The Federal Reserve System

3 The Federal Reserve
System
CHAPTER
3.1 Structure of the Federal Reserve System
3.2 Monetary and Fiscal Policy
3.3 Consumer Protection
3.4 Role in Determining Banks’ Financial Health
3.5 International Banking and the Federal Reserve System
© CORBIS
58
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skills that pay dividends
Understanding Public Policy and Its Impact on Business
Money flows through the economy. It allows people to trade products and
services at a fair value. With money as a medium of exchange, products and
services can be exchanged directly between individuals, businesses, and
governments without the intervention of third parties.
Government exists to protect people from each other, to protect people
from private interests, and to further the ideas that society holds valuable.
Government also provides the legal framework to ensure that protections are
provided in an organized way. Through legal requirements, the government
mandates accountability. Individuals and corporations are legally responsible for
their actions and they are required to comply with existing laws.
It is important to understand how these concepts intersect to achieve the
goal of economic stability in a thriving society. One example of government
policy impacting business is energy conservation. Increased public concern over
the condition of the environment and the impact of global warming has been
steadily gaining momentum.
In 1992, the Environmental Protection Agency (EPA) began a program called Energy Star, which is a voluntary
labeling program. Products that are energy efficient and reduce the emission of greenhouse gases can earn an
Energy Star rating.
In 1996, the United States Department of Energy (DOE) entered into a joint partnership with the EPA for
the Energy Star program. This joint effort resulted in a substantial increase in the number of products that are
eligible for an Energy Star rating.
In 2007, it was estimated that households using Energy Star products could save about 30% on their annual
utility bills. Nationally, this represents a savings of $16 billion on consumers’ utility bills.
Another method of promoting energy conservation is through tax incentives. Hybrid vehicles, which are
powered by both batteries and fuel, achieve higher fuel efficiency and lower emissions than standard
vehicles. To encourage consumers to begin using hybrid vehicles, the government developed an Alternative
Motor Vehicle Credit.
This credit is structured to jump start purchases of hybrid vehicles by providing the largest amount of credit
to consumers who purchase the vehicles closest to their release dates. The tax credit allows consumers to
reduce the amount of federal tax owed by the amount of the credit.
The money consumers save through utility bill reductions and tax credits is
money they have available to spend or invest. Government policies, which
reflect the goals of the voting public, are designed to influence consumer
Develop Your Skill
behavior through financial incentives.
Research the tax incentives
When government policy subsidizes an industry, as is the case for hybrid homeowners with mort-
vehicles, it is impacting the growth and development of the industry. gages receive. Determine
If consumers are eager to help the environment and receive a tax credit, whether mortgage tax
they will purchase hybrid vehicles. This increases demand for hybrid credits subsidize the real
PHOTODISC
vehicles and encourages more companies to manufacture hybrid vehicles. estate market.
Chapter 3 The Federal Reserve System 59

3.1 Structure of the Federal
goals
Reserve System
+ Identify the organization
of the Federal Reserve
System.
+ Explain how the Federal
Banking Scene
Reserve influences banks
and the economy. After opening an account at People’s State Bank, Kareema stopped at a fast food
+ Describe proposed drive-thru for a soft drink. Waiting to pay, she happened to glance at the bill in
reorganization of her hand. At the top of her bill, she saw the words “Federal Reserve Note.” Why,
the Fed.
she wondered, are these bills called Federal Reserve notes? Kareema resolved to
find out more about the Federal Reserve System. Where might she start?
terms
+ member bank
+ District Reserve Bank
Structure of the Fed• • • • • • • • • • • • • • • • • • • • • • •
The Federal Reserve was created in 1913 to respond to problems with the
nation’s changing money supply. Now you will look more closely at the
modern Federal Reserve System, learn who makes it up, what the system
does, and how it does it. The “Fed,” as it is often called, functions as the
government’s banker, providing a range of financial services both to the
government and to all financial institutions. It also supervises banks, con-
ducting examinations to identify risk or bookkeeping problems. The Fed-
eral Reserve manages monetary policy as well, hoping to benefit not only
banks but also the economy at large.
The Federal Reserve is a uniquely American approach to central banking.
It is a combination of public and private policymakers working together
to control the nation’s monetary policy, supervise banks, and provide financial
services to the government and banks. The Federal Reserve is set up like a
private corporation, with member banks holding stock in their District Reserve
Bank. The President of the United States nominates candidates for the Board of
Governors. The U.S. Senate confirms
nominees. Congress compromised on
Chair
a mix of private and public interests for
the Federal Reserve, and that mix is Board of
intended to serve the interests of the na- Governors
tion at large. The Federal government
District Reserve Banks
appropriates no money for the Federal
Reserve. Its income is derived from
financial services and interest on loans Member Banks
to its member banks. Any money made
60 Chapter 3 The Federal Reserve System
above the cost of providing services is turned over to the U.S. Treasury. Think
of the structure of the Federal Reserve as a pyramid, with member banks as
the base, District Reserve Banks in the middle, the Board of Governors near
the top, and the Chairman at the very peak. Each of these levels depends
upon information and action from other parts to hold up the system.
Member Banks
Any bank that is part of the Federal Reserve System is known as a member
bank. All national banks must be member banks of the Federal Reserve
System. They must purchase stock in the District Reserve Banks in their
regions. This stock cannot be bought or sold, and it does not offer control
of the District Reserve Bank. It does convey voting rights, however, for
directors of the District Bank, and it also pays a 6 percent dividend. State-
chartered banks are not required to be members of the Federal Reserve
System, although they may choose to do so if they meet requirements.
Investment banks are currently not required to be member banks.
District Reserve Banks
District Reserve Banks carry out banking functions for government of-
fices in their area, examine member banks in the district, decide whether to
loan banks funds, recommend
interest rates, and implement District Bank Branch Bank
policy decisions of the Board of 1. Boston, MA
Governors. There are twelve 2. New York, NY Buffalo, NY
regional District Reserve Banks, 3. Philadelphia, PA
located in Atlanta, Boston, Chi- 4. Cleveland, OH Cincinnati, OH
Pittsburgh, PA
cago, Cleveland, Dallas, Kansas 5. Richmond, VA Baltimore, MD
City, Minneapolis, New York, Charlotte, NC
Philadelphia, Richmond, San 6. Atlanta, GA Birmingham, AL
Francisco, and St. Louis. As of Jacksonville, FL
October 2007, there were 25 Miami, FL
branch offices supporting the Nashville, TN
New Orleans, LA
regional offices. The district and 7. Chicago, IL Detroit, MI
regional branches are shown at 8. St. Louis, MO Little Rock, AR
the right. Louisville, KY
Each district bank is gov- Memphis, TN
erned by a nine-member board 9. Minneapolis, MN Helena, MT
of directors, six of whom are 10. Kansas City, MO Denver, CO
Oklahoma City, OK
nonbankers elected by member Omaha, NE
banks. The Board of Governors 11. Dallas, TX El Paso, TX
selects the three other board Houston, TX
members. Each board also elects San Antonio, TX
the president of its district bank, 12. San Francisco, CA Los Angeles, CA
subject to approval by the Board Portland, OR
Salt Lake City, UT
of Governors. Seattle, WA
3.1 Structure of the Federal Reserve System 61

