Federal Reserve System (“Fed”)

The Federal Reserve System is the central bank of the United States. It was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system. Over the years, its role in banking and the economy has expanded.

The Federal Reserve’s duties fall into four general areas:

• Conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employ­ment, stable prices, and moderate long-term interest rates
• Supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers
• Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets
• Providing financial services to depository institutions, the U.S. gov­ernment, and foreign official institutions, including playing a major role in operating the nation’s payments system

Most developed countries have a central bank whose functions are broadly similar to those of the Federal Reserve.

History

During the nineteenth century and the beginning of the twentieth cen­tury, financial panics plagued the nation, leading to bank failures and business bankruptcies that severely disrupted the economy. The failure of the nation’s banking system to effectively provide funding to troubled depository institutions contributed significantly to the economy’s vulner­ability to financial panics. Short-term credit is an important source of liquidity when a bank experiences unexpected and widespread withdraw­als during a financial panic. A particularly severe crisis in 1907 prompted Congress to establish the National Monetary Commission, which put forth proposals to create an institution that would help prevent and con­tain financial disruptions of this kind. After considerable debate, Congress passed the Federal Reserve Act “to provide for the establishment of Federal reserve banks, to furnish an elastic cur­rency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.” President Woodrow Wilson signed the act into law on December 23, 1913.

Structure of the System

The Federal Reserve implements monetary policy through its control over the federal funds rate—the rate at which depository institutions trade bal­ances at the Federal Reserve. It exercises this control by influencing the demand for and supply of these balances through the following means:

• Open market operations—the purchase or sale of securities, primarily U.S. Treasury securities, in the open market to influence the level of balances that depository institutions hold at the Federal Reserve Banks
• Reserve requirements—requirements regarding the percentage of certain deposits that depository institutions must hold in reserve in the form of cash or in an account at a Federal Reserve Bank
• Contractual clearing balances—an amount that a depository institu­tion agrees to hold at its Federal Reserve Bank in addition to any required reserve balance
• Discount window lending—extensions of credit to depository in­stitutions made through the primary, secondary, or seasonal lending programs

Federal Reserve Banks

Member Banks

The nation’s commercial banks can be divided into three types according to which governmental body charters them and whether or not they are members of the Federal Reserve System. Those chartered by the federal government (through the Office of the Comptroller of the Currency in the Department of the Treasury) are national banks; by law, they are members of the Federal Reserve System. Banks chartered by the states are divided into those that are members of the Federal Reserve System (state member banks) and those that are not (state nonmember banks). State banks are not required to join the Federal Reserve System, but they may elect to become members if they meet the standards set by the Board of Governors. As of March 2004, of the nation’s approximately 7,700 com­mercial banks approximately 2,900 were members of the Federal Reserve System—approximately 2,000 national banks and 900 state banks.

Advisory Committees

The Federal Reserve System uses advisory committees in carrying out its varied responsibilities. Three of these committees advise the Board of Governors directly:

• Federal Advisory Council. This council, which is composed of twelve representatives of the banking industry, consults with and advises the Board on all matters within the Board’s jurisdiction. It ordinarily meets four times a year, as required by the Federal Reserve Act. These meetings are held in Washington, D.C., customarily on the first Friday of February, May, September, and December, although occasionally the meetings are set for different times to suit the convenience of either the council or the Board. Annually, each Reserve Bank chooses one person to represent its District on the Federal Advisory Committee, and members customarily serve three one-year terms and elect their own officers.
• Consumer Advisory Council. This council, established in 1976, advises the Board on the exercise of its responsibilities under the Consumer Credit Protection Act and on other matters in the area of consumer financial services. The council’s membership represents the interests of consumers, communities, and the financial services industry. Members are appointed by the Board of Governors and serve staggered three-year terms. The council meets three times a year in Washington, D.C., and the meetings are open to the public.
• Thrift Institutions Advisory Council. After the passage of the Deposi­tory Institutions Deregulation and Monetary Control Act of 1980, which extended to thrift institutions the Federal Reserve’s reserve requirements and access to the discount window, the Board of Gov­ernors established this council to obtain information and views on the special needs and problems of thrift institutions. Unlike the Federal Advisory Council and the Consumer Advisory Council, the Thrift Institutions Advisory Council is not a statutorily mandated body, but it performs a comparable function in providing firsthand advice from representatives of institutions that have an important relationship with the Federal Reserve. The council meets with the Board in Washing­ton, D.C., three times a year. The members are representatives from savings and loan institutions, mutual savings banks, and credit unions. Members are appointed by the Board of Governors and generally serve for two years.

The Federal Reserve Banks also use advisory committees. Of these advi­sory committees, perhaps the most important are the committees (one for each Reserve Bank) that advise the Banks on matters of agriculture, small business, and labor. Biannually, the Board solicits the views of each of these committees by mail.

Monetary Policy and the Economy

The Federal Reserve sets the nation’s monetary policy to promote the objectives of maximum employment, stable prices, and moderate long-term interest rates. The challenge for policy makers is that tensions among the goals can arise in the short run and that information about the economy becomes available only with a lag and may be imperfect.

Goals of Monetary Policy

The goals of monetary policy are spelled out in the Federal Reserve Act, which specifies that the Board of Governors and the Federal Open Mar­ket Committee should seek “to promote effectively the goals of maxi­mum employment, stable prices, and moderate long-term interest rates.” Stable prices in the long run are a precondition for maximum sustainable output growth and employment as well as moderate long-term interest rates. When prices are stable and believed likely to remain so, the prices of goods, services, materials, and labor are undistorted by inflation and serve as clearer signals and guides to the efficient allocation of resources and thus contribute to higher standards of living. Moreover, stable prices foster saving and capital formation, because when the risk of erosion of asset values resulting from inflation—and the need to guard against such losses—are minimized, households are encouraged to save more and busi­nesses are encouraged to invest more.

How Monetary Policy Affects the Economy

The initial link in the chain between monetary policy and the economy is the market for balances held at the Federal Reserve Banks. Depository institutions have accounts at their Reserve Banks, and they actively trade balances held in these accounts in the federal funds market at an interest rate known as the federal funds rate. The Federal Reserve exercises con­siderable control over the federal funds rate through its inf luence over the supply of and demand for balances at the Reserve Banks.

The FOMC sets the federal funds rate at a level it believes will foster financial and monetary conditions consistent with achieving its monetary policy objectives, and it adjusts that target in line with evolving economic developments. A change in the federal funds rate, or even a change in expectations about the future level of the federal funds rate, can set off a chain of events that will affect other short-term interest rates, longer-term interest rates, the foreign exchange value of the dollar, and stock prices. In turn, changes in these variables will affect households’ and businesses’ spending decisions, thereby affecting growth in aggregate demand and the economy.

Short-term interest rates, such as those on Treasury bills and commercial paper, are affected not only by the current level of the federal funds rate but also by expectations about the overnight federal funds rate over the duration of the short-term contract. As a result, short-term interest rates could decline if the Federal Reserve surprised market participants with a reduction in the federal funds rate, or if unfolding events convinced participants that the Federal Reserve was going to be holding the federal funds rate lower than had been anticipated. Similarly, short-term interest rates would increase if the Federal Reserve surprised market partici­pants by announcing an increase in the federal funds rate, or if some event prompted market participants to believe that the Federal Reserve was going to be holding the federal funds rate at higher levels than had been anticipated.

