and inflation could be expected
to return to levels consistent with the Committee’s mandate. In addi-
tion, the FOMC considers any risks associated with the economic out-
look, including risks to the financial system that could impede attaining
the Committee’s goals.

26 Conducting Monetary Policy

 How Monetary Policy
Affects the Economy
FOMC policymakers set monetary policy to foster financial conditions
they judge to be consistent with achieving the Federal Reserve’s statu-
tory mandate of maximum employment, stable prices, and moderate
Monetary policy: Easing
and tightening defined long-term interest rates. Monetary policy affects the U.S. economy—
The FOMC changes and the achievement of the statutory mandate—primarily through
monetary policy primarily by its influence on the availability and cost of money and credit in the
raising or lowering its target
economy.
for the federal funds rate,
the interest rate for overnight
borrowing between banks. As conditions in the economy change, the Committee adjusts mon-
Lowering the target rate
etary policy accordingly, typically by raising or lowering its target for
represents an “easing”
of monetary policy, while the federal funds rate. A change in the target for the federal funds rate
increasing the target rate is a normally will be accompanied by changes in other interest rates and in
“tightening” of policy.
financial conditions more broadly; those changes will then affect the
spending decisions of households and businesses and thus will have
implications for economic growth, employment, and inflation.

Effect of Changes in Federal Funds Rate Target

on Financial Markets and Spending
Short-term interest rates. Short-term interest rates—for example, the
rate of return paid to holders of U.S. Treasury bills or commercial paper
(a short-term debt security) issued by private companies—are affected
by changes in the level of the federal funds rate.

Short-term interest rates would likely decline if the FOMC reduced

its target for the federal funds rate, or if unfolding events or Federal
Reserve communications led the public to think that the FOMC would
soon reduce the federal funds rate to a level lower than previously
expected. Conversely, short-term interest rates would likely rise if the
FOMC increased the funds rate target, or if unfolding events or Federal
Reserve communications prompted the public to believe that the funds
rate would soon be moved to a higher level than had been anticipated.

The Federal Reserve System Purposes & Functions 27

These changes in short-term market interest rates resulting from a
change in the FOMC’s target for the federal funds rate typically are
transmitted to medium- and longer-term interest rates, such as those
on Treasury notes and bonds, corporate bonds, fixed-rate mortgages,
and auto and other consumer loans. Medium- and longer-term inter-
est rates are also affected by how people expect the federal funds rate
to change in the future. For example, if borrowers and lenders think,
today, that the FOMC is likely to raise its target for the federal funds
rate substantially over the next several years, then medium-term inter-
est rates today will be appreciably higher than short-term interest rates.
Open market purchases of
longer-term securities
Generally speaking, the effect on short-term interest rates of a single
Prior to the 2007–09
change in the FOMC’s target for the federal funds rate will be some- financial crisis, the Federal
what larger than the effect on longer-term rates because long-term Reserve’s Open Market Desk
typically bought Treasury
rates typically reflect the expected course of short-term rates over a
securities with an average
long period. However, the influence of a change in the FOMC’s target maturity of about three
for the federal funds rate on longer-term interest rates can also be sub- years. Since 2008, the Desk
purchased securities with
stantial if it has clear implications for the expected course of short-term
longer remaining maturi-
rates over a considerable period. ties in order to increase the
effects of the purchases on
longer-term interest rates,
Longer-term interest rates and stock prices. Changes in longer-
and purchased mortgage-
term interest rates usually also affect stock prices, and because many backed securities to reduce
individuals hold some stocks either directly or indirectly (through a the cost and increase the
availability of credit for the
mutual fund or as part of a pension plan), the change in stock prices
purchase of homes.
will have implications for personal wealth. For example, if longer-term
interest rates decline, then investors may decide to purchase stocks,
thus bidding up stock prices. Moreover, lower interest rates may lead
investors to anticipate that the economy will be stronger and profits
will be higher in the future, and this expectation may add further to the
demand for stocks.

Dollar exchange rates and international trade. Changes in mon-

etary policy can also affect the value of the U.S. dollar in international
currency markets. For example, if monetary policy causes interest rates
to fall in the United States, yields on U.S. dollar assets will look less
favorable to international investors. With U.S. dollar assets less attrac-

28 Conducting Monetary Policy

 tive, international investors may invest less in dollar-denominated assets,
lowering the value of the dollar in foreign exchange markets. A fall in
the value of the dollar will tend to boost U.S. exports because it reduces
the price that residents of other countries would need to pay in their
own currencies for U.S. goods and services. Moreover, a dollar deprecia-
tion means that U.S. residents’ purchases of imported products become
more expensive, giving U.S. consumers and firms an incentive to pur-
What is dollar
chase domestically produced goods and services instead of foreign ones.
depreciation?
On August 15, 2008, $1
could be exchanged for Effects on wealth and spending. Regardless of whether they result
110.48 Japanese yen (¥). from an actual or expected change in monetary policy, the changes in
Over the next several
longer-term interest rates, stock prices, and the foreign exchange value
months, the U.S. dollar
depreciated against the of the dollar will affect a wide range of spending decisions made by
yen—a period when the households and businesses. For example, when the FOMC eases mon-
FOMC was reducing its
etary policy (that is, reduces its target for the federal funds rate), lower
target for the federal funds
rate. By mid-December 2008, interest rates on consumer loans will elicit greater spending on durable
$1 would purchase goods (long-lasting manufactured goods) such as televisions and auto-
only ¥90.68.
mobiles. Lower mortgage rates will make buying a house more afford-
able and lead to more home purchases. In addition, lower mortgage
rates will encourage homeowners to refinance their mortgages, freeing
up some cash for other purchases. For individuals holding stocks either
directly, through mutual funds, or as part of a retirement plan, higher
stock prices will add to wealth, helping to spur more spending. Invest-
ment projects that businesses previously believed would be only mar-
ginally unprofitable will become attractive because of reduced financ-
ing costs, particularly if businesses expect their sales to rise.

Degree of Slack or Overheating

FOMC policymakers, in determining the appropriate position or
“stance” of monetary policy, must assess the current and likely future
degree of slack or overheating in the economy. Because measuring the
maximum sustainable level of employment or the potential output of
the national economy is a complex undertaking, and inherent uncer-
tainties surround any particular estimate, policymakers consider a wide
range of indicators of resource utilization when thinking about appro-
priate monetary policy.

The Federal Reserve System Purposes & Functions 29

If resources are underused—for example, employment is below what
policymakers judge to be its maximum sustainable level and seems
likely to remain below—then they have scope for easing monetary
policy to move the economy to its full employment level. Conversely,
if resource utilization appears likely to remain above the level associ-
ated with maximum employment, then policymakers may judge that
a tighter monetary policy is necessary to prevent inflation from rising
above 2 percent.

Other Factors Affecting Monetary Policy

Monetary policy affects the economy with a lag. Although the
channels through which the FOMC’s monetary policy decisions are
transmitted to financial conditions and the economy are reasonably
straightforward, monetary policy affects the economy with a lag. This
means that an FOMC policy decision will not change consumer or busi-
ness spending immediately. When the FOMC adjusts monetary policy,
it expects that the adjustment will affect economic conditions in the
future, and that those economic conditions will differ from what they
would have been in the absence of the policy adjustment. Thus, in
setting monetary policy, policymakers must not only evaluate current
economic conditions, they must also forecast how the economy is likely
to evolve over the next few years.

Anticipated factors. Monetary policy is not the only influence on the

economy. Many other factors can affect spending, output, employ-
ment, and inflation.

Some of these factors can be anticipated and factored into the FOMC’s
policymaking. For example, the government influences demand in the
economy through changes in taxes and spending programs, which are
often anticipated. Indeed, the economic effects of a tax cut may pre-
cede its actual implementation if businesses and households increase
their spending in anticipation of lower taxes. In addition, forward-look-
ing financial markets may build anticipated fiscal events into the level
and structure of interest rates.

30 Conducting Monetary Policy

 Demand shocks. Other factors that affect spending on goods and
services can come as a surprise and can influence the economy in
unforeseen ways. Examples of these “demand shocks” include shifts in
consumer and business confidence or unexpected changes in the credit
standards that banks and other lenders apply when they consider mak-
ing loans. Once a demand shock is identified, monetary policy can be
used to address it.

For instance, if consumer and business confidence falter and spending

slows, the FOMC can ease monetary policy, lowering interest rates to
help move spending back up. But because data and other informa-
tion on the state of the economy are not available immediately, it can
take time before a demand shock is identified and, given that policy
actions operate with a lag, an even longer time before it is countered.
Thus, demand shocks—even ones that can be addressed by monetary
policy—can push the economy away from the Federal Reserve’s goals
of maximum employment and price stability for a time.

Supply shocks. Other shocks can affect the production of goods and
services and their prices by affecting the costs associated with produc-
tion or the technology used in production.

Examples of such “supply shocks” include crop losses due to extreme

weather and slowdowns in productivity growth relative to what would
have occurred otherwise—these sorts of adverse supply shocks tend to
raise prices and reduce output (and also employment). A disruption in
the oil market that reduces the supply of oil and increases its price sub-
stantially can also raise other prices and reduce output because oil is an
input to the production of many products. In the face of these adverse
supply shocks, FOMC policymakers can attempt to counter the loss
of output by easing monetary policy and making financial conditions
more conducive to spending; alternatively, policymakers can attempt to
counter the rise in prices by tightening policy.

The Federal Reserve System Purposes & Functions 31

As discussed, the FOMC has indicated in its “Statement on Longer-
Run Goals and Monetary Policy Strategy” that, in such a situation, it
would follow a balanced approach to achieving its goals, taking into
account how close or far employment is from its maximum level and
how close or far inflation is from 2 percent. Of course, the economy
can also experience beneficial supply shocks, such as technological
breakthroughs or reductions in the cost of important raw materials, and
these beneficial supply shocks can both lower prices and boost output.

Monetary Policy in Practice

How are monetary policy decisions made? The members of the Board
of Governors and the presidents of the 12 Federal Reserve Banks gather Overview of the Federal
Reserve System and
at the Board’s office in Washington, D.C., for eight regularly scheduled
the FOMC
meetings of the FOMC each year to discuss economic and financial
See section 1 for an overview
conditions and deliberate on monetary policy. If necessary, FOMC par- of the Federal Reserve
ticipants may also meet by video conference at other times. The Federal System and the FOMC.

Reserve Bank of New York carries out the policy decisions made at
FOMC meetings primarily by buying and selling securities as authorized
by the FOMC.

Federal Open Market Committee Meetings

At its meetings, the FOMC considers three key questions: How is the
U.S. economy likely to evolve in the near and medium term, what is the
appropriate monetary policy setting to help move the economy over
the medium term to the FOMC’s goals of 2 percent inflation and
maximum employment, and how can the FOMC effectively communi-
cate its expectations for the economy and its policy decisions to the
public? For a closer look at FOMC meeting deliberations and open
market operations, see box 3.1 and figure 3.3, respectively.

Keeping Policy in Step with Evolving Economic Conditions

As discussed, the FOMC’s overall approach to its decisionmaking is
described in its statement on its longer-run goals and its strategy for

32 Conducting Monetary Policy

Box 3.1. What Happens at an FOMC Meeting
In preparation for each FOMC meeting, policymakers analyze economic and financial developments and update their forecasts
of economic activity, employment, and inflation over the near and medium term. The materials that they and their staffs
review include a wide range of U.S. and inter­national economic and financial data, statistical and judgmental economic
forecasts, and analyses of alternative policy approaches. Participants also consult business, consumer, and financial industry
contacts to hear their perspectives on economic and financial conditions and the outlook.

The staff of the Federal Reserve Banks economic outlook and the appropriate period prior to the next FOMC meet-
collect and summarize information on policy response in preparation for their ing, how they expect policy to evolve
current economic conditions in their meeting in Washington. over the medium run, and how the
Districts. An overall summary, com- Committee’s policy intentions should be
During the first part of the meeting, the
monly known as the Beige Book, is communicated to the public. While all
Federal Reserve governors and Reserve
released to the public one week before participants are included in the discus-
Bank presidents receive briefings that
the FOMC meeting. (The Beige Book is sions, the policy decision rests with the
review the operations of the System
available at www.­federalreserve.gov/ voting members of the FOMC—the
Open Market Desk at the Federal
monetarypolicy/beigebook/default. members of the Board of Governors,
Reserve Bank of New York and recent
htm.) At about the same time, the the president of the Federal Reserve
economic and financial developments
staff of the Federal Reserve Board Bank of New York, and four of the
in the United States and abroad. Each
distributes to all FOMC participants its Bank presidents (on a rotating basis).
Bank president around the table then
analysis of the economy, its economic
takes a turn presenting his or her views For more information on the FOMC
forecasts, and an analysis of several
on economic conditions in his or her and other key Federal Reserve entities,
policy options that span the range of
District, and both the presidents and see section 2. For an in-depth look at
plausible monetary policy responses
governors offer their assessments of what happens at an FOMC meeting,
to the current and expected economic
recent developments and the outlook. see the speech that former Federal
situation. Economic research groups at
Reserve Governor Elizabeth A. Duke
the Reserve Banks separately brief their After a staff presentation on options
delivered in October 2010, “Come
Bank presidents on relevant economic for monetary policy, participants again
with Me to the FOMC,” available at
developments and policy choices. Using share their individual judgments of how
www.federalreserve.gov/newsevents/
these materials, FOMC participants for- policy should be conducted over the
speech/duke20101019a.htm.
mulate their preliminary views on the

setting monetary policy to achieve them. In practice, however, selecting

policy tools to implement the FOMC’s policy strategy is not clear cut.
The U.S. and global economies are complex and evolving, and changes
in monetary policy take time to affect economic activity, employment,
and inflation.

Moreover, monetary policy is just one of the factors determining the

pace of domestic economic activity, employment, and inflation. Accord-
ingly, in making their assessment of how the economy is likely to evolve

The Federal Reserve System Purposes & Functions 33

in the near and medium term, policymakers take into account a range
of other influences on the economy. Some can readily be built into eco-
nomic forecasts. For example, federal, state, and local tax and spending
policies have important and relatively predictable effects on household
and business spending and are typically budgeted in advance. Even so,
the range of uncertainty about the effects of some predictable factors
may be wide.

And, of course, some economic developments—such as shifts in

consumer and business confidence, changes in the terms under which
banks extend loans, or disruptions to oil or agricultural supplies—can
occur suddenly and with little warning. Finally, the actions of other
central banks and fiscal authorities abroad also play a role through the
effects on international trade and global financial flows and exchange
rates.

How the FOMC Determines Its Monetary Policy Stance Using statistical models in
monetary policy analysis
FOMC policymakers use a broad range of information to assess trends Federal Reserve staff use
in the U.S. economy and to judge the appropriate stance of monetary statistical economic models
policy. They analyze the most up-to-date economic data and review to help the FOMC forecast
economic developments
reports and surveys from business and financial market contacts. In and evaluate the effects of
addition, they use various tools for forecasting economic developments monetary policy decisions.
and evaluating the effects of monetary policy decisions. Statistical mod- For more detail on these
models, see “The FRB/US
els can help analyze how changes in economic conditions may affect Model: A Tool for Macro-
the outlook for economic activity, employment, and inflation, and economic Policy Analysis”
how the level of the target federal funds rate might respond to those at www.federalreserve.gov/
econresdata/notes/feds-
changes. Simulations of these models, including results using a variety notes/2014/a-tool-for-macro-
of policy rules that relate the setting of the target federal funds rate to economic-policy-analysis.
the objectives of monetary policy, can provide some indication of how html.

monetary policy is likely to affect the economy over the longer run.

Because policy actions take time to affect the economy and inflation,
policymakers may assess the effects of their policies by looking at
various indicators that are likely to respond more quickly to changes
in the federal funds rate. Over the years, policymakers have at times
monitored indicators such as the monetary aggregates (measures of the

34 Conducting Monetary Policy

Figure 3.3. How the Federal Reserve conducts open market operations
When the Federal Open Market Committee (FOMC) sets monetary policy that, for example, requires adding liquidity to the
banking system to spur economic activity, it instructs the Federal Reserve Bank of New York’s (FRBNY) Open Market Desk to
purchase U.S. Treasury securities in the open market.

FOMC FRBNY DESK PRIMARY DEALERS

1 2 3 4
decides to instructs FRBNY purchases securities in the highly ensure that the market for U.S. Treasury
reduce the Desk to purchase liquid market for U.S. Treasury securities is liquid—in other words, they are
target for the securities securities from one of the designated, always willing to sell securities and always
federal funds approved primary dealers willing to buy securities
rate
5
credits account that the primary
FED BALANCE SHEET dealer’s bank holds at FRBNY in
exchange for securities
Assets Liabilities 7 BANKS
U.S. Accounts at with the added funds in their accounts at
Treasury FRBNY held the FRBNY, banks can make more loans to
securities by banks of businesses and individuals
primary
dealers

6 GROCERIES
the securities acquired are assets,
and the bank accounts credited with
the payment are liability items on the
Federal Reserve’s balance sheet
BUSINESSES AND INDIVIDUALS
8
with increased opportunity to borrow,
businesses and individuals are able to
purchase mortgages, cars, and other items,
boosting spending in the economy

Note: A more detailed explanation of open market operations, including information on the Open Market Desk’s purchases
and sales of securities, is available on the website of the Federal Reserve Bank of New York, www.newyorkfed.org/markets/.

stock of money), changes in Treasury yields and private-sector interest

rates and the levels of those rates for securities that mature at different
times in the future, and exchange rates. Importantly, to be valuable to
policymakers, these and other possible policy guides must have a close,
predictable relationship with the ultimate goals of monetary policy, but
this has not always been the case.

The Federal Reserve System Purposes & Functions 35

Forward Guidance Signals
the FOMC’s Policy Intentions
In addition to adjusting the target for the federal funds rate, the
FOMC also can influence financial conditions by communicating how
it intends to adjust policy in the future. Since March 2009, when the
federal funds rate was effectively at its lower bound, this form of com-
munication, called “forward guidance,” has been an important signal
to the public of the FOMC’s policy intentions. For example, when the
FOMC said in its March 2009 postmeeting statement that it intended
to keep the target for the federal funds rate “exceptionally low” for
FOMC postmeeting
“an extended period,” its goal was to cause financial market partici- statements
pants to adjust their expectations to assume a longer period of lower The release of postmeeting
short-term interest rates than they had previously expected and, thus, communications often
put downward pressure on long-term interest rates to provide more provides the broader context
for FOMC policy decisions.
support for the economic recovery. See the FOMC’s most recent
postmeeting statement at
Between 2009 and 2014, the FOMC revised its forward guidance www.federalreserve.gov/
monetarypolicy/
several times, strengthening its intent to put downward pressure on fomccalendars.htm. For more
interest rates when the economy appeared to be operating at a lower detailed information on the
level than desirable and, more recently, revising it to clarify how, when history of FOMC commu-
nications, see “A Modern
the time was appropriate, the Committee would make the decision to History of FOMC Commu-
raise the target federal funds rate. nication: 1975–2002”
at www.federalreserve.
gov/monetarypolicy/files/­
What Monetary Policymakers FOMC20030624memo01.
Say to the Public pdf.

While the use of forward guidance as a policy tool is relatively new, the
Federal Reserve has had a long-standing commitment to communicate
regularly with the public and Congress concerning its monetary policy
activities and the pursuit of its mandate. While some communications
are required by statute, most represent an effort by the Federal Reserve
to increase the transparency of its policy decisions and operations.

Statements after FOMC meetings. Since 1994, the Federal Reserve

has issued statements announcing FOMC decisions. In recent years,
those statements have summarized the Committee’s judgment about
the appropriate conduct of monetary policy over the intermeeting

36 Conducting Monetary Policy

 period and provided guidance about the factors that the FOMC will
consider in setting policy as economic and financial developments
evolve. The postmeeting statements also indicate which FOMC mem-
bers voted for an action, and which members, if any, dissented from
it. At times, the FOMC also issues broader statements that represent
the consensus of almost all participants. An example of a consensus
statement is the “Statement on Longer-Run Goals and Monetary Policy
Strategy” that was discussed earlier in this section.

Meeting minutes. Detailed minutes of FOMC meetings are released

three weeks after each meeting. The minutes cover all policy-related
topics that receive a significant amount of attention during the meet-
ing. They describe the views expressed by the participants, the risks and
uncertainties attending the outlook, and the reasons for the Commit-
tee’s decisions. The minutes can help the public interpret economic
and financial developments and better understand the Committee’s
decisions. As an official record of the meeting, the minutes identify all
attendees and include votes on all authorized policy operations.

Summary of Economic Projections. Beginning in late 2007, Fed-

eral Reserve policymakers began to publish economic projections, the
FOMC postmeeting press “Summary of Economic Projections,” four times each year. Those pro-
conferences jections, published along with the FOMC postmeeting statement, now
In April 2011, the Federal provide participants’ assessments of the most likely outcomes for real
Reserve Chair began to hold
press briefings following
gross domestic product growth, the unemployment rate, inflation, and
each of the four FOMC the federal funds rate over the medium term and over the longer run.
meetings per year at which Each participant bases his or her projection on his or her assessment of
participants provide their
economic projections. For
appropriate monetary policy and assumptions about the factors likely
more information, see to affect economic outcomes. In April 2011, the Federal Reserve Chair
www.federalreserve. began to hold press briefings following each of the four FOMC meet-
gov/­monetarypolicy/­
fomccalendars.htm.
ings per year at which participants provide their projections. At the
press conferences, the Chair discusses current and prospective mon-
etary policy and presents a summary of the participants’ projections.

Testimonies to Congress, speeches, and transcripts. The FOMC’s

communication of its policy actions and intentions extends well beyond

The Federal Reserve System Purposes & Functions 37

the postmeeting statements and minutes. By statute, the Federal
Reserve Chair testifies twice each year on economic developments and
monetary policy before the congressional committees that oversee
the Federal Reserve. At those times, the Board of Governors delivers
the semiannual Monetary Policy Report to Congress that discusses the
conduct of monetary policy and economic developments and prospects
for the future. In addition, the Chair and other Board members appear
frequently before Congress to report and answer questions on eco-
nomic and financial market developments and on monetary and regula-
tory policy. Many Federal Reserve policymakers regularly give public
speeches. And a wide range of documents, including transcripts of the
FOMC meetings, is made available after a five-year lag.

Communicating with other organizations. Federal Reserve officials

also maintain regular channels of communication with officials of other
U.S. and foreign government agencies, international organizations, and
foreign central banks on subjects of mutual concern.

Although the ­Federal Reserve’s policy objectives are limited to economic

outcomes in the United States, it is mutually beneficial for macroeco-
nomic and financial policymakers in the United States and in other
countries to maintain a continuous dialogue. This dialogue enables
the Federal Reserve to better understand and anticipate influences on
What is a depository
the U.S. economy that emanate from abroad. It also helps the Federal institution?
Reserve and other central banks work together to address common Depository institutions
economic challenges and threats to the global financial system. (also referred to as banks
interchangeably here) include
commercial banks, savings
institutions, credit unions,
and U.S. branches and agen-
cies of foreign banks. In early
Monetary Policy Implementation 2016, there were more than
12,500 depository institu-
tions in the United States
The Federal Funds Market with accounts at the Federal
At the end of any business day, a depository institution may need to Reserve.

borrow funds overnight to make payments on its own behalf or on

behalf of its customers, to cover a shortfall in its balances held at the

38 Conducting Monetary Policy

Box 3.2. Banks Must Meet Reserve Requirements Set by the Federal Reserve Board
The Federal Reserve Board, by law, sets reserve requirements on all depository institutions: They are required to hold cash in
their vaults or reserve balances at the Federal Reserve (or a combination of the two) in an amount equal to a certain fraction
of their deposits.

Since the early 1990s, these require- A bank may choose to hold reserve website at www.federalreserve.
ments have been applied only to the balances in excess of the requirement gov/monetarypolicy/reservereq.htm.
trans­action deposits held at banks— as a means of protecting against an Additional discussion about the evol­
that is, accounts such as checking overdraft in its Federal Reserve account ution of reserve requirements can be
accounts or interest-bearing accounts or to reduce the risk of failing to hold found in the Federal Reserve Bulletin
that offer unlimited checking privileges. enough balances to satisfy its reserve reports “Open Market Operations
The Board sets a required reserve ratio requirement. More generally, a bank’s in the 1990s,” www.federalreserve.
within limits prescribed by the Federal desired level of reserve balances is likely gov/pubs/bulletin/1997/199711lead.
Reserve Act, and that ratio determines to depend upon the volume of, and pdf and “Reserve Requirements:
the fraction of deposits that a bank uncertainty about, payments flowing ­History, Current Practice, and Potential
must hold as vault cash or reserve bal- through its Federal Reserve account. Reform,” www.federalreserve.gov/
ances. The Federal Reserve infrequently monetarypolicy/0693lead.pdf.
To read more about reserve require-
adjusts the required reserve ratio.
ments, see the Federal Reserve Board’s

Federal Reserve, or to meet reserve requirements imposed by the Federal

Reserve Board (see box 3.2). An institution that finds itself with excess
funds on hand at the end of the business day can arrange to lend those
funds overnight to another depository institution in the federal funds
market. When banks borrow and lend in the federal funds market, the
exchange of funds is reflected in the accounts they hold at the Federal
Reserve—funds banks hold in these accounts are known as reserve bal-
ances. Since late 2008, the Federal Reserve has paid interest on banks’
reserve balances (for a ­discussion, see box 3.3).

In many ways, this process is analogous to what happens when an

individual makes a private loan to another individual. When one person
borrows from another, balances from the checking account of the
lender are transferred to the checking account of the borrower. Simi-
larly, when a depository institution lends funds to another depository
institution in the federal funds market, reserve balances in the lender’s
“checking account” at the Federal Reserve are transferred to the Fed-
eral Reserve account of the borrower.

The Federal Reserve System Purposes & Functions 39

To be more precise, only depository institutions (banks, savings institu-
tions, credit unions, and U.S. branches of foreign banks) and selected
other institutions (the Federal Home Loan Banks and other government-
sponsored enterprises) are permitted to hold accounts at the Federal
Reserve. Banks use these accounts to make and receive payments
in much the same way that a customer would use his or her check-
ing account at a commercial bank. The interest rate on federal funds
transactions is called the federal funds rate. For many years before the
2007–09 financial crisis, the FOMC carried out monetary policy by set-
ting a target for the federal funds rate.

Monetary Policy before the

2007–09 Financial Crisis
Open market operations. Over the years, the Federal Reserve has
relied upon open market operations to manage conditions in the
federal funds market and to keep the federal funds rate at the target
level set by the FOMC. The Open Market Desk (the Desk) at the Federal
Reserve Bank of New York conducts open market operations by buying
or selling securities issued or guaranteed by the U.S. Treasury or U.S.
government agencies (figure 3.4).

Box 3.3. The Federal Reserve Pays Interest on Required Reserve Balances and
Excess Balances
In 2006, Congress authorized the Federal Reserve to pay interest on reserve balances beginning in 2011. However, the
Emergency Economic Stabilization Act of 2008 accelerated this authority, and the Federal Reserve began paying interest
on reserve balances in October 2008. The Federal Reserve also pays interest on balances held in excess of the reserve
requirement. The interest rates on reserve balances and on excess balances are both set by the Board of Governors.

The payment of interest on balances conduct of monetary policy. By raising More detailed information on the inter-
maintained to satisfy reserve balance or lowering the interest rate paid on est on required reserve balances and
requirements is intended to eliminate excess reserves (the IOER rate), the excess reserve balances is available on
or reduce the implicit tax that reserve Federal Reserve can change the attrac- the Federal Reserve Board’s website at
requirements impose on depository tiveness of holding excess balances and www.federalreserve.gov/monetary
institutions. The interest rate paid thus affect the federal funds rate and policy/reqresbalances.htm.
on excess balances gives the Federal other short-term market interest rates.
Reserve an additional tool for the

40 Conducting Monetary Policy

 The Federal Reserve Act requires that the Desk conduct its purchases
and sales in the open market. To do so, the Desk has established
relationships with securities dealers known as primary dealers that are
active in the market for U.S. government securities. For example, in
an open market purchase, the Desk would buy eligible securities from
primary dealers (at prices determined in a competitive auction). The
Federal Reserve would pay for those securities by crediting the reserve
accounts that the banks used by the primary dealers maintain at the
Federal Reserve. (The banks, in turn, would credit the dealers’ bank
accounts.) In this way, the open market purchase leads to an increase
in reserve balances. A greater supply of reserve balances would tend
to put downward pressure on the federal funds rate, as banks would
be willing to lend their excess funds at somewhat lower interest rates.
In contrast, an open market sale would reduce reserve balances and
put upward pressure on the federal funds rate. Each business day, the

Figure 3.4. Traditional monetary policy: Tools for achieving the targeted federal funds rate

Tool What is it? How does it work? Who uses it?

Reserve requirements The percentage of deposits Reserve requirements create Determined by the Board of
that commercial banks and a stable demand for reserves. Governors (within ranges
other depository institutions The Federal Reserve then specified by the Federal
must hold as reserves. adjusts the supply of reserves Reserve Act).
through open market opera-
tions to keep the level of the
federal funds rate close to
the target rate established
by the Federal Open Market
Committee (FOMC).

Open market operations Purchases or sales—tempo- Each purchase or sale of Directed by the FOMC;
rary or permanent—of U.S. securities directly affects the conducted by the Federal
government and agency se- volume of reserves in the Reserve Bank of New York
curities in the open market. banking system and thus (in competitive operations
the level of the federal funds with primary dealers).
rate.

Discount window lending Depository institutions can Credit provided by the Feder- Reserve Banks lend to de-
borrow from a Federal Re- al Reserve’s discount window pository institutions; interest
serve Bank. supplies balances and can rate charged is determined
help address pressures in the by the Board of Governors.
federal funds market.

The Federal Reserve System Purposes & Functions 41

Box 3.4. Discount Window Lending as a Monetary Policy Tool
When the Federal Reserve Act became law in 1913, the Federal Reserve was authorized to lend only to banks that were
members of the Federal Reserve System. At the time, this included all nationally chartered banks and those state-chartered
banks that had chosen to join the System. Today, by law, all depository institutions that offer transactions accounts subject to
reserve requirements can borrow from the Federal Reserve.