The Twelve Federal Reserve Districts
9
Cleveland
Minneapolis
2 1
Chicago Boston
12 Kansas City 7 3
4 New York
10 Philadelphia
San Francisco St. Louis
5
8 Board of
11 Governors
Dallas Atlanta Richmond
6
Alaska and Hawaii

are part of the
San Francisco District
The Federal Reserve officially identifies Districts by number and Reserve Bank city.
In the 12th District, the Seattle Branch serves Alaska, and the San Francisco Bank serves
Hawaii. The System serves commonwealths and territories as follows: the New York Bank
serves the Commonwealth of Puerto Rico and the U.S. Virgin Islands; the San Francisco Bank
serves American Samoa, Guam, and the Commonwealth of the Northern Mariana Islands.
The Board of Governors revised the branch boundaries of the System in February 1996.
Source: Federal Reserve System
Board of Governors
The President of the United States selects members of the Board of
Governors, subject to consent of the Senate. Each of the seven governors
serves a 14-year term, one beginning January 31 of
every even-numbered year so that terms are staggered.
The Board of Governors is the policy-making arm
of the Federal Reserve Board, and its decisions
control monetary policy. The Board of Governors
oversees the District Reserve Banks and also controls
mergers, bank holding companies, U.S. offices of
international banks, and the reserves of depository
institutions.
The Chair
The President also selects the chair and vice-chair
of the Federal Reserve from the membership of the
Board of Governors, subject to confirmation of the
Senate. The chair and vice-chair each serve a four-year
AP PHOTOS/SUSAN WALSH
term, but no limit is set on the number of terms.

The current chairman, Ben Bernanke, has served
since February 2006. The Chair is a visible symbol
and powerful spokesperson of Federal Reserve
policies.

The Federal Reserve structure allows for both central control of monetary
policy and regional control of district and member banks. Thus, the Federal
Reserve, though a central bank, has a decentralized structure that bases poli-
cies on both national and regional concerns through close communication.
checkpoint
What are the four structural elements of the Federal Reserve?
Functions of the Fed• • • • • • • • • • • • • • • • • • • • • • •

The Federal Reserve serves as the central banking authority of the United
States, managing the banking system of the country. The five main func-
tions of the Federal Reserve are to serve as the government’s bank, to ensure
that the financial system remains stable through judicious use of monetary
policy, to supervise and regulate bank operations, to protect consumers’
credit rights, and to serve as a bank for other banks.
The Government’s Bank
The U.S. government performs many financial actions through the Federal
Reserve. Tax payments to the Internal Revenue Service go to accounts in
Federal Reserve banks. From these accounts, the government makes pay-
ments to employees, to Social Security recipients, to military personnel, and
for other expenses associated with the government.
In addition, Federal Reserve banks perform some services for the gov-
ernment that add directly to its income. The Federal Reserve is responsible
for selling and redeeming various government securities, such as savings
bonds, treasury bills, treasury notes, and treasury bonds.
The Banks’ Bank

One of the main reasons the Federal Reserve was created was to serve as
a reserve bank for other banks to ease shortages of cash or to credit banks
that have an excess. The Federal Reserve also processes payments between
banks. Originally, this function developed to speed the collection of checks,
but the task expanded to processing payments for other large accounts, such
as payroll accounts and payments for large manufacturing orders. Today,
this role also includes not only paper checks, but also electronic funds trans-
fers, the means by which most large transactions move.
Bank Supervision
The Federal Reserve supervises and regulates all member banks. Agencies
such as the Office of the Comptroller of the Currency and the FDIC par-
ticipate in regulatory activities as well. State banking authorities also

interesting facts conduct supervisory activities, so that banks, whether members of the Fed
or not, are supervised to ensure responsible banking practice. For interna-
The Federal Reserve has actu- tional banks operating in the United States, the Federal Reserve ensures
ally been making electronic fair competition and communicates with central banking authorities in
funds transfers since the other countries to promote consistent policies.
1920s, when the telegraph was
used to “wire” money. The Fed Protecting Consumers
used telegraph technology until Consumer protection is another function of the Federal Reserve. Bank ex-
the 1970s. aminers monitor whether customers are treated fairly in terms of fees, prices,
penalties, and even advertising. Banks must show that they offer and perform
their services, including making loans, on an equal opportunity basis.
checkpoint
What are the primary functions of the Federal Reserve?
Proposed Reorganization of the Fed • • • • • • • • • • •

The financial crisis which the United States began to experience in the
latter half of 2007 helped spur discussion regarding whether the banking
regulation system should be reorganized. A number of federal agencies,
including the Fed, regulate portions of the banking industry. There is some
overlap between agencies and there are some areas not covered by federal
oversight. For example, the Fed, the FDIC, the Office of the Comptroller
of the Currency and the SEC are all involved in banking regulation.
Other agencies are also involved in their regulation.
In response to the need for reorganization, the Treasury Department
released a proposed plan for reorganizing the management of domestic
financial markets. This plan acknowledged that, given the evolving nature of
financial markets and the way that financial institutions overlap in products
offered, a new system was required to respond quickly to market needs. For
example, as financial institutions routinely sell diverse products covering secu-
rities, banking, and insurance, regulation needed to be positioned to manage
those areas in a cohesive fashion. Following are some highlights of the report.
President’s Working Group on Financial Markets (PWG) Originally
established in 1988, this group was responsible for communicating across
agencies to help ensure a healthy stock market that inspired investor con-
fidence. Inter-agency communication was achieved by having leadership
representatives from the Treasury, the Fed, the SEC, and the Commodities
Futures Trading Commission serve on the PWG committee. In March 2008,
the Treasury recommended expanding the PWG committee to include repre-
sentatives from the Office of the Comptroller of the Currency, the FDIC, and

the Office of Thrift Supervision. This broader-based
committee should help achieve the expanded goals of
the PWG, including lessening system-wide risk to
financial markets, improving the integrity of financial
markets, improving protection for consumers and
investors, and enhancing the competitiveness of
financial markets.
PHOTODISC/GETTY IMAGES
Mortgage Origination Commission (MOC) This
proposed commission would be an inter-agency group
with responsibility for developing federal legislation
requiring states to develop consistent licensing and
training requirements for participants in the mortgage
industry. Also, states would have a way to enforce federal laws for mortgage
originators that are not part of a regulated financial institution. (Independent
mortgage originators developed a majority of the subprime mortgage loans.)
Payment and Settlement Systems Oversight Used to transfer funds
between businesses, financial institutions, and consumers, the payment and
settlement systems help lubricate the economy by making sure money is
accurately sent and received. The proposed revisions would include a uni-
form method for regulating these systems.
Insurance Historically operated under state regulation, the proposed plan
recommends establishing an organization to federally regulate insurance
providers who opt in to the federal program. Federal oversight would help
meet the needs of companies that provide insurance on either a national or
international basis.
Futures and Securities Separating the regulation of futures and securities,
which made sense in the 1930s when the regulations were established, does
not make sense in today’s market. As products and markets have converged
and as international trading has increased, there is a need to regulate futures
and securities together. To achieve this objective, the proposal recommends
merging the Securities and Exchange Commission (SEC) and the Commod-
ity Futures Trading Commission (CFTC). One regulatory body would pro-
vide a more agile response to the changing needs of the marketplace.
As this report was first released in March 2008, and as the report in its
entirety recommends a multitude of changes that cut across many federal,
state, and private entities, it will be some time before the recommendations
can be considered and acted upon.
checkpoint
Why is consideration of reorganizing the Fed such a complicated task?

assessment 3.1
Think Critically
1. Why do you think only national banks are required to be members of the
Federal Reserve System?
2. Why are Federal Reserve District Banks distributed across the nation?
3. Why did the Treasury Department feel the need to initiate reorganiza-
tion of the management of domestic financial markets?
4. List five areas of economic management that are facing possible reorga-
nization based on the Treasury Department’s recommendations.
Make Academic Connections

5. Education Visit the Federal Reserve Board of Governors’ website at
www.federalreserve.gov. From the Site Map link, find the District Re-
serve Bank that serves your area. Find and visit that bank’s site, and dis-
cover what materials it makes available for citizen education. List those
resources here.
6. Biography One of the most influential Federal Reserve chairs in

recent history has been Alan Greenspan. Use resource material of your
own choosing, and write a one-page report on the life and career of this
powerful figure. Include reflections on his comments in the fall of 2008
when he acknowledged that relying on the “self-interest of lending
institutions” to behave in a way that made businesses self-sustaining was
a gross miscalculation and contributed to the 2008 financial crises.