Limitations of Monetary Policy

Monetary policy is not the only force acting on output, employment, and prices. Many other factors affect aggregate demand and aggregate supply and, consequently, the economic position of households and businesses. Some of these factors can be anticipated and built into spending and other economic decisions, and some come as a surprise. On the demand side, the government inf luences the economy through changes in taxes and spending programs, which typically receive a lot of public attention and are therefore anticipated. For example, the effect of a tax cut may precede its actual implementation as businesses and households alter their spend­ing in anticipation of the lower taxes. Also, forward-looking financial markets may build such fiscal events into the level and structure of interest rates, so that a stimulative measure, such as a tax cut, would tend to raise the level of interest rates even before the tax cut becomes effective, which will have a restraining effect on demand and the economy before the fiscal stimulus is actually applied.

Other changes in aggregate demand and supply can be totally unpredict­able and inf luence the economy in unforeseen ways. Examples of such shocks on the demand side are shifts in consumer and business confidence, and changes in the lending posture of commercial banks and other creditors. Lessened confidence regarding the outlook for the economy and labor market or more restrictive lending conditions tend to curb business and household spending. On the supply side, natural disasters, disruptions in the oil market that reduce supply, agricultural losses, and slowdowns in productivity growth are examples of adverse supply shocks. Such shocks tend to raise prices and reduce output. Monetary policy can attempt to counter the loss of output or the higher prices but cannot fully offset both.

In practice, as previously noted, monetary policy makers do not have up-to-the-minute information on the state of the economy and prices. Useful information is limited not only by lags in the construction and availability of key data but also by later revisions, which can alter the picture consid­erably.

Guides to Monetary Policy

Although the goals of monetary policy are clearly spelled out in law, the means to achieve those goals are not.

Among those frequently mentioned are monetary aggregates, the level and structure of interest rates, the so-called Taylor rule, and foreign exchange rates. Some suggest that one of these guides be selected as an intermediate target—that is, that a specific formal objective be set for the intermediate target and pursued aggressively with the policy instruments.

Monetary Aggregates

Monetary aggregates have at times been advocated as guides to monetary policy on the grounds that they may have a fairly stable relationship with the economy and can be controlled to a reasonable extent by the central bank, either through control over the supply of balances at the Federal Reserve or the federal funds rate. An increase in the federal funds rate (and other short-term interest rates), for example, will reduce the attrac­tiveness of holding money balances relative to now higher-yielding money market instruments and thereby reduce the amount of money demanded and slow growth of the money stock. There are a few measures of the money stock—ranging from the transactions-dominated M1 to the broad­er M2 and M3 measures, which include other liquid balances—and these aggregates have different behaviors.

The Components of the Monetary Aggregates

The Federal Reserve publishes data on three monetary aggre­gates. The first, M1, is made up of types of money commonly used for payment, basically currency and checking deposits. The second, M2, includes M1 plus balances that generally are similar to transaction accounts and that, for the most part, can be con­verted fairly readily to M1 with little or no loss of principal. The M2 measure is thought to be held primarily by households. The third aggregate, M3, includes M2 plus certain accounts that are held by entities other than individuals and are issued by banks and thrift institutions to augment M2-type balances in meeting credit demands; it also includes balances in money market mutual funds held by institutional investors.

The aggregates have had different roles in monetary policy as their reliability as guides has changed. The following details their prin­cipal components:

M1

• Currency (and traveler’s checks)
• Demand deposits
• NOW and similar interest-earning checking accounts

M2

• M1
• Savings deposits and money market deposit accounts
• Small time deposits
• Retail money market mutual fund balances

M3

• M2
• Large time deposits
• Institutional money market mutual fund balances
• Repurchase agreements
• Eurodollars

Interest Rates

Interest rates have frequently been proposed as a guide to policy, not only because of the role they play in a wide variety of spending decisions but also because information on interest rates is available on a real-time basis. Arguing against giving interest rates the primary role in guiding monetary policy is uncertainty about exactly what level or path of interest rates is consistent with the basic goals of monetary policy. The appropriate level of interest rates will vary with the stance of fiscal policy, changes in the pattern of household and business spending, productivity growth, and economic developments abroad. It can be difficult not only to gauge the strength of these forces but also to translate them into a path for interest rates.

The slope of the yield curve (that is, the difference between the interest rate on longer-term and shorter-term instruments) has also been suggested as a guide to monetary policy. Whereas short-term interest rates are strongly inf luenced by the current setting of the policy instrument, longer-term interest rates are inf luenced by expectations of future short-term interest rates and thus by the longer-term effects of monetary policy on inflation and output. For example, a yield curve with a steeply positive slope (that is, longer-term interest rates far above short-term rates) may be a signal that participants in the bond market believe that monetary policy has become too expansive and thus, without a monetary policy correc­tion, more inf lationary. Conversely, a yield curve with a downward slope (short-term rates above longer rates) may be an indication that policy is too restrictive, perhaps risking an unwanted loss of output and employment. However, the yield curve is also inf luenced by other factors, including prospective fiscal policy, developments in foreign exchange markets, and expectations about the future path of monetary policy. Thus, signals from the yield curve must be interpreted carefully.

The Taylor Rule

The “Taylor rule,” named after the prominent economist John Taylor, is another guide to assessing the proper stance of monetary policy. It relates the setting of the federal funds rate to the primary objectives of monetary policy—that is, the extent to which inflation may be departing from something approximating price stability and the extent to which out­put and employment may be departing from their maximum sustainable levels. For example, one version of the rule calls for the federal funds rate to be set equal to the rate thought to be consistent in the long run with the achievement of full employment and price stability plus a component based on the gap between current inflation and the inflation objective less a component based on the shortfall of actual output from the full-employment level. If inflation is picking up, the Taylor rule prescribes the amount by which the federal funds rate would need to be raised or, if output and employment are weakening, the amount by which it would need to be lowered. The specific parameters of the formula are set to describe actual monetary policy behavior over a period when policy is thought to have been fairly successful in achieving its basic goals.

Although this guide has appeal, it too has shortcomings. The level of short-term interest rates associated with achieving longer-term goals, a key element in the formula, can vary over time in unpredictable ways. Moreover, the current rate of inf lation and position of the economy in relation to full employment are not known because of data lags and diffi­culties in estimating the full-employment level of output, adding another layer of uncertainty about the appropriate setting of policy.

Foreign Exchange Rates

Exchange rate movements are an important channel through which monetary policy affects the economy, and exchange rates tend to respond promptly to a change in the federal funds rate. Moreover, information on exchange rates, like information on interest rates, is available continu­ously throughout the day.

Interpreting the meaning of movements in exchange rates, however, can be difficult. A decline in the foreign exchange value of the dollar, for ex­ample, could indicate that monetary policy has become, or is expected to become, more accommodative, resulting in inf lation risks. But exchange rates respond to other inf luences as well, notably developments abroad; so a weaker dollar on foreign exchange markets could instead ref lect higher interest rates abroad, which make other currencies more attrac­tive and have fewer implications for the stance of U.S. monetary policy and the performance of the U.S. economy. Conversely, a strengthening of the dollar on foreign exchange markets could ref lect a move to a more restrictive monetary policy in the United States—or expectations of such a move. But it also could ref lect expectations of a lower path for interest rates elsewhere or a heightened perception of risk in foreign financial as­sets relative to U.S. assets.

Some have advocated taking the exchange rate guide a step further and using monetary policy to stabilize the dollar’s value in terms of a par­ticular currency or in terms of a basket of currencies. However, there is a great deal of uncertainty about which level of the exchange rate is most consistent with the basic goals of monetary policy, and selecting the wrong rate could lead to a protracted period of def lation and economic slack or to an overheated economy. Also, attempting to stabilize the ex­change rate in the face of a disturbance from abroad would short-circuit the cushioning effect that the associated movement in the exchange rate would have on the U.S. economy.