At first, the Federal Reserve lent facilities through which the Federal assess whether a depository institu-
primarily by “discounting” short-term Reserve lends to depository institutions. tion is in sound financial condition,
commercial loans owned by banks. Because a bank would be unlikely to its Reserve Bank regularly reviews the
In essence, the Federal Reserve made borrow in the federal funds market institution’s condition, using supervi-
a loan by purchasing the commercial at an interest rate much higher than sory ratings and data on the adequacy
loans for less than their face value, the discount rate, the availability of of the institution’s capital. Depository
with the difference between the discount window loans at an interest institutions are not required to seek
purchase price and the face value (the rate above the targeted federal funds alternative sources of funds before
discount) representing interest the rate has acted as an upper limit on the requesting occasional advances of
Federal Reserve received on its loan. funds rate and helped to keep it close primary credit, but primary credit
Originally, these loans were made at to the FOMC’s target. The volume of is expected to be used as a backup
a special lending window at each of discount window lending and borrow- source of funding rather than a routine
the Reserve Banks called the discount ing is usually relatively small. one. Because primary credit is the Fed-
window. For that reason, over time, eral Reserve’s main discount window
Depository institutions have access to
Federal Reserve lending to deposi- program, the Federal Reserve and oth-
three types of discount window lend-
tory institutions became known as ers in the banking industry at times use
ing—primary credit, secondary credit,
“discount window lending.” Today, the term “discount rate” specifically to
and seasonal credit.
most extensions of credit by the Fed- refer to the primary credit rate.
eral Reserve are made in the form of Primary credit is available to generally
Secondary credit may be available to
advances—loans backed by collateral sound depository institutions on a very
depository institutions that are eligible
pledged by the borrower—rather than short-term basis, typically overnight,
to borrow from the discount window
as discounts, but the term “discount but at times for longer periods. To
but that do not meet the criteria for
window” is still used to refer to the
(continued on the next page)

Desk would determine the quantity of open market operations neces-

sary to keep the federal funds rate at the FOMC’s target after taking
into account factors in the market for federal funds, including banks’
estimated funding needs.

Discount window lending. If a depository institution finds that its

need for overnight funding cannot be satisfied in the federal funds
market or similar markets, it can borrow from the Federal Reserve’s
discount window, and the proceeds of the loan would be added to the
institution’s balance in its reserve account at the Federal Reserve. Rules

42 Conducting Monetary Policy

primary credit. Secondary credit is throughout the year—these institutions for sound asset quality. This category
extended on a very short-term basis, are usually located in agricultural or of assets includes most performing
typically overnight. The financial condi- tourist areas. Borrowing longer-term loans and most high-grade securities.
tion of secondary credit borrowers is funds from the discount window dur- Reserve Banks must be able to establish
generally less sound than the financial ing periods of seasonal need allows a legal right to be first in line to take
condition of primary credit borrowers. institutions to carry fewer liquid assets possession of and, if necessary, sell all
For that reason, the rate on secondary during the rest of the year and makes collateral that secures discount window
credit has typically been 50 basis points more funds available for local lending. loans in the event of default. The col-
above the primary credit rate—to com- The seasonal credit rate is based on lateral cannot be an obligation of the
pensate for the greater risk of credit market interest rates. pledging institution.
loss, although the spread can vary
Credit terms. By law, depository Assets accepted as collateral are
as circumstances warrant. Secondary
institutions that have either transaction assigned a lendable value deemed
credit is available to help a depository
accounts or nonpersonal time deposits appropriate by the Reserve Bank.
institution meet backup liquidity needs
that are subject to reserve require- Lendable value is the maximum loan
when its use is consistent with the
ments may borrow from the discount amount that can be backed by that
borrowing institution’s timely return
window. U.S. branches and agencies asset and is calculated as the value
to a reliance on market sources of
of foreign banks with transaction of the asset, less a deducted amount
funding or with the orderly resolution
accounts or nonpersonal time deposits referred to as the “haircut”—that is,
of a troubled institution’s difficulties.
are also eligible to borrow under the the loan is limited relative to the value
Secondary credit may not be used to
same general terms and conditions of the collateral to provide a cushion
fund an expansion of the borrower’s
that apply to domestic depository in case the value of the collateral falls.
assets.
institutions. This haircut helps to protect the Federal
Seasonal credit is designed to help Reserve from loss should the borrower
By law, all discount window loans must
small depository institutions manage fail to repay the loan.
be secured to the satisfaction of the
significant seasonal swings in their
lending Reserve Bank. The Federal
loans and deposits. Seasonal credit
Reserve generally accepts as collat-
is available to depository institutions
eral for discount window loans any
that can demonstrate a clear pattern
assets that meet regulatory standards
of recurring swings in funding needs

governing access to the discount window are established by the Federal

Reserve Act and by the regulations issued by the Board of Governors;
after posting collateral, depository institutions can borrow from the
discount window at interest rates set by the Reserve Banks, subject to
review and determination by the Board.

Since early 2003, interest rates for discount window loans have been
set above the target for the federal funds rate. As a result, depository
institutions have generally borrowed from the discount window in
significant volume only when overall market conditions have tightened
enough to push the federal funds rate above the discount rate. Prior to

The Federal Reserve System Purposes & Functions 43

the financial crisis that began in the summer of 2007, discount window
borrowing was infrequent (see box 3.4 for additional detail).

Monetary Policy during and after the

2007–09 Financial Crisis
The crisis in global financial markets that began during the summer of
2007 became particularly severe during 2008. One way that the Federal
Reserve responded to the crisis was by expanding its lending through
the discount window to banks that were experiencing shortages of
liquidity. In addition, the Federal Reserve introduced a variety of pro-
grams, using legal authority provided by Congress in several sections

Figure 3.5. Selected assets of the Federal Reserve, August 2007–December 2015
As the 2007–09 crisis intensified, the Federal Reserve introduced a variety of programs—and expanded its balance sheet in the
process—to address financial institutions’ need for short-term liquidity and strains in many markets.

Billions of dollars
5,000

4,500

4,000

3,500 Securities held outright

3,000

2,500

2,000
Total
1,500 assets

1,000 Support
All
for specific
500 liquidity
institutions**
facilities*
0
2008 2009 2010 2011 2012 2013 2014 2015

* “All liquidity facilities” includes term auction credit, primary credit, secondary credit, seasonal credit, Primary Dealer Credit
Facility, Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, Term Asset-Backed Securities Loan
Facility, Commercial Paper Funding Facility, and central bank liquidity swaps.
** “Support for specific institutions” includes Maiden Lane LLC, Maiden Lane II LLC, Maiden Lane III LLC, and support to
American International Group (AIG).
Source: Board of Governors of the Federal Reserve System, statistical release H.4.1, “Factors Affecting Reserve Balances,”
www.federalreserve.gov/releases/h41.

44 Conducting Monetary Policy

 of the Federal Reserve Act, which were designed to address financial
institutions’ need for short-term liquidity and strains in many markets.

The Federal Reserve also established dollar liquidity swap arrangements

with several foreign central banks to address dollar funding pressures
abroad. These programs are discussed in greater detail in box 3.5
“Extraordinary Liquidity Provision during the 2007–09 Financial Crisis.”
Together, these policy initiatives greatly increased the size of the Federal
Reserve’s balance sheet as shown in figure 3.5. (For more detail on the
balance sheet, see the discussion on page 52 and box 3.6 on page 53
“Under­standing the Federal Reserve’s Balance Sheet.”)

Figure 3.6. Reaching the “zero bound”

The federal funds rate neared its “zero bound” in December 2008. Around that time, the Federal Reserve began to use
nontraditional policy tools to boost economic activity.

Percent
7.0
6.5
6.0 Effective federal funds rate
5.5 Target federal funds rate
5.0 Target federal funds range
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
.5
0

2001 2003 2005 2007 2009 2011 2013 2015

Source: Intended federal funds rate. See the Monetary Policy section of the Board’s website, www.federalreserve.gov. For the
federal funds rate target, see www.federalreserve.gov/monetarypolicy/openmarket.htm. For the federal funds effective rate,
see https://apps.newyorkfed.org/markets/autorates/fed%20funds.

The Federal Reserve System Purposes & Functions 45

Box 3.5. Extraordinary Liquidity Provision during the 2007–09 Financial Crisis

In response to the financial crisis, the Federal Reserve provided liquidity to firms and markets in a variety of ways. Initially,
the Federal Reserve eased the terms on primary credit, the principal type of discount window credit that the Federal Reserve
extends to depository institutions. As the crisis intensified, however, the Federal Reserve provided liquidity in nontraditional
ways to firms and markets outside of the banking system.

In some cases, the Federal Reserve used Federal Reserve conducted regular financial markets. To counter these
its regular authorities in new ways. auctions of fixed quantities of discount strains, the Federal Reserve estab-
Even after easing the terms on primary window credit. Because the credit was lished foreign currency swap lines with
credit, banks were highly reluctant to extended through a market mecha- several foreign central banks. Under
borrow primary credit out of concern nism, and because funds were provided the lines, the Federal Reserve provided
that borrowing from the Federal several days after the auction, banks the foreign central bank with dollars,
which those central banks could lend
Reserve would indicate that the bank were less concerned that borrowing
to financial institutions in their local
was experiencing financial difficulties. would signal weakness and were less
markets, and received foreign currency
As a result, the eased terms on primary reluctant to borrow. At the same time,
in exchange.
credit did not significantly reduce the because dollar funding markets are
pressures on bank funding markets. global, strains in foreign dollar markets During the financial crisis, the Federal
To address the banks’ concerns, the were contributing to volatility in U.S. Reserve used its emergency lending
(continued on the next page)

Another way that the Federal Reserve responded to the crisis was
through its traditional policy tool, the federal funds rate. Beginning in
the fall of 2007, the FOMC cut its target for the federal funds rate and
by the end of 2008, that target had been reduced from 5¼ percent to
a range of 0 to ¼ percentage point (figure 3.6). While this monetary
easing was substantial, with the federal funds rate at nearly zero, the
FOMC could no longer rely on reducing that rate to provide much fur-
ther support for the economy.

Although the Federal Reserve’s initial responses to the crisis helped

financial markets to recover and function more normally, the recession
in the U.S. economy that began in December of 2007 was particularly
severe and long-lasting. With the federal funds rate near zero, the
FOMC turned to two less conventional policy measures—large-scale
asset purchases and forward guidance.

Large-scale asset purchases. In late 2008, the Federal Reserve began

purchasing longer-term securities through a series of large-scale asset

46 Conducting Monetary Policy

authority to establish broad-based established to provide liquidity to the and every loan was repaid in full, on
lending facilities to provide liquidity market for repurchase agreements, or time, and with interest. In most cases,
to financial markets other than the repos, the commercial paper market, the interest rate charged on the loans
interbank market that were important and the asset-backed securities market. was above those that prevailed in
for the provision of credit to U.S. busi- A facility was also established to help normal times. As a consequence, the
nesses and households. In particular, money market mutual funds meet the lending wound down, with many bor-
many critical financial institutions that heavy withdrawals that occurred after rowers even repaying their loans early,
depended on short-term funding were the failure of Lehman Brothers. as the financial situation improved.
not depository institutions and so could Similarly, all dollar liquidity provided to
Lastly, the Federal Reserve used its
not borrow from the discount window foreign central banks via the swap lines
emergency authority to provide sup-
when the liquidity of short-term fund- was repaid, and the Federal Reserve
port to certain specific institutions in
ing markets deteriorated. Moreover, earned fees for providing the service.
order to avert disorderly failures that
a material fraction of business and As shown in figure 3.5 on page 44,
could have led to even more severe
household loans were funded through liquidity provision through broad-based
dislocations and strains for the financial
securitizations; when markets for facilities peaked at about $1.5 trillion in
system as a whole and harmed the U.S.
securitized products deteriorated, the early 2009. For detailed information on
economy.
supply of credit to businesses and these liquidity provisions, see the Fed-
households declined, further weak- All Federal Reserve lending during the eral Reserve Board’s website at www.
ening the economy. Federal Reserve financial crisis was well collateralized federalreserve.gov/­monetarypolicy/bst.
emergency lending facilities were htm.

purchase programs, thereby putting downward pressure on longer-

term interest rates, easing broader financial market conditions, and
thus supporting economic activity and job creation. Between December
2008 and August 2010, the Federal Reserve purchased $175 billion in
direct obligations of the government-sponsored entities Fannie Mae,
Freddie Mac, and the Federal Home Loan Banks as well as $1.25 tril-
lion in mortgage-backed securities (MBS) guaranteed by Fannie Mae,
Freddie Mac, and Ginnie Mae. These purchases were intended to help
reduce the cost and increase the availability of credit for the purchase
of homes.

In addition, between March 2009 and October 2009, the Federal

Reserve purchased $300 billion of longer-term Treasury securities.
Later, in the face of a sluggish economic recovery, the Federal Reserve
expanded its asset holdings in a second purchase program between
November 2010 and June 2011, buying an additional $600 billion of
longer-term Treasury securities.

The Federal Reserve System Purposes & Functions 47

Maturity extension program. Between September 2011 and Decem-
ber 2012, the Federal Reserve undertook a “maturity extension pro-
gram” or MEP. Under the MEP, the Federal Reserve bought $667 billion
of Treasury securities with remaining maturities of 6 to 30 years and
sold an equivalent value of Treasury securities with remaining maturities
of 3 years or less. The MEP added to the downward pressure on longer-
term interest rates without affecting the size of the Federal Reserve’s
balance sheet.

Open-ended asset purchases. Finally, with considerable slack remain-

ing in the economy (as evidenced by an unemployment rate of more
than 8 percent), in September 2012 the FOMC began making addi-
tional purchases of MBS at a pace of $40 billion per month. In Janu-
ary 2013, these MBS purchases were supplemented by $45 billion per
month in purchases of longer-term Treasury securities. Unlike its first
two asset purchase programs and the MEP, in which the total size of
the program was announced at the time the program was undertaken,
the Federal Reserve’s third asset purchase program was open-ended.
The FOMC indicated that it would continue to purchase assets until
the outlook for the labor market had improved substantially so long
as inflation and expected inflation remained stable, and so long as the
benefits of the purchases continued to outweigh their costs and risks.

In December 2013, the FOMC began to slow the pace of its asset
Reinvestment to slow as
purchases. It continued to slow the pace of purchases at its subsequent the economy improves

meetings, concluding its third asset purchase program in October 2014. The FOMC indicated
in December 2015 that
Box 3.6 illustrates the effects of the Federal Reserve’s asset purchase
it expects to cease or
programs on its holdings of securities (on the asset side of the balance commence phasing out
sheet) and the corresponding increase in deposits of depository institu- reinvestments well after it
begins increasing the target
tions or reserve balances (on the liability side of the balance sheet).
range for the federal funds
rate. The timing of this
Since the summer of 2010, the Federal Reserve has continued to rein- step will depend on how
economic and financial
vest the proceeds of securities that mature or prepay. Maturing Treasury
conditions and the economic
securities are reinvested in Treasury securities, while principal payments outlook evolve.
on holdings of agency debt and agency MBS are reinvested in agency
MBS. By reinvesting, the Federal Reserve continues to hold a large

48 Conducting Monetary Policy

 amount of longer-term securities and thereby maintains downward
pressure on longer-term interest rates.

Forward guidance. In addition to its asset purchase programs, the

FOMC used “forward guidance”—that is, it provided information
about its intentions for the federal funds rate—to influence expecta-
tions about the future course of monetary policy. In December 2008,
when the Committee reduced the target for the federal funds rate to
nearly zero, it indicated in its postmeeting statement that it expected
that “weak economic conditions are likely to warrant exceptionally low
levels of the federal funds rate for some time.” As the economic effects
of the crisis worsened, the FOMC amended its forward guidance in
order to help the public understand the Committee’s thinking about
the future course of policy.

The forward guidance language in the FOMC’s postmeeting state-

ment has taken different forms since the onset of the financial crisis.
In March 2009, as the economic downturn worsened, the Committee
changed the forward guidance to indicate that the federal funds rate
could remain at exceptionally low levels “for an extended period.” In
August 2011, the Committee began using calendar dates in its policy
statement in order to indicate the period over which it expected eco-
nomic conditions to warrant maintaining the federal funds rate near
zero. As economic conditions did not improve in line with the Com-
mittee’s expectations, the calendar date in the forward guidance was
extended.

Later, in its December 2012 statement, the FOMC replaced the date-
based forward guidance with language indicating the economic
conditions that the Committee expected to see before it would begin
to consider raising its target for the federal funds rate. When the Com-
mittee added the economic conditionality to its statement in December
2012, it also indicated a variety of other economic factors that it would
take into account before raising interest rates.

The Federal Reserve System Purposes & Functions 49

The FOMC’s communications about likely future settings of its target
What is a reverse
for the federal funds rate and its other policy tools have continued to repurchase agreement?

evolve. In particular, since the Committee began to normalize mon- In a reverse repurchase
agreement, or “reverse
etary policy by modestly raising its target for the federal funds rate in
repo,” the Federal Reserve
December of 2015, it has indicated that monetary policy is not on a Open Market Desk sells a
predetermined path and that its policy decisions will depend on what security to an eligible reverse
repo counterparty with an
incoming information tells policymakers about whether a change in
agreement to purchase it
policy is necessary to move the economy toward, or keep it at, maxi- back at a specified date in
mum employment and 2 percent inflation. the future. For more detailed
information on reverse repos
or the Federal Reserve’s over-
Monetary Policy Normalization night reverse repo facility, see
www.federalreserve.gov/
Monetary policy has been consistently accommodative in recent years
monetarypolicy/overnight-
as the FOMC sought to counter the economic effects of the financial reverse-repurchase-­
crisis and support the recovery from the Great Recession. In late 2015, agreements.htm.

when the unemployment rate was at or near levels that policymak-

ers judge consistent with maximum employment, the Federal Reserve
began taking steps to “normalize” the stance of monetary policy in
order to continue to foster its macroeconomic objectives. The term
“normalization” refers to steps the FOMC is taking to return short-term
interest rates to more-normal levels and reduce the size of the Federal
Reserve’s balance sheet.

In December 2015, the FOMC began the normalization process by

raising its target range for the federal funds rate by ¼ percentage
point—the first change since December 2008—bringing the target
range to 25 to 50 basis points. The FOMC based its decision on the
considerable improvement in labor market conditions during 2015 and
reasonable confidence that inflation, which had been running below the
Committee’s objective, would rise to 2 percent over the medium term.
During normalization, the FOMC is continuing to set a target range for
the federal funds rate and communicate its policy through this rate.
To keep the federal funds rate in its target range, the Federal Reserve
uses two administered rates, the interest rate the Federal Reserve pays
on excess reserve balances (the IOER rate, discussed in box 3.3 “The
Federal Reserve Pays Interest on Required Reserve Balances and Excess

50 Conducting Monetary Policy

 Balances” on page 40) and the interest rate it pays on overnight reverse
repurchase agreements (the ON RRP rate).

Overnight reverse repurchases. During normalization, the Com-

mittee is using an overnight reverse repurchase (ON RRP) facility as a
supplementary tool as needed to help control the federal funds rate.

In an ON RRP operation, an eligible financial counterparty provides

funds to the Federal Reserve in exchange for Treasury securities on the
Federal Reserve’s balance sheet and is paid the ON RRP rate; the follow-
ing day, the funds are returned to the counterparty and the securities
are returned to the Federal Reserve. In general, any counterparty that
is eligible to participate in ON RRP operations should be unwilling to
invest funds overnight with another counterparty at a rate below the
ON RRP rate. The FOMC plans to use the ON RRP facility only to the
extent necessary and will phase it out when it is no longer needed to
help control the funds rate.

The Federal Reserve’s

changing approach to Policy implementation during normalization. By paying interest on
policy implementation
reserves and offering ON RRPs, the Federal Reserve is providing safe,
For a primer on the frame-
liquid investments for banking institutions and ON RRP counterparties.
work the Federal Reserve
is using for monetary The Federal Reserve intends to set the IOER rate equal to the top of the
policy normalization, see FOMC’s target range for the federal funds rate and the ON RRP rate
“Monetary Policy 101: The
equal to the bottom of the target range. Increasing these two rates
Fed’s Changing Approach
to Policy Implementation” puts upward pressure on short-term market rates, including the federal
at www.federalreserve.gov/ funds rate, as investors are less willing to accept a lower rate elsewhere.
econresdata/feds/2015/
files/2015047pap.pdf.
Other policy tools. Other supplementary tools, such as term depos-
its offered through the Federal Reserve’s Term Deposit Facility and
term reverse repurchase agreements, will also be used, if needed, to
put upward pressure on money market interest rates and so help to
control the federal funds rate and keep it in the target range set by the
FOMC. Term deposits are like interest-bearing certificates of deposit
that depository institutions hold at Federal Reserve Banks for a specified
length of time; the Board of Governors sets the interest rate on term
deposits. Funds placed in term deposits are transferred from the reserve

The Federal Reserve System Purposes & Functions 51

balances of participating institutions into a term deposit account at
the Federal Reserve for the life of the term deposit, thereby draining
reserves from the banking system.

The balance sheet. As the policy normalization process proceeds, the

Federal Reserve’s securities holdings—and the supply of reserve bal-
ances—will be reduced in a gradual and predictable manner primarily
by ceasing to reinvest repayments of principal on securities held in the
portfolio. As of October 2016, the FOMC had not decided when to
begin tapering or ceasing its reinvestments and did not anticipate sell-
ing agency MBS as part of the normalization process, although limited
sales might be warranted in the longer run to reduce or eliminate
residual holdings. The FOMC will announce the timing and pace of any
sales in advance.

The FOMC intends that the Federal Reserve will, over the longer run,
hold no more securities than necessary to implement monetary policy
efficiently and effectively, and that it will hold primarily Treasury securi-
ties, thereby minimizing the effect of Federal Reserve holdings on the
allocation of credit across sectors of the economy.

52 Conducting Monetary Policy

Box 3.6. Understanding the Federal Reserve’s Balance Sheet
The Federal Reserve’s balance sheet, published weekly, contains a great deal of information about the scale and scope of
its operations. For decades, market participants have closely studied the evolution of the Federal Reserve’s balance sheet to
understand important details about the implementation of monetary policy.

The table below shows the major asset Market Desk at the Federal Reserve to reflect payment for the security; the
and liability categories on the Federal Bank of New York purchases a security liability item “deposits of depository
Reserve’s balance sheet. Conventional in the open ­market, Federal Reserve institutions” rises when the account
open market operations and large- assets increase by the value of the that the seller’s depository institution
scale asset purchases affect the Federal security purchased. A corresponding holds at the Federal Reserve is credited.
Reserve’s balance sheet in a similar increase is recorded on the liability side
fashion. For example, when the Open of the Federal Reserve’s balance sheet

Simplified view of the Federal Reserve balance sheet, as of January 20, 2016
The Federal Reserve publishes data weekly regarding its balance sheet.

Assets (millions of dollars) Liabilities (millions of dollars)

Treasury securities held outright 2,461,396 Federal Reserve notes in circulation 1,369,051
Agency debt and mortgage-backed
1,750,275 Deposits of depository institutions 2,412,078
securities holdings
Other assets 277,169 Capital and other liabilities 707,711

Total 4,488,840 Total 4,488,840

Note: More detailed information on the balance sheet is available on the Federal Reserve Board’s website,
www.federalreserve.gov/monetarypolicy/bst.htm. The H.4.1 statistical release, “Factors Affecting Reserve Balances,”
is published every Thursday at www.federalreserve.gov/releases/h41/.

The Federal Reserve System Purposes & Functions 53

Function Promoting Financial
System Stability
The Federal Reserve monitors financial system
risks and engages at home and abroad to help
ensure the system supports a healthy economy for
U.S. households, communities, and businesses.

4
What Is Financial Stability? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56

Monitoring Risk across

the Financial System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

Macroprudential Supervision and Regulation

of Large, Complex Financial Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . 65

Domestic and International Cooperation and Coordination . . . . . . . . 68

54 Promoting Financial System Stability

 T   he Federal Reserve was created in 1913 to promote greater financial
stability and help avoid banking panics like those that had plunged the
country into deep economic contractions in the late nineteenth and
early twentieth centuries.

Over the past century, as the U.S. and global financial system have
evolved, the Federal Reserve’s role in promoting financial stability has
necessarily changed with it. The 2007–09 financial crisis and the sub-
sequent deep recession revealed shortcomings in the financial system
infrastructure and the framework for supervising and regulating it (see
figure 4.1). Indeed, reforms enacted under the Dodd-Frank Wall Street
Reform and Consumer Protection Act of 2010 assigned the Federal
Reserve new responsibilities in the effort to promote financial system
stability and keep pace with changing dynamics and innovation in the
broader economy.

Figure 4.1. The financial system: key participants and linkages

Key participants in the U.S. and global financial system include the lenders and savers who are matched up with borrowers
and spenders through various markets and intermediaries. The Federal Reserve monitors the financial system to ensure the
linkages among these three entities are well-functioning and adjusts its policymaking or engagement with other policymakers
to address any emerging concerns.

Indirect finance

Financial intermediaries

Investing/ Investing/
funding funding

Lender-savers Borrower-spenders

Households Direct finance Business firms

Investing/ Investing/
Business firms funding funding Governments
Financial markets
Governments Households
Foreign entities Foreign entities

Source: Adapted from Frederic S. Mishkin and Stanley G. Eakins, Financial Markets and Institutions, 7th Edition (Boston:
Prentice Hall, 2012), 16.

The Federal Reserve System Purposes & Functions 55

What Is Financial Stability?
A financial system is considered stable when financial institutions—
banks, savings and loans, and other financial product and service pro-
viders—and financial markets are able to provide households, commu-
nities, and businesses with the resources, services, and products they
need to invest, grow, and participate in a well-functioning economy.

These resources and services include

• business lines of credit, mortgages, student loans, and the other
critical offerings of a sophisticated financial system; and
• savings accounts, brokerage services, and retirement accounts,
among many others.

Effective Linking of Savers and Investors

with Borrowers and Businesses
A healthy and stable financial system links, at the lowest possible cost,
savers and investors seeking to grow their money with borrowers and
businesses in need of funds. If this critical role of intermediation be-
tween savers and borrowers is disrupted in times of stress, the adverse
impact will be felt across the economy.

And such disruption can carry a very high price. As a result, financial
stability in its most basic form could be thought of as a condition
where financial institutions and markets are able to support consumers,
communities, and businesses even in an otherwise stressed economic
environment.

Keeping Institutions and

Market Structures Resilient
To support financial stability, it is critical that financial institutions and
market structures are resilient, so that they are able to bend but not

56 Promoting Financial System Stability

Box 4.1. Financial Stability and the Founding of the Federal Reserve
Financial stability considerations were a key element in the founding of the Federal Reserve System. Indeed, it was created in
response to the Panic of 1907, which was at the time the latest in a series of severe financial panics that befell the nation in
the late nineteenth and early twentieth centuries.

The 1907 panic led to the creation Reserve System began full-fledged energies of the nation which is the
of the National Monetary Commis- operations. question of vital importance.”
sion, whose 1911 report was a major In the words of one Federal Reserve Act For more information on the Federal
impetus to the Federal Reserve Act, author, U.S. Senator Robert Latham Reserve founding, see The Federal
signed into law by President Woodrow Owen of Oklahoma, “It should always Reserve Act: Its Origin and Principles,
Wilson on December 23, 1913. Upon be kept in mind that . . . it is the available on the Federal Reserve Bank
enactment, the process of organizing prevention of panic, the protection of of St. Louis website (https://fraser.
and opening the Board and the Reserve our commerce, the stability of business stlouisfed.org/docs/publications/books/
Banks across the country began. On conditions, and the maintenance in fra_owen_1919.pdf).
November 16, 1914, the Federal active operation of the productive

break under extreme economic pressures. Such a dynamic does not

mean that market prices will never rise or fall quickly. Volatility may
reflect changes in economic conditions and would be a concern with
respect to financial stability only when institutions and markets are not
adequately prepared. Financial stability depends on firms and critical
financial market structures having the financial strength and operational
skills to manage through volatility and continue to provide their essential
products and services to consumers, communities, and other businesses.

Monitoring Risk across

the Financial System
The Federal Reserve and other bank regulators have long supervised
individual banks and financial institutions to make sure they are run in
a “prudent” and “safe and sound” manner and are not taking exces-
sive risks. The goal of this traditional “microprudential” supervisory

The Federal Reserve System Purposes & Functions 57

approach is to ensure individual banks and financial institutions are less
likely to fail and to help avoid any associated adverse circumstances for
their customers.

In the heat of the 2007–09 financial crisis, however, it became clear

this microprudential focus did not adequately identify risks that devel-
oped across and between markets and institutions and that, in turn,
threatened to set off a cascade of failures that could have undermined
the entire financial system. Thus, a central element of the Dodd-Frank
Act—the landmark legislative response to the 2007–09 crisis—is the Microprudential
supervision and regulation
requirement that the Federal Reserve and other financial regulatory
The Federal Reserve also “mi-
agencies look across the entire financial system for risks, adopting a
croprudentially” supervises
macroprudential approach to supervision and regulation. and regulates the operations
of large financial institu-
tions—that is, it monitors
Whereas a traditional—or microprudential—approach to supervision
the safety and soundness of
and regulation focuses on the safety and soundness of individual insti- these and other individual
tutions, the macroprudential approach centers on the stability of the institutions—and integrates
this monitoring into its mac-
financial system as a whole (see section 5, “Supervising and Regulating
roprudential supervisory and
Financial Institutions and Activities,” on page 72, for more on micro- regulatory efforts.
and macroprudential supervision). For more information, see
section 5, “Supervising and
Regulating Financial Institu-
tions and Activities,” on
Types of Financial System page 72.

Vulnerabilities and Risks

Federal Reserve staff regularly and systematically assess a standard set
of vulnerabilities as part of a Federal Reserve System macroprudential
financial stability review:
• asset valuations and risk appetite
• leverage in the financial system
• liquidity risks and maturity transformation by the financial system
• borrowing by the nonfinancial sector (households and nonfinancial
businesses)

These vulnerability assessments inform internal Federal Reserve discus-

sions concerning both macroprudential supervision and regulatory

58 Promoting Financial System Stability

Figure 4.2. Four standard components of financial system vulnerability review
Four vulnerability assessments inform the broad efforts undertaken by the Federal Reserve—with entities both in the United
States and abroad—to monitor financial system stability.

Asset valuations Financial system Liquidity Nonfinancial sector

and risk appetites leverage risks/maturity borrowing
transformation
The “unwinding” of Financial system If credit exposure in
high prices of assets intermediaries (such as Traditional banks, U.S. households and
(e.g., housing prices in traditional banks, money market funds, nonfinancial
the mid-2000s) can insurance companies, and exchange-traded businesses is high,
destabilize the and hedge funds) with funds are among the these borrowers often
financial system and significantly more debt institutions that might curtail spending and
the economy than equity can experience a “run” by disengage from other
amplify an economic investors that economic activity and
downturn amplifies an economic may contribute to a
downturn severe downturn

Source: Tobias Adrian, Daniel Covitz, and Nellie Liang, “Financial Stability Monitoring,” Finance and Economics Discussion
Series 2013-21 (Washington: Board of Governors of the Federal Reserve System, 2013), www.federalreserve.gov/pubs/
feds/2013/201321/201321pap.pdf.

policies and monetary policy (see figure 4.2). They also inform Federal
Reserve interactions with broader monitoring efforts, such as those by
the Financial Stability Oversight Council (FSOC) and the Financial Stabil-
ity Board.

