Purposes of a Central Bank
• Supervise a nation’s money supply and payments
• Act as the chief regulator of the nation’s financial
• Be “lender of last resort” when financial system has
liquidity problems.
• Implement nation’s monetary policy (setting interest
rates, controlling money supply, and so forth).
• Act as the national government’s “fiscal agent” (i.e.
depository bank)
Central Banks of U.S.
• Bank of the United States 1791-1811
• Second Bank of the United States 1816-1832
 Free Banking Era 1837-1863
 National Banking System Era 1863-1914
• Federal Reserve System 1914-present
First two banks failed because of (a) a general distrust in
centralized power, (b) too many regions of country felt
they weren’t being treated fairly.
What is a Banknote?
• In U.S. past, various private banknotes served as
money as they were supposed to be redeemable for
bullion on demand.
• Could take gold, silver, U.S. government bond, or
another bank’s banknotes to a bank. (a) Get in
exchange banknotes from the current bank, or (b)
leave amount in bank as a demand deposit
(denominated in banknotes from the current bank).
• A loan from the bank came in the form of banknotes
from that bank.
• Today, all paper money consists of “banknotes” issued
by a nation’s central bank.
No Central Bank 1832-1914
• Banknotes carried the default risk of the bank that
issued it.
• What a good cost depended on the banknote used to
pay for it.
• At one time, there were 15,000 different banks
issuing banknotes.
• Discount books were published by dealers who dealt
in banknotes listing what they would pay for a given
• The different banknotes made commerce difficult.
Free Banking Era 1837-1863
• Federal legislation in 1837 removed restraints on banking.
• Money supply was unstable during era
No standard currency, only various private banknotes
“Hard currency” (gold/silver) much preferred
No coordinated payments system
• All banks became state-chartered and unregulated
No deposit insurance or capital requirements
No supervision over lending or accounting practices
Many financial shenanigans (bogus banknotes,
unwillingness to redeem, etc.)
Frequent bank failures
National Banking System Era 1863-1914
National Banking Acts of mid-1860s
• Purpose was to strengthen the banking system, to try to
make all banks federally chartered, and move toward a
more uniform currency.
• State chartered banks had to pay 10% annual tax on
their banknotes, but began to focus on checking accounts
• Federally chartered “National Banks” could issue
banknotes without being taxed. But must be printed by
the U.S. Mint to prevent counterfeiting.
• Banknotes had to be backed by U.S. government bonds.
• Banks had to maintain minimum reserve requirements
and submit to periodic bank examinations under
auspices of Comptroller of the Currency.
Meaning of the Term “Reserves”
The term “reserves” refers to the proportion of
deposits that are not used to buy financial claims or
lent out to clients.
i.e., the money the bank has immediately available to
meet withdrawal requests.
National Banking System Era Problems
“Run” on a bank (everybody attempts to withdraw at
Pyramiding of reserves. Banks were allowed to count
deposits at other banks as reserves. Thus, a “run” on one
bank could result in a “run” on others -- contagion.
Call loans. Typical of loans during this era. Were due
when “called in” by the bank. Banks low on reserves
called in loans. Caused borrowers to draw down their
own deposits or default. Caused more bank illiquidity
and more “calls.”
Bank panics would spread, dragging economy into
Boom/Bank Panic/Recession Cycle
• Economy starts improving. Loan demand starts
increasing. System builds upon itself. Eventually
banking system makes too many bad loans.
• A few run low on cash. Since accounts not insured,
people panic.
• Everybody runs to get their money out of bank. Makes
crisis worse. Banks call in loans.
• Disrupts businesses. Employees laid off. They take
savings out of bank. Bank’s cash situation gets worse.
Banks fail. Country goes into recession.
• Major panics since Civil War: 1873, 1893, 1907, 1930-32
Panic of 1907
• Stock market fell close to 50%
• Contraction of liquidity by a number of New York City
banks caused a loss of confidence among depositors
• Bank runs across the country (despite most banks
being solvent)
• Was no central bank to inject liquidity
• Bank failures.
• From repeated boom/bank panic/recession cycles,
people began to learn. Panic of 1907 was last straw.
• Commission charged to investigate the crisis proposed
solution that led to the creation of Federal Reserve
Bank Insolvency
• When a bank’s liabilities exceed its assets
• Whether bank gets shut down by regulators is a
judgment call
• Depends upon whether situation is temporary or
• So a bank may fail for either reasons of illiquidity or
Federal Reserve Act of 1913
• Federal Reserve Act of 1913 (passed in Dec but went
into effect in 1914) designed to
to create a central banking system designed to
assure that no region or group had an unfair say.
to provide for an “elastic” standardized currency in
the form of Federal Reserve Notes that could be
adjusted in amount to meet the needs of a changing
to serve as lender of last resort to keep banks liquid.
improve payments system (check clearing).
provide more vigorous supervision of banks.