The Implementation of Monetary Policy

The Federal Reserve exercises considerable control over the demand for and supply of balances that depository institutions hold at the Reserve Banks. In so doing, it influences the federal funds rate and, ultimately, employment, output, and prices.

The Federal Reserve implements U.S. monetary policy by affecting con­ditions in the market for balances that depository institutions hold at the Federal Reserve Banks. The operating objectives or targets that it has used to effect desired conditions in this market have varied over the years. At one time, the FOMC sought to achieve a specific quantity of balances, but now it sets a target for the interest rate at which those balances are traded between depository institutions—the federal funds rate. By conducting open market operations, imposing reserve requirements, permitting depository institutions to hold contractual clearing balances, and extending credit through its discount window facility, the Federal Reserve exercises con­siderable control over the demand for and supply of Federal Reserve bal­ances and the federal funds rate. Through its control of the federal funds rate, the Federal Reserve is able to foster financial and monetary condi­tions consistent with its monetary policy objectives.

The Market for Federal Reserve Balances

The Federal Reserve inf luences the economy through the market for balances that depository institutions maintain in their accounts at Federal Reserve Banks. Depository institutions make and receive payments on behalf of their customers or themselves in these accounts. The end-of-day balances in these accounts are used to meet reserve and other bal­ance requirements. If a depository institution anticipates that it will end the day with a larger balance than it needs, it can reduce that balance in several ways, depending on how long it expects the surplus to persist. For example, if it expects the surplus to be temporary, the institution can lend excess balances in financing markets, such as the market for repurchase agreements or the market for federal funds.

In the federal funds market, depository institutions actively trade balances held at the Federal Reserve with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend those balances to institutions in need of larger balances. The federal funds rate—the interest rate at which these transactions occur—is an im­portant benchmark in financial markets. Daily f luctuations in the federal funds rate ref lect demand and supply conditions in the market for Federal Reserve balances.

Demand for Federal Reserve Balances

The demand for Federal Reserve balances has three components: required reserve balances, contractual clearing balances, and excess reserve balances.

• Required Reserve Balances

Required reserve balances are balances that a depository institution must hold with the Federal Reserve to satisfy its reserve requirement. Reserve requirements are imposed on all depository institutions—which include commercial banks, savings banks, savings and loan associations, and credit unions—as well as U.S. branches and agencies of foreign banks and other domestic banking entities that engage in international transactions. Since the early 1990s, reserve requirements have been applied only to transaction deposits, which include demand deposits and interest-bearing accounts that offer unlimited checking privileges. An institution’s reserve requirement is a fraction of such deposits; the fraction—the required reserve ratio—is set by the Board of Governors within limits prescribed in the Federal Reserve Act. A depository institution’s reserve requirement expands or contracts with the level of its transaction deposits and with the required reserve ratio set by the Board. In practice, the changes in required reserves ref lect movements in transaction deposits because the Federal Reserve adjusts the required reserve ratio only infrequently.

A depository institution satisfies its reserve requirement by its holdings of vault cash (currency in its vault) and, if vault cash is insufficient to meet the requirement, by the balance maintained directly with a Federal Re­serve Bank or indirectly with a pass-through correspondent bank (which in turn holds the balances in its account at the Federal Reserve). The difference between an institution’s reserve requirement and the vault cash used to meet that requirement is called the required reserve balance. If the balance maintained by the depository institution does not satisfy its reserve balance requirement, the deficiency may be subject to a charge.

• Contractual Clearing Balances

Depository institutions use their accounts at Federal Reserve Banks not only to satisfy their reserve balance requirements but also to clear many financial transactions. Given the volume and unpredictability of transac­tions that clear through their accounts every day, depository institutions seek to hold an end-of-day balance that is high enough to protect against unexpected debits that could leave their accounts overdrawn at the end of the day and against any resulting charges, which could be quite large. If a depository institution finds that targeting an end-of-day balance equal to its required reserve balance provides insufficient protection against over­drafts, it may establish a contractual clearing balance (sometimes referred to as a required clearing balance).

A contractual clearing balance is an amount that a depository institution agrees to hold at its Reserve Bank in addition to any required reserve balance. In return, the depository institution earns implicit interest, in the form of earnings credits, on the balance held to satisfy its contractual clearing balance. It uses these credits to defray the cost of the Federal Reserve services it uses, such as check clearing and wire transfers of funds and securities. If the depository institution fails to satisfy its contractual requirement, the deficiency is subject to a charge.

• Excess Reserve Balances

A depository institution may hold balances at its Federal Reserve Bank in addition to those it must hold to meet its reserve balance requirement and its contractual clearing balance; these balances are called excess reserve balances (or excess reserves). In general, a depository institution attempts to keep excess reserve balances at low levels because balances at the Fed­eral Reserve do not earn interest. However, a depository institution may aim to hold some positive excess reserve balances at the end of the day as additional protection against an overnight overdraft in its account or the risk of failing to hold enough balances to satisfy its reserve or clearing bal­ance requirement. This desired cushion of balances can vary considerably from day to day, depending in part on the volume and uncertainty about payments f lowing through the institution’s account. The daily demand for excess reserve balances is the least-predictable component of the de­mand for balances. (See table 3.1 for data on required reserve balances, contractual clearing balances, and excess reserve balances.)

Measures of aggregate balances, 2001–2004

Billions of dollars; annual averages of daily data

Supply of Federal Reserve Balances

The supply of Federal Reserve balances to depository institutions comes from three sources: the Federal Reserve’s portfolio of securities and re­purchase agreements; loans from the Federal Reserve through its discount window facility; and certain other items on the Federal Reserve’s balance sheet known as autonomous factors.

Securities Portfolio

The most important source of balances to depository institutions is the Federal Reserve’s portfolio of securities. The Federal Reserve buys and sells securities either on an outright (also called permanent) basis or tem­porarily in the form of repurchase agreements and reverse repurchase agreements.

Discount Window Lending

The supply of Federal Reserve balances increases when depository institu­tions borrow from the Federal Reserve’s discount window. Access to dis­count window credit is established by rules set by the Board of Governors, and loans are made at interest rates set by the Reserve Banks and approved by the Board. Depository institutions decide to borrow based on the level of the lending rate and their liquidity needs.

Autonomous Factors

The supply of balances can vary substantially from day to day because of movements in other items on the Federal Reserve’s balance sheet. These so-called autonomous factors are generally outside the Federal Reserve’s direct day-to-day control. The most important of these factors are Federal Reserve notes, the Treasury’s balance at the Federal Reserve, and Federal Reserve float.

Consolidated balance sheet of the Federal Reserve Banks, December 31, 2004

Millions of dollars

Controlling the Federal Funds Rate

The Federal Reserve’s conduct of open market operations, its policies related to required reserves and contractual clearing balances, and its lend­ing through the discount window all play important roles in keeping the federal funds rate close to the FOMC’s target rate. Open market opera­tions are the most powerful and often-used tool for controlling the funds rate. These operations, which are arranged nearly every business day, are designed to bring the supply of Federal Reserve balances in line with the demand for those balances at the FOMC’s target rate. Required reserve balances and contractual clearing balances facilitate the conduct of open market operations by creating a predictable demand for Federal Reserve balances. If, even after an open market operation is arranged, the supply of balances falls short of demand, then discount window lending provides a mechanism for expanding the supply of balances to contain pressures on the funds rate.

Open Market Operations

In theory, the Federal Reserve could conduct open market operations by purchasing or selling any type of asset. In practice, however, most assets cannot be traded readily enough to accommodate open market operations. For open market operations to work effectively, the Federal Reserve must be able to buy and sell quickly, at its own convenience, in whatever volume may be needed to keep the federal funds rate at the target level. These conditions require that the instrument it buys or sells be traded in a broad, highly active market that can accommodate the transactions with­out distortions or disruptions to the market itself.