Asset Valuations and Risk Appetite

Overvalued assets constitute a fundamental vulnerability because the
unwinding of high prices can be destabilizing in the financial system
and economy, especially if the assets are widely held and the values
are supported by excessive leverage, maturity transformation, or risk
opacity. Moreover, stretched asset valuations may be an indicator of a
broader buildup in risk-taking.

However, it is very difficult to judge whether an asset price is overval-

ued relative to fundamentals. As a result, analysis typically considers a
range of possible valuation metrics, developments in areas where asset
prices are rising especially rapidly or into which investor flows have
been considerable, or the implications of unusually low or high levels of
volatility in certain markets.

The Federal Reserve System Purposes & Functions 59

Figure 4.3. Monitoring leverage in the financial system
The collective financial strength of the banking sector—and its prevailing activities—can be an important indicator in
understanding risks to the nation’s financial stability. The Federal Reserve focuses on metrics like the ratio of common equity
to risk-weighted assets in the banking sector, which has risen in recent years as a reflection of tougher capital standards for
major banking institutions.

Percent
18

16

14

12

10

6
Total (tier 1 + tier 2)
4
Common equity tier 1 ratio
2 Leverage ratio*

1997 1997 1998 1999 2000 2000 2001 2002 2003 2003 2004 2005 2006 2006 2007 2008 2009 2009 2010 2011 2012 2012 2013 2014 2015 2015
Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Q4

Note: Prior to 2014:Q1, the numerator of the common equity tier 1 ratio is tier 1 common capital. Beginning in 2014:Q1 for
advanced-approaches bank holding companies (BHCs) and in 2015:Q1 for all other BHCs, the numerator is common equity
tier 1 capital. The data for the common equity tier 1 ratio start in 2001:Q1. An advanced-approaches BHC is defined as a large
internationally active banking organization, generally with at least $250 billion in total consolidated assets or at least
$10 billion in total on-balance-sheet foreign exposure. The shaded bars indicate periods of business recession as defined by
the National Bureau of Economic Research.
* Leverage ratio is the ratio of tier 1 capital to total assets.
Source: Federal Reserve Board, FR Y-9C, Consolidated Financial Statements for Holding Companies.

Leverage in the Financial System

Highly leveraged financial system intermediaries—those with significantly
more debt than equity—can amplify the effect of negative shocks in the
financial system and broad economy (see figure 4.3).

For example, if a highly leveraged institution needs to shrink its balance

sheet in response to an otherwise standard economic downturn, the
resulting contraction in credit will have broader economic implications.
Moreover, sufficiently large losses for highly leveraged institutions can

60 Promoting Financial System Stability

 lead to “fire sales,” where assets are unloaded quickly at extremely low
prices. Fire sales, in turn, increase the potential for runs on banks—and
even on nonbanks—if liabilities have short maturities.

The Federal Reserve monitors leverage in the banking sector with the
help of an extensive data collection program. Nevertheless, these
monitoring efforts are complicated by off-balance-sheet exposures and
rapidly changing trading exposures. Monitoring leverage in the nonbank
sector (hedge funds, for example) proves even more difficult, but periodic
surveys of the providers of leverage through the Senior Credit Officer
Monitoring leverage in
the nonbank sector Opinion Survey (SCOOS) offers valuable insights.
The Federal Reserve’s quar-
terly Senior Credit Officer Liquidity Risks and Maturity Transformation
Opinion Survey on Dealer by the Financial System
Financing Terms (SCOOS)
provides information about One key benefit provided by the financial system is to transform short-
the availability and terms of maturity (or liquid) liabilities into long-maturity (illiquid) assets. This
credit in securities financing
function is done primarily through the traditional banking system or
and over-the-counter de-
rivatives markets. See “Data other depository institutions, but it also occurs outside the banking
Releases” in the Economic system, for example, through money market mutual funds.
Research & Data section of
the Federal Reserve Board’s
website (www.federalreserve. Liquidity and maturity transformation is productive in the sense that it
gov/econresdata/releases/ allows investment projects to be funded with long-term financing while
scoos.htm).
still satisfying the liquidity needs of lenders. However, the experience
of the 2007–09 financial crisis demonstrated that liquidity and maturity
transformation introduces systemic vulnerabilities that can threaten the
broader economy (see box 4.2, “Responding to Financial System Emer-
gencies: The Lender of Last Resort Concept in Central Banking”).

When a systemwide shock results in all lenders demanding liquidity at

the same time, institutions engaged in this maturity transformation are
at risk of being run. Deposit insurance provides protection within the
traditional banking system. Nevertheless, some assets such as repur-
chase agreements (or “repos”), asset-backed commercial paper (ABCP),
or money market funds are also subject to run risk and, indeed, came
under considerable pressure during the crisis. For this reason, the Fed-
eral Reserve actively monitors, as best it can given available data and

The Federal Reserve System Purposes & Functions 61

Figure 4.4. Monitoring borrowing in the nonfinancial sector
Borrowing by households and nonfinancial sector businesses can also influence financial stability. The Federal Reserve focuses
on metrics like the ratio of household and nonfinancial business credit to nominal U.S. gross domestic product. This ratio
dropped below peaks around the time of the 2007–09 crisis.

Ratio
1.8

1.6

1.4

1.2

1.0

.8

.6
Business
.4
Household
.2 Total

.0

1980 1981 1983 1984 1986 1987 1989 1990 1992 1993 1995 1996 1998 1999 2001 2002 2004 2005 2007 2008 2010 2011 2013 2014
Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q 3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3

Note: The shaded bars indicate periods of business recession as defined by the National Bureau of Economic Research.
Source: Federal Reserve Board, Statistical Release Z.1, “Financial Accounts of the United States.”

measurement, both liquidity risk and the degree of maturity transfor-

mation in the financial system.

Borrowing by the Nonfinancial Sector

Excessive credit in the private nonfinancial sector can provide a trans-
mission channel for a disruption in financial markets to affect the real
economy (see figure 4.4). Highly indebted households and nonfinan-
cial businesses may have a difficult time withstanding negative shocks
to incomes or asset values, and may be forced to curtail spending in
ways that amplify the effects of financial shocks. In turn, losses among
households and businesses can lead to mounting losses at financial
institutions, creating an adverse feedback loop. The Federal Reserve
monitors measures of vulnerabilities in the nonfinancial sector includ-

62 Promoting Financial System Stability

 ing, for example, leverage and debt service burdens as well as under-
writing standards on new loans to households and businesses.

This monitoring program is complemented by a broader effort to foster

greater transparency in financial markets through improved data col-
lection and enhanced disclosures by regulated financial market partici-
pants. Greater transparency helps lead to meaningful implementation
of macroprudential regulatory and supervisory policies to target build-
ing vulnerabilities and to pre-position the financial system to be better
able to absorb shocks.

Why Proactive Monitoring of Domestic

and Foreign Markets Matters
The changing nature of risks and fluctuations in financial markets and
the broader economy require timely monitoring of the effects of condi-
tions in domestic and foreign financial markets on financial institutions
and even in the nonfinancial sector in order to identify the buildup of
vulnerabilities that might require further study or policy action.

Financial stability policy

and research To this end, the Federal Reserve maintains a flexible, forward-looking fi-
The Federal Reserve works to nancial stability monitoring program to help inform policymakers of the
identify threats to financial
financial system’s vulnerabilities to a range of potential adverse events
stability and develop effective
policies to address those or shocks. Such a monitoring program is a critical part of a broader
threats through its Division of Federal Reserve System effort to assess and address vulnerabilities in
Financial Stability. This office
the U.S. financial system. In the case of individual institutions, the Fed-
monitors financial markets,
institutions, and structures eral Reserve may take more direct action and in various ways (for more
and also conducts research information, see “Macroprudential Supervision and Monitoring” on
on financial stability issues.
page 98 in section 5, “Supervising and Regulating Financial Institutions
For more information, see the
complete list of Federal Re- and Activities”).
serve Board working papers
(www.federalreserve.gov/
econresdata/workingpapers.
htm). Examining Causes, Effects, and
Remedies for Financial Instability
A macroprudential approach to ensuring financial stability builds on a
substantial and growing body of research on the factors that lead to

The Federal Reserve System Purposes & Functions 63

Box 4.2. Responding to Financial System Emergencies: The Lender of Last Resort Concept in
Central Banking
The idea that a central bank should provide liquidity to support the financial system was refined by nineteenth-century econo-
mist Walter Bagehot, who suggested that during times of financial panic or crisis, a central bank should lend quickly and
freely, at a penalty rate of interest, to any borrower with good collateral.
When a major shock—like a natural In an emergency, the Federal Reserve Dodd-Frank Act, emergency lending
disaster, a terrorist attack, or a financial has the power to provide liquidity to programs under section 13(3) of the
panic—occurs that severely stresses the depository institutions using standard, Federal Reserve Act must be broad-
financial system, people, businesses, traditional tools, like open market based and not designed to support a
and financial institutions need access operations and discount window lend- single institution, among other require-
to money and credit. Indeed, having ing. Under section 13(3) of the Federal ments. In addition, Congress requires
this liquidity available can improve Reserve Act, the U.S. central bank also that the Federal Reserve ensure that
confidence in the economy and restore has authority to provide liquidity to taxpayers are protected against losses.
calm to markets, bolstering the stability nondepository institutions in “unusual For a fuller discussion of how each
of the financial system. and exigent circumstances.” Although of these lending tools works, see
General authority during times of the Federal Reserve has rarely exercised ­section 3, “Conducting ­Monetary
crisis. To provide liquidity during times this LOLR clause enacted in 1932, it Policy,” on page 20 (see also
of crisis, the Federal Reserve—like did use it during the 2007–09 financial the 2013 Federal Reserve paper
many central banks—is empowered crisis to prevent harm to the U.S. “Financial Stability Monitoring,”
to function as a “lender of last resort” economy. www.federalreserve.gov/pubs/
(LOLR), and it uses different tools to Broad-based lending only. Under feds/2013/201321/201321pap.pdf).
fulfill this role. amendments enacted under the

Federal Reserve lending under normal and “unusual and exigent” circumstances
As a major financial crisis began to unfold in 2007 and its magnitude became clearer, the Federal Reserve invoked its statutory
authority to lend to qualified institutions with adequate collateral. At its peak, Federal Reserve credit outstanding reached more
than $1.2 trillion—but within four years it had abated to near pre-crisis levels as economic and financial conditions improved.

Billions
$1,400
Total credit outstanding
$1,200

$1,000

$800

$600

$400

$200

$0

Jan 3 May 3 Sept 3 Jan 3 May 3 Sept 3 Jan 3 May 3 Sept 3 Jan 3 May 3 Sept 3 Jan 3 May 3 Sept 3 Jan 3 May 3 Sept 3 Jan 3
2007 2007 2007 2008 2008 2008 2009 2009 2009 2010 2010 2010 2011 2011 2011 2012 2012 2012 2013

Source: Federal Reserve H.4.1 Statistical Release, Table 1. Factors Affecting Reserve Balances of Depository Institutions and
Condition Statement of Federal Reserve Banks. See the Economic Research & Data section of the Federal Reserve Board’s
website, www.federalreserve.gov.

64 Promoting Financial System Stability

 vulnerabilities in the financial system and how government policies can
mitigate such risks.

The Federal Reserve actively engages in financial stability research to

improve understanding of issues related to financial stability and to
engage with the broader research community on crucial policy matters.
This engagement often involves collaboration with researchers at other
domestic and international institutions.

Macroprudential Supervision and

Regulation of Large, Complex
Financial Institutions
Large, complex financial institutions interact with financial markets and
the broader economy in a manner that may—during times of stress and
in the absence of an appropriate regulatory framework and effective
supervision—lead to financial instability. The Federal Reserve promotes
the safety and soundness of these institutions through robust supervi-
sion and regulation programs, two components of which are integral to
its macroprudential efforts.

Types of systemically
important financial Monitoring Systemically Important
institutions
Financial Institutions
Visit the Financial Stability
Oversight Council website at The macroprudential approach informs Federal Reserve supervision
www.treasury.gov/­initiatives/
of systemically important financial institutions (SIFIs)—including large
fsoc/designations for a
discussion of systemically bank holding companies (BHCs), the U.S. operations of certain foreign
important institutions. banking organizations (FBOs), and financial market utilities (FMUs). In
addition, the Federal Reserve serves as a “consolidated supervisor” of
nonbank financial companies that the FSOC has determined should
be supervised by the Federal Reserve Board and subject to prudential

The Federal Reserve System Purposes & Functions 65

standards. (See “Domestic and International Cooperation and Coordi-
nation” on page 68 for more information on the FSOC.)

The Federal Reserve actively monitors indicators of the riskiness of

SIFIs, both individually as well as through interlinkages in the broader
network of financial institutions, to help identify vulnerabilities. It also
imposes certain regulatory requirements on SIFIs in order to limit po-
tentially risky activities by these institutions and to mitigate spillover of
distress into the broader economy. If a SIFI were to become distressed,
disruptions in the financial system could arise from direct losses im-
posed on SIFI counterparties, contagion, fire sales effects, or a loss of
critical services.

SIFIs are also subject to additional capital and liquidity regulations

imposed by the Federal Reserve in order to help mitigate some of the ad-
ditional risks they pose to the financial system as a whole, given their size
and interconnectedness.

Moreover, during the 2007–09 financial crisis, the lack of effective

resolution strategies contributed to the pernicious spillovers of distress
at or between individual institutions and from those institutions to the
broader economy. The Federal Reserve, in collaboration with other U.S.
agencies, has continued to work with large financial institutions to de-
velop a range of recovery and resolution strategies in the event of their
distress or failure. Improvements in resolution planning are intended to,
among other things, mitigate adverse effects from perceptions of “too
big to fail” and contribute to more orderly conditions in the financial
system if institutions face strains or fail. (For more information on re-
covery and resolution planning activity, see section 5, “Supervising and
Regulating Financial Institutions and Activities,” on page 72.)

Stress Testing of Key Financial Institutions

One important element of enhanced supervision of SIFIs is the stress-
testing process, which includes the Dodd-Frank Act stress tests and the

66 Promoting Financial System Stability

 Comprehensive Capital Analysis and Review. In addition to fostering
the safety and soundness of the participating institutions, the stress test
program includes macroprudential elements such as
• examination of the loss-absorbing capacity of institutions under a
“Stress testing” of large
financial institutions common macroeconomic scenario that has features similar to the
In 2015, 31 institutions strains experienced in a severe recession and which includes, as ap-
participated in the Federal propriate, identified salient risks;
Reserve stress testing pro-
cess, which occurs annually. • conducting horizontal testing across large institutions to understand
For more information, see the potential correlated exposures; and
the “Stress Tests and Capital
Planning” web page, located • consideration of the effects of counterparty distress on the largest,
on the Banking Informa- most interconnected firms.
tion & Regulation section of
the Federal Reserve Board’s
website (www.federalreserve. The macroeconomic and financial scenarios that are used in the stress
gov/bankinforeg/stress-tests- tests have proved to be an important macroprudential tool. The Federal
capital-planning.htm).
Reserve adjusts the severity of the macroeconomic scenario used in the
stress tests in a way that counteracts the natural tendency for risks to
build within the financial system during periods of strong economic
activity. The scenarios can also be used to assess the financial system’s
vulnerability to particularly significant risks and to highlight certain risks
to institutions participating in the testing.

Intersection of Financial Stability

and Monetary Policy
Promotion of financial stability strongly complements the primary
goals of monetary policy—maximum employment and price stability. A
smoothly operating financial system promotes the efficient allocation of
saving and investment, facilitating economic growth and employment.
And price stability contributes not only to the efficient allocation of re-
sources in the real economy (that is, the part of the economy that pro-
duces goods and services), but also to reduced uncertainty and efficient
pricing in financial markets that, in turn, supports financial stability.

The Federal Reserve System Purposes & Functions 67

Domestic and International
Cooperation and Coordination Central banks around
the world
The central bank concept
Economic and financial volatility in any country can have negative dates to 1668 when Swe-
consequences for the world, but sizable and significant spillovers are den’s Riksbank was formed.
almost assured from an economy that is large. As of December 2015, there
were 178 central banks and
monetary authorities around
In its role promoting financial stability, the Federal Reserve cooperates the world, and the Federal
and coordinates with many other domestic and international regulatory Reserve interacts with many
of them in its efforts to pro-
and policy entities. The FSOC is an important forum for cooperation
mote financial stability in the
with other domestic agencies (see figure 4.5). The primary venues for U.S. and global economies.
international cooperation occur through the Basel Committee on Bank- See www.bis.org/cbanks.htm
ing Supervision and the Financial Stability Board. for a listing of central banks.

Domestic Engagement through the

Financial Stability Oversight Council
The FSOC, created in 2010 under the Dodd-Frank Act and chaired
by the U.S. Treasury Secretary, draws on the expertise of the Federal
Reserve and other regulators to proactively identify risks to financial
stability, promote market discipline, and respond to emerging threats.
The Chair of the Federal Reserve is a member of the FSOC, and the Regular reporting on
FSOC activities
Federal Reserve works to support the activities of the FSOC and other
The Financial Stability
U.S. government agencies in the pursuit of financial stability. Oversight Council (FSOC)
meets routinely to coordinate
on financial stability topics
Through collaborative participation in the FSOC, U.S. financial regula-
that might affect the U.S.
tors monitor not only institutions but the financial system as a whole. economy and publishes both
The Federal Reserve plays an important role in this macroprudential its monthly meeting minutes
and annual report. For more
framework: it assists in monitoring financial risks, analyzes the implica-
information, see the FSOC
tions of those risks for financial stability, and identifies steps that can be website (www.treasury.gov/
taken to mitigate those risks. initiatives/fsoc/pages/home.
aspx).

68 Promoting Financial System Stability

Figure 4.5. The framework for monitoring U.S. financial system stability
The Financial Stability Oversight Council, a blend of federal and state regulators, meets routinely to coordinate on financial
stability topics that might affect the U.S. economy and makes publicly available its meeting minutes, annual report, and
various other studies and statements. For more information, see the FSOC website (www.treasury.gov/initiatives/fsoc/pages/
home.aspx).

FSOC Chairman
(Secretary State securities
Federal Reserve of the Treasury) commissioner
Board Chair
or officer1
(designated by the
state securities
commissioners) State insurance
Commodity Futures commissioner1
Trading Commission
(designated by the
Chairperson state insurance
commissioners)

Comptroller of State banking supervisor1

the Currency (designated by the
state banking supervisors)
Financial
Stability
Consumer Financial
Protection Bureau
Oversight Director of the Office
of Financial Research2
Director Council (Treasury)

Director
National Credit of the Federal
Union Administration Insurance Office2
Chairman (Department
of the Treasury)
Federal Deposit Securities
Insurance and Exchange
Corporation Insurance Commission
Chairperson expert Chairman
Federal Housing (Presidential
Finance Agency appointee;
Director Senate-confirmed
for a six-year term)

1
Non-voting member serves two-year term.
2
Non-voting member.

The Federal Reserve System Purposes & Functions 69

Figure 4.6. Monitoring financial system stability requires global cooperation
What happens in the global economy can influence—sometimes greatly—the stability of the U.S. economy. Because the U.S.
dollar is a widely used global currency and because the world’s economies are interdependent, the Federal Reserve works
closely with central banks and other public authorities around the world to address international financial issues and promote
financial stability.

International authority/ Overview/Federal Reserve engagement

deliberative body

Central banks Nearly all developed and developing nations maintain central banks to promote a sound and
Established: 1668 or later stable financial system and well-functioning economies. Indeed, Federal Reserve officials en-
Location: Throughout the world gage regularly and collectively with other central banks to discuss broad trends affecting the
Website: www.bis.org/central_bank_hub_ global financial system; one-on-one bank engagement also occurs in special circumstances
overview.htm where coordination and cooperation can help keep the global financial system operating
smoothly.

Bank of International Settlements The Bank of International Settlements seeks, among other things, to foster discussion and
Established: 1930 facilitate collaboration among central banks and supports dialogue with other authorities
Location: Basel, Switzerland that are responsible for promoting financial stability. The Federal Reserve participates in the
Website: www.bis.org deliberations of this financial organization, whose members include 60 member central banks,
representing countries from around the world that together make up about 95 percent of
world gross domestic product.

Financial Stability Board The Financial Stability Board (FSB), successor to the Financial Stability Forum, promotes
Established: 2009 stability in the international financial system through enhanced cooperation among various
Location: Basel, Switzerland national and international supervisory bodies and international financial institutions. The Fed-
Website: www.fsb.org eral Reserve Board and other U.S. agencies participate in FSB efforts, which specifically seek
to coordinate the development of regulatory, supervisory, and other financial sector policies.

G7 & G20 The Group of Seven (G7) is an informal bloc of industrialized democracies (also including
Established: 1975 (as G6) Canada, France, Germany, Italy, Japan, and the United Kingdom) that meets annually to
Location: Varies by nation hosting discuss global economic issues. Federal Reserve officials engage regularly with the G7 and
Website: Varies by nation hosting G20 to discuss macroeconomic policy surveillance, the international financial system, and a
wide range of policy issues such as development and policy proposals to encourage strong,
sustainable, and balanced growth.

International Monetary Fund The International Monetary Fund (IMF) works to “foster global monetary cooperation, secure
Established: 1945 financial stability, facilitate international trade, promote high employment and sustainable
Location: Washington, DC economic growth, and reduce poverty around the world.” The Federal Reserve is a member
Website: www.imf.org of the International Monetary and Financial Committee, which advises and reports to the IMF
Board of Governors on the supervision and management of the international monetary and
financial system, including on responses to unfolding events that may disrupt the system.

Organisation for Economic The Organisation for Economic Co-operation and Development (OECD) promotes “policies
Co-operation and Development that will improve the economic and social well-being of people around the world.” The
Established: 1961 Federal Reserve participates in several OECD forums to discuss current economic issues and
Location: Paris, France projections for the global economic outlook, and to promote policies that will improve global
Website: www.oecd.org economic well-being.

World Bank The World Bank functions as a cooperative of 189 member countries. These member countries,
Established: 1944 or shareholders, are represented by a board of governors, who are the ultimate policymak-
Location: Washington, DC ers at the World Bank. Generally, the governors are member countries’ ministers of finance
Website: www.worldbank.org or ministers of development. The Federal Reserve interacts informally with the World Bank,
largely through the International Monetary Fund.

70 Promoting Financial System Stability

 Engagement with Regulatory
Authorities Abroad
The Federal Reserve participates in international bodies, such as the
­Basel Committee on Banking Supervision and the Financial Stability
Board, to address issues associated with the interconnected global
financial system and the global activities of large U.S. financial institu-
tions (see figure 4.6).

Through both venues, the Federal Reserve is engaged with the interna-
tional community in monitoring the global financial system and promot-
ing the adoption of sound policies across countries.

The Federal Reserve System Purposes & Functions 71

Function Supervising and
Regulating Financial
Institutions and
Activities
The Federal Reserve promotes the safety and
soundness of individual financial institutions and
monitors their impact on the financial system as
a whole.

5
Regulation versus Supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

Entities the Federal Reserve Oversees . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

Oversight Councils . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81

How the Federal Reserve Supervises Financial Institutions . . . . . . . 82

Overseeing the Structure of the Banking System . . . . . . . . . . . . . . . . 100

Regulation: Keeping Pace with Innovation and Evolution . . . . . . . . 108

Promoting Market Discipline: Public Disclosure

and Accounting Policy Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . 116

72 Supervising and Regulating Financial Institutions and Activities

 T   he Federal Reserve Act of 1913 established the Federal Reserve Sys-
tem to provide the nation with a safer, more flexible, and more stable
monetary and financial system. One of the principal functions of the
Federal Reserve in achieving this goal is to regulate and supervise vari-
ous financial entities. It performs this function, in part, through micro-
prudential regulation and supervision of banks; holding companies and
their affiliates; and other entities, including nonbank financial companies
that the Financial Stability Oversight Council (FSOC) has determined
should be supervised by the Board and subject to prudential standards. In
addition, the Federal Reserve engages in “macroprudential” supervision
and regulation that looks beyond the safety and soundness of individual
institutions to promote the stability of the financial system as a whole.

Figure 5.1. How the regulation and supervision process works

When Congress passes a law that impacts the financial industry, the Federal Reserve—sometimes in cooperation with other
federal agencies—often drafts regulations that determine how the law will be implemented.

CONGRESS
CONGRESS FEDERAL RESERVE AMERICAN PUBLIC FEDERAL RESERVE
votes
votestotoapprove
approve drafts, proposes, and institutions, individuals, considers public input,
legislation;
legislation;President
President invites public comment and others review finalizes regulations,
signs
signs intolaw
into law on regulations that proposed regulations and issues and
specify how laws are and respond with disseminates final
implemented comments and regulations publicly,
suggestions including rationale
for actions

REGULATION
SUPERVISION

REGULATED
REGULATED FEDERAL
FEDERALRESERVE
RESERVE FEDERAL
FEDERALRESERVE
RESERVE FEDERAL
FEDERALRESERVE
RESERVE
INSTITUTIONS EXAMINERS BANKS issues
issuesand
anddisseminates
disseminates
INSTITUTIONS EXAMINERS BANKS publicly
implement
implementinternal
internal conduct
conducton-
on-and
andoff-site
off-site train
trainexaminers
examinerstoto publiclythe
theprocedures
procedures
practices examinations/inspections Reserve
Reserve Bankexaminers
Bank
practicesto
toensure
ensurethat
that examinations/inspections evaluate
evaluateinstitutions’
institutions’ will use to
examiners
evaluate
they are in compliance
they are in compliance of
ofregulated
regulatedinstitutions
institutions compliance with
compliance with will use to evaluate
to institutions’ compliance
with regulations
with regulations todetermine
determinetheir
their regulations
regulations institutions’ compliance
with
compliance
compliancewith
with withlaws
lawsand
and
regulations regulations
regulations
regulations

The Federal Reserve System Purposes & Functions 73

Regulation versus Supervision
Regulation and supervision are distinct, but complementary, activities
(see figure 5.1). Regulation entails establishing the rules within which
financial institutions must operate—in other words, issuing specific reg-
ulations and guidelines governing the formation, operations, activities,
and acquisitions of financial institutions. Once the rules and regulations
are established, supervision—which involves monitoring, inspecting,
and examining financial institutions—seeks to ensure that an institution
complies with those rules and regulations, and that it operates in a safe
and sound manner.

Entities the Federal Reserve Oversees

By law, the Federal Reserve is responsible for supervising and regulating
certain segments of the financial industry to ensure they employ safe
and sound business practices and comply with all applicable laws and
regulations (see figure 5.2).

Bank Holding Companies (Including Financial Holding

Companies)
Banks are often owned or controlled by another company, called a
bank holding company (BHC). The Federal Reserve has supervisory
and regulatory authority for all BHCs, regardless of whether subsidiary
banks of the holding company are national banks, state “member”
banks, or state “nonmember” banks (see a complete discussion of
“State Member Banks” beginning on page 77). It also has supervisory
authority over any nonbank subsidiary of a BHC that is not function-
ally regulated by another federal or state regulator, such as a leasing
subsidiary.

The Gramm-Leach-Bliley Act of 1999 permits BHCs that meet certain

criteria to become financial holding companies (also under Federal
Reserve supervisory and regulatory authority). These entities may own

74 Supervising and Regulating Financial Institutions and Activities

Figure 5.2. The Federal Reserve oversees a broad range of financial entities
Bank holding companies constitute the largest segment of institutions supervised by the Federal Reserve, but the Federal
Reserve also supervises state member banks, savings and loan holding companies, foreign banks operating in the United
States, and other entities.

(Number of
institutions/entities,
year-end 2015) State Savings and loan
member holding companies (470)
banks (839)

Foreign banks operating

Domestic in the U.S. (154)
financial holding
companies (442)
Bank holding Edge Act and agreement
companies (4,922) corporations1 (41)

State member banks’

foreign branches (52)

Foreign financial
holding companies (40)

Designated financial
market utilities2 (8)

1
Edge Act and agreement corporations are subsidiaries of banks or bank holding companies, organized to allow
international banking and financial business.
2
Financial market utilities (FMUs) are multilateral systems that provide the essential infrastructure for transferring, clearing,
and settling payments, securities, and other financial transactions among financial institutions or between financial
institutions and within those systems. The Federal Reserve supervises FMUs, including certain ones that have been
designated systemically important by the Financial Stability Oversight Council.
Note: Entities supervised are not mutually exclusive; for example, bank and savings and loan holding companies may own
other supervised entities listed.
Source: 2015 Annual Report, “Supervision and Regulation” (available on the Federal Reserve Board’s website, www.
federalreserve.gov/publications/annual-report/2015-supervision-and-regulation.htm).

(1) broker-dealers engaged in securities underwriting and dealing and

(2) business entities engaged in merchant banking, insurance under-
writing, and insurance agency activities.

When a financial holding company owns a subsidiary broker-dealer or in-

surance company, the Federal Reserve coordinates its supervisory efforts
with those of the subsidiary’s functional regulator—for example, the U.S.

The Federal Reserve System Purposes & Functions 75

Securities and Exchange Commission (SEC) in the case of a broker-dealer,
and state insurance regulators in the case of an insurance company.

For a current list of financial holding companies, visit the Banking In-
formation & Regulation section of the Federal Reserve Board’s website
(Banking Structure section), at www.federalreserve.gov.

Savings and Loan Holding Companies

Savings and loan holding companies directly or indirectly control either
a savings association or other savings and loan holding companies.
Federal savings associations (those with federal charters) are supervised
by the Office of the Comptroller of the Currency (OCC) while state-
chartered savings associations are generally supervised by the Federal
Deposit Insurance Corporation (FDIC) and their chartering state. Besides
owning federal and/or state savings associations, a savings and loan
holding company that meets capital and management requirements
and elects to be treated as a financial holding company may also Bank charters affect their
supervision
(1) operate as or own a broker-dealer engaged in securities underwrit-
The current U.S. supervisory
ing and dealing, (2) engage in merchant banking, and (3) operate as or
system for banks, in which
own an insurance company. an institution may be either
federally or state-chartered,
and may belong to the
Historically, savings and loan holding companies were regulated by
Federal Reserve System or
other agencies: at first, the Federal Home Loan Bank Board, and more not, has evolved historically.
recently, by the Office of Thrift Supervision (OTS). In 2010, the Dodd- The Federal Reserve shares
supervisory and regulatory
Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank
responsibility for domestic
Act) transferred supervisory and regulatory responsibilities for savings banks with other federal
and loan holding companies from the now-defunct OTS to the Federal regulators and with
individual state banking
Reserve.
departments.