Monetary and Fiscal 3.2
Policy goals
+ Explain how the Fed im-
pacts monetary policy.
Banking Scene + Identify how fiscal policy

affects the economy.
+ Explore criticisms of mon-
Kareema was delighted to get so many outfits for the fall on sale. She’d heard
etary and fiscal policy.
a lot of talk regarding how “money was tight.” This was causing many custom-
ers to cut back on their spending. Because fewer people were buying clothes, terms
she could get many discounted items. She was happy to get the sale prices,
+ Federal Open Market
but she wondered what it meant that “money was tight.” How can she learn Committee (FOMC)
more about the supply of money in the economy? Which government agencies + Taylor rule
influence the supply of money? Where should she begin her research? + adverse feedback loop
Monetary Policy • • • • • • • • • • • • • • • • • • • • • • • • • •
The most famous function of the Federal Reserve is conducting monetary
policy. The goals of the Federal Reserve’s monetary policy are to maintain
economic growth, to stabilize prices, and to keep international payments
flowing smoothly. Federal Reserve actions affect the amount of reserves
banks hold, as well as the money supply, which in turn affects the economy.
Open Market Operations The Fed buys and sells securities issued by the
Treasury Department or other government agencies. These are called open
market sales because the Fed does not control with whom it is doing busi-
ness in the sales, but trades at a profit or loss in order to accomplish mone-
tary control. These transactions affect the federal funds rate, the rate at which
banks borrow from each other. When the Fed wants to increase reserves, it
buys securities. When it wants to decrease reserves, it sells them. Although
this is the most powerful tool of the Fed, these adjustments are short-term
and may take place within either days or hours.
Primary Dealers There is a select group of 20 dealers that the Fed works
with to buy and sell securities. These primary dealers must be either broker-
dealers that are registered with the SEC or commercial banks that are
regulated by supervisors of federal banks. To qualify as a primary dealer,
certain capital standards must be met and a certain volume of business must
be maintained. Primary dealers engage in a competitive bidding process
each time new securities are offered on the open market.
3.2 Monetary and Fiscal Policy 67

interesting facts Setting Reserve Requirements The Fed adjusts the portion of total
deposits that banks must keep on hand in their vaults or at the Federal
The Council of Economic Reserve. Higher reserve requirements result in less money in circulation.
Advisers analyzes and inter- Reserve requirement changes are the least frequently used monetary
prets economic developments. tool of the Fed because changing the reserve requirements fundamentally
It recommends to the Presi- affects the operations of banks.
dent of the United States
Adjusting the Discount Interest Rate The Fed indirectly affects interest
national economic policy rates at large. The discount rate is the rate of interest that the Federal
to promote employment, Reserve charges banks for short-term loans. Other interest rates often
production, and purchasing rise or fall with the discount rate. The Federal Open Market Committee
power. (FOMC) makes discount rate decisions. The committee consists of the
seven-member Board of Governors (which includes the Chairman of the
Federal Reserve), the Chairman of the New York District Reserve Bank,
and presidents of four other District Reserve Banks who serve on a rotating
basis. Although legally required to meet four times annually, the FOMC
generally meets about eight times per year. Policy changes, when needed,
are decided during the meetings.
The Federal Reserve determines necessary interest rate changes in
response to economic conditions. A staff compiles and analyzes large
amounts of data for support. Economics is an inexact science. The Federal
Reserve had avoided the catastrophes of the 1930s until 2008. As a result
of the financial crises of 2008, challenges abound for the Fed and other
financial regulatory agencies.
Adjusting Monetary Policy

Tinkering with monetary policy does not occur in a vacuum. FOMC mem-
bers provide input, through discussion and votes on actions. The market
then responds to FOMC actions. During early 2008, market observers had
hoped the Fed would cut interest rates by one percent. They thought a
one percent cut would help keep inflation at bay. However, the Fed decided
to cut rates by three quarters of a percent. (Combined with prior inter-
est rate reductions, this cut led to a two percent rate cut in a two-month
period.)
Illustrating that setting monetary policy is not an exact science, two mem-
bers of the FOMC voted against the three quarter percent interest rate reduc-
tion. Even experts do not always agree on the most effective course of action.
The three quarter percent rate cut was enough, in the short term, to help
improve stock market performance and to improve the international value of
the dollar. In essence, the markets gained confidence and responded favorably
to the Fed’s efforts to help stabilize the economy through interest rate reduc-
tions. Adjusting interest rates is one of the many components of monetary
policy. Predicting the impact of these adjustments is not straightforward.
Developing Monetary Policy

Did you ever consider all the parties who review, analyze, and try to predict
the overall state of the economy? In addition to government staffers and

investors, college professors also are interested not only in the economy’s
performance, but in what drives that performance.
A Stanford University professor, John Taylor, published the Taylor rule
in 1993. In simplified terms, the Taylor rule provides ideas for how to use
short-term interest rates to achieve the goals of a central bank. These goals
include keeping the economy stable and controlling inflation.
The Taylor rule recommends looking at how the economy is perform-
ing relative to three targeted indicators. Inflation, full employment, and
short-term interest rates are the indicators. When inflation is high or when
the economy is above its targeted full employment rate, the Taylor rule
suggests that having a high interest rate, which in turn would decrease the
money supply, is a good mechanism for restoring the economy to its tar-
geted levels.
The rule provides a simplified method for assessing and forming mon-
etary policy. Although the rule has some limitations, including not being
comprehensive enough to capture the essence of a complex economy and
not being able to incorporate decisions that might be made to manage spe-
cific risks, it is often included as part of the analytical and decision-making
process of those who set monetary policy.
New Tools to Manage Monetary Policy
In order to help combat the financial crisis that began to appear in the econ-
omy during the summer of 2007, the Fed developed three new tools to help
manage monetary policy. Term Auction Facility (TAF), Term Securities
Lending Facility (TSLF), and Primary Dealer Credit Facility (PDCF) are
the new tools.
There are a number of factors that set these tools apart from each other.
The fees charged to the borrower for using the tools, how long the loan will
last, the type of financial institution that can use the loan, and the type of
collateral that can be used to secure the loan all contribute to the differences
between the loans.
• Term Auction Facility (TAF) Commercial banks can borrow money
from the Fed for a maximum of 28 days. Types of collateral for these loans
can vary.
• Term Securities Lending Facility (TSLF) Treasury securities can be
borrowed by primary dealers. The loans, which last up to 28 days, can be
secured by a broader range of collateral than TAF loans.
• Primary Dealer Credit Facility (PDCF) Primary dealers can take out
loans for up to 120 days. A larger group securities than the TSLF securities
will be accepted as collateral.
To avoid having these loans increase the total amount of money in
the economy, each time the Fed issues one of these loans, the Fed sells an
equal amount of Treasury securities. The TSLF and PDCF were initially
planned as short-term measures.