Composition of the Federal Reserve’s Portfolio

The overall size of the Federal Reserve’s holdings of Treasury securities depends principally on the growth of Federal Reserve notes; however, the amounts and maturities of the individual securities held depends on the FOMC’s preferences for liquidity. The Federal Reserve has guidelines that limit its holdings of individual Treasury securities to a percentage of the total amount outstanding. These guidelines are designed to help the Federal Reserve manage the liquidity and average maturity of the Sys­tem portfolio. The percentage limits under these guidelines are larger for shorter-dated issues than longer-dated ones. Consequently, a sizable share of the Federal Reserve’s holdings is held in Treasury securities with re­maining maturities of one year or less. This structure provides the Federal Reserve with the ability to alter the composition of its assets quickly when developments warrant. At the end of 2004, the Federal Reserve’s holdings of Treasury securities were about evenly weighted between those with maturities of one year or less and those with maturities greater than one year

U.S. Treasury securities held in the Federal Reserve’s open market account, December 31, 2004

Billions of dollars

Types of Credit

In ordinary circumstances, the Federal Reserve extends discount window credit to depository institutions under the primary, secondary, and seasonal credit programs. The rates charged on loans under each of these programs are established by each Reserve Bank’s board of directors every two weeks, subject to review and determination by the Board of Governors. The rates for each of the three lending programs are the same at all Reserve Banks, except occasionally for very brief periods following the Board’s action to adopt a requested rate change. The Federal Reserve also has the author­ity under the Federal Reserve Act to extend credit to entities that are not depository institutions in “unusual and exigent circumstances”; however, such lending has not occurred since the 1930s.

Primary Credit

Primary credit is available to generally sound depository institutions on a very short-term basis, typically overnight. To assess whether a depository institution is in sound financial condition, its Reserve Bank regularly re­views the institution’s condition, using supervisory ratings and data on ad­equacy of the institution’s capital. Depository institutions are not required to seek alternative sources of funds before requesting occasional advances of primary credit, but primary credit is expected to be used as a backup, rather than a regular, source of funding.

The rate on primary credit has typically been set 1 percentage point above the FOMC’s target federal funds rate, but the spread can vary depending on circumstances. Because primary credit is the Federal Reserve’s main dis count window program, the Federal Reserve at times uses the term discount rate specifically to mean the primary credit rate.

Reserve Banks ordinarily do not require depository institutions to provide reasons for requesting very short-term primary credit. Borrowers are asked to provide only the minimum information necessary to process a loan, usually the requested amount and term of the loan. If a pattern of borrow­ing or the nature of a particular borrowing request strongly indicates that a depository institution is not generally sound or is using primary credit as a regular rather than a backup source of funding, a Reserve Bank may seek additional information before deciding whether to extend the loan.

Primary credit may be extended for longer periods of up to a few weeks if a depository institution is in generally sound financial condition and can­not obtain temporary funds in the market at reasonable terms. Large and medium-sized institutions are unlikely to meet this test.

Secondary Credit

Secondary credit is available to depository institutions that are not eligible for primary credit. It is extended on a very short-term basis, typically overnight. Ref lecting the less-sound financial condition of borrowers of secondary credit, the rate on secondary credit has typically been 50 basis points above the primary credit rate, although the spread can vary as circumstances warrant. Secondary credit is available to help a deposi­tory institution meet backup liquidity needs when its use is consistent with the borrowing institution’s timely return to a reliance on market sources of funding or with the orderly resolution of a troubled institution’s difficulties. Secondary credit may not be used to fund an expansion of the borrower’s assets.

Loans extended under the secondary credit program entail a higher level of Reserve Bank administration and oversight than loans under the primary credit program. A Reserve Bank must have sufficient information about a borrower’s financial condition and reasons for borrowing to ensure that an extension of secondary credit would be consistent with the purpose of the facility. Moreover, under the Federal Deposit Insurance Corpora­tion Improvement Act of 1991, extensions of Federal Reserve credit to an FDIC-insured depository institution that has fallen below minimum capital standards are generally limited to 60 days in any 120-day period or, for the most severely undercapitalized, to only five days.

Seasonal Credit

The Federal Reserve’s seasonal credit program is designed to help small depository institutions manage significant seasonal swings in their loans and deposits. Seasonal credit is available to depository institutions that can demonstrate a clear pattern of recurring swings in funding needs through­out the year—usually institutions in agricultural or tourist areas. Borrow­ing longer-term funds from the discount window during periods of sea­sonal need allows institutions to carry fewer liquid assets during the rest of the year and make more funds available for local lending.

The seasonal credit rate is based on market interest rates. It is set on the first business day of each two-week reserve maintenance period as the aver­age of the effective federal funds rate and the interest rate on three-month certificates of deposit over the previous reserve maintenance period.

The Federal Reserve in the International Sphere

The U.S. economy and the world economy are linked in many ways. Economic developments in this country have a major influence on production, employment, and prices beyond our borders; at the same time, developments abroad significantly affect our economy. The U.S. dollar, which is the currency most used in international transactions, constitutes more than half of other countries’ official foreign exchange reserves. U.S. banks abroad and foreign banks in the United States are important actors in international financial markets.

The activities of the Federal Reserve and the international economy inf lu­ence each other. Therefore, when deciding on the appropriate monetary policy for achieving basic economic goals, the Board of Governors and the FOMC consider the record of U.S. international transactions, movements in foreign exchange rates, and other international economic developments. And in the area of bank supervision and regulation, innovations in inter­national banking require continual assessments of, and occasional modifi­cations in, the Federal Reserve’s procedures and regulations.

The Federal Reserve formulates policies that shape, and are shaped by, international developments. It also participates directly in international affairs. For example, the Federal Reserve occasionally undertakes foreign exchange transactions aimed at inf luencing the value of the dollar in rela­tion to foreign currencies, primarily with the goal of stabilizing disorderly market conditions. These transactions are undertaken in close and con­tinuous consultation and cooperation with the U.S. Treasury. The Federal Reserve also works with the Treasury and other government agencies on various aspects of international financial policy. It participates in a num­ber of international organizations and forums and is in almost continuous contact with other central banks on subjects of mutual concern.

International Linkages

The Federal Reserve’s actions to adjust U.S. monetary policy are designed to attain basic objectives for the U.S. economy. But any policy move also inf luences, and is inf luenced by, international developments. For example monetary policy actions inf luence exchange rates. The dollar’s ex­change value in terms of other currencies is therefore one of the channels through which U.S. monetary policy affects the U.S. economy. If Federal Reserve actions raised U.S. interest rates, for instance, the foreign ex­change value of the dollar generally would rise. An increase in the foreign exchange value of the dollar, in turn, would raise the price in foreign cur­rency of U.S. goods traded on world markets and lower the dollar price of goods imported into the United States. By restraining exports and boost­ing imports, these developments could lower output and price levels in the economy. In contrast, an increase in interest rates in a foreign coun­try could raise worldwide demand for assets denominated in that country’s currency and thereby reduce the dollar’s value in terms of that currency. Other things being equal, U.S. output and price levels would tend to increase—just the opposite of what happens when U.S. interest rates rise.

Foreign Currency Operations

The Federal Reserve conducts foreign currency operations—the buying and selling of dollars in exchange for foreign currency—under the direc­tion of the FOMC, acting in close and continuous consultation and coop­eration with the U.S. Treasury, which has overall responsibility for U.S. international financial policy. The manager of the System Open Market Account at the Federal Reserve Bank of New York acts as the agent for both the FOMC and the Treasury in carrying out foreign currency op­erations. Since the late 1970s, the U.S. Treasury and the Federal Reserve have conducted almost all foreign currency operations jointly and equally.