Today’s Federal Reserve System
• 12 district Federal Reserve Banks
• About 3,000 member commercial banks
• 7-member Board of Governors
• 12-member Federal Open Market Committee
• All kinds of advisory committees
12 District Federal Reserve Banks
1 to 12, or A to L
7-Member Board of Governors
• 7 Governors appointed by President, confirmed by
• No two Governors from same Federal Reserve District
• Governors have staggered 14-year terms.
• Governors’ terms are nonrenewable.
• Which Governor is to be Chairman is determined by
the President
• Chairman has 4-year term and may be reappointed (Alan
Greenspan since 1987-2006, followed by Ben Bernanke 20062014, now Janet Yellen).
• When new Chairman is named, old one leaves (regardless of
time left in underlying appointment as a Governor) .
About 3,000 Member Commercial Banks
All nationally-chartered banks are members of the Fed.
17% of state-chartered banks also belong (for 36% of all
banks, but 76% of all banking assets)
Dependent upon assets, all member banks must own
stock in the Federal Reserve Bank of its district. Just get
6% dividend ($1.4 billion in total in 2009).
After dividends, rest of the profits distributed to the
Federal Government (see chart next slide).
Each District Bank has a 9-member board:
• 6 elected by member banks in district, 3 appointed by
the Board of Governors
• with the restriction 3 from banking, 3 from business,
3 to represent the public.
Distributions (in billions)
About 3,000 Member Commercial Banks
Membership advantages
get to vote
but not as important as in past. Fed services (such as,
payment system) now available to nonmember banks
for a fee.
Nonmember banks still have to post reserves, but done
at a member bank.
Fed regulates all depository institutions without regard
to membership.
12-Member FOMC
FOMC has 12 members (8 permanent, 4 rotating)
• The 7 Governors are permanent members
• President of FRB of New York has a permanent seat
(because FRB of NY carries out FOMC’s open market directives)
• Presidents of 4 other FRBs rotate through 1-year terms
• Chairman of Board of Governors is Chair of the
• FOMC meets 8 times per year
FOMC Meeting
Decides when and how much to expand or contract
money supply.
Instructs FRB of New York to conduct open market
operations, which involve buying and selling of US
Government and agency securities.
Works mostly with primary approved dealers.
Buying securities increases the money supply, selling
decreases money supply.
Primary Approved Dealers
Bank of Nova Scotia, New York Agency
BMO Capital Markets Corp.
BNP Paribas Securities Corp.
Barclays Capital Inc.
Cantor Fitzgerald & Co.
Citigroup Global Markets Inc.
Credit Suisse Securities (USA) LLC
Daiwa Capital Markets America Inc.
Deutsche Bank Securities Inc.
Goldman, Sachs & Co.
HSBC Securities (USA) Inc.
Jefferies LLC
J. P. Morgan Securities LLC
Merrill Lynch
Mizuho Securities USA Inc.
Morgan Stanley & Co. LLC
Nomura Securities International, Inc.
RBC Capital Markets, LLC
RBS Securities Inc.
SG Americas Securities, LLC
UBS Securities LLC.
When Fed buys securities, credits the dealer’s reserves at
the Fed.
When Fed sells securities, debits the dealer’s reserves at
the Fed.
Elaborate System of Checks and Balances
Functions of the Federal Reserve
• Sets reserve requirements
• Propose discount rates
• Regulates banking institutions
• Holds reserve balances
• Regulates consumer finance
• Lends through discount window
• Oversees district FRBs
• Furnishes currency
• Transfers funds among dep institutions
• Handles US Treasury bank account
• Specifies open market operations
• Set Fed Fund target rate
• Decides on discount rates
• Carries out open market operations
Regulatory Responsibilities of the Fed
Independence of the Fed
Created by Congress, not under its control, but gets a
lot of pressure.
Governors appointed by, but not answerable to
Government has no “power of the purse” as Fed is
very profitable
Fed operates this way because monetary policy has
historically been a non-partisan issue
An independent Fed can take necessary but unpopular
Government generally content with Fed independence,
can always blame the Fed when economy falters
Central Bank Independence vs. Inflation
Fed Balance Sheet (in millions), Dec 2006
Gold & Coin
Loans to depository institutions
Repurchase agreements
US Treasury securities
Liabilities & Capital
Agency securities
Foreign currency
Federal Reserve Notes
Rev Repurchase agreements
Depository inst balances
US Treasury
Liabilities and Capital
Depository institution balances (reserves). Depository
institution balances are kept at the Fed to meet
required reserves (RR). Relationships:
RR  k (DEP )
T R  balance at F ed  vault cash
TR  RR  ER
where TR is total reserves, ER is excess reserves, DEP
is institution’s total deposits, and k is a “simplistic”
reserve requirement
Before crisis of 2007, balances at Fed (for meeting RR
and clearing checks) earned no interest, but now they
do (.25%).