checkpoint
Why is it hard to predict the impact of monetary policy adjustments?
Fiscal Policy • • • • • • • • • • • • • • • • • • • • • • • • • • • • •
Just as the Federal Reserve System dominates monetary policy, Congress
and the President control fiscal policy and are considered co-equal with the
Fed in economic decision making. Congress and the President attempt to
smooth economic ups and downs by manipulating the federal budget to
create enough demand for goods to keep people working but not so much
as to cause inflation. This process controls the total demand for goods and
services by managing government spending and the amount of taxes col-
lected. This economic management is called fiscal policy. Administered
independently of the Fed’s monetary policy, fiscal policy involves adjusting
budgetary deficits or surpluses to achieve desired economic goals.
“Priming the Pump” in an Economic Downturn When the economy
experiences high unemployment and little or no business growth, the federal
government attempts to add jobs and stimulate business by “priming the
pump,” or cutting taxes. Theoretically, doing so gives businesses and indi-
viduals more money to spend, which results in increased demand for goods
and services. Expanded demand causes industries to manufacture more prod-
ucts, hire additional employees, and invest in new buildings and equipment.
The expansion thus stimulates the economy. This policy is often referred to as
Keynesian economics for John Maynard Keynes, who is credited with develop-
ing it to address the economic crisis during the Great Depression.
In addition to cutting taxes, which impacts workers’ current and future
paychecks, sometimes the government issues tax rebates. In effect, rebates
provide a retroactive reduction in the level of taxation. They provide a par-
tial refund on previously paid taxes.
During the second quarter of 2008, U.S. the government started issuing
tax rebates. By using the rebates to pump $168 billion into the economy, the
government hoped to stimulate the slow U.S. economy.
According to economists, tax rebates do not always provide the anticipated
stimulus. While studying the affects of a 2001 tax rebate, which ranged in
value from $300 to $600, Matthew D. Shapiro and Joel Slemrod, both Univer-
sity of Michigan economists, concluded that only about 20 percent of people
spent their rebates on new purchases. A majority of taxpayers either put their
rebate money into savings or used it to pay off debt.
Slowing the Boom Economy In contrast, when the economy is prosper-
ous, demand can exceed supply. This causes prices to increase and, unless

stopped, leads to inflation when rising prices decrease the value of money.
When this happens, the government uses the opposite policy. It cuts spending,
raises taxes, or uses a combination of the two. As a result, consumers and busi-
nesses have less money to spend, reducing demand and stabilizing prices.
checkpoint
Explain Keynesian economics.
Criticism of Monetary and Fiscal Policies • • • • • • •

Both monetary and fiscal policies have their critics. The two policies often
work at cross-purposes. In general, monetary policies seek to control infla-
tion and tolerate relatively high unemployment to achieve their goal. In
contrast, fiscal policy appeals to politicians who want to keep the economy
vigorous and growing even at the cost of moderately higher prices.
Monetary policy is relatively more agile than fiscal policy. It is easier for
the Fed to change bank reserve requirements than to go through the fairly
cumbersome process of changing legislation to alter taxes. It is quicker for
the Fed to adjust the amount of money flowing into the economy, by buy-
ing or selling dollars on the open market, than altering the level of taxes.
branching out
Skip the Bank, Come to the Store
Retailers were licking their chops hoping to feast settle for a portion of the rebate check, required
on the tax rebate checks that the U.S. government that a portion of the check be used for a purchase
began to distribute during April 2008. The checks at its store. It would then load the remaining bal-
were part of a $168 billion dollar economic stimu- ance onto a prepaid credit card that could be used
lus package. In an effort to capture the entire rebate at other retailers.
check from as many customers as possible, retail-
ers developed a variety of incentives. A number Think Critically Is it ethical for retail-
of grocery chains offered a 10% bonus for rebate ers to try to get consumers to tie up their stimulus
checks used to buy gift cards—therefore a $600 re- checks with just one store? How would being ob-
bate check could be redeemed for $660 of grocer- ligated to spend a large portion of a rebate check
ies. Some department and clothing stores offered at just one store impact the speed with which the
similar bonuses. One electronics retailer, happy to stimulus is felt in the economy?

Monetary policy has a downside. If the
flow of cash into the economy is too severely
restricted, consumers and businesses cannot
afford to borrow. This results in a decline in
spending and investments, leading to a failure
to sell products—especially “big ticket” items
such as new homes, automobiles, and appli-
STOCKBYTE/GETTY IMAGES
ances. Factories close. As the economy cools
off, more and more workers are laid off,
and the downward plunge picks up
momentum. This cycle is often called an
adverse feedback loop.
A recent adverse feedback loop began to
occur during the fourth quarter of 2007. By
the end of that year, about 8 percent of home loans were either late in pay-
ments or in the midst of foreclosure. Some banks wanted to have a smaller
portion of their assets tied up in home mortgages. Because the market was
unstable and so many home loans were in default, banks began to ask for
larger down payments. They also began to cut way back on home equity
loans.
With less money available to spend, consumers began to change their
consumption patterns. Buying habits at the grocery store changed. Instead
of buying convenient, single-serve packages, they bought in bulk. Entrees
shifted from expensive meats to less expensive pastas. Other buying patterns
also shifted. Instead of buying designer clothing, store brands were bought.
In lieu of going out to the movies, DVDs were rented.
Although consumers who are caught in an adverse feedback loop may
continue to meet their basic needs, they do so in the least expensive way
possible. This reduces the total amount of money flowing through the
economy.
Fiscal policy has created deep misgivings and endless controversy. Many
economists doubt that the Federal government can regulate the economy
by raising or lowering taxes and expenditures. In addition to being clumsy
and time-consuming, these methods involve enormous uncertainties.
Fiscal policy is especially difficult to use for stabilization because of the gap
between the recognition of its need and its implementation by the President
and Congress. For example, the tax cut proposed by President John F.
Kennedy in 1962 to stimulate the economy was not legislated until 1964.
Both policies are based on predictions. Even made by experienced econ-
omists, predictions are just that—forecasts of what could happen.
checkpoint
What is an adverse feedback loop?

assessment 3.2
Think Critically
1. How does increasing a bank’s required reserve result in less money
circulating in the economy?
2. Why doesn’t the government legislate the value of money and set interest
rates by law?
3. Explain the Taylor rule.
4. List and define three new tools for managing monetary policy.

5. Prefferred Vendors The website of the Federal Reserve Bank of
New York lists current primary dealers. Review the list and determine
whether the status of any primary dealers has been or will be impacted
by changes that have occurred in overall market conditions. List your
thoughts below.
6. Research A tax rebate was issued in April 2008. Go online to research

the effect of the rebate on the economy. Be prepared to discuss with the
class whether you believe rebates are an effective stimulus tool.

3.3 Consumer Protection
goals
+ Explain the various acts
that protect consumer
Banking Scene
rights.
Kareema decided to open a new credit card to take advantage of the customer
+ Understand how enforce-
ment responsibilities are reward program at her favorite clothing store. She was shocked to see all the
shared across agencies. forms and all the fine print she had to read and sign off on before getting a credit
card. There was a lot of discussion regarding interest rates and finance charges.
terms
Kareema wondered why there was so much information on the forms. Who
+ Truth in Lending Act decides what information should be included on the forms? Where can she get
(TILA)
help to understand what’s on the forms?
+ Equal Credit Opportunity
Act (ECOA)
+ Fair Credit Reporting Act
(FCRA)
Credit Transaction Protection • • • • • • • • • • • • • • •
+ Fair Debt Collection Prac-
tices Act (FDCPA) An important role of the Fed is to protect consumers. This protection is
ensured when the Fed establishes and enforces regulations that promote
+ Government Accountabil-
fairness in the treatment of consumers by private businesses. Financial
ity Office (GAO)
transactions of consumers are usually protected by consumer protection
laws. Protected credit transactions run the gamut from debit cards, car
leases, and mortgage loans to ATM transactions.
Credit policies are not always easy to understand. In the past lenders
sometimes made it purposefully difficult. In a wave of consumer protec-
tion legislation during the 1960s, ’70s, and ’80s, Congress enacted several
important laws to guarantee the rights of consumers. These disclosure laws
require that details of lending agreements be specified in writing. Other
important laws require far more than disclosure, guaranteeing equal access
to credit for qualified consumers, accurate credit reporting, and freedom
from unfair or deceitful collection practices. Banks are required not only to
conform to federal and state laws, but also to document their compliance.
Truth in Lending
Credit cards are the most common form of open-end credit account that
are not secured by a home. The Truth in Lending Act (TILA), Title I of
the Consumer Credit Protection Act of 1968, was landmark legislation.
Amended many times, it guarantees that all information about costs of a
loan is provided in writing to consumers. Items that must be disclosed
include the following.