Sterilization

Intervention operations involving dollars affect the supply of Federal Re­serve balances to U.S. depository institutions, unless the Federal Reserve offsets the effect. A purchase of foreign currency by the Federal Reserve increases the supply of balances when the Federal Reserve credits the account of the seller’s depository institution at the Federal Reserve. Con­versely, a sale of foreign currency by the Federal Reserve decreases the supply of balances. The Federal Reserve offsets, or “sterilizes,” the effects of intervention on Federal Reserve balances through open market opera­tions; otherwise, the intervention could cause the federal funds rate to move away from the target set by the FOMC.

US Foreign Currency Resources

The main source of foreign currencies used in U.S. intervention opera­tions currently is U.S. holdings of foreign exchange reserves. At the end of June 2004, the United States held foreign currency reserves valued at $40 billion. Of this amount, the Federal Reserve held foreign currency assets of $20 billion, and the Exchange Stabilization Fund of the Treasury held the rest.

The U.S. monetary authorities have also arranged swap facilities with for­eign monetary authorities to support foreign currency operations. These facilities, which are also known as reciprocal currency arrangements, pro­vide short-term access to foreign currencies. A swap transaction involves both a spot (immediate delivery) transaction, in which the Federal Re­serve transfers dollars to another central bank in exchange for foreign cur­rency, and a simultaneous forward (future delivery) transaction, in which the two central banks agree to reverse the spot transaction, typically no later than three months in the future. The repurchase price incorporates a market rate of return in each currency of the transaction. The original purpose of swap arrangements was to facilitate a central bank’s support of its own currency in case of undesired downward pressure in foreign exchange markets. Drawings on swap arrangements were common in the 1960s but over time declined in frequency as policy authorities came to rely more on foreign exchange reserve balances to finance currency operations.

Federal Reserve standing reciprocal currency arrangements, June 30, 2004

Millions of U.S. dollars

International Banking

The Federal Reserve is interested in the international activities of banks, not only because it functions as a bank supervisor but also because such activities are often close substitutes for domestic banking activities and need to be monitored carefully to help interpret U.S. monetary and credit conditions. Moreover, international banking institutions are important vehicles for capital f lows into and out of the United States.

Where international banking activities are conducted depends on such factors as the business needs of customers, the scope of operations permit­ted by a country’s legal and regulatory framework, and tax considerations. The international activities of U.S.-chartered banks include lending to and accepting deposits from foreign customers at the banks’ U.S. offices and engaging in other financial transactions with foreign counterparts. However, the bulk of the international business of U.S.-chartered banks takes place at their branch offices located abroad and at their foreign-incorporated subsidiaries, usually wholly owned. Much of the activity of foreign branches and subsidiaries of U.S. banks has been Eurocurrency¹ business—that is, taking deposits and lending in currencies other than that of the country in which the banking office is located. Increasingly, U.S. banks are also offering a range of sophisticated financial products to resi­dents of other countries and to U.S. firms abroad.

The international role of U.S. banks has a counterpart in foreign bank op­erations in the United States. U.S. offices of foreign banks actively partici­pate as both borrowers and investors in U.S. domestic money markets and are active in the market for loans to U.S. businesses. (See chapter 5 for a discussion of the Federal Reserve’s supervision and regulation of the inter­national activities of U.S. banks and the U.S. activities of foreign banks.)

International banking by both U.S.-based and foreign banks facilitates the holding of Eurodollar deposits—dollar deposits in banking offices out­side the United States—by nonbank U.S. entities. Similarly, Eurodollar loans—dollar loans from banking offices outside the United States—can be an important source of credit for U.S. companies (banks and non-banks). Because they are close substitutes for deposits at domestic banks, Eurodollar deposits of nonbank U.S. entities at foreign branches of U.S. banks are included in the U.S. monetary aggregate M3; Eurodollar de­posits of nonbank U.S. entities at all other banking offices in the United Kingdom and Canada are also included in M3.

Supervision and Regulation

The Federal Reserve has supervisory and regulatory authority over a wide range of financial institutions and activities. It works with other federal and state supervisory authorities to ensure the safety and soundness of financial institutions, stability in the financial markets, and fair and equitable treatment of consumers in their financial transactions. As the

U.S. central bank, the Federal Reserve also has extensive and well-established relationships with the central banks and financial supervisors of other countries, which enables it to coordinate its actions with those of other countries when managing international financial crises and supervising institutions with a substantial international presence.

The Federal Reserve has responsibility for supervising and regulating the following segments of the banking industry to ensure safe and sound banking practices and compliance with banking laws:

• Bank holding companies, including diversified financial holding com­panies formed under the Gramm-Leach-Bliley Act of 1999 and foreign banks with U.S. operations
• State-chartered banks that are members of the Federal Reserve System (state member banks)
• Foreign branches of member banks
• Edge and agreement corporations, through which U.S. banking orga­nizations may conduct international banking activities
• U.S. state-licensed branches, agencies, and representative offices of foreign banks
• Nonbanking activities of foreign banks

Although the terms bank supervision and bank regulation are often used inter­changeably, they actually refer to distinct, but complementary, activities. Bank supervision involves the monitoring, inspecting, and examining of banking organizations to assess their condition and their compliance with relevant laws and regulations. When a banking organization within the Federal Reserve’s supervisory jurisdiction is found to be noncompliant or to have other problems, the Federal Reserve may use its supervisory authority to take formal or informal action to have the organization correct the problems.

Bank regulation entails issuing specific regulations and guidelines governing the operations, activities, and acquisitions of banking organizations.

Responsibilities of the Federal Banking Agencies

The Federal Reserve shares supervisory and regulatory responsibilities for domestic banking institutions with the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), and the Office of Thrift Supervision (OTS) at the federal level, and with the banking departments of the various states. The primary supervisor of a domestic banking institution is generally determined by the type of institution that it is and the governmental authority that granted it permis­sion to commence business (commonly referred to as a charter). Banks that are chartered by a state government are referred to as state banks; banks that are chartered by the OCC, which is a bureau of the Depart­ment of the Treasury, are referred to as national banks.

The Federal Reserve has primary supervisory authority for state banks that elect to become members of the Federal Reserve System (state member banks). State banks that are not members of the Federal Reserve System (state nonmember banks) are supervised by the FDIC. In addition to being supervised by the Federal Reserve or FDIC, all state banks are supervised by their chartering state. The OCC supervises national banks. All national banks must become members of the Federal Reserve System. This dual federal–state banking system has evolved partly out of the complexity of the U.S. financial system, with its many kinds of depository institutions and numerous chartering authorities. It has also resulted from a wide variety of federal and state laws and regulations designed to remedy problems that the U.S. commercial banking system has faced over its history.

Banks are often owned or controlled by another company. These com­panies are referred to as bank holding companies. The Federal Reserve has supervisory authority for all bank holding companies, regardless of whether the subsidiary bank of the holding company is a national bank, state member bank, or state nonmember bank.

Savings associations, another type of depository institution, have histori­cally focused on residential mortgage lending. The OTS, which is a bureau of the Department of the Treasury, charters and supervises federal savings associations and also supervises companies that own or control a savings association. These companies are referred to as thrift holding companies.