As a result, the Federal Reserve now supervises and regulates all savings
and loan holding companies regardless of the charters of the subsidiary
savings associations. The Federal Reserve coordinates its supervisory ef-
forts with the appropriate functional regulator(s) for a savings and loan
holding company that owns or operates as a broker-dealer or insurance
company.

76 Supervising and Regulating Financial Institutions and Activities

 State Member Banks
The Federal Reserve is the primary federal supervisor of state-chartered
banks that have chosen to join the Federal Reserve System. Such do-
mestically operating banks are called “state member banks.”

The Federal Reserve shares supervisory and regulatory responsibility for

domestic banks with the OCC and the FDIC at the federal level, and
with individual state banking departments at the state level.

Figure 5.3. Oversight of the financial industry is shared among federal regulators
The primary supervisor of a domestic banking organization is generally determined by the type of institution it is and the
governmental authority that granted it permission to commence business.

FBO Federal
branches Foreign banking branches &
Bank holding in the U.S. organization agencies of
FBOs
Nonbanking companies National (FBO) operating
subsidiaries banks in the U.S.

FBO FBO
agencies nonbanking
State- State- in the U.S. activities
chartered chartered FBO in the U.S.
member nonmember representative
banks banks offices in
the U.S.
Foreign
branches of
member
banks Certain “Systemically
“systemically important”
important” Savings &
loan holding nonbank
financial financial
market utilities companies
institutions
(FMUs) (SIFIs)
State-
Federal chartered
savings savings
associations associations
Nonbanking
subsidiaries

Edge Act &

agreement Federal credit
corporations unions1

Note: Figure 5.3 focuses on the federal banking regulators. Other federal regulators oversee the financial industry as well,
including the Securities and Exchange Commission, the Commodities Futures Trading Commission, and the Consumer Financial
Protection Bureau, among others.
1
Federal credit unions are not considered part of the banking industry, but offer similar if more limited services than banks.

The Federal Reserve System Purposes & Functions 77

The primary federal supervisor of a domestic bank (see figure 5.3) is
generally determined by two key factors: (1) whether the bank chooses
to operate under a federal or state charter and (2) the governmental
authority (federal or state) that then grants it permission to commence
business operations.

Banks chartered by a state government entity are referred to as state

banks; banks that are chartered by the OCC, an independent bureau of
the U.S. Department of the Treasury, are referred to as national banks.

State banks that are not members of the Federal Reserve System (col-
lectively referred to as “state nonmember banks”) are supervised by
the FDIC. In addition to being supervised by the Federal Reserve or
the FDIC, state banks are also supervised by their chartering state. In
contrast, the OCC supervises national banks that choose to charter at
the federal level.

Edge Act and Agreement Corporations

Edge Act and agreement corporations are U.S. financial institutions that
carry out international banking and financing operations, some of which
the parent banks themselves are not permitted to undertake under exist-
ing laws. These corporations, which are examined annually, may act as
holding companies, provide international banking services, and finance
industrial and financial projects abroad, among other activities.

Financial Market Utilities

Financial market utilities (FMUs) and financial institutions participat-
ing in payment, clearance, and settlement (PCS) activities comprise the
nation’s financial infrastructure. This infrastructure supports millions of
financial transactions every day and encompasses many transactional
elements: small-value retail payment systems (such as credit card and
debit card networks) and large-value PCS systems for financial transac-
tions, including central counterparties, foreign-exchange settlement
systems, and large-dollar funds transfer systems. The smooth and
reliable functioning of this financial infrastructure at all times is vitally

78 Supervising and Regulating Financial Institutions and Activities

 important to the stability of the financial system and the health of the
broader economy.

Because their operations are so vital, FMUs can contribute to systemic

risk. In other words, problems at one system or institution could spill over
to other systems or financial institutions in the form of liquidity or credit
disruptions—particularly since FMUs have become increasingly interde-
pendent. For example, today, fewer and larger utilities (such as clear-
inghouses) support more integrated markets and global financial firms.
Moreover, the same large banks participate in all of the major clearing-
houses, and the major clearinghouses often rely on similar sets of banks
for payment services, funding, settlement, and emergency liquidity. In
this environment, problems at one clearinghouse could have significant
effects on others, even in the absence of explicit operational links.

What does “systemically

important” mean? For more information on regulation and supervision of the payment
If the Financial Stability and settlement system, see ”Regulating and Supervising the Payment
Oversight Council (FSOC) System” on page 142.
determines that a nonbank
financial company’s material
financial distress—or
Nonbank Financial Companies
the nature, scope, size, The Dodd-Frank Act assigned the Federal Reserve the authority and re-
scale, concentration,
sponsibility to supervise and regulate certain nonbank financial compa-
interconnectedness, or
mix of its activities—could nies that the FSOC has determined should be subject to Board supervi-
pose a threat to U.S. sion and prudential standards pursuant to section 113 of that act.
financial stability, the
company is often referred
to as being “systemically These firms—whose failure could pose a threat to U.S. financial
important.” Similarly, the stability—are subject to comprehensive, consolidated supervision and
FSOC may designate certain
regulation by the Federal Reserve. This provision of the Dodd-Frank Act
financial market utilities as
systemically important. addresses an important regulatory gap that existed before the 2007–09
financial crisis.

Because the material distress or failure of a nonbank financial institu-

tion supervised by the Federal Reserve can have an outsized effect on
the financial sector and the real economy, the Dodd-Frank Act requires
the Federal Reserve to reduce the probability of such events through

The Federal Reserve System Purposes & Functions 79

prudential standards for nonbank financial institutions designated by
the FSOC. These heightened prudential standards, stipulated in section
165 of the Dodd-Frank Act and applicable also to the largest U.S. BHCs
and foreign banking organizations, become progressively more strin-
gent as the systemic importance of that regulated entity increases and
include enhanced risk-based capital and leverage requirements, liquidity
requirements, overall risk-management requirements, concentration
limits, resolution plan (that is, “living will”) requirements, and credit
exposure reporting requirements. In addition to the mandatory height-
ened standards, the Federal Reserve may establish additional prudential
standards for designated nonbank financial companies that the Federal
Reserve determines are appropriate.

The Federal Reserve’s Role in the Supervision

of Certain Insurance Holding Companies
The Federal Reserve assumed responsibility as the consolidated super-
visor of certain insurance holding companies as a result of the Dodd-
Frank Act. In addition to certain nonbank financial companies described
above that may have significant insurance activities, the Federal Reserve
is responsible for the consolidated supervision of insurance holding
companies that are savings and loan holding companies. While the
activities of insurance companies may differ from the activities of state
member banks and BHCs, the Federal Reserve’s principal supervisory
objectives for insurance holding companies remain protecting the safety
and soundness of the consolidated firms and their subsidiary depository
institutions. To achieve these objectives, the Federal Reserve coordinates
supervisory activities with state insurance regulators, who continue to
have oversight of insurance legal entities.

80 Supervising and Regulating Financial Institutions and Activities

 Oversight Councils
Two councils—comprised of federal and state regulators and includ-
ing Federal Reserve representatives—play important coordinating
roles in the supervision and regulation of financial institutions.

Financial Stability Oversight Council

As noted earlier, the FSOC is a formal interagency body established
by the Dodd-Frank Act. Its statutory purposes are to
• identify risks to the stability of the U.S. financial system that could
arise from the distress or failure, or ongoing activities, of large,
interconnected bank holding companies or nonbank financial
companies or that could arise outside the financial service market-
place;
• promote market discipline by eliminating expectations on the part
of the shareholders, creditors, and counterparties of such compa-
nies that the U.S. government will shield them from losses in the
event of the company’s failure; and
• respond to emerging threats to U.S. financial stability.

Also among its responsibilities are determining whether nonbank

financial companies should be subject to Board supervision and pru-
dential standards and designating FMUs as systemically important, as
appropriate. The FSOC is also responsible for identifying and work-
ing to address gaps in regulation.

Federal Financial Institutions Examination Council (FFIEC)

The FFIEC is a formal interagency body that includes representatives
of the Federal Reserve Board, the FDIC, the OCC, the Consumer
Financial Protection Bureau (CFPB), the National Credit Union Admin-
istration, and the State Liaison Committee.

The Federal Reserve System Purposes & Functions 81

The FFIEC was created in 1978 to
• prescribe uniform federal principles and standards for the examina-
tion of depository institutions,
• promote coordination of supervision among the federal agencies
that regulate financial institutions, and
• encourage better coordination of federal and state regulatory
activities.

Through the FFIEC, state and federal regulatory agencies may exchange
views on important regulatory issues. Among other things, the FFIEC
has developed uniform financial reports that federally supervised banks
file with their federal regulator.

How the Federal Reserve Supervises

Financial Institutions
In overseeing the institutions under its authority, the Federal Reserve
seeks primarily to promote their safe and sound functioning, as well as
their compliance with all applicable laws and regulations that govern
their activities.

Microprudential, Safety-and-Soundness
Supervision
As a matter of law and practice, the Federal Reserve and other financial
regulatory agencies have traditionally adhered to a microprudential
approach to supervision; in other words, the regulator has focused on
ensuring the health and soundness of individual financial institutions,
particularly insured depository institutions (such as banks).

This approach remains a key component in Federal Reserve supervision.

But, as the 2007–09 financial crisis demonstrated, the Federal Reserve
and other financial regulatory agencies must also take into account

82 Supervising and Regulating Financial Institutions and Activities

Box 5.1. Microprudential versus Macroprudential Supervision
The Federal Reserve takes a two- 2. The macroprudential approach system as a whole is more likely to be
pronged approach to its oversight of focuses on the soundness and stable if its constituent organizations
financial institutions: resilience of the financial system are sound. And traditional, firm-specific
1. The microprudential approach as a whole and addresses how the oversight provides the knowledge base
seeks to ensure the safety and actions of one institution, or set for a more systemic, macroprudential
soundness of individual institutions of institutions, can impact other approach. It is not possible to under-
and involves in-depth examinations institutions and the U.S. economic stand developments in the financial
and inspections of the structure, and financial system overall. system as a whole without a clear view
operations, and compliance of These two approaches to supervision of developments within key firms and
individual entities regulated by the are complementary. The financial markets.
Federal Reserve.

macroprudential risks to overall financial stability when supervising

financial institutions and critical financial infrastructures. A too-narrow
focus on the safety and soundness of individual banking organizations
makes it harder to assess the broader financial landscape, and to detect
and mitigate potential threats to financial stability that cut across many
firms and markets.

Examinations and Inspections

The main objective of the Federal Reserve’s longstanding micropruden-
tial supervisory process is to assess and ensure the overall safety and
soundness of individual banking organizations. This evaluation includes
an assessment of an organization’s risk-management systems, financial
condition, and compliance with applicable laws and regulations.

The supervisory process entails both on-site examinations and inspec-

tions and off-site scrutiny and monitoring. For the largest financial
institutions, the Federal Reserve maintains a continuous supervisory
presence, with dedicated teams of full-time examiners.

By statute, state member banks must have an on-site examination at

least once every 12 months. Banks that have assets of less than $1 bil-
lion and that also meet certain management, capital, and other criteria
may be examined less frequently (once every 18 months). Conversely,

The Federal Reserve System Purposes & Functions 83

banks that are in troubled condition may be examined more frequently.
The Federal Reserve coordinates its examinations of state member
banks with those of the chartering state’s bank supervisor and it may
alternate examinations with the bank’s state supervisor.
Who conducts
examinations and
The objectives of an examination are, essentially, to
inspections?
1. provide an objective evaluation of a bank’s soundness; Examinations and inspections
are conducted by Federal
2. determine the level of risk involved in the bank’s transactions and
Reserve examiners,
activities; professionals who work at
local Federal Reserve Banks.
3. ascertain the extent of the bank’s compliance with banking laws and
They are rigorously trained to
regulations; keep abreast of ever-evolving
4. evaluate the adequacy of the bank’s corporate governance and as- laws and regulations to
which regulated entities are
sess the quality of its board of directors and management; and subject.
5. identify those areas where corrective action is required to strengthen
the bank, improve the quality of its performance, and enable it to
comply with applicable laws, regulations, and supervisory policies
and guidance.

The Federal Reserve generally conducts an annual full-scope inspection

of BHCs and savings and loan holding companies with consolidated as-
sets of $1 billion or greater, as well as smaller bank or savings and loan
holding companies that have significant nonbank activities or elevated
risk profiles.

In the case of small, noncomplex BHCs and savings and loan holding
companies whose consolidated assets are primarily held by subsidiaries,
Federal Reserve examiners rely heavily on continuous off-site monitor-
ing and on the results of examinations of the company’s subsidiary
banks or savings associations by the primary federal or state authorities.
This approach minimizes duplication of effort and reduces burden on
smaller financial institutions.

84 Supervising and Regulating Financial Institutions and Activities

 Risk-Focused Approach to
Consolidated Supervision
The Federal Reserve takes a risk-focused approach to consolidated
supervision, the goal of which is twofold:
1. to identify the greatest risks and emerging risks to a supervised
institution; and
2. to assess the ability of the institution’s management to identify, mea-
sure, monitor, and control these risks.

Consolidated supervision of holding companies encompasses the par-

ent company and its subsidiaries, and allows the Federal Reserve to un-

Figure 5.4. Federal Reserve committee strengthens supervision of largest,

most complex institutions
The Large Institution Supervision Coordinating Committee is a collaborative body providing Systemwide and cross-
disciplinary perspectives on the supervision of selected large and complex domestic bank holding companies, foreign banking
organizations, and nonbank financial companies.1

Dedicated Supervisory Execute supervisory strategies for their assigned firms and
Teams contribute to cross-firm supervisory exercises2

Discusses the results of key components of the supervisory

LISCC Vetting Committee program, and provides feedback and guidance to the dedicated
supervisory and cross-firm teams
Operating
Identifies risks to firms’ operations, evaluates their risk-
Committee Risk Secretariat management practices, and supports supervisory activities

LISCC Sets priorities

for and oversees
to mitigate key risks

the execution Capital and Performance Supports the identification of emerging risks by monitoring and
of the LISCC Secretariat analyzing firms’ performance and financial condition
supervisory
program Supervisory Program
Coordinates supervisory program management for firms
Management Committee

Other Subgroups Support data needs and ensure consistent and high-quality
written communication to firms

1
For more information on the committees, subgroups, and dedicated supervisory teams that comprise the LISCC governance
structure, see SR letter 15-7, Governance Structure of the LISCC Supervisory Program at www.federalreserve.gov/
bankinforeg/srletters/sr1507.htm.
2
For a list of firms in the LISCC portfolio, see www.federalreserve.gov/bankinforeg/large-institution-supervision.htm.

The Federal Reserve System Purposes & Functions 85

derstand the organization’s structure, activities, resources, and risks, as
well as to address financial, managerial, operational, or other deficien-
cies before they pose a danger to the holding company’s subsidiary de-
pository institution(s). Under the risk-focused approach, Federal Reserve
examiners focus on those business activities that may pose the greatest
risk to the institution. For the largest financial institutions, which have
Finding reporting data on
grown in both size and complexity in recent years, this risk-focused ap- institutions supervised by
proach is typically implemented through a continuous process of on-site the Federal Reserve

supervision rather than through point-in-time examinations. The National Information

Center (www.ffiec.gov/
nicpubweb/nicweb/nichome.
In 2010, to strengthen its supervision of the largest, most complex aspx) is a repository,
financial institutions, the Federal Reserve created a centralized multi- maintained by the Federal
Financial Institutions
disciplinary body called the Large Institution Supervision Coordinating
Examination Council, that
Committee (LISCC) to coordinate the supervision and evaluate the provides data about banks
conditions of these supervised institutions, which include and other institutions,
including both domestic
• domestic BHCs that have been designated as G-SIBs (global systemi- and foreign banking
cally important banks), organizations operating in
the United States.
• foreign banking organizations that maintain large and complex
operations in the United States, and
• nonbank financial companies that the FSOC has determined should
be supervised by the Board.

The LISCC’s primary functions are to provide (1) Systemwide and

cross-disciplinary perspectives on the supervision of firms in the LISCC
portfolio and (2) advice on the strategic direction of LISCC portfolio
supervision to the Board’s Director of Banking Supervision and Regula-
tion, who serves as the Chair of the LISCC.

The LISCC Operating Committee (OC), in consultation with the LISCC,

is responsible for setting priorities for and overseeing the execution
of the LISCC supervisory program. The OC is a multidisciplinary group
comprised of senior officials from various divisions at the Board of Gov-
ernors and Reserve Banks. The OC is chaired by a senior officer from
the Board’s Division of Banking Supervision and Regulation who reports
to the division director.

86 Supervising and Regulating Financial Institutions and Activities

 The OC provides direction to the LISCC firms’ dedicated supervisory
teams and directly oversees several subgroups, described in figure 5.4,
which are collectively tasked with execution of the LISCC supervisory
program.

One major supervisory exercise conducted by the LISCC each year is the
Comprehensive Capital Analysis and Review (CCAR) of the largest U.S.
banking firms. Building on supervisory work coming out of the crisis,
CCAR was established to ensure that each of the largest U.S. BHCs
maintains (1) rigorous, forward-looking capital planning processes that
effectively account for the unique risks of the firm and (2) sufficient
capital to continue operations throughout times of economic and
financial stress.

For more information about CCAR, as well as stress testing required

under the Dodd-Frank Act, see section 4, “Promoting Financial System
Stability,” on page 54, and “Capital Planning, Stress Testing, and Capi-
tal Distributions” on page 112.

In addition to CCAR, major annual, cross-firm supervisory exercises

conducted by the LISCC include the Comprehensive Liquidity Annual
Review (CLAR) and Supervisory Assessment of Recovery and Resolution
Preparedness (SRP). CLAR is the Federal Reserve’s program to evaluate
the liquidity position and liquidity risk-management practices of LISCC
firms. SRP is the Federal Reserve’s review of the LISCC firms’ options
to support recovery and progress in removing impediments to orderly
resolution. The LISCC also oversees additional cross-firm initiatives that
are developed in support of LISCC priorities.

Areas and Types of Examination

The Federal Reserve examines institutions for compliance with a broad
range of laws, regulations, and other legal requirements to ensure their
safe and sound functioning. Further, it supervises for compliance with
laws and regulations on focused topics, such as anti-money laundering
and consumer protection. For more information on consumer-oriented

The Federal Reserve System Purposes & Functions 87

supervision, see “Consumer-Focused Supervision and Examination” on
page 154.

Financial Condition: Call Reports, the FR Y-9C,

and Other Disclosures
In conducting examination programs, Federal Reserve examiners and How the Federal Reserve
supervisory staff rely on many sources of information about financial enforces consumer- and
community-oriented laws
institutions and activities, including reports of recent examinations and and regulations
inspections, public filings with the SEC, other publicly available informa- To learn more about the
tion, and the standard financial regulatory reports filed by institutions. Federal Reserve’s
enforcement of consumer
protection laws and
The primary financial report for banks and savings associations is the regulations, see section 7,
Consolidated Report of Condition and Income (FFIEC 031/041), often “Promoting Consumer
Protection and Community
referred to as the Call Report. It is used to prepare a Uniform Bank
Development,” on page 152.
Performance Report, which employs ratio analysis to detect unusual
or significant changes in a bank’s financial condition that may warrant
supervisory attention. The primary financial report for large BHCs and
savings and loan holding companies is the Consolidated Financial State-
ment for Holding Companies (FR Y-9C).

The number and types of reports that must be filed by a financial

institution depend on its size, the scope of its operations, and the types
of activities that it conducts either directly or through a subsidiary. The
reports filed by larger institutions that engage in a wider range of ac-
tivities are generally more numerous and more detailed than those filed
by smaller entities.

Transactions with Affiliates: An Illustration

of Safety-and-Soundness Supervision
Among many topics covered in a safety-and-soundness review of a
financial institution, Federal Reserve examiners evaluate transactions
between an insured depository institution and its affiliates to ascertain
whether or not the transactions are consistent with sections 23A and
23B of the Federal Reserve Act, which restrict such transactions with
the goal of limiting risk to the insured depository institution.

88 Supervising and Regulating Financial Institutions and Activities

 Section 23A limits an insured depository institution’s loans (and other
extensions of credit, asset purchases, guarantees, and certain other
transactions) to any single affiliate to 10 percent of the bank’s capital
and surplus. It also limits such “covered transactions” with all affiliates
in the aggregate to 20 percent of the bank’s capital and surplus. Securi-
ties lending and borrowing transactions—and derivatives transactions
that result in credit exposure—also are subject to the limits prescribed
by section 23A.

Section 23A also prohibits an insured depository institution from

purchasing low-quality assets from an affiliate, and it requires that
an institution’s transactions with affiliates be conducted in a safe and
sound manner. Section 23B requires that most transactions between an
insured depository institution and its affiliates be on terms substantially
the same—or at least as favorable to the insured depository institu-
tion—as those prevailing at the time for comparable transactions with
nonaffiliated companies.

Anti-Money-Laundering Compliance: An Illustration of

Safety-and-Soundness
Banking organizations are expected to maintain compliance with the
Bank Secrecy Act (BSA) and anti-money laundering laws and regula-
tions. Federal Reserve examiners also verify an institution’s compliance
with economic sanctions imposed by Congress against certain countries,
as implemented by the Office of Foreign Assets Control. The Federal Re-
serve has issued regulations to implement the BSA, including regulations
that require banking organizations to establish a compliance program.
During examinations of state member banks and U.S. branches and
agencies of foreign banks (and inspections of BHCs and certain savings
and loan holding companies), the Federal Reserve conducts a BSA and
sanctions compliance review as part of its regular safety-and-soundness
examination program. The Federal Reserve employs a risk-based super-
visory approach to assess a regulated financial institutions’ compliance
with the BSA and economic sanctions using procedures developed
jointly with the member agencies of the FFIEC.

The Federal Reserve System Purposes & Functions 89

Figure 5.5. U.S. banks operate in more than 60 countries around the world
The Federal Reserve is responsible for examining the international operations of member banks and bank holding companies.
As of December 31, 2015, that included operations in the highlighted countries.

Source: Federal Financial Institutions Examination Council (2015), Statistical Release E.16, “Country Exposure Lending Survey
and Country Exposure Information Report” (December 31, 2015), www.ffiec.gov/E16.htm.

Under the BSA, U.S. financial institutions must report large currency
transactions and retain certain records, including information about
persons and businesses that conduct large currency transactions, pur-
chase certain monetary instruments, and conduct large funds transfers.
Furthermore, the BSA requires financial institutions to report suspicious
activity related to possible violations of federal law, such as money
laundering, terrorist financing, and other financial crimes. Regulations
H, K, and Y provide clarification on compliance with suspicious activ-
ity reporting requirements with respect to state member banks, Edge
and agreement corporations, U.S. offices of foreign banking organiza-
tions supervised by the Federal Reserve, and BHCs and their nonbank
subsidiaries.

90 Supervising and Regulating Financial Institutions and Activities

 Off-Site Monitoring
In its ongoing off-site supervision of banks and holding companies, the
Federal Reserve uses automated systems to (1) proactively identify insti-
tutions with poor or deteriorating financial profiles and (2) help detect
adverse trends developing in the banking industry.

For example, the Federal Reserve’s Supervision and Regulation Statistical

Assessment of Bank Risk (SR-SABR) system uses an econometric model-
ing framework to identify weak and potentially weak banks. By using
this system, the Federal Reserve can more effectively direct examiner
resources to those institutions needing supervisory attention.

Supervision of U.S. Banks’ International Operations

The Federal Reserve has supervisory and regulatory responsibility for
the international operations of state member banks and BHCs (see
­figure 5.5). These responsibilities include
• authorizing the establishment of foreign branches of national banks
and state member banks, and regulating the scope of their activities;
• chartering and regulating the activities of Edge Act and agreement
corporations (as noted earlier, specialized institutions used for inter-
national and foreign business);
• authorizing the foreign investments of member banks, Edge Act and
agreement corporations, and BHCs, and regulating the activities of
foreign firms acquired by such investors; and
• establishing supervisory policies and practices regarding foreign
lending by state member banks.

U.S. banking organizations may conduct a wide range of overseas activi-

ties. The Federal Reserve has broad discretionary powers to regulate the
foreign activities of member banks and BHCs so that, in financing U.S.
trade and investments abroad, these U.S. banking organizations can be
fully competitive with institutions of the host country without compro-
mising the safety and soundness of their U.S. operations.

The Federal Reserve System Purposes & Functions 91

The Federal Reserve examines the international operations of state mem-
ber banks, Edge Act and agreement corporations, and BHCs principally
at the U.S. head offices of these organizations. When appropriate, the
Federal Reserve conducts examinations at the foreign operations of a
U.S. banking organization in order to review the accuracy of financial and
operational information maintained at the head office as well as to test
the organization’s adherence to safe and sound banking practices and
to evaluate its efforts to implement corrective measures. Examinations
abroad are conducted in cooperation with the responsible host-country
supervisor.

Supervision of Foreign Banks’ U.S. Operations

Although foreign banks have been operating in the United States for
more than a century, before 1978 the U.S. branches and agencies of
these banks were not subject to supervision or regulation by any fed-
eral banking agency.

The International Banking Act of 1978 (IBA) created a federal regula-

tory structure for the activities of foreign banks with U.S. branches and
agencies. The IBA also established a policy of “national treatment” for
foreign banks operating in the United States to promote competitive
equality between them and domestic institutions. This policy generally
gives foreign banking organizations operating in the United States the
same powers as U.S. banking organizations and subjects them to the
same restrictions and obligations that apply to the domestic operations
of U.S. banking organizations.

The Foreign Bank Supervision Enhancement Act of 1991 (FBSEA) in-

creased the responsibility and the authority of the Federal Reserve to
regularly examine the U.S. operations of foreign banks. Under the FBSEA,
U.S. branches and agencies of foreign banks must be examined on-site at
least once every 12 months, although this period may be extended to 18
months if the branch or agency meets certain criteria. Supervisory actions
resulting from examinations may be taken by the Federal Reserve alone
or in conjunction with other agencies. Representative offices of these
institutions are also subject to examination by the Federal Reserve.

92 Supervising and Regulating Financial Institutions and Activities

 The Federal Reserve coordinates the supervisory program for the U.S.
operations of foreign banking organizations with other federal and
state banking agencies. Since a foreign banking organization may
have both federally chartered and state-chartered offices in the United
States, the Federal Reserve plays a key role in assessing the condition
of the organization’s entire U.S. operations and the foreign banking
organization’s ability to support its U.S. operations.

In carrying out their supervisory responsibilities, the Federal Reserve and

other U.S. regulators rely on two supervisory tools: Strength of Sup-
port Assessment (SOSA) rankings and Risk Management, Operational
Controls, Compliance, and Asset Quality (ROCA) ratings. SOSA rank-
ings reflect the Federal Reserve staff’s assessment of a foreign bank’s

Figure 5.6. Depository institutions and holding companies receive ratings based on the
result of examinations and inspections
Ratings, which are assigned to an institution after an examination or inspection, provide a summary measure of the
examination’s findings.

Rating system CAMELS RFI/C(D)

Entity Depository institutions Bank holding company

Savings and loan holding company

Components •  Capital adequacy •  Risk management

•  Asset quality –  effectiveness of the banking organiza-
tion’s risk management and controls;
•  Management board and senior management over-
•  Earnings sight; policies, procedures, and limits;
risk monitoring and management infor-
•  Liquidity
mation systems; and internal controls
•  Sensitivity to market risk •  Financial condition
–  an assessment of the banking organiza-
tion’s capital, asset quality, earnings,
and liquidity
• potential Impact of the parent company
and nondepository subsidiaries on the
affiliated depository institutions
•  the consolidated Composite condition of
the institution
• the CAMELS rating of the affiliated
Depository institutions

Results For both rating systems, institutions score on a scale of 1 (best) to 5 (worst) for each factor.

The Federal Reserve System Purposes & Functions 93

ability to provide support for its U.S. operations; ROCA ratings provide
an assessment of its U.S. branch and agency activities. The Federal Re-
serve also assesses the entirety of a foreign banking organization’s U.S.
operations through a single U.S. composite rating.
Under the Bank Holding Company Act and the IBA, the Federal Reserve
is also responsible for reviewing and monitoring the U.S. nonbanking
activities of foreign banking organizations that have a branch, agency,
commercial lending company, or subsidiary bank in the United States.

In 2014, the Federal Reserve Board approved a final rule required by

section 165 of the Dodd-Frank Act (which also requires enhanced
prudential standards for large U.S. BHCs) to strengthen supervision and
regulation of foreign banking organizations. The final rule recognized
that the U.S. operations of foreign banking organizations had become
increasingly complex, interconnected, and concentrated, and estab-
lished a number of enhanced prudential standards for foreign bank- Finding orders and
ing organizations to help increase the resiliency of their operations. agreements online

The requirements of the final rule will bolster the capital and liquidity All formal enforcement
orders issued by the Fed-
positions of the U.S. operations of foreign banking organizations and
eral Reserve and all written
promote a level playing field among all banking firms operating in the agreements executed by
United States. A foreign banking organization with U.S. nonbranch as- Reserve Banks are available
to the public in the News &
sets of $50 billion or more is required to establish an intermediate hold-
Events section of the Federal
ing company over its U.S. subsidiaries, which will facilitate consistent Reserve Board’s website,
supervision and regulation of the U.S. operations of the foreign bank. www.federalreserve.gov.

The foreign-owned U.S. intermediate holding company is generally

subject to the same risk-based and leverage capital standards applicable
to U.S. BHCs. The intermediate holding companies are also subject to
the Federal Reserve’s rules pertaining to regular capital plans and stress
testing.