• Total sales price • Schedule of payments
• Amount financed • Prepayment policies
• Annual percentage rate (APR) • Late payment policies
• Variable rate information • Security interest
• Total payments
In addition, the act provides for a right of rescission, which allows a con-
sumer to change his or her mind about a loan until midnight of the third
business day following the signing of papers. The law also prescribes com-
plaint procedures and penalties.
Legislation to update TILA was pending as of May 2008. These pend-
ing amendments involve ensuring that interest rate increases, discounted
promotional rates, and all payments are applied fairly.
Equal Credit Opportunity Act

The Equal Credit Opportunity Act (ECOA) prohibits the use of race,
color, religion, national origin, marital status, age, receipt of public assis-
tance, or exercise of any consumer right against a lender as a factor in deter-
mining creditworthiness. If a credit request is denied, the law also requires
that the lender provide the reasons for the denial upon request.
Fair Credit Reporting Act

The Fair Credit Reporting Act
(FCRA) aims to protect the infor-
mation that credit bureaus, medical
information companies, and ten-
ant screening services may collect.
First enacted in 1971, the legislation
provided the first legal oversight
of the credit information industry.
The FCRA establishes the following
©RADU RAZVAN/SHUTTERSTOCK
rights, some of which were added in
2003.
• Consumers must be told what is
in their file and who has had ac-
cess to the information.
• Consumers must be told if infor-
mation in their file has been used
against them.
• Consumers can dispute inaccurate information in their reports. The
agency must investigate disputes within 30 days.
3.3 Consumer Protection 75

• Inaccurate information must be corrected or
deleted.
• Credit bureaus cannot report information
more than seven years old in most cases, or
Tax incentives influence consumer behavior in sup-
more than ten for bankruptcies.
port of government objectives. Access www.cengage.
com/school/pfinance/banking and click on the link for • Access to consumer files is limited.
Chapter 3. Visit the IRS website to learn about hybrid
cars and alternative fuel vehicles. Review the current
• Consumers must authorize the release of
status of hybrid vehicle tax credits. Would the stated
reports to employers.
tax credit influence your decision about what type of • Lenders cannot obtain medical history or use
car to purchase? Why or why not? medical history to determine a credit appli-
cant’s worthiness of obtaining a loan.
www.cengage.com/school/pfinance/banking
• Consumers can seek damages for violations
of the law.
• By standardizing the information included
on credit reports, bias is removed from the
reports. These unbiased credit reports enable
a broader spectrum of consumers to receive
credit.
Legislation to update FCRA was pending as of 2008. A summary of these
pending amendments follow.
• A company cannot share customer contact information with its affiliates
unless the consumer is offered an easy way to opt out of the solicitation.
This rule has been finalized.
• All businesses that hold a consumer account must develop an identity
theft prevention program to proactively thwart attempted identity
theft.
• Risk-based pricing is when a business offers less favorable credit terms to
a consumer with a relatively weaker credit score. This proposal would
require businesses that use risk-based pricing to provide a risk-based
pricing notice to the consumer before the consumer commits to the
transaction.
Fair Debt Collection Practices Act

The Fair Debt Collection Practices Act (FDCPA) protects consumers from
unfair collection techniques. Third-party collectors may not use deceptive
or abusive tactics as they try to collect overdue bills. Such collectors may not
contact debtors at odd hours, call repeatedly or in a harrassing manner, or
threaten them in any way, even with legal action, unless it is actually con-
templated. Nor may collectors reveal the debts or collection actions to other
people, such as employers, in an attempt to embarrass the debtor. Penalties
are prescribed for violations of the act.

checkpoint
Name four important pieces of consumer protection legislation.
Other Legislation • • • • • • • • • • • • • • • • • • • • • • • • •
The preceding four laws are the foundation of consumer protection, but
there are many other laws that apply as well.
• Fair Credit Billing Act An amendment of TILA, it specifies fair pro-
cedures for resolving billing disputes and prevents creditors from taking
adverse action until the dispute is resolved.
Ethics in Action
FCRA, like many consumer protection laws, focuses on privacy rights
of individuals. Privacy rights are an inherent part of the American
psyche. The 2001 Patriot Act, enacted as a way to help combat the
potential financing of terrorism, put into effect a number of policies
that enabled government agencies to obtain personal financial
information about citizens. By issuing requests either through the For-
eign Intelligence Surveillance Act (FISA) or through national security
letters (NSLs), government agencies are authorized to obtain this
personal financial information without the knowledge of affected
citizens. The financial institutions providing the financial information
to the government are prohibited from revealing the requests to
affected account holders. Although the Patriot Act was reauthorized
by Congress in 2006, certain provisions to the Act are being challenged
in court. The premise of the challenges is whether the First Amend-
ment rights of citizens are being unlawfully violated. Litigation on
this issue is pending.
Think Critically
Is it ethical for the government to obtain confidential information
about citizens without the knowledge of citizens? When do national
security concerns supersede individual privacy rights? How should
oversight of government agencies occur in this situation?

• Fair Credit and Charge Card Disclosure Act Also an amendment of
TILA, it requires credit and charge card issuers to provide information
about open-end credit in direct mail or telephone solicitations. Credit
card issuers must advise consumers of all fees prior to assessing the fees.
• Home Equity Loan Consumer Protection Act Also amending TILA, it
requires lenders to make appropriate disclosures about open-end loans
that are secured by homes and places limitations on such plans.
• Credit Repair Organization Act Prohibits credit repair companies from
misleading consumers about their services and costs and requires agree-
ments to be in writing.
• Gramm-Leach-Bliley Act Compels banks and other financial institu-
tions to protect the privacy of consumers. Institutions must develop
written policies, notify consumers of them, and allow consumers the
opportunity to “opt out” before a bank can sell some forms of personal
information to others.
In addition to these federal regulations, many states have enacted similar
laws intended to protect the rights and privacy of consumers.
Housing and Real Estate

A number of acts have been passed to ensure consumer protection in real
estate and housing. These acts include the Flood Disaster Protection Act of
1973, the Real Estate Settlement Procedures Act of 1974, the Home Equity
Loan Consumer Protection Act of 1988, and the Home Ownership and
Equity Protection Act of 1994. Requiring flood insurance for designated
areas, mandating that real estate settlement costs be disclosed to consumers,
and protecting against exploitative real estate lending practices are protec-
tions provided under these acts. Lenders are also required to clearly list all
terms for home equity loans and to limit rates and fees on home equity loans.
Educating the Public on Their Rights

The Fed offers a variety of brochures on its website aimed at educating
consumers, in easily understandable language, about their rights. The bro-
chures span topics from shopping for a mortgage, identity theft protection,
and understanding credit scoring to information on leasing a car. To serve
as broad an audience as possible, and to keep pace with the changing demo-
graphics in the U.S., many of these brochures are also offered in Spanish.
checkpoint
Name three other pieces of lending legislation.