Federal Financial Institutions Examination Council

To promote consistency in the examination and supervision of banking organizations, in 1978 Congress created the Federal Financial Institu­tions Examination Council (FFIEC). The FFIEC is composed of the chairpersons of the FDIC and the National Credit Union Administration, the comptroller of the currency, the director of the OTS, and a governor of the Federal Reserve Board appointed by the Board Chairman. The FFIEC’s purposes are to prescribe uniform federal principles and standards for the examination of depository institutions, to promote coordination of bank supervision among the federal agencies that regulate financial insti­tutions, and to 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 for federally super­vised banks to file with their federal regulator.

Supervisory Process

The main objective of the supervisory process is to evaluate the over­all safety and soundness of the banking organization. This evaluation includes an assessment of the organization’s risk-management systems, financial condition, and compliance with applicable banking laws and regulations.

The supervisory process entails both on-site examinations and inspections and off-site surveillance and monitoring. Typically, state member banks must have an on-site examination at least once every twelve months. Banks that have assets of less than $250 million and that meet certain management, capi­tal, and other criteria may be examined once every eighteen months. The Federal Reserve coordinates its examinations with those of the bank’s char­tering state and may alternate exam cycles with the bank’s state supervisor.

The Federal Reserve generally conducts an annual inspection of large bank holding companies (companies with consolidated assets of $1 billion or greater) and smaller bank holding companies that have significant non­bank assets. Small, noncomplex bank holding companies are subject to a special supervisory program that permits a more f lexible approach that relies on off-site monitoring and the supervisory ratings of the lead subsid­iary depository institution. When evaluating the consolidated condition of the holding company, Federal Reserve examiners rely heavily on the results of the examination of the company’s subsidiary banks by the pri­mary federal or state banking authority, to minimize duplication of efforts and reduce burden on the banking organization.

Risk-Focused Supervision

With the largest banking organizations growing in both size and com­plexity, the Federal Reserve has moved towards a risk-focused approach to supervision that is more a continuous process than a point-in-time examination. The goal of the risk-focused supervision process is to iden­tify the greatest risks to a banking organization and assess the ability of the organization’s management to identify, measure, monitor, and control these risks. Under the risk-focused approach, Federal Reserve examiners focus on those business activities that may pose the greatest risk to the organization.

Supervisory Rating System

The results of an on-site examination or inspection are reported to the board of directors and management of the bank or holding company in a report of examination or inspection, which includes a confidential super­visory rating of the financial condition of the bank or holding company. The supervisory rating system is a supervisory tool that all of the federal and state banking agencies use to communicate to banking organizations the agency’s assessment of the organization and to identify institutions that raise concern or require special attention. This rating system for banks is commonly referred to as CAMELS, which is an acronym for the six com­ponents of the rating system: capital adequacy, asset quality, management and administration, earnings, liquidity, and sensitivity to market risk. The Federal Reserve also uses a supervisory rating system for bank holding companies, referred to as RFI/C(D), that takes into account risk manage­ment, financial condition, potential impact of the parent company and nondepository subsidiaries on the affiliated depository institutions, and the CAMELS rating of the affiliated depository institutions.

Financial Regulatory Reports

In carrying out their supervisory activities, Federal Reserve examiners and supervisory staff rely on many sources of financial and other information about banking organizations, including reports of recent examinations and inspections, information published in the financial press and else­where, and the standard financial regulatory reports filed by institutions.

Off-Site Monitoring

In its ongoing off-site supervision of banks and bank holding companies, the Federal Reserve uses automated screening systems to identify orga­nizations with poor or deteriorating financial profiles and to help detect adverse trends developing in the banking industry.

Accounting Policy and Disclosure

Enhanced market discipline is an important component of bank supervi­sion. Accordingly, the Federal Reserve plays a significant role in promot­ing sound accounting policies and meaningful public disclosure by finan­cial institutions.

Umbrella Supervision and Coordination with Other Functional Regulators

In addition to owning banks, bank holding companies also may own broker-dealers engaged in securities activities or insurance companies. In­deed, one of the primary purposes of the Gramm-Leach-Bliley Act (GLB Act), enacted in 1999, was to allow banks, securities broker-dealers, and insurance companies to affiliate with each other through the bank hold­ing company structure. To take advantage of the expanded affiliations permitted by the GLB Act, a bank holding company must meet certain capital, managerial, and other requirements and must elect to become a “financial holding company.” When a bank holding company or financial holding company owns a subsidiary broker-dealer or insurance company, the Federal Reserve seeks to coordinate its supervisory responsibilities with those of the subsidiary’s functional regulator—the Securities and Exchange Commission (SEC) in the case of a broker-dealer and the state insurance authorities in the case of an insurance company.

The Federal Reserve’s role as the supervisor of a bank holding company or financial holding company is to review and assess the consolidated organization’s operations, risk-management systems, and capital adequacy to ensure that the holding company and its nonbank subsidiaries do not threaten the viability of the company’s depository institutions. In this role, the Federal Reserve serves as the “umbrella supervisor” of the con­solidated organization. In fulfilling this role, the Federal Reserve relies to the fullest extent possible on information and analysis provided by the appropriate supervisory authority of the company’s bank, securities, or insurance subsidiaries.

Anti-Money-Laundering Program

To enhance domestic security following the terrorist attacks of September 11, 2001, Congress passed the USA Patriot Act, which contained provi­sions for fighting international money laundering and for blocking ter­rorists’ access to the U.S. financial system. The provisions of the act that affect banking organizations were generally set forth as amendments to the Bank Secrecy Act (BSA), which was enacted in 1970.

The BSA requires financial institutions doing business in the United States to report large currency transactions and to retain certain records, includ­ing information about persons involved in large currency transactions and about suspicious activity related to possible violations of federal law, such as money laundering, terrorist financing, and other financial crimes. The BSA also prohibits the use of foreign bank accounts to launder illicit funds or to avoid U.S. taxes and statutory restrictions.

Business Continuity

After September 11, 2001, the Federal Reserve implemented a number of measures to promote the continuous operation of financial markets and to ensure the continuity of Federal Reserve operations in the event of a future crisis. The process of strengthening the resilience of the private-sector financial system—focusing on organizations with systemic elements—is largely accomplished through the existing regulatory framework. In 2003, responding to the need for further guidance for financial institutions in this area, the Federal Reserve Board, the OCC, and the SEC issued the “Interagency Paper on Sound Practices to Strengthen the Resilience of the U.S. Financial System.” The paper sets forth sound practices for the financial industry to ensure a rapid recovery of the U.S. financial system in the event of a wide-scale disruption that may include loss or inacces­sibility of staff. Many of the concepts in the paper amplify long-standing and well-recognized principles relating to safeguarding information and the ability to recover and resume essential financial services.

Other Supervisory Activities

The Federal Reserve conducts on-site examinations of banks to ensure compliance with consumer protection laws (discussed in chapter 6) as well as compliance in other areas, such as fiduciary activities, transfer agency, securities clearing agency, government and municipal securities dealing, securities credit lending, and information technology. Further, in light of the importance of information technology to the safety and soundness of banking organizations, the Federal Reserve has the authority to examine the operations of certain independent organizations that provide informa­tion technology services to supervised banking organizations.

Enforcement

If the Federal Reserve determines that a state member bank or bank hold­ing company has problems that affect the institution’s safety and soundness or is not in compliance with laws and regulations, it may take a supervi­sory action to ensure that the institution undertakes corrective measures. Typically, such findings are communicated to the management and direc­tors of a banking organization in a written report. The management and directors are then asked to address all identified problems voluntarily and to take measures to ensure that the problems are corrected and will not recur. Most problems are resolved promptly after they are brought to the attention of an institution’s management and directors. In some situations, however, the Federal Reserve may need to take an informal supervisory action, requesting that an institution adopt a board resolution or agree to the provisions of a memorandum of understanding to address the problem.