Supervisory Colleges
Through participation in supervisory colleges, the Federal Reserve
cooperates with foreign banking supervisors, both as the home-country
supervisor of U.S. banking organizations with overseas operations and
as the host-country supervisor of the U.S. operations of foreign bank-

94 Supervising and Regulating Financial Institutions and Activities

Box 5.2. A Further Evolution: Taking Corrective Action to Address
Troubled Institutions
The Federal Deposit Insurance Corpora- Call Report data. Based on its levels of tion Act (Dodd-Frank Act) directed
tion Improvement Act of 1991 requires these ratios, a bank can be deemed the Federal Reserve to promulgate
regulators to take prompt corrective (1) well-capitalized, (2) adequately capi- regulations providing for the early
action (PCA) to address the problems talized, (3) undercapitalized, (4) signifi- remediation of financial weaknesses
of troubled depository institutions. The cantly undercapitalized, or (5) critically at bank holding companies with total
intent of PCA is to minimize the long- undercapitalized. The law provides for consolidated assets of $50 billion or
term cost to the Deposit Insurance increasingly stringent corrective provi- more and nonbank financial companies
Fund of resolving such institutions. sions as a bank is placed in progres- that the Financial Stability Oversight
The PCA framework specifies mandato- sively lower capital categories. Council has determined should be sub-
ry actions that regulators must take, as Undercapitalized and significantly un- ject to Board supervision. More specifi-
well as discretionary actions they must dercapitalized institutions likely would cally, the Dodd-Frank Act requires the
consider taking, when a bank’s capital be required to submit and implement Federal Reserve to define measures of
position declines or is deemed to have an acceptable plan to restore capital. these companies’ financial condition,
declined below certain threshold levels A critically undercapitalized bank including, but not limited to, regulatory
as a result of an unsafe or unsound faces receivership unless its condition capital, liquidity measures, and other
condition or practice. improves and the activities that expose indicators that would trigger remedial
it to risk are restricted. action. As the financial condition of
The state of a bank’s capital position
a company declines, the stringency
is based on risk-based capital and More recently, the Dodd-Frank Wall
of the remedial action requirements
leverage ratios derived from the bank’s Street Reform and Consumer Protec-
increases.

ing organizations. This cooperation involves bilateral and multilateral

contacts and formal and informal information-sharing arrangements.

With the growth, in recent years, of the international operations of

large global financial institutions, the Federal Reserve and other U.S.
and foreign banking supervisors have broadened and formalized coop-
erative arrangements through these “supervisory colleges.” Supervisory
colleges are multilateral working groups of relevant supervisors that are
formed to promote effective, ongoing consolidated supervision of the
overall operations of an international banking group. In this regard, the
Federal Reserve—in performing the role of a home-country supervi-
sor—organizes supervisory colleges that include the most significant
host supervisors of those U.S. banking organizations with the largest
global systemic presence. Similarly, it participates as a host-country
supervisor in colleges organized by foreign banking supervisors.

The Federal Reserve System Purposes & Functions 95

Participation in supervisory colleges enhances the Federal Reserve’s
communication and collaboration with foreign supervisors and supple-
ments bilateral working relationships with foreign supervisors. These
relationships are vitally important to the Federal Reserve’s supervision
of the overseas operations of U.S. banking organizations and the U.S.
operations of foreign banking organizations.

Other Elements of Supervision

A Federal Reserve examination can focus on a specific functional area
within a regulated entity, such as its fiduciary activities, its securities
dealing, or its information technology activities. Furthermore, in light of
the importance of information technology to the safety and soundness
of banking organizations, the Federal Reserve has the authority to ex-
amine the operations of certain independent organizations that provide
information technology services to supervised banking organizations,
and it examines these service providers on a regular basis.

Results of an Examination or Inspection

Supervisory Ratings
The results of an on-site examination or inspection are reported to the
board of directors and management of the bank, BHC, or savings and
loan holding company in a confidential report of examination or inspec-
tion, which can include a confidential supervisory rating of the condi-
tion of the institution. Each state member bank receives a composite
rating, which reflects the Federal Reserve’s assessment and rating of the
bank’s capital adequacy, asset quality, management, earnings, liquidity,
and sensitivity to market risk (CAMELS). In addition, each BHC receives
a composite rating, which reflects the Federal Reserve’s assessment and
ratings of the company’s risk management, financial condition, and
potential impact on affiliated depository institutions (RFI/C(D)). Ratings
range from “1” to “5,” with “1” being the best (see figure 5.6).

The CAMELS supervisory rating for banks and other depository institu-
tions is a tool that all federal and state banking agencies use to convey
to financial institutions the agencies’ assessment of the institution and

96 Supervising and Regulating Financial Institutions and Activities

 to identify institutions whose operations raise concern or require special
attention.

Examination Report
In addition to assigning a rating, examiners also prepare a detailed
report that, besides formally communicating the rating, (1) describes the
institution’s activities and management structure, (2) assesses the institu-
tion’s performance, and (3) recommends changes or improvements in
certain policies and procedures.

Enforcement
If the Federal Reserve determines that a supervised institution has prob-
lems that affect its safety and soundness, or that the institution is not
in compliance with applicable laws and regulations, the Federal Reserve
may, by law, take action to ensure that the institution undertakes cor-
rective measures.

Informal supervisory actions. Informal supervisory actions are used to

address less-significant deficiencies or problems that the Federal Reserve
believes a bank’s board of directors or management can correct with-
out the need for more extensive regulatory intervention. For example,
the Federal Reserve may address issues detected during the supervisory
process by requesting that the institution’s board adopt a resolution
or enter into a memorandum of understanding to correct potentially
unsafe or unsound practices or other deficiencies that do not require
elevation to a formal supervisory action.

Formal supervisory actions. If an institution fails to remedy an unsafe

or unsound practice or to comply with banking laws, or if the practices
or violations are so widespread or serious that recourse to informal su-
pervisory methods is not appropriate or sufficient, the Federal Reserve
may take a formal supervisory action, which may compel the institution
to take specific actions and which can be enforced in court.

The Federal Reserve System Purposes & Functions 97

Formal enforcement actions may include
• imposing orders directing the financial institution or its institution-
affiliated parties to cease and desist from engaging in the improper
or prohibited conduct;
• directing the firm to take certain actions to return to safe and sound
banking practices;
• requiring the firm to make restitution or provide reimbursement,
indemnification, or guaranty to third parties harmed by the wrongful
conduct;
• removing an institution-affiliated party from the banking institution
and prohibiting the party from participating in banking at other
financial institutions; and
• assessing civil money penalties against either the offending institu-
tion or an institution-affiliated party.

Macroprudential Supervision and Monitoring

Ensuring the safe and efficient functioning of the nation’s banking sys-
tem requires that the Federal Reserve consider more than the safety
and soundness of individual organizations.

This duty requires that the Federal Reserve also consider factors that
can affect the stability of the entire financial system, including the
interactions between firms and markets. In other words, the Federal Re-
serve’s supervision includes a macroprudential aspect that focuses on
promoting overall financial stability. In this regard, the Dodd-Frank Act
explicitly directs the Federal Reserve to routinely factor macroprudential
considerations into its supervisory and regulatory activities.

As part of its effort to improve macroprudential supervision, the Federal

Reserve Board created the Division of Financial Stability (see section 4,
“Promoting Financial System Stability,” on page 54). This multidisci-
plinary division coordinates Federal Reserve efforts to identify and ana-
lyze potential risks to financial institutions, the broader financial system,
and the economy, and helps develop and evaluate policies to promote
financial stability. It also acts as the Board’s liaison to the FSOC.

98 Supervising and Regulating Financial Institutions and Activities

 The Federal Reserve also monitors (1) risks that can arise because of
substantial interconnections among financial firms and (2) risks that
can develop more broadly in the financial system, including at other
financial institutions, in financial markets, and in the general market
infrastructures.

Financial imbalances can arise, for example, from leverage and maturity
mismatch at financial intermediaries, stretched asset valuations, and lax
loan-underwriting standards. In addition, the Federal Reserve conducts
research to develop measures of systemic risk and to develop a bet-
ter understanding of how distress at individual firms or sectors can be
transmitted to the broader financial system and the economy.

Crisis Management Groups

The Federal Reserve participates in crisis management groups with
other state and U.S. regulatory agencies and foreign banking supervi-
sors responsible for the oversight of large cross-border banking groups.
The purpose of crisis management groups is to enhance preparedness
for, and facilitate the management and resolution of, a financial crisis
affecting a large global banking group. Crisis management groups
typically include supervisors, central banks, resolution authorities, and
other public authorities from jurisdictions with significant operations in
the international banking group or respective foreign economy. Similar
to supervisory colleges, the Federal Reserve—in performing the role of a
home-country supervisor—organizes crisis management groups that in-
clude the most significant host supervisors of those U.S. banking organi-
zations with the largest global systemic presence. Similarly, it participates
as a host-country supervisor in crisis management groups organized by
foreign banking supervisors where U.S. operations of those groups are
significant and where the home supervisor has invited the Federal Re-
serve to participate. This cooperation involves bilateral and multilateral
contacts and formal and informal dialogue focused on the development
of a framework for early intervention triggers around recovery efforts
and resolution planning.

The Federal Reserve System Purposes & Functions 99

Participation in crisis management groups also furthers the Federal
Reserve’s communication and collaboration with foreign supervisors and
supplements bilateral working relationships with foreign supervisors.
These relationships are vitally important to the Federal Reserve’s supervi-
sion of the overseas operations of U.S. banking organizations and the
U.S. operations of foreign banking organizations.

Overseeing the Structure

of the Banking System
The Federal Reserve exerts an important influence over the structure
of the U.S. banking system by administering several federal statutes
that govern the formation, acquisition, and mergers of BHCs, mem-
ber banks, savings and loan holding companies, and foreign banking
organizations.

Under these statutes, the Federal Reserve has authority to approve or

deny a variety of proposals that directly or indirectly affect the structure
of the U.S. banking system at the local, regional, and national levels;
the international operations of domestic banking organizations; or the
U.S. banking operations of foreign banks.

Specifically, the Federal Reserve administers several federal statutes that

apply to BHCs, financial holding companies, member banks, and for-
eign banking organizations, including the Bank Holding Company Act
(BHC Act), the Bank Merger Act, the Change in Bank Control Act of
1978 (CIBCA), the Federal Reserve Act, and the IBA. As a result of the
Dodd-Frank Act, the Federal Reserve also administers section 10 of the
Home Owners’ Loan Act (HOLA) that applies to savings and loan hold-
ing companies, and for administering the CIBCA with respect to savings
and loan holding companies.

100 Supervising and Regulating Financial Institutions and Activities

 Bank Holding Company Formations and Acquisitions
Under the BHC Act, a firm that seeks to become a BHC must first
obtain approval from the Federal Reserve. The act defines a BHC as any
company that directly or indirectly owns, controls, or has the power to
vote 25 percent or more of any class of the voting shares of a bank;
controls in any manner the election of a majority of the directors or
trustees of a bank; or is found to exercise a controlling influence over
the management or policies of a bank. A BHC must obtain the approval
of the Federal Reserve before acquiring more than 5 percent of the
shares of an additional bank or BHC. All BHCs must file certain reports
with the Federal Reserve System.

When considering applications to acquire a bank or a BHC, the Federal

Reserve is required to take into account the likely effects of the acquisi-
tion on competition, financial stability, the convenience and needs of
the communities to be served, the financial and managerial resources
and future prospects of the companies and banks involved, and the
effectiveness of the company’s policies to combat money laundering. In
the case of an interstate bank acquisition, the Federal Reserve also must
consider certain other factors and may not approve the acquisition if
the resulting organization would control more than 10 percent of all
deposits held by insured depository institutions. When a foreign bank
seeks to acquire a U.S. bank, the Federal Reserve also must consider
whether the foreign banking organization is subject to comprehensive
supervision or regulation on a consolidated basis by its home-country
supervisor.

Savings and Loan Holding Company

Formations and Acquisitions
Under HOLA, a firm that seeks to become a savings and loan holding
company must first obtain approval from the Federal Reserve. HOLA
defines a savings and loan holding company as any company that
directly or indirectly controls a savings association or that controls any
other company that is a savings and loan holding company.

The Federal Reserve System Purposes & Functions 101

Once formed, a savings and loan holding company must receive Federal
Reserve approval before acquiring or establishing additional savings as-
sociations. Savings and loan holding companies generally may engage
in only those business activities that are specifically enumerated in
HOLA or which the Board has previously determined by regulation to
be closely related to banking under section 4(c)(8) of the BHC Act. De-
pending on the circumstances, these activities may or may not require
Federal Reserve approval in advance of their commencement.

In general, a company controls a savings association if one or more

persons directly or indirectly owns, controls, or has the power to vote
more than 25 percent of the voting shares of the savings association, or
controls in any manner the election of a majority of the directors of the
savings association. A savings and loan holding company must obtain
approval of the Board before acquiring more than 5 percent of the
voting shares of an additional savings association or savings and loan
holding company.

Formation and Activities of Financial Holding Companies

As authorized by the Gramm-Leach-Bliley Act, the Federal Reserve
Board’s regulations allow a BHC or a foreign banking organization to
become a financial holding company and engage in an expanded array
of financial activities if the company meets certain capital, managerial,
and other criteria. In addition, a savings and loan holding company may
elect to be treated as a financial holding company if it meets the same
criteria that apply to BHCs and financial holding companies under the
BHC Act. Permissible activities for financial holding companies include
conducting securities underwriting and dealing, serving as an insur-
ance agent and underwriter, and engaging in merchant banking. Other
permissible activities include those that the Federal Reserve Board, after
consulting with the Secretary of the Treasury, determines to be financial
in nature or incidental to financial activities. Financial holding compa-
nies also may engage to a limited extent in a nonfinancial activity if the
Board determines that the activity is complementary to one or more of
the company’s financial activities and would not pose a substantial risk

102 Supervising and Regulating Financial Institutions and Activities

 to the safety or soundness of depository institutions or the financial
system.

Bank Mergers
Another responsibility of the Federal Reserve is to act on proposed bank
mergers when the resulting institution would be a state member bank.
The Bank Merger Act of 1960 sets forth the factors to be considered in
evaluating merger applications. These factors are similar to those that
must be considered in reviewing bank acquisition proposals by BHCs. To
ensure that all merger applications are evaluated in a uniform manner,
the act requires that the responsible agency request reports from the
Department of Justice and from the other approving banking agencies
addressing the competitive impact of the transaction.

Federal Reserve Act Proposals

Under the Federal Reserve Act, a member bank may be required to
seek Federal Reserve approval before expanding or materially modifying
its operations domestically or internationally. State member banks must
obtain Federal Reserve approval to establish domestic branches, and all
member banks (including national banks) must obtain Federal Reserve
approval to establish foreign branches.

State member banks must also obtain Federal Reserve approval to es-
tablish financial subsidiaries. These subsidiaries may engage in activities
that are financial in nature or incidental to financial activities, including
securities-related and insurance agency-related activities.

Changes in Bank Control

The CIBCA authorizes the federal bank regulatory agencies to act
on proposals by a single “person” (which includes an individual or
an entity), or several persons acting in concert, to acquire control of
an insured bank, BHC, or a savings and loan holding company. The
Federal Reserve is responsible for approving changes in the control of
BHCs, savings and loan holding companies, and state member banks;
the FDIC and the OCC are responsible for approving changes in the
control of insured state nonmember and national banks, respectively. In

The Federal Reserve System Purposes & Functions 103

Figure 5.7. Federal Reserve regulations by topic
The Federal Reserve maintains and ensures compliance with the following regulations, which implement federal banking laws
and govern the operations of regulated institutions.

Topic Regulation (by letter and name) Description

Banks and banking F Limitations on Interbank Liabilities Prescribes standards to limit the risks that the failure of one
depository institution would pose to another

H Membership of State Banking Institu- Defines the requirements for membership of state-chartered
tions in the Federal Reserve System banks in the Federal Reserve System; sets limitations on certain
investments and requirements for certain types of loans; de-
scribes rules pertaining to securities-related activities; establishes
the minimum ratios of capital to assets that banks must maintain
and procedures for prompt corrective action when banks are not
adequately capitalized; prescribes real estate lending and ap-
praisal standards; sets out requirements concerning bank security
procedures, suspicious-activity reports, and compliance with the
Bank Secrecy Act; and establishes rules governing banks’ owner-
ship or control of financial subsidiaries

I Issue and Cancellation of Federal Sets out stock-subscription requirements for all banks joining the
Reserve Bank Capital Stock Federal Reserve System

K International Banking Operations Governs the international banking operations of U.S. banking
organizations and the operations of foreign banks in the United
States

L Management Official Interlocks Generally prohibits a management official from serving two non-
affiliated depository institutions, depository institution holding
companies, or any combination thereof, in situations where the
management interlock would likely have an anticompetitive effect

O Loans to Executive Officers, Directors, Restricts credit that a member bank may extend to its executive
and Principal Shareholders of Member officers, directors, and principal shareholders and their related
Banks interests

Q Capital Adequacy of Bank Holding Establishes minimum capital requirements and overall capital
Companies, Savings and Loan Holding adequacy standards for bank holding companies, savings and
Companies, and State Member Banks loan holding companies, and state member banks

R Exceptions for Banks from the Definition Defines the scope of securities activities that banks may conduct
of Broker in the Securities Exchange Act without registering with the Securities Exchange Commission as
of 1934 a securities broker and implements the most important excep-
tions from the definition of the term broker for banks under
section 3(a)(4) of the Securities Exchange Act of 1934

S Reimbursement for Providing Financial Establishes rates and conditions for reimbursement to financial
Records; Recordkeeping Requirements institutions for providing customer records to a government au-
for Certain Financial Records thority and prescribes recordkeeping and reporting requirements
for insured depository institutions making domestic wire transfers
and for insured depository institutions and nonbank financial
institutions making international wire transfers

104 Supervising and Regulating Financial Institutions and Activities

 Topic Regulation (by letter and name) Description
Banks and banking W Transactions Between Member Banks Implements sections 23A and 23B of the Federal Reserve Act,
(continued) and Their Affiliates which establish certain restrictions on and requirements for
transactions between a member bank and its affiliates

KK Swaps Margin and Swaps Push-Out Implements the prohibition against federal assistance to swap
entities

NN Retail Foreign Exchange Transactions Sets standards for banking organizations regulated by the Federal
Reserve that engage in certain types of foreign exchange transac-
tions with retail consumers

VV Proprietary Trading and Certain Interests Establishes prohibitions and restrictions on proprietary trading
in and Relationships with Covered Funds and investments in or relationships with covered funds by certain
banking entities
Federal Reserve J Collection of Checks and Other Items Establishes procedures, duties, and responsibilities among
Bank activities by Federal Reserve Banks and Funds (1) Federal Reserve Banks, (2) the senders and payors of checks
Transfers Through Fedwire and other items, and (3) the senders and recipients of Fedwire
funds transfers

N Relations with Foreign Banks and Governs relationships and transactions between Federal Reserve
Bankers Banks and foreign banks, bankers, or governments
Holding companies Y Bank Holding Companies and Change in Regulates the acquisition of control of banks and bank holding
and nonbank Bank Control companies by companies and individuals, defines and regulates
financial companies the nonbanking activities in which bank holding companies
(including financial holding companies) and foreign banking
organizations with U.S. operations may engage, and imposes
capital planning requirements on large bank holding companies

LL Savings and Loan Holding Companies Regulates the acquisition of control of savings associations,
defines and regulates the activities of savings and loan holding
companies, and sets forth procedures under which directors and
executive officers may be appointed or employed

MM Mutual Holding Companies Regulates the reorganization of mutual savings associations to

mutual holding companies and the creation of subsidiary holding
companies of mutual holding companies, defines and regulates
the operations of mutual holding companies and their subsidiary
holding companies, and sets forth procedures for securing ap-
proval for these transactions

OO Securities Holding Companies Outlines the procedures and requirements for securities holding
companies to elect to be supervised by the Federal Reserve

QQ Resolution Plans Requires large, systemically significant bank holding companies

and nonbank financial companies to submit annual resolution
plans

RR Credit Risk Retention Requires sponsors of securitization transactions to retain risk in

those transactions

TT Supervision and Regulation Assessments Establishes an annual assessment of fees on certain bank holding
of Fees companies, savings and loan holding companies, and nonbank
financial companies supervised by the Federal Reserve

The Federal Reserve System Purposes & Functions 105

 Topic Regulation (by letter and name) Description
Holding companies WW Liquidity Risk Measurement Standards Establishes a minimum liquidity standard for certain Board-
and nonbank regulated institutions on a consolidated basis
financial companies
(continued) XX Concentration Limits Establishes a financial sector concentration limit that generally
prohibits a financial company from merging or consolidating
with, or acquiring, another company if the resulting company’s
liabilities would exceed 10 percent of the aggregated liabilities of
all financial companies

YY Enhanced Prudential Standards Implements the enhanced prudential standards mandated by the
Dodd-Frank Wall Street Reform and Consumer Protection Act for
large bank holding companies
Federal Reserve Credit A Extensions of Credit by Federal Reserve Governs borrowing by depository institutions and others at the
Banks Federal Reserve discount window
Monetary policy and D Reserve Requirements of Depository Sets uniform requirements for all depository institutions to
reserve requirements Institutions maintain reserves either with their Federal Reserve Bank or as
cash in their vaults
Securities credit T Credit by Brokers and Dealers Governs extension of credit by securities brokers and dealers,
transactions including all members of national securities exchanges (see also
Regulations U and X)

U Credit by Banks and Persons Other Than Governs extension of credit by banks or persons other than bro-
Brokers or Dealers for the Purpose of kers or dealers to finance the purchase or the carrying of margin
Purchasing or Carrying Margin Stock securities (see also Regulations T and X)

X Borrowers of Securities Credit Applies the provisions of Regulations T and U to borrowers who
are subject to U.S. laws and who obtain credit within or outside
the United States for the purpose of purchasing securities

Note: For a list of consumer and community affairs-related regulations, see figure 7.2, “Federal consumer financial protection
laws and regulations applicable to banks,” on page 158. For a list of regulations governing the U.S. payment system, see
figure 6.1, “Federal Reserve regulations governing the payment system,” on page 143.

106 Supervising and Regulating Financial Institutions and Activities

 considering a proposal under CIBCA, the Federal Reserve must review
several factors, including the financial ability, competence, experience,
and integrity of the acquiring person or group of persons; the effect of
the transaction on competition; and the adequacy of the information
provided by the acquiring party.

Overseas Investments by U.S. Banking Organizations

U.S. banking organizations may engage in a broad range of activities
overseas. Many of the activities are conducted indirectly through Edge
Act and agreement corporation subsidiaries. Most foreign investments
involve only after-the-fact notification to the Federal Reserve, but large
and other significant investments require prior approval.

International Banking Act Proposals

The IBA, as amended by the Foreign Bank Supervision Enhancement
Act, requires foreign banks to obtain Federal Reserve approval before
establishing branches, agencies, commercial lending company subsid-
iaries, or representative offices in the United States.

An application by a foreign bank to establish such offices or subsidiar-

ies generally may be approved only if the Federal Reserve determines
that the foreign bank and any foreign-bank parents engage in banking

Box 5.3. Significant Financial Industry Reform Legislation

Throughout the Federal Reserve’s history, tive Equality Banking Act of 1987; the A few years later, Congress passed
Congress has enacted, repealed, and Financial Institutions Reform, Recovery, the Riegle-Neal Interstate Banking
amended significant banking industry and Enforcement Act of 1989; and the and Branching Efficiency Act of 1994,
laws that have dramatically changed the Federal Deposit Insurance Corpora- which significantly reduced the legal
landscape of the industry. The Federal Re- tion Improvement Act of 1991. These barriers that had restricted the ability of
serve has been instrumental in ensuring legislative initiatives restricted banking banks and bank holding companies to
that these laws are carried out. practices, limited supervisors’ discretion expand their activities across state lines.
For example, during the savings and in dealing with weak banks, imposed In 1999, Congress passed the Gramm-
loan crisis of the 1980s and 1990s, new regulatory requirements—includ- Leach-Bliley Act, which repealed certain
Congress enacted several laws to im- ing prompt corrective action (described Depression-era banking laws and
prove the condition of individual insti- above)—and strengthened supervisory permitted banks to affiliate with securi-
tutions and of the overall banking and oversight overall. ties and insurance firms within financial
thrift industries, including the Competi- holding companies.

The Federal Reserve System Purposes & Functions 107

business outside the United States and are subject to comprehensive
supervision or regulation on a consolidated basis by their home-country
supervisors. The Federal Reserve may also take into account other factors.

Public Notice of Federal Reserve Decisions

Certain decisions by the Federal Reserve that involve an acquisition by
a BHC or savings and loan holding company, a bank merger, a change
in bank control, or the establishment of a new U.S. banking presence
by a foreign bank are made known to the public by an order or an an- How do capital and
liquidity differ?
nouncement.
Capital acts as a financial
cushion to absorb
Orders state the Federal Reserve’s decision, the essential facts of the ap- unexpected losses and
generally is the difference
plication or notice, and the basis for the decision; announcements state
between all of a firm’s assets
only the decision. All orders and announcements are reported publicly and its liabilities. Liquidity
in the Board’s weekly H.2 statistical release. Information about orders is a measure of the ability
and ease with which a firm’s
and announcements is available on the Federal Reserve Board’s website,
assets can be converted to
www.federalreserve.gov. cash. To remain viable, a
financial institution must have
enough liquid assets to meet
its near-term obligations,
such as withdrawals by
depositors and short-term

Regulation: Keeping Pace with

debt obligations that are
coming due.

Innovation and Evolution

Regulation of the financial system must continuously evolve in response
to changing laws and conditions in the marketplace in order to ensure
that supervised institutions operate in a safe and sound manner.

The Federal Reserve is empowered, therefore, to issue regulations,

rules, and policy statements or other forms of supervisory guidance to
supervised institutions. Regulations can be restrictive (limiting the scope
of an institution’s activities), prescriptive (requiring institutions to take
certain actions), or permissive (authorizing institutions to engage in
certain activities).

108 Supervising and Regulating Financial Institutions and Activities

Figure 5.8. International evolutions: The Basel Capital Accords
With other federal banking agencies, the Federal Reserve drafts and finalizes rules to implement the capital adequacy
standards set by the Basel Committee. Since 1988, there have been three iterations of the Basel Capital Accords; each iteration
is phased in over a multiyear period.

Basel I Basel II Basel III

1988 2004 2009–11

• Increased capital requirements for Building on Basel I, Basel II introduced a Building on Basel II, and in the wake of the
internationally active banking three-pillar framework for assessing capital 2007–09 financial crisis, Basel III included
­organizations. adequacy: measures to
• Reduced international competitive • Pillar 1: Minimum regulatory capital • improve the quality of regulatory capital to
inequities. requirements more closely align banking include instruments that are fully able to
• Increased comparability of institutions’ organizations’ capital requirements with absorb unexpected losses, with a particular
capital positions. their underlying risks, including operational focus on common equity;
risk. • increase the minimum quantity of capital
• Introduced measures for market risk for
institutions with trading activities of • Pillar 2: Supervisory oversight requires that banking organizations are required to
$1 billion or more. supervisors to evaluate banking organiza- hold as a proportion of their risk-weighted
tions’ capital adequacy and to encourage assets and provide incentives for banking
better risk-management techniques. organizations to conserve capital; and
• Pillar 3: Market discipline calls for • require global systemically important
enhanced public disclosure of banking U.S. and foreign banks to hold additional
organizations’ risk exposures. capital based on measures of their systemic
importance.

New regulations may be added, or existing ones revised, in response to

new laws enacted by Congress or because of evolving conditions in the
financial marketplace. If Congress adopts a legislative change—perhaps
in response to a past crisis or problem, or to help adapt the nation’s
banking laws to respond to changes in the marketplace—the Federal
Reserve might issue regulations or rules to ensure that institutions
comply with the new law (see figure 5.7 for a list of Federal Reserve
regulations and the topics they address).

Evolutions under the Dodd-Frank Act

In 2010, for example, the enactment of the Dodd-Frank Act—the most
comprehensive statutory effort to reshape the financial industry since
the Great Depression—ushered in many regulatory reforms that help
strengthen the financial system and reduce the likelihood of future
financial crises. The act calls for consolidated supervision of all nonbank
financial companies supervised by the Federal Reserve; requires that

The Federal Reserve System Purposes & Functions 109

such nonbank financial companies, large BHCs, and foreign banking or-
ganizations be subject to enhanced prudential standards; and provides
for the strengthened supervision of systemically important payment,
settlement, and clearing utilities.

The Dodd-Frank Act also required the Federal Reserve and other federal
regulatory authorities to translate the law’s provisions into workable
Financial disclosures by
rules, regulations, and guidelines that will achieve the necessary reform
state member banks
to ensure the financial system’s stability and sustainability.
State member banks that
issue securities registered
Since 2010, the Federal Reserve, often in cooperation with other regula- under the Securities
Exchange Act of 1934 must
tors, has finalized or proposed dozens of new rules to implement provi-
disclose certain information
sions of the Dodd-Frank Act. These rules touched on topics ranging from of interest to investors,
residential mortgages and credit scores to risk-based capital requirements including annual and
quarterly financial reports
and risk-management standards for certain FMUs designated as systemi-
and proxy statements.
cally important. By statute, the Federal
Reserve administers these
requirements and has
Promoting Capital Adequacy and Planning adopted financial disclosure
regulations for state member
A key goal of banking regulation is to ensure that banks maintain suf- banks that are substantially
ficient capital to absorb unexpected losses. similar to the Securities and
Exchange Commission’s
regulations for other public
The Basel Accords: Global Standards for Capital Adequacy
companies.
Because of the interconnectedness of the global banking system, the
United States is a participating member in the Basel Committee on
Banking Supervision, the primary global standard-setter for the pruden-
tial regulation of banks. The Basel Committee’s mandate is to strength-
en the regulation, supervision, and practices of banks worldwide for
the purpose of enhancing global financial stability.

Members of the Basel Committee work together to formulate broad

supervisory standards and guidelines and to recommend best practices
in the expectation that those individual national authorities will take
steps to implement them in their respective jurisdictions, as appropriate
(see figure 5.8). Basel Committee members strive to ensure that banks

110 Supervising and Regulating Financial Institutions and Activities

 are held to consistently high standards and are competing on a level
playing field.

Reforms resulting from such cooperative efforts generally aim to

address (1) weaknesses or gaps in bank-level regulation, in order to
promote resilience of individual banking institutions during periods of
stress, (2) systemwide risks that can build up across the banking sector,
and (3) the pro-cyclical amplification of these systemwide risks over time.

More recently, the Basel III reforms were designed in part to address
weaknesses in the regulatory capital framework for internationally ac-
tive banking organizations that became apparent during the 2007–09
financial crisis. Basel III includes changes that increase the minimum
risk-based capital requirements, introduce a minimum common equity
tier 1 capital ratio and a minimum international leverage ratio, and
establish a capital conservation buffer designed to limit capital distribu-
tions and certain discretionary bonus payments if a banking organiza-
tion’s risk-based capital ratios fall below certain levels.

Capital Requirements under the Dodd-Frank Act

The Dodd-Frank Act requires the Federal Reserve, as well as the other
federal banking agencies, to establish minimum leverage and risk-based
capital requirements on a consolidated basis for
• insured depository institutions,
• BHCs and savings and loan holding companies that are organized
in the United States (including any such company that is owned or
controlled by a foreign organization), and
• nonbank financial companies supervised by the Federal Reserve.

The act further requires that the minimum leverage and risk-based
capital standards established for these institutions cannot be less than
the “generally applicable” capital requirements that apply to insured
depository institutions, regardless of their total consolidated assets
or foreign financial exposure. Thus, the generally applicable capital
requirements serve as a floor for a banking organization’s capital ratios.