Reserve Requirements (RR)
0 to $10.7 milllion
$10.7 million to $55.2 million
Over $55.2 million
Borrowing at the “Discount Window”
• Borrowing from the Federal Reserve Bank’s lending facility, i.e.,
borrowing at the “discount window,” which is done at district FRB,
increases money supply.
• Part of Fed’s “lender of last resort” function.
• Borrowing at “discount window” done for short term (usually
overnight). In normal times, only done occasionally.
• Historically, discount window borrowing has carried stigma of bank
failure. Banks are wary of “discount window scrutiny.”
• All borrowings must be fully collateralized with high-quality
securities (usually Treasuries and agency securities).
• Fed actually extends three types of credit: primary, secondary,
seasonal. Primary rate is also known as the discount rate. 6 years
ago: primary 5.75%. Secondary usually 0.50-1.00% higher.
Seasonal is for vacation and agricultural areas. Currently: primary
0.75%, secondary 1.25%.
Capital Adequacy
In addition to reserve requirements,
Reserves/Deposits ≥ “10.7/55.2” calculation
a bank must satisfy a capital adequacy ratio
Capital/“Loans” ≥ h%
where h is from 6 to 12, depending on bank.
Also (this is new), people who start a bank have to buy
stock in the bank (creates paid-in capital entry on
balance sheet), i.e., owners must have skin in the game.
Things for Sure To Know for Quiz
Know everything on all slides of Module 1.1 and up to this slide of
Module 1.2.
Study all End-of-Chapter Problems and Solutions.
“10.7/55.2” schedule.
Know how to multiply large numbers by small numbers. Set
calculator so can do 6 places to right of decimal point.
Friday and Monday 2:00-3:30pm accessibility. Never hurts to send
email saying you are coming.
“Simplistic” Example:
A bank creates a trust, ie, special purpose vehicle (SPV).
Then lends SPV money to buy many loans of a particular
type. Go into a pool. SPV then sells bonds, structured into
tranches, to investors to pay back bank with proceeds.
Loans in pool pay interest and make principal repayments,
which flow through to service the bonds and pay them off.
Bank makes money two ways: (1) annual fees for
operating the SPV, (2) selling the bonds for more than it
cost to buy the loans.
Mortgage Backed Security (MBS)
In simplest form, an MBS is a security whose cash flows
are derived from a pool of mortgages.
Two types of MBSs:
mortgage bonds (created from a pool of mortgages)
CDOs (created from a pool of mortgage bonds)
MBSs can get extremely complicated.
ABS (asset backed security) is same as MBS but cash
flows are from a pool of home equity loans, auto loans,
student loans, credit card receivables, . . .
Now over $1.2 trillion in student loans (but not all have
been securitized, i.e., made into ABSs).
Repos & Reverse Repos on Fed Bal Sheet
Used by Fed for temporary adjustments to money supply.
Repurchase agreements. Securities sold by dealers under
agreement to repurchase on a certain date at a certain
price. (adds reserve balances to the banking system)
Reverse repurchase agreements. Securities purchased by
dealers under agreement to resell back on a certain date
at a certain price. (drains reserve balances from the
banking system)
repo -- economic equivalent of a collateralized loan
reverse repo -- economic equivalent of collateralized borrowing
Repos & Reverse Repos on Fed Bal Sheet
Repurchase agreement (dealer borrows from Fed)
Fed buys securities from dealer for X
Dealer repurchases securities from Fed for X+interest
Reverse repurchase agreement (dealer loan to Fed)
Fed sells securities to dealer for X
Fed repurchases securities from dealer for X+interest
Repos are used all over the financial world. Need to
study repos hard.
It is called a repo or reverse repo depending upon how it
looks to a dealer.
 1 
L oan M ultiplier      1 
 k 
Example. Assume banking system fully loaned up,
“simplistic” k = 20%, and money supply is increased by
If banking system proceeds to again become fully loaned
up, total loans will increase by how much?
answer 20,000
Reserves will increase by how much?
Multiplier Effect (assume “simplistic” k = 20%)
week = 0
5,000 deposit (say, money Assets
from abroad)
4,000 5,000 deposits
reserves 1,000
week= 1: new loans create
4,000 more in deposits
7,200 9,000 deposits
reserves 1,800
week=2: new loans create
3,200 more in deposits
9,760 12,200 deposits
reserves 2,440
Banking System Getting Fully “Loaned Up”
week=3: new loans create
2,560 more in deposits
week=4: new loans create
2,048 more in deposits
week=5: new loans create
1,638 more in deposits
loans 11,808 14,760 deposits
reserves 2,952
13,446 16,808 deposits
reserves 3,362
14,757 18,446 deposits
reserves 3,689
Banking System Getting Fully “Loaned Up”
week=6: new loans create
_____ more in deposits
week=7: new loans create
_____ more in deposits
week = infinity
20,000 25,000 deposits
reserves 5,000

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