Enforcement of Policies Outlined in Acts • • • • • • •
Authority for enforcing consumer protection acts varies with the individual
law and the government agency associated with it.
Shared Responsibilities
In addition to the Federal Reserve Board, agencies that
share enforcement responsibilities include the Federal
Deposit Insurance Agency (FDIC), the Securities and
Exchange Commission (SEC), the Office of Thrift
Supervision (OTS), the Federal Trade Commission
(FTC), the National Credit Union Administration
(NCUA), the Office of the Comptroller of Currency
(OCC), and the Commodity and Futures Trading
Commission. These agencies have specific areas of
responsibility and work together jointly on various
aspects of enforcement.
In addition, audits are conducted to test compliance
©DANIEL GILBEY/SHUTTERSTOCK
at banks and other financial institutions. Examiners typi-
cally review randomly selected loan files for complete-
ness of documentation. They also watch for patterns of
credit granting and denial, look at the way disputes are
resolved, and check to see that privacy regulations are
being observed.
One such audit was conducted in January 2008 by the
Government Accountability Office (GAO). The GAO
is the auditing arm of Congress that helps ensure that federal laws and
policies are implemented properly. The 2008 audit was a comprehensive
study of the banking industry’s compliance with the fee disclosure
requirements of the Fed.
The report indicated that for over 20 percent of the branches included
in the survey, it was difficult to easily obtain complete information about
account terms and conditions. In response to the issuance of the report,
numerous government agencies with oversight and implementation
responsibilities have pledged their support to make sure customers can
easily obtain all banking fees and terms.
checkpoint
Why are so many agencies involved in enforcing consumer protection?

assessment 3.3
Think Critically
1. What factors brought consumer protection laws into being?
2. How might incomplete disclosure in an advertisement about a car loan

have misled consumers before passage of the Truth in Lending Act?
Give an example.
3. Why is it in a bank’s best interest to provide complete disclosure in a lend-

ing agreement and documentation of compliance with all lending laws?
4. Some bankers feel that the banking industry is overregulated. What

probably leads them to feel this way?

5. Communication Work in teams to conduct a poll of at least 30 people.
Find out how many of them have examined their credit reports in the last
12 months. How many of them have been the victim of an erroneous entry
in a credit report? How many are aware of key provisions of FCRA?
6. Problem Solving Conduct research to learn what information you
should include in a letter of dispute to a consumer reporting agency.
Draft a sample letter to a consumer reporting agency disputing a charge
for an unpaid dental bill from a dentist of whom you’ve never heard.
7. Consumer Affairs Review the privacy policy of a local bank’s web-
site. Report your findings.

Role in Determining 3.4
Banks’ Financial Health goals
+ Explain the regulatory pro-
cess and how it works.
Banking Scene + Review how regulations

affect the banking business.
Kareema was visiting her Grandma and they decided to order pizza. Grandma
terms
said she was short on cash and was going to run to the bank. One minute later,
Grandma reappeared with cash. Puzzled, Kareema asked her how she got to and + charter
from the bank so quickly. With a wry smile, Grandma indicated that the “bank” + Call report
+ System to Estimate Exami-
was a secret stash under her mattress. Having lived through the Great Depression
nations Ratings (SEER)
and the crash of the banks, Grandma was leery of banks. Kareema wondered how
+ CAMELS
banks stayed secure today. What safeguards are in place to keep banks secure?
Oversight Responsibilities of the FED • • • • • • • • • •

The banking crisis that began during the second half of 2007 caused many
people to be quite concerned with the stability of the nation’s financial mar-
kets. Indeed, for individuals who have (or had) friends or relatives who
lived through the Great Depression of the 1930s, anxiety about the stability
of banks may have been heightened.
How does the Fed
Federal Deposit Insurance Corporation
work to promote the Summary of Deposits
stability of the bank- Deposits of FDIC-insured Commercial Banks and Savings Institutions
By Charter Class
ing system? Congress As of June 30, 2007
gave the Fed the jobs
of regulating and State Chartered National Chartered
supervising the bank- OTS-Supervised

Savings Associations
Commercial Banks
$3,274 Billion(49%)
$11 Billion(0%)
ing system. The
State Chartered
Board of Gover- FDIC-Supervised State Chartered
Savings Banks Commercial Banks
nors writes banking $220 Billion(3%) Federal Reserve Members
$831 Billion(12%)
regulations. These Federal chartered
regulations provide a Savings Associations
$935 Billion(14%)
blueprint of appropri- State Chartered
Commercial Banks
ate business practices Federal Reserve Nonmembers
$1,426 Billion(21%)
for banks.
Excludes U.S. branches of foreign banks and OTS trust institutions that are not required
to file the Branch Office Survey
Source: Federal Deposit Insurance Corporation
3.4 Role in Determining Banks’ Financial Health 81

“communicate” Enforcing the rules is the responsibility of the 12 Reserve banks.
Enforcement of a variety of financial institutions is required. International
Two countries an ocean apart corporations that do banking in the U.S., state-chartered member banks,
took similar steps to rescue fail-
and bank holding companies are under the supervision of Reserve banks.
ing financial institutions. In
The Fed has help supervising banks. The FDIC, the OTS, and the OCC
2008, the British government
nationalized Northern Rock also supervise banking institutions. The pie chart on page 81 helps clarify
and the U.S. government took supervisory roles and relative dollar volumes.
control of Fannie Mae and
Freddie Mac. In both instances The Review Process
the rescue occurred because The Reserve banks ensure that each bank complies with state and federal
each lender was a significant legal requirements. They also make sure that each bank adheres to its own
participant in the mortgage internally developed methods for conducting business. Most importantly,
lending market. Research these the Reserve banks make sure that each bank has sufficient reserves to han-
government rescues and prepare dle outstanding loans and the risks associated with those loans.
a two-page paper outlining the Banks are given permission to operate as a business based on their charter,
root causes of the need for the which is a legal approval to operate a business as a bank. Charters are issued by a
rescue and the impact of gov-
government authority. The specific agency that issued the charter is responsible
ernment intervention.
for regulating the bank. The table below clarifies some of these relationships.
Supervising Authority Type of Institution
Federal Reserve State banks (that have joined the Fed)
Bank holding companies
Office of Thrift Supervision Savings and loan associations
Thrift holding companies
Comptroller of the Currency National banks
Federal Deposit Insurance Corporation State banks (that have not joined the Fed)
Size and structure of the financial institutions dictate the frequency of

on-site reviews. Member banks, which are state banks that have chosen to
become members of the Fed, usually receive an on-site review annually.
Small banks, with assets of less than $250 million, might only be reviewed
every 18 months. For some state member banks, the Fed may alternate
on-site reviews with the overseeing state.
Processes and technologies are in place to streamline the off-site moni-
toring of banks. Actual reports that banks must complete on a regular basis
vary by the size and scope of the bank. Larger banks with more diversified
activities are required to complete more reports.
To make sure that bank reports and supervision are performed in a
uniform manner, the Federal Financial Institutions Examination Council
(FFIEC) was established by Congress in 1978. Membership on the council
includes representatives from the Federal Reserve Board of Governors, the
Comptroller of the Currency, the National Credit Union Administration,
the FDIC, and the OTS. By having members from a variety of agencies, the
FFIEC fosters information sharing between state and federal agencies with
the common goal of providing consistent methods for banking supervision.
Each quarter, banks are required to complete a Consolidated Reports
of Condition and Income, or Call report. This report is the basis for the
Uniform Bank Performance Report. By comparing current financial ratios to
past financial ratios, the Uniform Bank Performance Report highlights any

changes in a bank’s performance. Declines or startling changes in perfor-
mance trigger investigation by the supervising agencies.
The System to Estimate Examinations Ratings (SEER) is an automated
system that analyzes and compares historical supervisory ratings of banks
with their Call report data. SEER provides an additional method of capturing
changes in financial performance that may require supervisory intervention.
SEER data can also be used to track trends within the banking industry.
checkpoint
Why is the authority that issued a bank’s charter important in the ongoing
operations of the bank?
The Score Card • • • • • • • • • • • • • • • • • • • • • • • • • •