The Federal Reserve System Purposes & Functions 111

The minimum capital requirements that are determined using the stan-
dardized approach for calculating risk-weighted assets under the agen-
cies’ revised regulatory capital framework are the generally applicable
capital requirements.

Capital Planning, Stress Testing, and Capital Distributions

Since the 2007–09 financial crisis, the Federal Reserve has worked to
ensure that large, complex financial institutions strengthen their capital
positions. One aspect of this has been working with firms to bolster
their internal processes for assessing capital needs.

Since early 2011, the Federal Reserve has developed and implemented
a regular supervisory review of the capital plans of 30 of the largest
banking organizations, including in the review any plans the institutions
had for increasing dividends or buying back common stock. Through its
capital-plan rule, the Federal Reserve requires each U.S. BHC with over
$50 billion in total consolidated assets to submit a capital plan annually
for review. The Federal Reserve reviews these plans to evaluate institu-
tions’ capital adequacy, internal capital adequacy processes, and capital
distribution plans. A key objective of this evaluation, officially known
as the Comprehensive Capital Analysis and Review, is to ensure firms’
capital processes are sufficiently comprehensive and forward-looking.

Part of CCAR is the routine use of stress testing by regulated banking

organizations and the Federal Reserve to assess whether an institution
will continue to hold sufficient capital to remain a viable financial
intermediary even after absorbing the increased losses and reduced
earnings associated with stressful economic conditions. If a company
is unable to meet its capital requirements under stress tests, or if the
company does not have strong processes for managing its capital and
evaluating its risks, the Federal Reserve places restrictions on the com-
pany’s dividends and stock repurchases.

CCAR incorporates aspects of the supervisory and company-run stress

tests conducted under the Federal Reserve’s Dodd-Frank Act stress test

112 Supervising and Regulating Financial Institutions and Activities

 rules. Under the stress test rules, the Federal Reserve conducts annual
supervisory stress tests on all BHCs with $50 billion or more in assets,
and requires these companies, along with all other Federal Reserve-
regulated companies with over $10 billion in assets, to conduct their
own internal stress tests. Each year, the Federal Reserve and the com-
panies disclose information about the results of the CCAR and the
Dodd-Frank Act stress tests in order to provide valuable information to
the public and to promote market discipline.

Liquidity Standards
While adequate capital is essential to the safety and soundness of
financial institutions and the financial system as a whole, adequate
liquidity is also vitally important. Capital adequacy and liquidity are
interdependent, particularly in times of stress.

For example, an institution that is perceived to be undercapitalized may

have difficulty borrowing the money it needs to fund itself, while an
institution that is illiquid may be in danger of failing regardless of its
capital level.

The 2007–09 financial crisis highlighted the importance of adequate

liquidity risk management. Many solvent financial institutions experi-
enced significant financial stress during the crisis because they had not
managed liquidity in a prudent manner. For example, some institutions
had relied excessively on volatile wholesale short-term funding sources
and were overly exposed when those funding sources were disrupted.

To address such scenarios, the Federal Reserve and other federal

banking agencies issued in 2010 joint guidance on sound practices
for managing funding and liquidity risks. This guidance re-emphasizes
the importance of sound liquidity-risk management that appropriately
identifies, measures, monitors, and controls funding and liquidity risks.
The guidance also highlights the importance of cash-flow projections,
diversified funding sources, liquidity stress testing, a cushion of liquid
assets, and a formal, well-developed contingency funding plan as pri-
mary tools for managing liquidity risk.

The Federal Reserve System Purposes & Functions 113

As a result of the Dodd-Frank Act, the Federal Reserve also established
heightened prudential standards for large BHCs, as well as foreign
banking organizations with significant U.S. operations it supervises.
Regulation YY prescribes heightened liquidity requirements and sub-
jects these institutions to qualitative liquidity risk-management stan-
dards generally based on the interagency liquidity risk-management
guidance issued in 2010.

These standards would, furthermore, require these institutions to

maintain a minimum liquidity buffer based on the institutions’ internal
30-day liquidity stress tests. The standards also establish specific related
responsibilities for boards of directors and risk committees, require
firms to establish specific internal quantitative limits to manage liquidity
risk, and impose specific monitoring requirements.

In 2014, the federal banking agencies created a standardized minimum

liquidity coverage ratio, or LCR, for large and internationally active
firms. Regulation WW requires large and internationally active firms
meeting certain criteria to hold high quality, liquid assets that can be
converted easily and quickly into cash. The ratio of the firm’s liquid
assets to its projected net cash outflow is its LCR. To review large firm
practices and risk areas not entirely captured in the LCR, the Federal
Reserve also conducts its annual Comprehensive Liquidity Analysis and
Review, which also serves to evaluate large firms’ liquidity positions and
risk-management practices.

Margin Requirements: Regulating the

Extension of Credit for Securities Purchases
The Securities Exchange Act of 1934 requires the Federal Reserve to
regulate the extension of credit used in connection with the purchase of
securities.

Through its regulations, the Federal Reserve establishes the minimum

amount the buyer must put forward when purchasing a security. This
minimum amount is known as the margin requirement. Regulation T

114 Supervising and Regulating Financial Institutions and Activities

 limits the amount of credit that may be provided by securities brokers
and dealers; meanwhile, Regulation U limits the amount of securities
credit extended by banks and other lenders.

These regulations generally apply to credit-financed purchases of securi-

ties traded on U.S. securities exchanges and when the credit is collater-
alized by such securities. In addition, Regulation X prohibits borrowers
who are subject to U.S. laws from obtaining such credit overseas on
terms more favorable than could be obtained from a domestic lender.

Compliance with the Federal Reserve’s margin regulations is enforced by

several federal regulatory agencies. The federal agencies that regulate
financial institutions check for compliance with the Federal Reserve’s
Regulation U during examinations. The Federal Reserve checks for Regu-
lation U compliance by securities credit lenders not otherwise regulated
by another federal agency. Compliance with Regulation T is verified
during examinations of broker-dealers by the securities industry’s self-
regulatory organizations under the general oversight of the SEC.

Supervision and Regulation

Letters and Guidance
Besides issuing regulations, the Federal Reserve also develops public
supervision and regulation (or SR) letters, and other policy statements
and guidance for examiners and financial institutions.

The Federal Reserve often works closely with other supervisors in craft-
ing these policy statements and guidance. For example, it participates
in supervisory and regulatory forums, provides support for the work
of the FFIEC, and participates in international forums such as the Basel
Committee on Banking Supervision and the Financial Stability Board.

One example of interagency policy development was the 2013 guid-

ance on troubled debt restructurings. This guidance addresses certain
issues related to the accounting treatment, and regulatory credit risk
grade or classification of commercial and residential real estate loans
that have undergone troubled debt restructurings. In addition, the

The Federal Reserve System Purposes & Functions 115

guidance notes that the agencies encourage financial institutions to
work constructively with borrowers and view prudent modifications as
positive actions that can mitigate an institution’s credit risk.

Promoting Market Discipline: Public

Disclosure and Accounting Policy
Requirements
Public disclosure helps market observers and participants assess the
strength of individual financial institutions, and the Federal Reserve’s
role in this regard is a critical element in promoting market discipline.
Market discipline, likewise, is an important complement to supervision.

Improved safety and soundness is often realized by heightened market

discipline achieved through improved financial reporting and disclosure
requirements. Such requirements can serve both institution-specific and
macroprudential purposes.

Market discipline can help to restrain imprudent risk-taking by limiting

funding of institutions perceived to be relatively risky, and in this way
can complement the efforts of supervisors.

Accordingly, the Federal Reserve plays a significant role in promoting

sound accounting policies and meaningful public disclosure by finan-
cial institutions. Through its supervision and regulation functions, the
Federal Reserve seeks to strengthen the accounting, audit, and control
standards related to financial institutions.

The Federal Deposit Insurance Corporation Improvement Act of 1991

emphasized the importance of such standards for financial institu-
tions. In addition, the Sarbanes-Oxley Act of 2002 sought to improve

116 Supervising and Regulating Financial Institutions and Activities

 the accuracy and reliability of corporate disclosures and to detect and
prevent significant weaknesses in internal control over financial report-
ing (including the detection of fraud). The Federal Reserve has issued
guidance to its supervised institutions to address the requirements
under these statutory mandates.

The Federal Reserve also is involved in the development of international

and domestic accounting and financial disclosure standards. In its
mission to improve financial accounting and reporting, the Financial Ac-
counting Standards Board (FASB) has focused on making improvements
to simplify the standard-setting process and guidance. Additionally,
the FASB and the International Accounting Standards Board continue
to work toward converging major accounting standards through joint
projects. The Federal Reserve actively participates in the accounting
standard-setting process.

The Federal Reserve System Purposes & Functions 117

 Function Fostering Payment
and Settlement System
Safety and Efficiency
The Federal Reserve works to promote a safe,
efficient, and accessible system for U.S. dollar
transactions.

6
Overview of Key Federal Reserve
Payment System Functions . . . . . . . . . . . . . . . . . . . . . . . . . . 120

Providing Services to Banks and the

Federal Government . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121

The U.S. Payment System Today

and Reserve Bank Services . . . . . . . . . . . . . . . . . . . . . . . . . . 122

Regulating and Supervising the

Payment System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142

Providing Vital Banking

System Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146

Exploring and Implementing

Payment System Improvements . . . . . . . . . . . . . . . . . . . . . . 148

118 Fostering Payment and Settlement System Safety and Efficiency

 A    n efficient, effective, and safe U.S. and global payment and settle-
ment system is vital to the U.S. economy, and the Federal Reserve plays
an important role in helping maintain that system’s integrity.

The U.S. dollar payment and settlement system is composed of payment

instruments and methods, systems, and institutions that have changed
over time. The Federal Reserve provides currency and operates some ele-
ments of this system.

This system facilitates financial transactions and purchases of goods and

services and the attendant movement of money at all levels of the U.S.
economy—on behalf of individuals and institutions, buyers and sellers,
consumers and businesses, investors and securities issuers—and sup-
ports interactions between the U.S. economy and others around the
world. The importance of the payment system and a sound currency in
our daily lives and interactions makes its safe and proper functioning es-
sential to the health of the U.S. financial system and overall economy.

Figure 6.1. The Federal Reserve’s role in everyday transactions

Whether you’re paying your babysitter, shopping for groceries, or getting your paycheck, you’re operating within the payment
system. The Federal Reserve plays an important role in maintaining that system’s integrity.

Business with
payroll payment Employees
Babysitter
Parent with cash AUTOMATED
CURRENCY CLEARINGHOUSE (ACH)
The Federal Reserve Board issues paper The Federal Reserve plays a key role in
currency (Federal Reserve notes). Federal processing small-value electronic credit or
Reserve Banks ensure adequate supply of debit transfers, such as direct deposits of
paper currency around the country. payroll or recurring bill payments.

Customer A’s Customer B’s

bank bank

Homeowner Plumber WHOLESALE PAYMENTS

with check CHECKS Services like the Federal Reserve’s Fedwire
Federal Reserve Banks collect checks Funds and Fedwire Securities services help
deposited by banks and return unpaid to process large-value financial transactions
checks to the bank on which among businesses, banks, and individuals.
the check is drawn.

The Federal Reserve System Purposes & Functions 119

Overview of Key Federal Reserve Major Events
in the History
Payment System Functions of the Federal
Reserve’s Role in
The Federal Reserve performs several key functions to maintain the the U.S. Payment
integrity of the payment system. These functions help keep cash, check, System
and electronic transactions moving reliably through the U.S. economy
The Federal Reserve System
on behalf of consumers, businesses, and others participating in the
was created by Congress to
economy. They include eliminate the severe financial
• providing services to depository institutions and the U.S. federal crises that had periodically
swept the nation by the early
government, 1900s, particularly of the sort
• regulating certain aspects of the payment system and supervising that occurred in 1907.

certain financial market utilities,

• providing intraday liquidity to payment system participants, and
1907
Many banks and
• analyzing the system to help identify and implement improvements. clearinghouses refuse to clear
checks drawn on certain
other banks, leading to the
All these functions underpin U.S. financial markets and private-sector failure of otherwise solvent
banks.
clearing, payment, and settlement arrangements; support the imple-
mentation of monetary policy; and contribute to the overall stability of
the U.S. financial system and economy. 1913
Congress creates the Federal
Reserve System, giving it
The Federal Reserve’s Board of Governors in Washington, D.C., and the the authority to establish a
12 Federal Reserve Banks located around the nation have distinct but nationwide check-clearing
system to eliminate system
complementary responsibilities with regard to the payment system. inefficiencies and inequities.

In general, the Board is responsible for developing regulations and

supervisory policies for elements of the payment system that fall within
1918
The Reserve Banks establish
the Federal Reserve’s jurisdiction. The Reserve Banks help supervise Fedwire, the world’s first wire
entities under the Federal Reserve’s jurisdiction pursuant to these regu- transfer system.

lations and policies.

1974
The Reserve Banks take the lead in providing accounts and payment The Reserve Banks begin
services to depository institutions, the federal government, and certain operating their automated
clearinghouse service.

120 Fostering Payment and Settlement System Safety and Efficiency

 other entities (such as government-sponsored enterprises and interna-
tional organizations), subject to oversight by the Board. The Reserve
Banks also provide—subject to Board policies—intraday and overnight
credit. Finally, both the Board and the Reserve Banks engage in pay-
ment system research and act as catalysts to improve the safety and
efficiency of the payment system.

1980
The Monetary Control
Act reaffirms the Federal
Reserve’s role in providing
Providing Services to Banks
payment services.
and the Federal Government
2003 The 12 Federal Reserve Banks and their various branches provide a
The Check Clearing for the range of payment and settlement services to the banking industry and
21st Century Act enables
the transformation of the
the federal government. The Banks
check-collection system
• maintain accounts for depository institutions,
from a paper-based to
a virtually all-electronic • transfer funds electronically,
system. The Board drafted
this law, collaborating with • collect checks,
various payment system
stakeholders, and the • distribute and receive currency and coin, and
Reserve Banks provided
• settle payments and eligible securities transactions by debiting and
services to accelerate this
transformation. crediting the appropriate accounts at the Reserve Banks.

2010 The Federal Reserve Banks also act as fiscal agents of the U.S. govern-
The Dodd-Frank Wall Street ment and certain other entities. In other words, they act as the “gov-
Reform and Consumer ernment’s bank” and maintain the U.S. Treasury’s operating cash ac-
Protection Act emphasizes
the Federal Reserve’s role in
count; pay Treasury checks and process electronic payments; and issue,
promoting financial stability transfer, and redeem U.S. government securities.
and mitigating systemic
risk in the financial system
and expands its supervision The Federal Reserve has provided payment services to the banking
of systemically important
industry since shortly after the Federal Reserve Banks were established
financial market utilities
and payment, clearing, and in 1914. At the time, these services were for the most part (1) available
settlement activities. only to banks that were members of the Federal Reserve System and
(2) provided without explicit charge.

The Federal Reserve System Purposes & Functions 121

Monetary Control Act of 1980
Congress reaffirmed and expanded the Federal Reserve’s role as a ser-
Federal Reserve Bank
vice provider with the enactment of the Monetary Control Act of 1980 service fees
(MCA), which gave all depository institutions access to the same pricing Under the Monetary Control
for the Federal Reserve’s payment services and required the Federal Act and the Board’s Principles
for Pricing Federal Reserve
Reserve to price specific types of services to recover fully the costs of
Bank Services, the Board
providing these services over the long run. is required to set fees for
Reserve Bank services to
recover the actual and
The MCA also encourages competition between the Federal Reserve
imputed costs of providing
Banks and private-sector providers of payment services by requiring the these services to the banking
Reserve Banks to recover not only their actual costs of providing priced industry. The services include
check clearing and collection,
services, but also the costs that would be incurred and profits that
wire transfer of funds,
would be earned if a private firm had provided these services. automated clearinghouse,
net settlement, securities
services, and new services
The Reserve Banks offer certain payment services in competition with
the Reserve Banks may
the private sector. The Board has adopted clear policies to avoid con- offer. For the most up-to-
flicts of interest within Reserve Banks that could arise from providing date schedule of fees, go
to www.frbservices.org/
priced payment services and carrying out monetary, supervisory, and
servicefees/index.html.
lending responsibilities.

The U.S. Payment System Today

and Reserve Bank Services
The U.S. payment system has evolved significantly since the Federal Re-
serve was established in 1913. At that time, cash and checks were the
predominant means of payment. In 2013, 124 billion noncash transac-
tions valued at $1,446 trillion passed through the U.S. payment system.
Measured by annual aggregate value, wire transfers, automated
clearinghouse (ACH) payments, and checks were the leading payment
methods in the United States. Measured by annual aggregate number,
however, debit cards, credit cards, and ACH payments were the leading

122 Fostering Payment and Settlement System Safety and Efficiency

payment methods (figure 6.2). Today’s prominence of electronic pay-
ments reflects a long-term shift away from the use of checks, particu-
larly in transactions between consumers and businesses.

The Federal Reserve’s noncash payment and settlement services are

typically categorized as retail or wholesale payment services. The check
and ACH services are generally called retail payment services, and the
Fedwire Funds and Securities Services and the National Settlement Ser-
vice (NSS) are generally called wholesale services. These names reflect
the lower typical value of the retail services. However, lower-value Fed-
wire transactions and higher-value check or ACH transactions are also
used by individuals and businesses, respectively, to meet their payment
needs.

In addition to providing noncash payment services, the Federal Reserve

also ensures that the cash (currency and coin) in circulation is sufficient

Figure 6.2. Total noncash payments (Federal Reserve and private sector), 2014

Wire transfers (1,477) Wire transfers (.31)

ACH (176.6) Checks (17.0)

Checks (19.8) ACH (24.1)

Credit cards* (2.8) Credit cards* (30.3)

Debit cards* (2.5) Debit cards* (67.2)

Annual value of payments Annual number of payments

(trillions of U.S. dollars) (billions)

Note: All figures include on-us transactions.

ACH Automated clearinghouse.
Source: Committee on Payments and Market Infrastructures (formerly the Committee on Payment and Settlement Systems)
Redbook 2015 except those marked with an asterisk (*), which are projections based on the Redbook 2014. Both are available
on the Bank for International Settlements website at www.bis.org/list/cpss/tid_57/index.htm.

The Federal Reserve System Purposes & Functions 123

to meet the public’s demand and that depository institutions have ready
What is the automated
access to Reserve Bank cash services. clearinghouse (ACH)?
The ACH is a nationwide
electronic network,
developed jointly by the
Retail Payment Services private sector and the Federal
Reserve, for the exchange of
Guided by public and private cooperation, the U.S. payment system
electronic files of payment
has evolved greatly to better serve all participants in the economy. In- instructions among financial
novations and reforms have ushered in greater convenience in many institutions, typically on
behalf of customers. ACH
ways, not least of which in the way individuals and institutions conduct
transactions are payment
transactions between and among themselves. instructions to either debit or
credit an originator’s deposit
Check Service and Its Origins account at an originating
depository institution. The
Perhaps no aspect of the payment system illustrates its evolution better ACH was developed in
than the nation’s check-clearing system. The Federal Reserve plays a key the early 1970s as a more
efficient alternative to paper
role in this system, serving as a major provider of paper and electronic
checks.
services to depository institutions. In 2014, it collected nearly 6 billion
checks, worth more than $6 trillion.

In the early 1900s—before the creation of the Federal Reserve System—

the nation’s check system was paper-based and used primarily for trans-
What are “clearing” and
actions between banks (interbank transactions) and between businesses.
“settlement”?
The check-collection system at that time was quite inefficient; for ex-
Clearing is the transfer and
ample, banks commonly routed checks circuitously to avoid presentment confirmation of information
fees, which banks receiving checks imposed on banks presenting checks between the payer’s
financial institution and
for payment. Such routing resulted in extensive delays and inefficiencies
payee’s financial institution.
in the check-collection system. Settlement is the actual
transfer of funds between the
payer’s financial institution
When the Federal Reserve Banks were established in 1914, Congress
and the payee’s financial
expected them to improve the efficiency of the check-collection system, institution.
which would benefit the depositors of checks by speeding up the
process and eliminating the practice of paying checks at less than their
full face value. This practice of not remitting payment for checks at face
value was called “nonpar banking.” In 1917, Congress amended the
Federal Reserve Act to prohibit banks from charging the Reserve Banks
presentment fees and to authorize nonmember banks as well as mem-
ber banks to collect checks through the Federal Reserve System.

124 Fostering Payment and Settlement System Safety and Efficiency

 Since then, the Federal Reserve has worked with the private sector to
improve the efficiency and cost-effectiveness of the check-collection
system. In its early years, the Federal Reserve took a number of steps to
reduce nonpar banking. The prevalence of nonpar banking was substan-
What is check truncation?
tially reduced by the 1920s but did not totally disappear in this country
Check truncation is the
practice of converting a until 1980.
paper check to electronic
information, which is
In the 1970s, check volume increased significantly, so the Federal
forwarded to the bank on
which it was written. Reserve established additional check-processing offices, called regional
check-processing centers, in new locations throughout the country
to improve further the efficiency of check clearing. In the 1980s, the
Reserve Banks began to offer expanded return check services based
on the new expeditious return rules adopted by the Board pursuant to
the Expedited Funds Availability Act. In expanding their return check

Figure 6.3. What are all those numbers on your checks?

Public- and private-sector coordination and cooperation have led to dramatic improvements in the check-collection process,
resulting in more efficient payment and settlement for individuals and institutions.

Your Name
1234 Your Street
Anywhere, US 10112 Date

PAY TO THE
ORDER OF
$

DOLLARS
Your Bank
5678 Bank Street
Anywhere, US 10112

MEMO

Bank routing number Account number MICR

The Federal Reserve and the banking Individual account In the 1950s, the magnetic ink character (MICR) system
industry developed the bank routing numbers are for encoding pertinent data on checks was developed
number system to facilitate the assigned to each so that the data could be read electronically. The MICR
sorting, bundling, and shipment of account. system contributed significantly to the automation of
paper checks. The routing number check processing. In the 1960s, the Federal Reserve Banks
identifies the bank on which a check began to require MICR-encoding of all checks deposited
is drawn. with them.

The Federal Reserve System Purposes & Functions 125

services, the Reserve Banks played a major role in speeding the return
of unpaid checks to banks of first deposit—banks in which checks are
initially deposited for collection.

Electronic Check Processing

The Federal Reserve served as a catalyst for the transition of the U.S.
economy to today’s electronic check-processing arrangements (includ-
ing check truncation). As a general matter, the faster and more resilient
electronic check-clearing and check-return methods have markedly im-
proved the efficiency of the nation’s payment system while at the same
time proving less costly and less error prone.

In the 1990s, the Reserve Banks began offering electronic check pre-
sentment services to banks. By the early 2000s, about 20 to 25 percent
of the checks the Reserve Banks handled were delivered electronically
to paying banks through these services. Overall, most banks continued
to simply demand that original checks be presented for payment. As
a result, the nation’s check-clearing system remained dependent on
paper and vulnerable to disruptions in transportation networks.

In 2003, Congress passed the Check Clearing for the 21st Century Act
(Check 21 Act), which facilitated electronic check processing by creat-
ing a new type of paper document, called a substitute check, which is
the legal equivalent of the original check. The Check 21 Act enables
banks to remove original paper checks from the check-collection system
(called check truncation) and send digital images of checks electroni-
cally to banks with which they have agreements to do so, and send
substitute checks to banks with which they do not. By creating wide-
spread opportunities for the truncation of checks and associated cost
savings, the act has resulted in the nation’s interbank check-collection
processes becoming almost entirely electronic.

The banking system and the Federal Reserve itself have been able to
almost completely eliminate the costly, dedicated air and ground trans-
portation networks that were once used to deliver checks around the
country on a daily basis. Further, banks’ transition to electronic check

126 Fostering Payment and Settlement System Safety and Efficiency

 processing has enabled them to offer their customers new products
and improved service.

Check volume in the United States peaked in the mid-1990s, when

about 50 billion checks were written annually. Since that time, check
volume has declined significantly as electronic forms of payment, such
as debit cards, credit cards, and ACH payments, have become increas-
ingly popular. In response to the growth in electronic check processing
and the reduced number of checks being written, the Reserve Banks
substantially reduced their costs and physical infrastructure associated
with processing checks. The number of Reserve Bank offices processing
paper checks declined from 45 in 2003 to just 1 beginning in 2010.

Figure 6.4. Checks collected by the Federal Reserve, selected years, 1920–2014
The number of checks written has been declining as individuals and institutions rely increasingly on electronic means to
execute transactions.

18,598
Millions of items
16,994

15,716

7,712
7,158
6,691
6,402
5,988
5,742

3,419

1,955
1,184
905
424

1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2014

For more information about the number and value of checks collected, visit the Payment Systems section of the Federal
Reserve Board’s website, www.federalreserve.gov.

The Federal Reserve System Purposes & Functions 127

Automated Clearinghouse Service
The ACH is a nationwide electronic payment system, developed jointly
by the private sector and the Federal Reserve in the early 1970s as a
more efficient alternative to checks. At that time, it seemed that the
increasing volume of paper checks used by businesses and consumers
would eventually exceed the ability of the existing equipment to pro-
cess and sort the checks efficiently.

How ACH Works

The ACH has grown into a major nationwide electronic payment mecha-
nism that processes files of electronic funds transfers (payments). In
general, ACH transactions are either credit or debit transfers. In an ACH
credit transfer, an individual, corporation, or other entity (originator)
“pushes” or sends funds from its account to that of the receiver. In a
debit transfer, the receiver authorizes an originator to “pull” funds from
the receiver’s account.

The Reserve Banks and the Electronic Payments Network, a private

organization, are currently the two national ACH operators. As an ACH
operator, the Reserve Banks receive files of payments from originating
institutions, edit and sort the payments, deliver the payments to receiv-
ing institutions, and settle the payments by crediting and debiting the
institutions’ accounts. Unlike Fedwire transfers, which are processed
and settled immediately, ACH transactions are value-dated—that is, the
originator of the ACH transaction includes the settlement date in the
payment instructions when they originate the transaction.

In the past, the United States had several regional ACH systems, but
over time, the industry consolidated to the current structure of two na-
tional ACH systems. In 2014, the Federal Reserve processed more than
11.6 billion commercial ACH payments, worth approximately $19.9
trillion, and more than 1.5 billion government ACH payments, worth ap-
proximately $4.9 trillion.

The ACH was originally designed to help automate recurring payments,

such as government benefit payments, payroll payments, and consumer

128 Fostering Payment and Settlement System Safety and Efficiency

 mortgage and utility payments. Much of the recent growth in ACH
payments has resulted from one-time transactions such as consumer
payments initiated over the Internet or telephone.

The Federal Reserve’s Role in ACH Development

The Reserve Banks became an ACH operator in large part because
of the Reserve Banks’ role as fiscal agents of the U.S. Treasury and
because of the synergies between the ACH and the Federal Reserve’s
then-existing check service. The U.S. Treasury, earlier than most busi-
nesses, embraced the use of the ACH as a potentially more efficient
way to make many of the government’s payments, particularly payrolls
for military and civilian workers and benefit payments such as Social
Security. (Until the mid-1980s, most ACH volume was originated by the
federal government.) The combination of commercial and government
ACH payments created economies of scale earlier than might other-
wise have been the case, allowing the ACH to become a broadly used
national service.

Initially, the ACH system relied on magnetic tapes and paper listings to
exchange ACH files. Their use required physical transport of tapes be-
tween the participants in the ACH system, which made use of the then-
existing Reserve Bank national check-transportation infrastructure (e.g.,
planes and trucks). In the mid-1990s, the Federal Reserve mandated
that all institutions’ ACH payment files be deposited electronically and
all output files be delivered electronically. That is, all institutions dealing
with the Federal Reserve directly were required to have an electronic
connection to participate in the ACH.

Figure 6.5. Examples of automated clearinghouse transfers

Automated clearinghouse (ACH) transfers can be categorized as either “credit transfers” or “debit transfers” based on the
type of instruction sent by the originator of the transfer.

Credit transfer Debit transfer

• Payroll direct deposits • Direct debits of recurring consumer bills, such as mortgages, utility
• Government benefit payments, such as Social Security benefits payments, and insurance premiums

• Corporate payments to contractors and vendors • Checks converted by merchants to ACH debits
• One-time payments authorized over the Internet or telephone

The Federal Reserve System Purposes & Functions 129

Figure 6.6. Commercial automated clearinghouse transactions processed by
the Federal Reserve, 1989–2014
In less than 25 years, the value of commercial automated clearinghouse transactions processed by the Federal Reserve has
more than quadrupled.

19,689 19,891
Billions of dollars 19,294

17,802
16,941
15,663
14,547
13,952 15, 419
13,135 14,547
12,707
11,620
10,862 12,544 12,802
10,388
9,129
8,288
7,817
7,094
6,531 6,455
5,549
4,174
3,840

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013

Source: Commercial automated clearinghouse transactions processed by the Federal Reserve—annual data (available in the
Payment Systems section of the Federal Reserve Board’s website, www.federalreserve.gov).

To provide a more cost-effective mechanism for cross-border payments,

the Reserve Banks launched their first commercial international ACH
service with Canada in 2001. The Reserve Banks have since established
“FedGlobal” international ACH services to Europe and Latin America.

Wholesale Payment Services

Wholesale payments, such as those related to large commercial loans
and transactions involving real estate, securities, and money markets,
tend to be small in number and large in value, and typically support
domestic and international commercial and financial activities. The

130 Fostering Payment and Settlement System Safety and Efficiency

 Reserve Banks operate services designed to support these complex,
high-value transactions.

Fedwire Funds Service

The Fedwire Funds Service is a real-time gross settlement (RTGS) system
through which participants are able to initiate electronic funds transfers
that are processed individually in real time as the funds transfer instruc-
tions are received by the Reserve Banks. Once processed, Fedwire Funds
transfers are final and irrevocable.

Established in 1918, Fedwire Funds was the world’s first RTGS system. It
initially used Morse code to communicate payment instructions via tele-
graph lines. Today, Fedwire Funds relies on secure, sophisticated propri-
etary data communications and data processing systems to ensure that
each transfer is authorized by the sender and not altered while under
the control of a Reserve Bank.

Participants—including depository institutions and other eligible finan-

cial institutions—use the Fedwire Funds Service to handle large-value,
time-critical payments, such as settling interbank purchases and sales of
federal funds; purchasing, selling, or financing securities transactions;
and disbursing or repaying large loans. Participants also use the Fedwire
Funds Service to make smaller-value funds transfers requiring immedi-
ate settlement, to make business-to-business remittance payments, and
to complete the U.S. dollar leg of international transactions. Fedwire
Funds transfers are settled individually by transferring balances held at
Reserve Banks from the sending bank’s account to the receiving bank’s
account.