Supervision of International Operations of U.S. Banking Organizations

The Federal Reserve also has supervisory and regulatory responsibility for the international operations of member banks (that is, national and state member banks) and bank holding companies. 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 and agreement cor­porations, which are specialized institutions used for international and foreign business;
• Authorizing foreign investments of member banks, Edge and agree­ment corporations, and bank holding companies and regulating the activities of foreign firms acquired by such investors; and
• Establishing supervisory policy and practices regarding foreign lending by state member banks.

Under federal law, U.S. banking organizations generally may conduct a wider range of activities abroad than they may conduct in this country.

Supervision of U.S. Activities of Foreign Banking Organizations

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 federal banking agency. When Congress enacted the International Banking Act of 1978 (IBA), it created a federal regulatory structure for the activities of foreign banks with U.S. branches and agencies.

Supervision of Transactions with Affiliates

As part of the supervisory process, the Federal Reserve also evaluates transactions between a bank and its affiliates to determine the effect of the transactions on the bank’s condition and to ascertain whether the transactions are consistent with sections 23A and 23B of the Federal Reserve Act, as implemented by the Federal Reserve Board’s Regulation W. Since the GLB Act increased the range of affiliations permitted to banking organiza­tions, sections 23A and 23B play an increasingly important role in limiting the risk to depository institutions from these broader affiliations. Among other things, section 23A prohibits a bank from purchasing an affiliate’s low-quality assets. In addition, it limits a bank’s loans and other exten­sions of credit to any single affiliate to 10 percent of the bank’s capital and surplus, and it limits loans and other extensions of credit to all affiliates in the aggregate to 20 percent of the bank’s capital and surplus. Section 23B requires that all transactions between a bank and its affiliates be on terms that are substantially the same, or at least as favorable, as those prevailing at the time for comparable transactions with nonaffiliated companies. The Federal Reserve Board is the only banking agency that has the author­ity to exempt any bank from these requirements. During the course of an examination, examiners review a banking organization’s intercompany transactions for compliance with these statutes and Regulation W.

Regulatory Functions

As a bank regulator, the Federal Reserve establishes standards designed to ensure that banking organizations operate in a safe and sound manner and in accordance with applicable law. These standards may take the form of regulations, rules, policy guidelines, or supervisory interpretations and may be established under specific provisions of a law or under more general legal authority. Regulatory standards may be either restrictive (limiting the scope of a banking organization’s activities) or permissive (authorizing banking organizations to engage in certain activities).

Acquisitions and Mergers

Under the authority assigned to the Federal Reserve by the Bank Hold­ing Company Act of 1956 as amended, the Bank Merger Act of 1960, and the Change in Bank Control Act of 1978, the Federal Reserve Board maintains broad authority over the structure of the banking system in the United States.

The Bank Holding Company Act assigned to the Federal Reserve primary responsibility for supervising and regulating the activities of bank holding companies. Through this act, Congress sought to achieve two basic objec­tives: (1) to avoid the creation of a monopoly or the restraint of trade in the banking industry through the acquisition of additional banks by bank holding companies and (2) to keep banking and commerce separate by restricting the nonbanking activities of bank holding companies. Histori­cally, bank holding companies could engage only in banking activities and other activities that the Federal Reserve determined to be closely related to banking. But since the passage of the GLB Act, a bank holding com­pany that qualifies to become a financial holding company may engage in a broader range of financially related activities, including full-scope securities underwriting and dealing, insurance underwriting and sales, and merchant banking. A bank holding company seeking financial holding company status must file a written declaration with the Federal Reserve System, certifying that the company meets the capital, managerial, and other requirements to be a financial holding company.

Bank Acquisitions

Under the Bank Holding Company Act, a firm that seeks to become a bank holding company must first obtain approval from the Federal Re­serve. The act defines a bank holding company 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 inf luence over the management or policies of a bank. A bank holding company must obtain the approval of the Federal Reserve before acquiring more than 5 percent of the shares of an addi­tional bank or bank holding company. All bank holding companies must file certain reports with the Federal Reserve System.

When considering applications to acquire a bank or a bank holding com­pany, the Federal Reserve is required to take into account the likely effects of the acquisition on competition, 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.

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 bank hold­ing companies. 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.

Other Changes in Bank Control

The Change in Bank Control Act of 1978 authorizes the federal bank regulatory agencies to deny 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 or a bank holding company. The Federal Re­serve is responsible for approving changes in the control of bank holding companies and state member banks, and the FDIC and the OCC are re­sponsible for approving changes in the control of insured state nonmember and national banks, respectively. In considering a proposal under the act, the Federal Reserve must review several factors, including the financial condition, 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.

Formation and Activities of Financial Holding Companies

As authorized by the GLB Act, the Federal Reserve Board’s regulations allow a bank holding company 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. Permissible activities for financial holding companies in­clude conducting securities underwriting and dealing, serving as an insur­ance 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 compa­nies 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 to the safety or soundness of depository institutions or the financial system.

Capital Adequacy Standards

A key goal of banking regulation is to ensure that banks maintain suffi­cient capital to absorb reasonably likely losses. In 1989, the federal banking regulators adopted a common standard for measuring capital adequacy that is broadly based on the risks of an institution’s investments. This com­mon standard, in turn, was based on the 1988 agreement “International Convergence of Capital Measurement and Capital Standards” (commonly known as the Basel Accord) developed by the Basel Committee on Bank­ing Supervision. This committee, which is associated with the Bank for International Settlements headquartered in Switzerland, is composed of representatives of the central banks or bank supervisory authorities from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom, and the United States.

Financial Disclosures by State Member Banks

State member banks that issue securities registered under the Securities Exchange Act of 1934 must disclose certain information of interest to investors, including annual and quarterly financial reports and proxy state­ments. By statute, the Federal Reserve administers these requirements and has adopted financial disclosure regulations for state member banks that are substantially similar to the SEC’s regulations for other public companies.

Securities Credit

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 Board establishes the minimum amount the buyer must put up when purchasing a security. This minimum amount is known as the margin requirement. In fulfilling its responsibility under the act, the Federal Reserve limits the amount of credit that may be provided by securities brokers and dealers (Regulation T) and the amount of securities credit extended by banks and other lenders (Regulation U). These regulations generally apply to credit-financed purchases of securities traded on securities exchanges and certain securities traded over the coun­ter when the credit is collateralized 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.

Consumer and Community Affairs

The number of federal laws intended to protect consumers in credit and other financial transactions has been growing since the late 1960s. Congress has assigned to the Federal Reserve the duty of implementing many of these laws to ensure that consumers receive comprehensive information and fair treatment.

Among the Federal Reserve’s responsibilities in this area are

• Writing and interpreting regulations to carry out many of the major consumer protection laws,
• Reviewing bank compliance with the regulations,
• Investigating complaints from the public about state member banks’ compliance with consumer protection laws,
• Addressing issues of state and federal jurisdiction,
• Testifying before Congress on consumer protection issues, and
• Conducting community development activities.

In carrying out these responsibilities, the Federal Reserve is advised by its Consumer Advisory Council, whose members represent the interests of consumers, community groups, and creditors nationwide. Meetings of the council, which take place three times a year at the Federal Reserve Board in Washington, D.C., are open to the public.

Consumer Protection

Most financial transactions involving consumers are covered by consumer protection laws. These include transactions involving credit, charge, and debit cards issued by financial institutions and credit cards issued by retail establishments; automated teller machine transactions and other electronic fund transfers; deposit account transactions; automobile leases; mortgages and home equity loans; and lines of credit and other unsecured credit.