After each on-site review is completed, the Fed issues a rating for the bank.
Examiners use the CAMELS system to evaluate six criteria of safety and
soundness. Each letter stands for one of the criteria: Capital adequacy,
Asset adequacy, Management, Earnings, Liquidity, and Sensitivity to risk.
Risk evaluation measures whether a bank makes good decisions in lend-
ing money. CAMELS ratings are not public information. The agency that
issues the rating has proprietary rights to the rating. Banks cannot release
their CAMELS rating to third parties without first obtaining approval
from the agency that issued the rating. This issue became prominent when
insurance companies began to ask banks for their CAMELS rating prior to
providing them with insurance.
Maintaining Balance in the Banking System

Banks are required to get permission from the Fed before they can acquire
another bank, introduce new products, or diversify. This mandatory ap-
proval process enables Reserve banks to make sure that regulatory require-
ments are met. The permission process also gives the Fed an opportunity to
ensure there will be sufficient competition in the regional market.
Trust Generates Trust

Remember, it takes a great deal of mutual trust for all parties in an economic
system to keep investing in a system. Each investor needs to be assured that
every other investor will act within a predefined and universally accepted
way. Banking regulations make a code of conduct explicit and mandatory.
This gives investors assurance that their money will be carefully and hon-
estly managed. This trust allows money to keep flowing through the system.
Regulations can be revised to reflect needs of society and still maintain the
safeguards necessary for ethical and safe practices.

Regulations that Encourage Private Investors to Aid Ailing Banks
A variety of privately financed entities, including private equity firms,
hedge funds, and mutual funds, were willing to provide capital to dis-
tressed banks during the recent mortgage and credit crises. Regulations that
were in place during April 2008 allowed these investors access to the banks’
books, including some confidential banking records. By being allowed to
carefully examine banks’ financial status before investing in them, privately
financed companies could obtain a solid understanding of actual finan-
cial positions of the bank. Knowing what they were getting into allowed
private equity firms the ability to negotiate the terms of their investment
and to invest with a clear understanding of any risks associated with their
investment.
During the savings and loan crisis that occurred during the late 1980s
and early 1990s, private investors did not have the same level of open access
to the books of banks. This lack of access discouraged private investment
firms from providing capital to help save failing savings and loans.
Future Regulations that May Facilitate Private Investment

Some market watchers think the government should make additional reg-
ulatory changes to further encourage private equity investors to help save
banks.
Current regulations cap the percent that a private equity firm can invest
in a bank at less than 10 percent of shares. There is a belief that by increas-
ing that cap, private equity firms would be more willing to invest in banks.
An increased percentage of ownership would provide stronger shareholder
voting power. With stronger voting power, firms would feel they have
more control over future management of the bank.
Another recommended change would impact banking acquisitions.
Currently, when one bank acquires another, any bad loans held by the
acquiree must be written off immediately by the acquiring bank. This re-
quires a lot of upfront capital from the acquiring banks. Similarly, a large
amount of capital for bad debt is a disincentive for many potential investors.
The recommended change would allow bad debt held by the acquiree to
be written off over time. This would lessen the amount of capital an acquir-
ing bank would need to provide. By lessening the immediate financial ex-
posure of the acquiring bank, the proposed change would lower the hurdle
for acquiring a bank.
checkpoint
Why is society interested in encouraging banks to help other ailing banks?

assessment 3.4
Think Critically
1. What is a charter?
2. What does the acronym CAMELS represent?
3. How does the Uniform Bank Report help regulators?
4. Why is trust necessary in the banking system?

5. Local Regulation Interview a local bank representative and ask
about the review process at his or her bank. Find out which regulatory
agencies participate in the review and the frequency of the reviews. In-
quire how the bank’s asset level affects the frequency of the review sched-
ule. Summarize your findings below.
6. Research Copies of Call reports are available to the public at the

FFIEC website. Go to cdr.ffiec.gov/public and look up the most recent
Call report for your bank. Scan the report to obtain an idea of the com-
pleteness of the data collected. Does the thoroughness of the data col-
lected make you, as a consumer, feel more confident that your bank is
closely regulated? Be prepared to discuss your thoughts and feelings with
the class.

3.5 International Banking and
goals
the Federal Reserve System
+ Explain the role of the Fed
in international banking.
+ Discuss how the Fed
works to keep the dollar
Banking Scene
strong.
Kareema had spent a few years saving money for her upcoming vacation to
+ Review how countries
work together to provide Europe. She had carefully planned her budget to cover transportation, lodging,
a stable international food, admittance to attractions, and some spare money for spontaneous “fun”
banking economy.
activities. She had recently read that the value of the dollar had declined relative
terms to the euro. She began to worry about her expenses. Realizing the dollar would
buy less on her trip, she was examining her budget to see where she could cut
+ Strength of Support
Assessment (SOSA) back. Why did the dollar weaken?
+ ROCA score
+ fixed exchange rate
+ flexible exchange rate
An Interdependent Global Economy • • • • • • • • • • •
+ balance of payments
+ Federal Reserve System
Globalization has led to increased interdependency between nations. Food,
Open Market Account
raw materials, medicines, electronics, and vehicles are just a few of the
(SOMA)
products that flow between borders. Money is required to enable these
transactions. A mutually acceptable method needs to be in place so that na-
+ U.S. Treasury Exchange tions that use different currency can exchange funds across international
Stabilization Fund (ESF) borders.
Just as products flow across borders, financial instruments flow across
borders. U.S. monetary policies affect the global economy just as financial
actions of the global economy affect the U.S. economy. Foreign-owned
banks operate in the U.S. and U.S.-owned banks have offices in foreign
countries. The Fed works, sometimes in conjunction with other U.S. agen-
cies or with central banks of other countries, to promote stability in interna-
tional financial markets. Efforts include supervising international banking,
minimizing disruptions in currency value, and sponsoring internationally
focused learning sessions.
Supervision of International Banks

There are multiple ways that the Fed regulates foreign banking. U.S.-
chartered banks that operate in foreign countries are regulated by the Fed.
Banks that are chartered in a foreign country and transact business in the
U.S. are also regulated by the Fed.