As financial markets have become more global in scope, the operat-

ing hours of the Fedwire Funds Service have expanded to increase the
amount of overlap with the hours of foreign markets. Fedwire Funds
now opens at 9:00 p.m. eastern time (ET) on the night before a busi-
ness day and closes at 6:30 p.m. ET on the business day. For example,
processing on a Monday begins at 9:00 p.m. ET on Sunday and ends

The Federal Reserve System Purposes & Functions 131

at 6:30 p.m. ET on Monday. In 2014, participants used the service to
make 135 million transfers worth more than $884 trillion.

Fedwire Securities Service

The Fedwire Securities Service is used by depository institutions and
others with a Reserve Bank account to hold, maintain, and transfer se-
curities issued by the U.S. Treasury and other federal agencies, govern-
ment-sponsored enterprises, and certain international organizations,
such as the World Bank. Participants use the Fedwire Securities Service
to issue and redeem securities, to transfer securities to settle second-
ary market trades, to move collateral used to secure obligations, and to
facilitate repurchase agreement (repo) transactions. Securities are kept
in the form of electronic records held in custody accounts.

Figure 6.7. Electronic payments processed by Fedwire Funds, selected years, 1920–2014
Fedwire Funds is used by depository institutions and other financial institutions to make large-value, time-critical payments.

Billions of dollars 884,552

713,310

663,838

608,326

599,200

379,756

199,067

78,595

199 92 509 2,428 12,332

31

1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2014

For more information about the number and value of transactions processed through the Federal Reserve’s Fedwire Funds
Service, visit the Payment Systems section of the Federal Reserve Board’s website, www.federalreserve.gov.

132 Fostering Payment and Settlement System Safety and Efficiency

 Until the late 1960s, U.S. government securities were only available in
paper form. As securities volumes grew, banks experienced paperwork
backlogs and errors. To improve market efficiency and reduce risk,
between 1965 and 1967, the Treasury began issuing securities in elec-
tronic form and the Federal Reserve implemented computer systems to
record, service, and transfer them.

The Fedwire Securities Service operates Monday to Friday from 8:30

a.m. to 3:30 p.m. ET, though participants can reposition securities held
in their accounts until 7:00 p.m. ET. In 2014, participants used the
service to initiate more than 17 million securities transfers, worth more
than $287 trillion.

Figure 6.8. Securities transfers processed by Fedwire Securities Service, selected years,
1970–2014
Financial institutions and other parties use this service to hold, maintain, and transfer securities issued by the U.S. Treasury and
other federal agencies, government-sponsored enterprises, and certain international organizations, such as the World Bank.

320,124
Billions of dollars
295,186

291,824
284,401 287,104

188,133

99,861

13,354
258

1970 1980 1990 2000 2010 2014

For more information about the number and value of transactions processed through the Federal Reserve’s Fedwire Securities
Service, visit the Payment Systems section of the Federal Reserve Board’s website, www.federalreserve.gov.

The Federal Reserve System Purposes & Functions 133

National Settlement Service
The Federal Reserve’s National Settlement Service (NSS) is used by
participants in multilateral clearing arrangements to settle transactions
on a multilateral basis through designated master accounts held at the
Federal Reserve Banks. Approximately 17 NSS arrangements are cur-
rently in use by financial market utilities, check clearinghouse associa-
tions, and other entities.

Using an automated mechanism, an agent for a multilateral clearing ar-

rangement submits a settlement file to a Reserve Bank. The settlement
file contains a list of the debit or credit positions of the settling deposi-
tory institutions in the arrangement that are to be settled.

The Reserve Bank first processes each debit individually, crediting those
funds to a settlement account on its books. Once the debits have been
processed, the Reserve Bank transfers funds from the settlement account
to the accounts of the participants with credit positions. NSS reduces
settlement risk for clearing arrangements because the funds transferred
are final and irrevocable when the debits and credits are posted.

NSS is open Monday through Friday from 7:30 a.m. to 5:30 p.m. ET.
In 2014, the Federal Reserve processed about 10,000 net settlement
service files, worth more than $17 trillion.

Cash Services
The Federal Reserve Board issues the nation’s currency in the form of
Federal Reserve notes to the Federal Reserve Banks, which, in turn,
distribute currency to the public through approximately 8,500 banks,
savings and loans, and credit unions. (The remaining depository institu-
tions obtain cash services from correspondent banks rather than directly
from a Reserve Bank.) Federal Reserve notes in circulation are liabilities
of the Federal Reserve Banks and are collateralized by the assets of the
Reserve Banks.

134 Fostering Payment and Settlement System Safety and Efficiency

 In contrast, coin in circulation is not a liability of the Federal Reserve
Banks. The Treasury’s United States Mint is the issuing authority for
coin. The Reserve Banks buy coin at face value from the Mint and, in
turn, sell it to depository institutions at face value. Coin held by the
Reserve Banks is a non-interest-earning asset of the Banks.

Establishing and Maintaining a Reliable U.S. Currency

Although the issuance of paper money in this country dates back to
1690, the U.S. government did not issue paper currency until 1861,
when Congress approved the issuance of demand Treasury notes.

Figure 6.9. Design of Federal Reserve notes aims to prevent counterfeiting

The Federal Reserve Board, the Treasury’s Bureau of Engraving and Printing, and the U.S. Secret Service primarily redesign U.S.
currency to stay ahead of counterfeiting threats and keep counterfeiting levels low.

Security thread. 3-D security ribbon. Watermark. Color-shifting ink.

Hold the note to light to see Tilt the note back and forth Hold the note to Tilt the note to see
an embedded thread running while focusing on the blue light and look for the numeral 100
vertically to the left of the ribbon. You will see the bells a faint image of in the lower right
portrait. The thread is imprinted change to 100s as they move. Benjamin Franklin corner of the front of
with the letters USA and the When you tilt the note back in the blank space the note shift from
numeral 100 in an alternating and forth, the bells and 100s to the right of the copper to green.
pattern and is visible from both move side to side. If you tilt it portrait. The image
sides of the note. The thread side to side, they move up and is visible from both
glows pink when illuminated by down. The ribbon is woven into sides of the note.
ultraviolet light. the paper, not printed on it.

For more information on the security and design of Federal Reserve notes, go to https://uscurrency.gov.

The Federal Reserve System Purposes & Functions 135

All currency issued by the U.S. government since then remains legal
tender. Today, virtually all currency in circulation is in the form of Fed-
eral Reserve notes, which were first issued in 1914.

As the issuing authority for Federal Reserve notes, the Board has a
wide range of responsibilities related to paper money, from ensuring an
adequate supply of currency to protecting and maintaining confidence
in the currency. To protect the integrity of Federal Reserve notes, the
Board works with the Reserve Banks, the Treasury Department, the
Treasury’s Bureau of Engraving and Printing (BEP), and the United States
Secret Service to monitor counterfeiting threats for each denomination
and to redesign notes to counter these threats.

New designs of Federal Reserve notes are periodically introduced to

make notes more difficult to counterfeit but still easy to authenticate as
genuine. The Board manages a program to educate the public on the
security and design features in Federal Reserve notes to help protect
and maintain confidence in U.S. currency.

The Reserve Banks also help maintain confidence in our nation’s cur-
rency by ensuring the quality and integrity of Federal Reserve notes in
circulation. The Reserve Banks accept and process deposits of currency
from depository institutions and credit their accounts at the Federal
Reserve. Using high-speed sorting equipment, the Reserve Banks
“piece-count” the deposits and remove worn and soiled currency and
suspected counterfeits. The fit currency that remains is packaged and
returned to the vault, to be used along with new currency to fill future
orders from depository institutions. Notes that are unfit for circulation
are destroyed. Suspected counterfeit notes are delivered to the United
States Secret Service for analysis and final adjudication.

Each year, the Board determines the number of new Federal Reserve
notes that are expected to be needed and submits a print order to the
BEP. The order reflects the Board’s estimate of the additional amount of
currency that the public will demand in the upcoming year and destruc-
tion rates of unfit currency. The Board pays the BEP the cost of manu-

136 Fostering Payment and Settlement System Safety and Efficiency

Figure 6.10. Value of U.S. currency in circulation, selected years, 1940–2014*
The Federal Reserve measures demand for U.S. currency, and the Reserve Banks ensure that depository institutions around the
country have ready access to cash.

Billions of dollars
1,298.7

1,198.3
1,127.1

1,034.5

942.0

563.9

268.2

124.8
50.8
26.2 30.4
8.1

1940 1950 1960 1970 1980 1990 2000 2010 2014

* Data include Federal Reserve notes and currency no longer issued but exclude coin and denominations larger than the $100
note. For more information about the value and volume of currency in circulation and the volume, value, and cost of the
new currency print order, visit the Payment Systems section of the Federal Reserve Board’s website, www.federalreserve.gov.

facturing new currency and arranges and pays the cost of transporting
the currency from the BEP’s facilities to Reserve Bank cash offices.

Demand for currency comes from both domestic and international

sources. Domestic demand for currency is largely based on the use of
currency for transactions and is influenced primarily by income levels,
prices of goods and services, the availability of alternative payment
methods, and the opportunity cost of holding currency rather than an
interest-bearing asset. In contrast, foreign demand for U.S. currency is
influenced primarily by the political and economic uncertainties associ-
ated with certain foreign currencies. As of 2014, there were nearly $1.3
trillion worth of Federal Reserve notes in circulation, and the Board

The Federal Reserve System Purposes & Functions 137

estimates that between one-half and two-thirds of the value of U.S.
currency is held outside the United States.

Coin
The Reserve Banks’ role in coin operations is more limited than their
role in currency operations. Although the Reserve Banks store some
coin in their own vaults, they also contract with armored carriers that
operate coin terminals to store, process, and distribute coin on behalf
of the Reserve Banks.

As the issuing authority for coins, the U.S. Mint determines annual coin
production. The Reserve Banks order coin from the Mint and pay the
Mint the full face value of the coin, rather than the cost to produce
it. The Mint transports the coin to the Reserve Banks and the Reserve
Banks’ coin terminal locations.

Fiscal Agency Services: Acting as

the U.S. Government Bank
The Federal Reserve Banks provide a range of services to the U.S. gov-
ernment, acting as the government’s fiscal agent. These services include
financial, account management, and securities services, as well as ap-
plication development and technology infrastructure support.

Early History of Fiscal Agency and Depository Services

The provision of fiscal agency and depository services began in 1915
when the Treasury began transferring U.S. government funds on de-
posit at national banks to its account at Reserve Banks. This action es-
tablished Reserve Banks as the key intermediaries through which funds
are collected and disbursed for the federal government.

In 1917, the Federal Reserve performed the first public debt func-
tions, when Reserve Banks were authorized to receive subscriptions
on the First Liberty Loan—bonds issued to help finance the United
States’ World War I effort. After World War I, the government’s need

138 Fostering Payment and Settlement System Safety and Efficiency

 to borrow compelled the Treasury to seek an operational alternative to
its limited network of subtreasuries—field offices that functioned as
the government’s bank in various regions of the country. The Federal
Reserve subsumed these public debt-related activities, and the last sub-
treasury closed in 1921.

Reserve Bank fiscal agency services continued to grow in response to

expanding government funding requirements. For example, the financ-
ing efforts associated with World War II increased the scope of Reserve
Bank fiscal agency functions to include the sale and redemption of
Series E savings bonds beginning in 1941. While initially known as De-
fense Bonds and War Savings Bonds, Series E bond issuance continued
until 1980, with millions of Americans purchasing these bonds.

In the 1960s and 1970s, the Reserve Banks’ role as fiscal agents
expanded to include services—primarily securities-related services—to
other federal agencies, government-sponsored enterprises, and inter-
national organizations, either at the Treasury’s request or through a
separate congressional mandate. As noted earlier, the federal govern-
ment in the 1970s became an early user of ACH services to expedite
the processing of government payments, and the ACH now plays a
central role in the government’s payments and collections.

Reserve Banks currently provide fiscal agency services to a significant

number of federal entities. Expenses associated with providing these
services account for approximately 15 percent of the Federal Reserve’s
total operating costs. The Treasury and other agencies reimburse the
Reserve Banks for the cost of providing fiscal agency services.

Tax Collections, Payments, and Account Management

The Federal Reserve Banks accept deposits of federal taxes and fees,
pay checks drawn on the Treasury’s account at the Federal Reserve,
and make and receive electronic payments on behalf of the Treasury
and government agencies. The Reserve Banks also process U.S. postal
money orders and conduct other activities on behalf of certain govern-
ment agencies.

The Federal Reserve System Purposes & Functions 139

Collection of taxes was once a paper-based, labor-intensive process, but
over time, the Reserve Banks and commercial banks worked with the
Treasury to provide secure and convenient ways to process tax collec-
tions electronically. In addition, the Reserve Banks operate Pay.gov, a
Treasury program that allows the public to use the Internet to authorize
and initiate payments to federal agencies.

Disbursements from the Treasury’s account at the Federal Reserve are

processed primarily through ACH payments or Fedwire Funds trans-
fers or, to a limited extent, by check. The increased use of electronic
payments provides the Treasury opportunities to minimize the costs
and inefficiencies associated with the delivery of check payments and
ultimately to reduce costs to U.S. taxpayers.

The Reserve Banks maintain the Treasury’s operating account, pro-

vide accounting and reporting services, monitor collateral pledged to
the government, and facilitate the investment of excess balances, as
directed by the Treasury.

Treasury Security Auctions and Related Services

As fiscal agents, the Reserve Banks auction marketable Treasury securi-
ties and reissue and redeem savings bonds. In addition, the Reserve
Banks provide securities-related services to federal agencies, govern-
ment-sponsored enterprises, and certain international organizations
under separate statutory authority.

Historically, Reserve Banks employed large staffs to process manually

paper-based Treasury bills, notes, bonds, and savings bonds until the
advent of marketable book-entry securities in the late 1960s.

Book-entry securities—which are electronic records rather than paper

certificates—were created primarily to gain efficiencies in the second-
ary market for Treasury securities. Beginning in 1986, individual inves-
tors could also buy and hold marketable book-entry securities in the
Treasury Direct system.

140 Fostering Payment and Settlement System Safety and Efficiency

 Over the years, the Reserve Banks have adapted their operations in sup-
port of the Treasury’s securities programs and worked with the Treasury
to respond to the declining volumes of paper-based products. The
Reserve Banks also work with the banking industry to make use of the
electronic check-collection mechanism to collect and process savings
bonds submitted for redemption.

Using Technology to Modernize Federal

Government Financial Services
In recent years, technological developments—many involving the use
of Internet technologies—have provided new opportunities for the
Reserve Banks to support the Treasury in modernizing federal govern-
ment financial services, such as collections and payment processes,
governmentwide financial reporting, and debt collection.

The Reserve Banks also actively support the Treasury’s efforts to increase
electronic payments transactions and reduce paper-based transactions,
and to reengineer the government’s accounting, reporting, and reconcili-
ation processes. The Reserve Banks have also developed tools to help the
Treasury and government agencies verify the accuracy of federal payments
before they are made and to assist in the collection of delinquent debt.

Services to Foreign Central Banks and

International Organizations
As the central bank of the United States, the Federal Reserve also
provides correspondent banking services to foreign central banks and
monetary authorities.

The Federal Reserve Bank of New York (FRBNY) provides several types
of services to these organizations, including maintaining noninterest-
bearing deposit accounts (in U.S. dollars), securities safekeeping
accounts, and gold safekeeping. Some foreign official institutions direct
a portion of their daily receipts and payments in U.S. dollars through
their funds accounts at the Federal Reserve.

The Federal Reserve System Purposes & Functions 141

If an account contains excess funds, the foreign official institution may
request that these funds be invested overnight in repurchase agree-
ments (repos) with the FRBNY. If investments are needed for longer
periods, the foreign official institution may provide instructions to the
FRBNY to buy securities to be held in safekeeping. Conversely, the
foreign institution may provide instructions to sell securities held in
safekeeping, with the proceeds deposited in its account.

The FRBNY also provides securities-issuing and paying-agent services

to international organizations such as the International Monetary Fund
and the World Bank.

Regulating and Supervising

the Payment System
For many decades, the Board’s authority to regulate the payment sys-
tem was limited to regulating payments handled by the Reserve Banks.
The Board used this authority to regulate check payments collected
or returned through the Reserve Banks and to regulate Fedwire Funds
transfers.

Beginning in the 1970s, Congress directed the Board to implement

several consumer protection statutes governing payments, including
the Fair Credit Billing Act of 1974, the Electronic Fund Transfer Act of
1978, and the Expedited Funds Availability Act of 1987 (EFAA). The
Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-
Frank Act) transferred the Board’s rulemaking authority with respect to
most consumer protection laws to the Consumer Financial Protection
Bureau (CFPB), but the Board shares rulemaking authority with the
CFPB with respect to the funds availability and disclosure requirements
of the EFAA.

142 Fostering Payment and Settlement System Safety and Efficiency

 During the last two decades, Congress has directed the Board to
prescribe regulations implementing a variety of other payments-related
statutes. For example, the Board and the Treasury jointly promulgated
regulations implementing the Unlawful Internet Gambling Enforcement
Act of 2006, which requires designated payment system participants
to establish policies and procedures to identify and block, or otherwise
prevent or prohibit, unlawful Internet gambling transactions.

In 2010, the Dodd-Frank Act provided the Board additional author-

ity to regulate and supervise certain payment, clearing, and settle-
ment systems and activities that have been designated as systemically
important, as well as prescribe rules related to debit card interchange
fees. In 2011, the Board adopted rules implementing the Dodd-Frank
Act’s “Durbin amendment,” which limits debit card interchange fees of

Figure 6.11. Federal Reserve regulations governing the payment system

The Federal Reserve has adopted the following set of regulations, which implement certain federal laws governing the U.S.
payment system and the operations of participating institutions.

Regulation (by letter and name) Description

J Collection of Checks and Other Items by Governs the collection and return of checks through the Reserve Banks and
Federal Reserve Banks and Funds Transfers Fedwire funds transfers
Through Fedwire

CC Availability of Funds and Collection of Governs the availability of funds deposited in transaction accounts and the collec-
Checks tion and return of checks

EE Netting Eligibility for Financial Institutions Defines financial institutions to be covered by statutory provisions that validate
netting contracts, thereby permitting one institution to pay or receive the net,
rather than the gross, amount due, even if the other institution is insolvent

GG Prohibition on Funding of Unlawful Internet Requires U.S. financial firms that participate in designated payment systems to
Gambling establish and implement policies and procedures reasonably designed to prevent
payments connected to unlawful Internet gambling

HH Designated Financial Market Utilities Establishes standards and procedures related to the supervision of certain financial
market utilities designated as systemically important

II Debit Card Interchange Fees and Routing Establishes standards for debit card interchange fees and prohibits payment
card network exclusivity arrangements and routing restrictions for debit card
transactions

Note: For a list of regulations governing banks and banking, holding companies and nonbank financial companies, and
securities credit transactions, see section 5, “Supervising and Regulating Financial Institutions and Activities,” on page 72.
For a list of consumer and community affairs-related regulations, see section 7, “Promoting Consumer Protection and Com-
munity Development,” on page 152.

The Federal Reserve System Purposes & Functions 143

certain issuers and prohibits network exclusivity arrangements and rout-
ing restrictions. In 2012, pursuant to the Dodd-Frank Act, the Board
adopted rules setting forth risk-management standards for certain
financial market utilities (FMUs) and requirements regarding advanced
notice to the Board from certain FMUs of material changes to their
rules, procedures, or operations.

Expedited Funds Availability Act

The EFAA broadened the Federal Reserve Board’s authority to regulate
interbank payments, including payments not handled by the Reserve
Banks.

The Board initially used this expanded authority to adopt rules to speed
the return of unpaid checks. These rules reduced the risk that banks in
which checks had first been deposited would have to make the funds
from check deposits available for withdrawal (under EFAA’s timing
requirements) before learning whether the checks had been returned
unpaid. In the 1990s, the Board used this authority to adopt its same-
day settlement rule, which improved competition between correspon-
dent banks and the Reserve Banks in the collection of checks, spurring
further efficiencies.

Electronic Check Processing

To help facilitate the electronic collection and return of checks, in 2001,
the Board proposed to Congress what would come to be known as
the Check Clearing for the 21st Century Act. The Check 21 Act was
enacted by Congress in 2003 and became effective in 2004. The Board
adopted regulations implementing the act in 2004. To improve the
efficiency of the check-collection process, the Check 21 Act enabled
collecting banks to truncate all paper original checks, to send checks
electronically to banks with which they have electronic exchange agree-
ments, and to send paper substitute checks to banks with which they
do not have such agreements. These changes materially hastened the
electronic processing of checks.

144 Fostering Payment and Settlement System Safety and Efficiency

 Financial Market Utilities
The Federal Reserve regulates and supervises certain financial market
utilities. FMUs are multilateral systems that provide the infrastructure
for transferring, clearing, and settling payments, securities, and other
financial transactions among financial institutions or between financial
institutions and the system. These systems include payment systems,
securities settlement systems, central securities depositories, and central
counterparties.

FMUs play a critical role in the U.S. and global financial system. FMUs
often give rise to risks and interdependencies among financial institu-
tions both within and across national borders, creating the potential for
widespread financial disruptions if an FMU fails to perform as expected.
The Federal Reserve, with its mandate for financial stability, is particu-
larly interested in the smooth functioning of these FMUs and their
robust supervision.

The Federal Reserve regulates and supervises certain FMUs under

several authorities. The Dodd-Frank Act sets forth an enhanced super-
visory framework for FMUs that have been designated as systemically
important by the Financial Stability Oversight Council. Among other
things, the Dodd-Frank Act authorizes the Board to supervise certain
designated FMUs and participate in the examinations of other desig-
nated FMUs. The Board also has other authority with respect to certain
payment and settlement systems, such as authority to oversee Reserve
Bank operations pursuant to the Federal Reserve Act.

The Board may also have an interest in the safety and efficiency of
systems outside the United States that provide services to financial in-
stitutions supervised by the Board or that conduct activity that involves
the U.S. dollar. In these cases, the Board will seek to cooperate with
relevant authorities to share information, understand the risks that
these systems pose to the U.S. financial system, and promote sound
risk management.

The Federal Reserve System Purposes & Functions 145

Regulation HH sets the Board’s risk-management standards for desig-
nated FMUs for which the Board is the supervisory agency pursuant
to the Dodd-Frank Act. The Federal Reserve Policy on Payment System
Risk (PSR policy) (www.federalreserve.gov/paymentsystems/psr_about.
htm) sets forth the Board’s views and related standards regarding risk
management in payment, clearing, settlement, and recording systems
more generally, including in payment and settlement systems operated
by the Federal Reserve Banks.

Providing Vital Banking

System Liquidity
For many years prior to the 2007–09 financial crisis, depository insti-
tutions in the aggregate typically held few funds overnight in their
accounts at Federal Reserve Banks relative to the trillions of dollars of
payments processed daily by the System. To ensure the U.S. payment
system’s smooth functioning, the 12 Federal Reserve Banks extend intra-
day credit, or “daylight overdrafts.”

Institutions incur daylight overdrafts in their Federal Reserve accounts

because of the mismatch in timing between the settlement of payments
owed and the settlement of payments due. To address the risk of provid-
ing such credit, the PSR policy—adopted by the Federal Reserve Board
in 1985 and adjusted since then—controls institutions’ use of daylight
overdrafts. The PSR policy balances the goals of ensuring smooth func-
tioning of the payment system with the need to manage the direct risk
to the Federal Reserve of offering institutions intraday credit.

The PSR policy establishes various measures to control the risks associ-
ated with daylight overdrafts. Beginning in 1985, the PSR policy set a
maximum limit, or net debit cap, on depository institutions’ daylight
overdraft positions. Institutions must have regular access to the Federal

146 Fostering Payment and Settlement System Safety and Efficiency

 Reserve’s discount window so that they can borrow overnight from
their Reserve Bank to cover any daylight overdrafts that are not elimi-
nated before the end of the day. Beginning in 1994, the Reserve Banks
began charging fees to depository institutions for their use of daylight
overdrafts as an economic incentive to reduce their overdrafts, thereby
reducing direct Federal Reserve credit risk and contributing to eco-
nomic efficiency. In 2011, the Board revised the PSR policy to recognize
explicitly the role of the central bank in providing intraday balances and
credit to healthy depository institutions and to provide collateralized
intraday credit at a zero fee.

Figure 6.12. Peak and average daylight overdrafts of depository institutions, 1986–2014
The Federal Reserve measures the account balance of each depository institution at the end of each minute during the
business day. An institution’s peak daylight overdraft for a given day is its largest negative end-of-minute balance.
Billions
$200
Peak daylight overdraft
$180

$160

$140

$120

$100

$ 80
Average daylight overdraft
$ 60

$ 40

$ 20

$ 0

1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Note: Quarterly averages of daily data. The Federal Reserve measures each depository institution’s account balance at the end
of each minute during the business day. An institution’s peak daylight overdraft for a given day is its largest negative end-of-
minute balance. The System peak daylight overdraft for a given day is determined by adding the negative account balances
of all depository institutions at the end of each minute and then selecting the largest negative end-of-minute balance. The
average daylight overdraft for a given day is the sum of the average per-minute daylight overdrafts for all institutions on that
day. Further data regarding peak and average daylight overdrafts can be found in the Payment Systems section of the Federal
Reserve Board’s website, www.federalreserve.gov.

The Federal Reserve System Purposes & Functions 147

Managing the Federal Reserve’s direct credit risk from institutions’ use
of Federal Reserve intraday credit can prove crucial because there have
been periods during which Reserve Bank exposure to daylight over-
drafts has been significant and highly concentrated in a few institu-
tions. For example, after the collapse of Lehman Brothers in Septem-
ber 2008, daylight overdraft activity rose to its highest level since the
Federal Reserve began measuring it in the 1980s. Since 2008, higher
overnight balances held at the Reserve Banks have been associated
with lower levels of daylight overdrafts.

Despite the decline in overall levels of daylight overdrafts, this impor-

tant tool continues to play a key role in many institutions’ efforts to
efficiently settle daily payments.

Exploring and Implementing

Payment System Improvements
Conducting Research and Analysis
The Federal Reserve conducts research on a wide range of topics re-
lated to the design and activities of payment, clearing, and settlement
(PCS) systems and financial market infrastructures, as well as the role
of these systems in the commercial activities of consumers, businesses,
and governments.

Both theoretical and empirical research and analysis of policy issues in-
form policymakers, the industry, and the public. Research topics include
• design of financial market infrastructure and risk management for
complex financial instruments, including derivatives;
• analysis of technological change and market structure in payment
and settlement activity;

148 Fostering Payment and Settlement System Safety and Efficiency

Figure 6.13. As popularity of electronic payments grows, use of checks declines
The Federal Reserve monitors trends in the payment system, such as the increasing use of electronic forms of payment. Since
2000, the use of debit cards has experienced the most growth, while the use of checks has steadily declined.

Number of noncash payments in billions

50
Debit card

40

30
Credit card

ACH
20
Checks (paid)

10 Prepaid card

0
2000 2003 2006 2009 2012

Note: Years in between studies are estimated linearly.

ACH Automated clearinghouse.
Source: The 2013 Federal Reserve Payments Study (available on the Federal Reserve Board’s website, www.federalreserve.gov).

• collection and analysis of data on the use of payment instruments

and on the drivers of payment behavior; and
• the effect of Federal Reserve policies on market participants, such as
the implications of daylight overdraft policy and the effect of pay-
ment regulations.

To inform its supervision of financial market infrastructures, the Federal

Reserve analyzes financial and technological trends in payments and
other financial instruments. Analysis often focuses on economic ef-
ficiency and risk, including systemic risk and the impact of financial in-
stitutions engaged in PCS activities on financial markets’ stability. Some
examples of recent research topics include the role of central counter-

The Federal Reserve System Purposes & Functions 149

parties in clearing over-the-counter financial transactions and develop-
ments and risks in the market for triparty repurchase agreements.

Serving as a Catalyst for

System Improvements
As the central bank, the Federal Reserve can act as a catalyst to im-
prove the safety and efficiency of PCS systems, working in coopera-
tion with the private sector and other public-sector institutions, both
domestically and internationally.

For example, to help facilitate the electronic collection and return of

checks, the Federal Reserve worked collaboratively with representatives
of depository institutions, businesses, consumer groups, and the Trea-
sury to develop the draft legislation that became the Check 21 Act. In
addition, the Federal Reserve provided leadership, working with other
central banks and market regulators to develop and, more recently, to
enhance risk-management standards for systemically important finan-
cial market infrastructures.

The Federal Reserve has also used its role as a leader and catalyst in
facilitating collaboration among industry stakeholders to identify, de-
velop, and implement improvements in the end-to-end speed, safety,
and efficiency of U.S. payments. Building on extensive stakeholder
outreach and market research, the Board and the Reserve Banks re-
leased the “Strategies for Improving the U.S. Payment System” paper
in January 2015 (go to www.federalreserve.gov and click on Payment
Systems). The paper communicates desired outcomes for the U.S. pay-
ment system and outlines the strategies and tactics the Federal Reserve
will pursue, in collaboration with stakeholders, to help the country
achieve these outcomes. As described in the paper, the Federal Reserve
established a task force to identify effective approaches for implement-
ing safe, ubiquitous, and faster payment capabilities, and a task force
to advise the Federal Reserve on reducing payment fraud and advanc-
ing the safety, security, and resiliency of the payment system.

150 Fostering Payment and Settlement System Safety and Efficiency

 The Federal Reserve’s research efforts may also act as a catalyst for
change. For example, the Federal Reserve’s payments surveys help
inform the strategic plans of payment system participants by providing
data and insights regarding payment trends.

The Federal Reserve System Purposes & Functions 151

 Function Promoting Consumer
Protection and
Community
Development

The Federal Reserve advances supervision,

community reinvestment, and research to
increase understanding of the impacts of financial
services policies and practices on consumers and
communities.

7
Consumer-Focused Supervision
and Examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154

Administering Consumer Laws, Drafting Regulations . . . . . . . . . . . . . 164

Research and Analysis of Emerging Consumer Issues . . . . . . . . . . . . . 165

Community Economic Development Activities . . . . . . . . . . . . . . . . . . . 167

152 Promoting Consumer Protection and Community Development

 T   he Federal Reserve is committed to ensuring that consumer and
community perspectives inform Federal Reserve policy, research, and
actions, with the mission of promoting a fair and transparent consumer
financial services marketplace and effective community development,
including for traditionally underserved and economically vulnerable
households and neighborhoods.