Educating Consumers about Consumer Protection Laws

Well-educated consumers are the best consumer protection in the market. They know their rights and responsibilities, and they use the information provided in disclosures to shop and compare. The Federal Reserve Board maintains a consumer information web site with educational materials related to the consumer protection regulations developed by the Board. In addition, the Federal Re­serve staff uses consumer surveys and focus groups to learn more about what issues are important to consumers and to develop and test additional educational resources.

Enforcing Consumer Protection Laws

The Federal Reserve has a comprehensive program to examine financial institutions and other entities that it supervises to ensure compliance with consumer protection laws and regulations. Its enforcement responsibili­ties generally extend only to state-chartered banks that are members of the Federal Reserve System and to certain foreign banking organizations. Other federal regulators are responsible for examining banks, thrift insti­tutions, and credit unions under their jurisdictions and for taking enforce­ment action.

Consumer Complaint Program

The Federal Reserve responds to inquiries and complaints from the public about the policies and practices of financial institutions involving consum­er protection issues. Each Reserve Bank has staff whose primary respon­sibility is to investigate consumer complaints about state member banks and refer complaints about other institutions to the appropriate regulatory agencies. The Federal Reserve’s responses not only address the concerns raised but also educate consumers about financial matters.

Community Affairs

Community affairs programs at the Board and the twelve Federal Reserve Banks promote community development and fair and impartial access to credit. Community affairs offices at the Board and Reserve Banks engage in a wide variety of activities to help financial institutions, community based organizations, government entities, and the public understand and address financial services issues that affect low- and moderate-income people and geographic regions. Each office responds to local needs in its District and establishes its own programs to

• Foster depository institutions’ active engagement in providing credit and other banking services to their entire communities, particularly traditionally underserved markets;
• Encourage mutually beneficial cooperation among community organi­zations, government agencies, financial institutions, and other com­munity development practitioners;
• Develop greater public awareness of the benefits and risks of financial products and of the rights and responsibilities that derive from com­munity investment and fair lending regulations; and
• Promote among policy makers, community leaders, and private-sector decision makers a better understanding of the practices, processes, and resources that result in successful community development programs.

Each Federal Reserve Bank develops specific products and services to meet the informational needs of its region. The community affairs offices issue a wide array of publications, sponsor a variety of public forums, and provide technical information on community and economic development and on fair and equal access to credit and other banking services.

Consumer Protection Laws

• Fair Housing Act (1968)

Prohibits discrimination in the extension of housing credit on the basis of race, color, religion, national origin, sex, handicap, or family status.

• Truth in Lending Act (1968)

Requires uniform methods for computing the cost of credit and for disclosing credit terms. Gives borrowers the right to cancel, within three days, certain loans secured by their residences. Prohibits the unsolicited issuance of credit cards and limits cardholder liability for unauthorized use. Also imposes limitations on home equity loans with rates or fees above a specified threshold.

• Fair Credit Reporting Act (1970)

Protects consumers against inaccurate or misleading information in credit files maintained by credit-reporting agencies; requires credit reporting agencies to allow credit applicants to correct erroneous reports.

• Flood Disaster Protection Act of 1973

Requires flood insurance on property in a flood hazard area that comes under the National Flood Insurance Program.

• Fair Credit Billing Act (1974)

Specifies how creditors must respond to billing-error complaints from consumers; imposes requirements to ensure that creditors handle accounts fairly and promptly. Applies primarily to credit and charge card accounts (for example, store card and bank card accounts). Amended the Truth in Lending Act.

• Equal Credit Opportunity Act (1974)

Prohibits discrimination in credit transactions on several bases, including sex, marital status, age, race, religion, color, national origin, the receipt of public assistance funds, or the exercise of any right under the Consumer Credit Protection Act. Requires creditors to grant credit to qualified individuals without requiring co-signature by spouses, to inform unsuccessful applicants in writing of the reasons credit was denied, and to allow married individuals to have credit histories on jointly held accounts maintained in the names of both spouses. Also entitles a borrower to a copy of a real estate appraisal report.

• Real Estate Settlement Procedures Act of 1974

Requires that the nature and costs of real estate settlements be dis¬closed to borrowers. Also protects borrowers against abusive practices, such as kickbacks, and limits the use of escrow accounts.

• Home Mortgage Disclosure Act of 1975

Requires mortgage lenders to annually disclose to the public data about the geographic distribution of their applications, originations, and purchases of home-purchase and home-improvement loans 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.

• Consumer Leasing Act of 1976

Requires that institutions disclose the cost and terms of consumer leases, such as automobile leases

• Fair Debt Collection Practices Act (1977)

Prohibits abusive debt collection practices. Applies to banks that function as debt collectors for other entities.

• Community Reinvestment Act of 1977

Encourages financial institutions to help meet the credit needs of their entire communities, particularly low- and moderate-income neighborhoods.

• Right to Financial Privacy Act of 1978

Protects bank customers from the unlawful scrutiny of their financial records by federal agencies and specifies procedures that government authorities must follow when they seek information about a customer’s financial records from a financial institution.

• Electronic Fund Transfer Act (1978)

Establishes the basic rights, liabilities, and responsibilities of consumers who use electronic fund transfer services and of financial institutions that offer these services. Covers transactions conducted at automated teller machines, at point-of-sale terminals in stores,  and through telephone bill-payment plans and preauthorized transfers to and from a customer’s account, such as direct deposit of salary or Social Security payments.

• Federal Trade Commission Improvement Act (1980)

Authorizes the Federal Reserve to identify unfair or deceptive acts or practices by banks and to issue regulations to prohibit them. Using this authority, the Federal Reserve has adopted rules substantially similar to those adopted by the FTC that restrict certain practices in the collection of delinquent consumer debt, for example, practices related to late charges, responsibilities of cosigners, and wage assignments.

• Expedited Funds Availability Act (1987)

Specifies when depository institutions must make funds deposited by check available to depositors for withdrawal. Requires institutions to disclose to customers their policies on funds availability.

• Women’s Business Ownership Act of 1988

Extends to applicants for business credit certain protections afforded consumer credit applicants, such as the right to an explanation for credit denial. Amended the Equal Credit Opportunity Act.

• Fair Credit and Charge Card Disclosure Act of 1988

Requires that applications for credit cards that are sent through the mail, solicited by telephone, or made available to the public (for example, at counters in retail stores or through catalogs) contain information about key terms of the account. Amended the Truth in Lending Act.

• Home Equity Loan Consumer Protection Act of 1988

Requires creditors to provide consumers with detailed information about open-end credit plans secured by the consumer’s dwelling. Also regulates advertising of home equity loans and restricts the terms of home equity loan plans

• Truth in Savings Act (1991)

Requires that depository institutions disclose to depositors certain information about their accounts—including the annual percentage yield, which must be calculated in a uniform manner—and prohibits certain methods of calculating interest. Regulates advertising of savings accounts.

• Home Ownership and Equity Protection Act of 1994

Provides additional disclosure requirements and substantive limitations on home-equity loans with rates or fees above a certain percentage or amount. Amended the Truth in Lending Act.

• Gramm-Leach-Bliley Act, title V, subpart A, Disclosure of Nonpublic Personal Information (1999)

Describes the conditions under which a financial institution may disclose nonpublic personal information about consumers to nonaffiliated third parties, provides a method for consumers to opt out of information sharing with nonaffiliated third parties, and requires a financial institution to notify consumers about its privacy policies and practices.

• Fair and Accurate Credit Transaction Act of 2003

Enhances consumers’ ability to combat identity theft, increases the accuracy of consumer reports, allows consumers to exercise greater control over the type and amount of marketing solicitations they receive, restricts the use and disclosure of sensitive medical information, and establishes uniform national standards in the regulation of consumer reporting. Amended the Fair Credit Reporting Act.