To fulfill this responsibility, the Federal Reserve performs a number

of functions to implement various consumer protection, fair lending,
fair housing, and community reinvestment laws and to improve un-
derstanding of the dynamics of the consumer financial marketplace,
including

Figure 7.1. The Federal Reserve works to ensure that the financial institutions it supervises
comply with laws that protect consumers
Federal Reserve survey data show that nearly all American families are involved in the financial services marketplace, whether
as bank account holders, credit card users, or borrowers. The Federal Reserve’s consumer-focused supervision and regulation,
research and analysis, and community engagement programs help ensure that consumer and community perspectives inform
supervisory and policy work.

93.2

Percent of U.S. households having:

48.1
38.1
30.2
19.2 11.5

Transaction Mortgage/ Credit card Auto Education Other

account* HELOC balance loan loan loan
* Transaction account includes checking, savings, and money market deposit accounts; money market mutual funds; and call
or cash accounts at brokerages.
HELOC Home equity line of credit.
Source: 2013 Survey of Consumer Finances (available in the Economic Research & Data section of the Federal Reserve Board’s
website, www.federalreserve.gov).

The Federal Reserve System Purposes & Functions 153

• formulating and carrying out consumer-focused supervision and
examination policy to ensure that financial institutions under its
jurisdiction comply with applicable consumer protection laws and
regulations and meet the requirements of community reinvestment
laws and regulations;
• conducting rigorous research, analysis, and data collection to iden-
tify emerging consumer financial issues and assess their implications
for economic and supervisory policy;
• engaging, convening, and informing key stakeholders to identify
emerging issues and policies and practices to advance effective com-
munity reinvestment and consumer protection; and
• writing and reviewing regulations that implement consumer protec-
tion and community reinvestment laws.

Consumer-Focused Supervision
and Examination
Various consumer protection, fair lending, fair housing, and community
reinvestment laws apply to how financial institutions interact with their
customers and their communities. A primary Federal Reserve responsi-
bility to consumers is to ensure that the financial institutions under its
jurisdiction comply with applicable laws and regulations established by
Congress and the federal regulatory agencies.

Who the Federal Reserve Supervises for

Consumer Protection Laws and Regulations
The Federal Reserve supervises state member banks for compliance
with consumer- and community-oriented laws (for a full discussion
of state member banks, see section 5, “Supervising and Regulating
Financial Institutions and Activities,” on page 72). The Federal Reserve
evaluates

154 Promoting Consumer Protection and Community Development

 • performance under the Community Reinvestment Act (CRA) for all
state member banks, regardless of size;
• compliance by all state member banks, regardless of size, and their
affiliates with the Fair Housing Act, the Servicemembers Civil Relief
Act, the National Flood Insurance Act, prohibitions on unfair or de-
ceptive acts or practices (UDAP) under the Federal Trade Commission
Act, and certain other federal consumer financial protection laws
not specifically under the Consumer Financial Protection Bureau’s
authority; and
• compliance by state member banks with total assets of $10 billion
or less with all federal consumer financial protection laws and regu-
lations. (See figure 7.2.)

In addition, the Federal Reserve serves as the consolidated supervisor

for all bank holding companies and ensures that consumer compliance
risk is appropriately incorporated into a holding company’s consoli-
dated supervision rating. The Federal Reserve has additional supervisory
responsibility as the federal supervisor for savings and loan holding
companies and the consolidated supervisor for foreign banking organi-
zations and nonbank financial companies designated by the Financial
Stability Oversight Council for supervision by the Federal Reserve under
the Dodd-Frank Wall Street Reform and Consumer Protection Act. (For
more details on entities the Federal Reserve supervises, see section 5,
“Supervising and Regulating Financial Institutions and Activities,” on
page 72.)

How the Federal Reserve Supervises for

Consumer Protection Laws and Regulations
The Federal Reserve Board of Governors, and the 12 Reserve Banks un-
der delegated authority, have responsibilities for consumer compliance
supervision of organizations under the Federal Reserve’s jurisdiction.

The Board develops consumer compliance supervisory policies and

identifies emerging issues; provides rigorous examiner training; and
assists with the enforcement of fair lending, UDAP, and flood insurance

The Federal Reserve System Purposes & Functions 155

violations. Further, the Board evaluates applications involving bank or
thrift holding companies or state member banks that present CRA or
consumer compliance issues, or that receive adverse comments from
external parties. The Board also works with other agencies to promote
consistency in examination principles, standards, and processes. The
Board’s Division of Consumer and Community Affairs (DCCA) provides
support to the Board in its consumer-focused supervisory activities.

A Regional Approach to Supervision

The Federal Reserve employs a regionalized approach to supervision.
The Board has delegated its examination authority to the 12 Reserve
Banks, which maintain consumer compliance supervisory programs
that evaluate institutions for their level of compliance with applicable
consumer protection laws, using policies set by the Board. Each Reserve
Bank has a staff of examiners who conduct periodic compliance exami-
nations at financial institutions under the Federal Reserve’s supervisory
authority, including state member banks and bank holding companies.
Consumer compliance examiners review the policies and practices that
pertain to consumer products and services offered at each of these
institutions. The Board oversees these Reserve Bank programs and rou-
tinely evaluates their effectiveness.

The network of Reserve Banks across the United States is integral to the
implementation of the Federal Reserve’s supervisory policy and helps
inform the Board’s understanding of consumer financial services trends
and issues that may be specific to some regions of the country.

Insights and examination findings from the Reserve Banks support the
Federal Reserve’s efforts to ensure that banking institutions effectively
serve consumers and communities and treat consumers fairly in their
credit and financial transactions.

Risk-Focused Consumer Compliance Supervision

The Federal Reserve applies a risk-focused approach to consumer
compliance supervision, focusing most intensely on those areas involv-
ing the greatest compliance risk. This approach is designed to promote

156 Promoting Consumer Protection and Community Development

 strong compliance risk management practices at financial institutions
and to enhance the efficacy of the Federal Reserve’s supervision pro-
gram while managing regulatory burden on many community banking
organizations.

Under the Federal Reserve’s risk-focused consumer compliance pro-

gram for community banks, consumer compliance examiners follow
procedures for assessing an individual financial institution’s risk pro-
file, including its consumer compliance culture and how effectively it
identifies and manages consumer compliance risk, to determine the
scope and resources needed when conducting an examination. The
risk-focused examination program also incorporates ongoing supervi-
sion to help identify and, if necessary, address significant changes in
the institution’s compliance risk management program or in the level of
consumer compliance risk present, as well as to ensure that supervisory
information is up to date.
Consumer Affairs (CA)
letters The Federal Reserve also maintains a risk-focused program for assessing
To see the wide range of consumer compliance risk at bank holding companies in the System, to
consumer issues addressed
by the Federal Reserve
ensure that consumer compliance risk is effectively integrated into the
through CA letters, visit holding company rating.
the Banking Information
& Regulation section,
Supervisory Policies and Guidance
subsection Supervision,
of the Board’s website at The Federal Reserve communicates significant consumer-related policy
www.federalreserve.gov/
and procedural matters through Consumer Affairs (CA) supervisory let-
bankinforeg/caletters/
caletters.htm. ters. The Federal Reserve often works closely with other supervisors in
crafting policy statements and guidance. CA letters can address a wide
range of topics, such as foreclosures, privacy of consumer financial
information, special legal protections for service members’ credit trans-
actions, and examination procedures for various consumer protection
laws and regulations and the CRA.

Interagency Initiatives
Through its participation on the Federal Financial Institutions Examina-
tion Council (FFIEC), the Federal Reserve collaborates with other federal
and state banking agencies on consumer financial supervisory guid-

The Federal Reserve System Purposes & Functions 157

Figure 7.2. Federal consumer financial protection laws and regulations applicable to banks
Financial institutions must comply with a variety of laws and regulations that protect consumers. The Federal Reserve Banks,
using policies set by the Board of Governors, maintain consumer compliance supervisory programs that evaluate institutions
for their level of compliance with applicable consumer protection laws.

General banking

Federal Trade Commission Act Prohibits unfair or deceptive acts or practices in any aspect of banking
transactions.

Gramm-Leach-Bliley Act (title V, Describes the conditions under which a financial institution may disclose
subpart A), Disclosure of Nonpub- nonpublic personal information about consumers to nonaffiliated third
lic Personal Information* parties, provides a method for consumers to opt out of information shar-
ing with nonaffiliated third parties, and requires a financial institution
to notify consumers about its privacy policies and practices.

Depository accounts

Electronic Fund Transfer Act/ Requires disclosure of the terms and conditions of electronic fund trans-
Regulation E* fers. Protects consumers against unauthorized transfers and establishes
procedures for resolving errors and disputes.

Expedited Funds Availability Act/ Limits hold periods on deposits made to depository institutions and
Regulation CC requires appropriate consumer disclosures.

Truth in Savings Act /Regulation Requires uniform disclosure of terms and conditions regarding interest
DD* rates and fees associated with deposit accounts. Prohibits misleading and
inaccurate advertisements.

Credit/general lending

Truth in Lending Act/Regulation Z* Requires lenders to clearly disclose lending terms and costs to borrow-
ers, and incorporates the provisions of the Credit Card Accountability
Responsibility and Disclosure Act, Fair Credit Billing Act, Fair Credit and
Charge Card Disclosure Act, Home Equity Loan Consumer Protection Act,
and Home Ownership and Equity Protection Act.

Fair Credit Reporting Act* Protects consumers from unfair credit reporting practices and requires
credit-reporting agencies to allow credit applicants to correct inaccurate
credit reports.

Equal Credit Opportunity Act/ Prohibits creditors from discriminating on the basis of race, color, nation-
Regulation B* al origin, religion, sex, marital status, age, receipt of public assistance,
and exercise of rights under the Consumer Credit Protection Act.

Community Reinvestment Act/ Encourages financial institutions to help meet the credit needs of their
Regulation BB entire communities, including low- and moderate-income neighborhoods.

158 Promoting Consumer Protection and Community Development

 Disclosure and Reporting of CRA- Requires banks and their affiliates and other parties to make public
Related Agreements/Regulation G  certain agreements that are in fulfillment of the Community Reinvest-
ment Act, and to file annual reports concerning the agreements with the
appropriate agency.

Fair and Accurate Credit Amends the Fair Credit Reporting Act. Enhances consumers’ ability to
Transaction Act* combat identity theft, increases the accuracy of consumer reports, allows
consumers to exercise greater control over the type and amount of mar-
keting solicitations they receive, restricts the use and disclosure of sensi-
tive medical information, and establishes uniform national standards in
the regulation of consumer reporting.

Servicemembers Civil Relief Act Provides members of the military certain financial protections while on
and Military Lending Act active duty.

Mortgage lending

Fair Housing Act Prohibits discrimination in the sale, rental, and financing of dwellings
and housing-related transactions on the basis of race, color, national
origin, religion, sex, handicap, or familial status.

Real Estate Settlement Procedures Requires that the nature and costs of real estate settlements be disclosed
Act/Regulation X* to borrowers. Also protects borrowers against abusive practices, such as
kickbacks, and regulates the use of escrow accounts.

Home Mortgage Disclosure Act/ Requires mortgage lenders to annually disclose to the public data on the
Regulation C* geographic distribution of applications and loans for originations, pur-
chases, home-improvement, and refinancings. Requires lenders to report
data on the ethnicity, race, sex, income of applicants and borrowers, and
other data. Also directs the Federal Financial Institutions Examination
Council, of which the Federal Reserve is a member, to make summaries
of the data available to the public.

Other financial topics

Flood Disaster Protection Act/ Requires flood insurance in connection with loans secured by property
Regulation H located in a flood hazard area designated under the National Flood
Insurance Program.

Consumer Leasing Act/ Requires disclosure of information about the costs and terms of consum-
Regulation M* er leases for vehicles and other personal property.

* The Federal Reserve System does not examine for these laws and regulations for depository institutions with total assets in
excess of $10 billion.

The Federal Reserve System Purposes & Functions 159

ance. The FFIEC works to develop uniform principles, standards, and
report forms for the federal examinations of financial institutions. These
efforts promote the goal of supervisory consistency and uniformity
across the banking industry.

The Board’s FFIEC representative is advised by DCCA staff regarding

policy, procedures, and guidance related to consumer compliance
supervision. For more information on interagency supervisory initiatives,
see “Oversight Councils” on page 81.

How the Federal Reserve Enforces

Consumer Protection Laws and Rules
After a consumer compliance examination, examiners issue a confi-
dential report of examination, which includes a consumer compliance
program rating that reflects the institution’s performance with regard to
consumer compliance. When an examination reveals that an institution’s
policies or practices do not comply with consumer protection rules and
regulations, examiners cite violations in the report of examination and
require management to correct the violations and address any program
deficiencies. The Federal Reserve also has additional supervisory tools to
ensure that bank management addresses consumer compliance pro-
gram weaknesses, including informal and formal enforcement actions.

Formal enforcement actions include

• executing a written agreement between the Federal Reserve and
the financial institution’s board of directors or its management that
requires the institution to take specified corrective action;
• issuing cease-and-desist orders to halt practices in violation;
• assessing civil money penalties, when appropriate, depending on
the nature, severity, and degree of harm to consumers as a result of
deficient practices; and
• ordering remedies or restitution to consumers affected by an institu-
tion’s violations.

160 Promoting Consumer Protection and Community Development

Box 7.1. Making Compliance with Consumer Laws a Priority

The Federal Reserve’s consumer compli- • Board of directors and senior man- to management on an institution’s
ance supervision program is founded on agement oversight. Directors have financial condition, operating perfor-
the expectation that consumer compli- ultimate responsibility for the risk mance, and risk exposure.
ance risk management is an integral taken by their institutions. Examiners • Internal controls. Examiners seek to
part of an institution’s corporate-wide seek to ensure that senior manage- ensure that an institution’s internal
risk management. ment is implementing strategies that control structure allows it to effec-
effectively identify and control for tively manage its consumer compli-
A key goal is ensuring that each institu- consumer compliance risk. ance risk, and creates effective lines
tion is in full compliance with federal • Policies and procedures. Examin- of authority and responsibility.
consumer protection laws and regula- ers seek to ensure that an effective • Training. Examiners seek to ensure
tions and has processes and programs compliance program is in place with that an institution provides its person-
in place to keep up with new or revised documented policies, procedures, and nel with training regarding rules,
compliance requirements that may arise processes for monitoring and control- regulations, policies, and procedures
as laws, regulations, and bank products ling compliance risks. that impact the institution’s business
and services change. Examiners look
• Risk monitoring. Examiners seek lines.
for a number of indicators of an
to ensure that information manage-
institution’s management of consumer
ment systems provide timely reports
compliance risk:

Evaluating Performance under the

Community Reinvestment Act
The Community Reinvestment Act encouraged depository institutions—
commercial banks and savings institutions—to help meet the credit
needs of their local communities, including low- and moderate-income
neighborhoods, consistent with safe and sound operations. The CRA
requires the Federal Reserve to evaluate each state member bank’s
CRA performance and assign one of four CRA ratings—Outstanding,
Satisfactory, Needs to Improve, or Substantial Noncompliance. The CRA
rating and conclusions, as well as the facts, data, and analysis that sup-
port the bank’s rating, are summarized in a publicly available perfor-
mance evaluation.

CRA examiners assess a bank’s performance using examination proce-

dures tailored to the bank’s size and the type of business it does. Perfor-
mance is evaluated in the context of the institution and the communities
within which it operates. That means examiners consider information
about the bank’s business strategy, product offerings, capacity, and con-

The Federal Reserve System Purposes & Functions 161

straints, as well as the economic conditions, lending, investment, and
service needs and opportunities in the bank’s communities.

The public can also play a role in the CRA examination process by offer-
ing comments on an institution’s CRA performance, which the financial
institution must make accessible to the public. Examiners review these
comments and consider them when evaluating a bank’s overall CRA
performance.
Public comments on
CRA performance
An institution’s CRA rating and comments from the public are also Public feedback about a
considered when the institution applies to open additional branches or depository institution’s
record in meeting the credit
to engage in a merger or acquisition. The public has the opportunity
needs of its community
to submit written comments on an application. These comments are helps inform the Federal
considered by the Board when it evaluates the application. Reserve’s overall evaluation
of that institution’s compli-
ance with the Community
Responding to Consumer Feedback Reinvestment Act (CRA) and
its decisions about a bank’s
In addition to on-site examiner reviews of financial institutions, Federal application to open more
Reserve staff identify and investigate possible violations of consumer branches or complete a
protection laws through the Federal Reserve System’s consumer merger or acquisition. For
information on submitting
complaint and consumer inquiry programs. Through these programs, comments about a bank’s
staff answer consumers’ questions, explain consumer rights under CRA performance, see
federal law, investigate complaints against entities supervised by the www.federalreserve.gov/
communitydev/cra_about.
Federal Reserve, and refer complaints about other entities to the htm. For information on
appropriate agency. Consumer complaints are a critical component of submitting comments on
the risk-focused supervisory program. The Federal Reserve uses data on banking applications, visit
www.federalreserve.gov/
consumer complaint activity in its supervisory processes when monitor- bankinforeg/afi/cra.htm.
ing financial institutions, scoping and conducting examinations, and
analyzing applications. Information about consumer complaints is also
reported in the Federal Reserve Board’s Annual Report to Congress
(available at www.federalreserve.gov).

Handling Complaints
The Federal Reserve has uniform policies and procedures for investigat-
ing and responding to consumer complaints, which are implemented
by staff at the 12 Federal Reserve Banks and the Federal Reserve Con-

162 Promoting Consumer Protection and Community Development

 sumer Help (FRCH) Center. The FRCH is a centralized consumer com-
plaint and inquiry processing center, which allows consumers to contact
the Federal Reserve online or by telephone, fax, mail, or e-mail.

When a consumer files a complaint with the FRCH, the first step is to
determine which Reserve Bank or other banking agency has responsibil-
ity for investigating that complaint. If the complaint involves an entity
that is not supervised by the Federal Reserve, the FRCH forwards the
complaint to the appropriate agency and then tells the consumer how
to contact that agency. If a complaint involves an institution supervised
by the Federal Reserve System, the FRCH forwards it to the Reserve
Bank that examines the institution in question to conduct an investiga-
tion. The FRCH typically responds to consumers within 15 business days
of the complaint submission.

After receiving the complaint from the FRCH, the Reserve Bank for-
wards the consumer complaint to the institution to obtain a written
response. During the complaint investigation, the Reserve Bank ana-
lyzes the documentation provided by the consumer and the institution
to determine if the institution violated a law, handled the situation
correctly, or corrected an error. The Reserve Bank communicates the
outcome of the investigation to the consumer in writing.

Addressing Inquiries and Potential Financial Scams

The FRCH receives thousands of consumer inquiries on a wide range of
topics each year. FRCH staff strive to provide consumers with informa-
tion about their rights to enable an understanding of financial products
and services, which may be useful in future financial decisionmaking.
The FRCH website offers information about many of these topics—
credit cards, checking accounts, electronic banking, mortgages, and
foreclosures. Consumers are directed to resources offered by federal
agencies and trusted organizations to get accurate and straightforward
information to answer their questions.

The FRCH also empowers consumers to recognize and report potential

scams. The FRCH website contains information alerting consumers to

The Federal Reserve System Purposes & Functions 163

Box 7.2. Federal Reserve Consumer Help: Responding to Consumer
Complaints and Inquiries
Federal Reserve Consumer Help (FRCH),
a centralized consumer complaint and
inquiry processing center, allows con-
sumers to contact the Federal Reserve
online or by telephone, fax, mail, or
e-mail.

The FRCH website (www.federalreserve

consumerhelp.gov) is a resource for
consumers to learn about financial
products and services and provides
instructions on how to file a consumer
complaint with the Federal Reserve.

characteristics of a scam and provides a link for reporting the informa-

tion on a product or service they suspect is a scam.

Administering Consumer Laws,

Drafting Regulations
The Federal Reserve Board has rulemaking responsibility under specific
statutory provisions of the consumer financial services and fair lending
laws. The Board issues regulations to implement those laws and also
issues (directly or through staff) official interpretations and compliance
guidance for the financial industry and for the Reserve Banks’ examina-
tion staff.

The Board also regularly works with other federal financial regulatory
agencies in proposing rules and procedures to implement new laws
and amendments to existing laws. For example, the Board collaborates

164 Promoting Consumer Protection and Community Development

 with the Consumer Financial Protection Bureau, the Federal Deposit
Insurance Corporation, the National Credit Union Administration, the
Office of the Comptroller of the Currency, and the Federal Housing
Finance Agency to establish appraisal requirements for home mortgage
transactions. Joint efforts such as these aim to ensure that consumer
protections mandated by the Congress are enforced effectively across
all institutions.

Research and Analysis of Emerging

Consumer Issues
Thorough research and analysis about consumers, their financial experi-
ences, and the communities in which they live inform Federal Reserve
policymaking.

Thus, the Board and the Reserve Banks collaborate to identify trends and
emerging issues that impact the financial livelihood and well-being of
consumers and communities. This effort relies on a variety of resources,
including a wealth of data collected through surveys and independent
research. Findings from compliance examinations and trends in con-
sumer complaints also help to shed light on emerging issues. Sources of
data and information continually evolve as information resources and
technology provide better insights into the financial services and com-
munity development issues of consumers and neighborhoods.

To inform its research efforts, the Federal Reserve conducts consumer

focus groups, outreach to consumer and community groups, outreach
to academic and policy organizations, and consumer surveys to gain
insight into trends in consumer financial services, community economic
development, and policy matters. This information and data contributes
to the Federal Reserve’s work and provides the consumer perspective
for other Federal Reserve System functions.

The Federal Reserve System Purposes & Functions 165

Figure 7.3. Federal Reserve research examines trends and issues in consumer
financial services
The Federal Reserve Board conducts the annual Survey of Household Economics and Decisionmaking (SHED), a nationally
representative survey that evaluates the economic well-being of U.S. households and identifies potential risks to their financial
stability. The survey includes modules on a range of topics of current relevance to financial well-being, including housing,
credit access and behaviors, savings, retirement, economic fragility, and education and student loans.

Why Can’t afford down payment 50

people
Can’t qualify for mortgage 31
rent
Cheaper to rent 27

81% More convenient to rent 25

of renters
Plan on moving soon 22
would prefer
to own their Prefer to rent 12
home if they
could afford Currently looking to buy 9
to do so
Other 9

0% 10% 20% 30% 40% 50% 60%

Source: Report on the Economic Well-Being of U.S. Households in 2014, May 2015 (available in the Community Development
section of the Federal Reserve Board’s website, www.federalreserve.gov).

The results of the Federal Reserve’s research and policy analysis inform
Federal Reserve policymaking in various ways. Tracking and studying
emerging issues allows the Federal Reserve to evaluate the impact
that financial services and market trends may have on consumers and
communities. Results are often published and disseminated to inform
and foster discussion among regulators, industry groups, consumer and
community advocates, and academic and policy organizations.

The Federal Reserve has produced consumer- and community-focused

research and analysis that looks at consumer and household issues

166 Promoting Consumer Protection and Community Development

 broadly, as well as a number of specialized topics, including
• unemployment and workforce development,
• community investment and stabilization,
• household economics and decisionmaking,
• consumers’ use of mobile devices to connect with financial services,
• financial decisionmaking by the older adult population, and
• economic and credit conditions in low- and moderate-income popu-
lations and neighborhoods.

For examples of the Federal Reserve’s research on consumer topics, visit

the Community Development section of the Federal Reserve Board’s
website at www.federalreserve.gov.

Community Economic
Development Activities
Because a strong economy and strong communities go hand-in-hand,
community development staff at the Federal Reserve Board and at each
of the Federal Reserve Banks work at the national, regional, and local
levels to help promote economic growth and financial stability in com-
munities across the country, particularly neighborhoods that are low-
and moderate-income and traditionally underserved.

Federal Reserve community development (CD) staff engage in a wide

variety of activities, focused on four topical areas:
• Policy and practice: Promoting the well-being of economically
vulnerable communities by enhancing the scale, sustainability, and
impact of the broader community development field.
• People: Helping to sustain and promote policies that improve the
financial stability and economic mobility of lower-income communi-
ties and individuals.

The Federal Reserve System Purposes & Functions 167

Figure 7.4. Federal Reserve community development efforts engage at the national and
local levels
The Federal Reserve has dedicated staff in each of its offices throughout the country who work collaboratively to engage
stakeholders; to understand issues and challenges in low- and moderate-income communities; and to provide research, policy
insights, and technical assistance to support community and economic development programs. Community development staff
are located in each of the Reserve Banks and Branches.

Seattle

Helena
Portland

Minneapolis
Detroit
Boston
Cleveland New York
Chicago
San Francisco Philadelphia
Salt Lake City Omaha Pittsburgh
Baltimore
Denver Kansas City Louisville Cincinnati Richmond
St. Louis
Los Angeles Oklahoma Nashville
City Charlotte
Memphis
Little Atlanta
Rock
El Paso
Dallas Birmingham

Houston
New Orleans Jacksonville
San Antonio

Miami
Districts
Bank cities
Branch cities

• Place: Engaging in “place-based” efforts to revitalize lower-income

communities by advancing comprehensive community development
efforts targeted to geographically defined areas.
• Small business: Working with intermediaries to support small busi-
nesses and microenterprises in order to help increase the capacity of
funding and technical assistance providers; enhancing the availabil-
ity of credit and capital for small businesses; and building a deeper
understanding of small business trends and conditions.

The CD function of the Federal Reserve System is made up of dedicated

community development departments at each of the 12 Federal Re-

168 Promoting Consumer Protection and Community Development

 serve Banks, as well as at the Board, that collaborate to advance effec-
tive community development policies and practices through a range of
activities, including
• Convening stakeholders: The function brings together practitio-
ners from financial institutions, nonprofits, governmental agencies,
and the philanthropic and private sectors to collaborate on commu-
nity and economic development initiatives and to identify both key
challenges and promising practices to address them.
• Conducting and sharing research: The function provides policy-
makers and practitioners with objective analysis on the economic
challenges facing lower-income communities and attendant policy
and program implications. CD research is often posted online in
blogs, articles, and working papers and is shared both in small group
settings and at larger scale conferences.
• Identifying emerging issues: The function gathers and analyzes
current information on economic and financial conditions to identify
emerging issues affecting lower-income communities and individu-
als. For example, staff regularly conduct web-based polls or surveys
of individuals and organizations to help track perceptions and pro-
vide market intelligence and sentiments around a wide range of CD
issues.

The CD function supports the implementation of the Community

Reinvestment Act through a wide range of activities, including assess-
ing community economic development and credit needs, fostering
conditions supportive of investment, lending and banking services in
low- and moderate-income communities, and sharing information
on lending and investment opportunities. CD also seeks to mobilize
ideas, networks, and approaches that address a wide range of com-
munity and economic development challenges. The function leverages
its capacity by working with intermediaries that offer financial, real
estate development, advisory, and human services, rather than working
directly with consumers or providing direct funding.

The Federal Reserve System Purposes & Functions 169

Working at the National Level
The community development program at the Board of Governors serves
as the Federal Reserve’s primary liaison to national community organi-
zations and financial intermediaries on interagency projects and task
forces. This effort convenes local and national stakeholders to discuss
potential solutions to issues faced by communities throughout the
country.

In 2015, the Board established its Community Advisory Council (CAC)

to provide insights on the economic circumstances and financial ser-
vices needs of consumers and communities, with a particular focus on
the concerns of low- and moderate-income consumers and communi-
ties. The members of the CAC represent a diverse group of experts and
representatives of consumer and community development organiza-
tions and interests, including from such fields as affordable housing,
community and economic development, small business, and asset and
wealth building. This council complements the Board’s other advisory
councils—the Community Depository Institutions Advisory Council and
the Federal Advisory Council (see page 18 in section 2, “The Three Key
System Entities,” for more information on Board advisory councils).

In addition to the CAC, the Board seeks perspectives directly from com-
munity organizations, with community development staff collaborating
with a wide range of private and public entities, such as Neighbor-
Works America®, the Department of Housing and Urban Development,
the Small Business Administration, the Department of the Treasury, the
Department of Agriculture, and the Bureau of Indian Affairs.

The Board’s community development staff also promote and coordinate

systemwide, high-priority efforts. Initiatives have included close coordi-
nation with community development staff at the Federal Reserve Banks
to study the impact of foreclosed properties on communities and con-
sumers as well as the credit needs of small businesses. Such initiatives
result in collaborations with a broad range of government agencies at
the federal, state, and local levels, and conferences and other events

170 Promoting Consumer Protection and Community Development

Box 7.3. Community Development: Targeting the Challenges and Concerns
on Main Street

The Federal Reserve leverages a net- Support for neighborhood revital-

work of regional Reserve Bank staff to ization: The Federal Reserve supports
support community development by efforts to align communities’ develop-
targeting the specific, unique chal- ment needs with available resources
lenges faced by different communities and advocates the strategic use of data
throughout the country. and other tools to achieve this goal.

Community development website:

The Federal Reserve’s work in communi-
ty development is captured in a central
portal at https://fedcommunities.org.
The site links the System’s community
development resources and research by
topic and region.

Support for employment and

workforce development: The Federal
Reserve recognizes the challenges fac-
ing populations with historically higher
unemployment rates, such as youth,
the less-educated, and minorities, and
works to help identify effective policies
and practices that address obstacles to
employment.

Support for small businesses and

entrepreneurship: Viable small busi-
nesses and small-business owners are Federal Reserve staff and officials routinely convene conferences and events focused on commu-
key to vibrant local economies. The nity development issues. In April 2015, Chair Yellen gave opening remarks at the System’s flag-
ship biennial community development research conference, “Economic Mobility: Research and
Federal Reserve works to help identify
Ideas on Strengthening Families, Communities, and the Economy.” (Conference materials are
opportunities to improve access to available at https://stlouisfed.org/community-development/economic-mobility-conference-2015.)
capital and credit for small-business
development.

that brought together community organizations, lenders, academics,

and government officials. These efforts also have resulted in publica-
tions and reports that share promising practices and policy solutions,
as well as research and ongoing projects to address the challenges
confronting lower-income communities and individuals.

The Federal Reserve System Purposes & Functions 171

Engaging at the Local Level
The community development issues faced by different regions of the
country are often unique to each region because of differing market
influences and trends. In recognition of this dynamic, the Reserve Banks
develop their own programs to target the most pressing community
and economic development needs and issues in their Districts.

Much of this work involves promoting mutually beneficial relationships

between local governments, financial institutions, nonprofit organiza-
tions, and the communities those entities serve. The Federal Reserve
Banks sponsor forums and conferences to provide research and policy
insights on community development issues and offer the opportunity
for stakeholders to engage face-to-face. In addition to bringing these
stakeholders together, community development staff provide them with
the information and technical assistance needed to develop and imple-
ment effective community and economic development programs.

172 Promoting Consumer Protection and Community Development

Board of Governors of the Federal Reserve System
www.federalreserve.gov
1016