Federal Regulation of foreign banks was formalized with the Interna-
tional Banking Act of 1978 (IBA). To ensure a level playing field between
international banks and domestic banks, this act gave the same powers to
foreign banks that U.S. banks have. On the flip side, foreign banks are sub-
jected to the same restrictions as U.S. banks.
Nearly 20 years later, this act was amended with the passage of the For-
eign Bank Supervision Enhancement Act of 1991 (FBSEA). Under FBSEA,
foreign banks are required to obtain the approval of the Fed before opening
offices in the U.S. In determining whether to approve these applications,
the Fed considers how stringently the bank is regulated in its country of
origin, the overall financial health of the bank, and whether the bank and
its country of origin actively seek to fight money laundering.
Sometimes the Fed partners with other U.S. supervisory agencies to
carry out regulations. Two sets of rankings have been established to help
with this process. The Strength of Support Assessment (SOSA) reflects
how well a foreign bank is able to provide appropriate guidance, oversight,
and financial backing to its U.S. offices. A composite score of performance
in four distinct areas is a ROCA score. The areas included in this score are
risk management, operational controls, compliance, and asset quality.
Stabilizing Currency Values

Promoting full employment, price stability, and economic growth is the
common goal of many monetary authorities in various countries.
Banking Math Connection

With a flexible exchange rate, currency values change relative to other
currencies. The following chart shows the values of a few currencies
relative to the dollar as of August 2008. These rates were listed in the
Foreign Exchange Rates section of the Federal Reserve. Find how
many euros equal 1 U.S. dollar.
Country Denomination $US August 2008

Australia dollar 0.8815
EMU members euro 1.4955
India rupee 42.9057
Solution
1 euro x euro
=
1.4955 $US 1 $US
1.4955 x = 1
x = 1 ÷ 1.4955
x = 0.67 euros
Therefore, 1 $US will buy 0.67 euros.
3.5 International Banking and the Federal Reserve System 87

Foreign exchange methodologies have changed through the years. From
about the mid 1940s until the early 1970s, the U.S. dollar was at the center of
international currency exchange. Under a fixed-rate exchange system, the U.S.
needed to maintain the dollar price of gold at about $35 per ounce. The U.S.
would buy and sell dollars to stay at or near the $35 rate. In turn, other countries
were required to maintain the value of their currency relative to the U.S. dollar
at a set amount. Only a one percent variation in value was allowed.
A fixed exchange rate is a bit of an artificial system. A monetary valu-
ation of one country’s currency is tied to the valuation of another country’s
currency. Sometimes the decision is made to maintain the international cur-
rency value at the expense of some other monetary goal—like maintaining
full employment, price stability, or economic growth.
A flexible exchange rate enables currencies to fluctuate based on market
conditions. However, to fully understand flexible exchange rates, an under-
standing of balance of payments is necessary.
Balance of Payments
Countries monitor the total amount of goods and services that leave their
country. They also monitor the amount of goods and services that enter their
country. Each country looks at the overall total of its imports and exports. It also
monitors the amount of goods and services it trades with individual countries.
The balance of payments is a record of all the exchanges of goods and services
that occur between two countries for a specified time period.
A flexible exchange rate allows currency values to move up or down in re-
sponse to changes in the balance of payments. If Country A sends more goods
and services to Country B than it receives from Country B, then Country A
has a surplus in the balance of payments with Country B. As a result of this
surplus, Country A’s exchange rate increases relative to Country B’s. There-
fore, Country A’s currency can buy Country B’s goods more cheaply. Like-
wise, Country B will find it more expensive to buy the goods of Country A.
tech talk
Electronic Funds Transfer
Like many businesses and private individuals, the Federal Reserve System uses elec-
tronic funds transfer (EFT) to make and receive payments. The Fed has its own sys-
tem, called Fedwire, with special capabilities. Fedwire connects the Federal Reserve,
the Treasury, other government agencies, and more than 9,500 financial institutions.
In 2000, an average of 430,000 daily payments totaling about $1.5 trillion took place
over the Fedwire network. The Federal Reserve by law must charge for its Fedwire
services and prices them according to cost.
Think Critically In what ways does Fedwire strengthen the entire Federal
Reserve System? Why might the law mandate a charge for this service?

checkpoint
How would a balance of payment deficit affect Countries A and B?
Keeping the Dollar Strong • • • • • • • • • • • • • • • • • •

In the mid 1970s, the method for managing international currency stabil-
ity changed to flexible exchange rates in the U.S. The Fed helps maintain
the international value of the dollar through foreign currency operations.
The FOMC provides guidance to the Fed when it buys or sells U.S. dollars.
The goal of stabilizing the international value of the dollar is to maintain a
stable currency value to encourage international trade. Countries who wish
to conduct business with the U.S. want a clear understanding of the profits
and/or risks associated with the trades. Knowing that the value of the dollar
will remain relatively stable allows foreign investors to predict the amount
of profit or risk they will experience.
How do actions of the Fed stabilize the dollar? If the value of the dollar is
falling, the Fed may purchase dollars by selling foreign currency. This tight-
ens the supply of dollars on the open market, which causes the value of the
dollar to increase. If the value of the dollar is high and the Fed wants to lower
it, the Fed may buy foreign currency with U.S. dollars. This increases the
supply of U.S. dollars in the marketplace, which lowers the value of the dol-
lar. The Fed seeks to maintain a steady balance of Federal Reserve balances.
When the Fed sells foreign currency, it sterilizes the impact of the sale by pur-
chasing an equivalent amount of U.S. currency. Sterilization is necessary to
maintain the federal funds rate at the target set by the FOMC. The account
the Fed maintains international reserves in is the Federal Reserve System
Open Market Account (SOMA). The account the Treasury maintains inter-
national reserves in is the U.S. Treasury Exchange Stabilization Fund (ESF).
As the U.S. Treasury and the Fed work in close cooperation on decisions
and policies affecting foreign currency issues, they also share responsibil-
ity for maintaining the levels of foreign exchange reserves in the U.S. This
shared responsibility results in a generally equal division of reserve hold-
ings. For example, at the end of June 2007, the Federal Reserve had nearly
$21 billion dollars in its SOMA account and the Treasury had a nearly
equal amount in its ESF account.
checkpoint
Why is the Fed interested in stabilizing the value of the dollar?

International Cooperation • • • • • • • • • • • • • • • • • •
Many countries realize their dependence on and vulnerability to international
market conditions. In addition to trading products across borders, countries or
citizens from one country may directly invest in businesses in another country.
One example of this direct investment is when foreign investors purchased
mortgage-backed securities during the U.S. mortgage crisis. These investors
were hoping to make a profit by purchasing the securities at a discount. By
doing this, foreign investors held a significant number of U.S. mortgages.
To foster a spirit of trust, and to develop laws that ensure transactions
are carried out in good faith and honestly, a number of organizations have
formed over the years that are designed to make banking safe and mutually
beneficial across international borders.
International Monetary Fund (IMF) Representatives from 185 member
countries work together to promote economic growth among member
countries. The IMF takes actions to encourage the stability of the finan-
cial exchange markets. Sometimes the IMF will lend money to a country
that needs help with its balance of payments. The IMF also seeks to avoid
money laundering in an effort to avoid financing terrorism.
Bank for International Settlements (BIS) With about 140 customers,
the BIS is a bank for central banks. Serving only countries (and not private
entities), it focuses on fostering international monetary and financial stabil-
ity. A variety of products aimed at helping central banks invest and manage
their foreign assets is offered by BIS.
Asia Pacific Economic Cooperation (APEC) The 21 members of APEC
are referred to as “member economies.” APEC encourages economic
growth in the Asia-Pacific Region. The U.S. is a member of APEC.
International Banking Seminars Since 1997, the Federal Reserve Bank
of Chicago has organized international conferences on banking. By bring-
ing together people who develop policy and people who do economic re-
search, the seminars provide a cross section of ideas regarding issues that cut
across many aspects of international banking. Recent seminars have focused
on “Globalization and Systemic Risk,” “International Financial Instability:
Cross Border Banking and National Regulation,” and “Credit Market
Turmoil of 2007–2008: Implications for Public Policy.”
checkpoint
How does bringing together policy makers and researchers to examine a common
topic facilitate smooth transactions for international banking?

assessment 3.5
Think Critically
1. Explain the key concepts of the International Banking Act of 1978.
2. What does the acronym ROCA mean and how does it relate to SOSA?
3. What is the balance of payments?
4. Name the account for international reserves maintained by the Fed and
by the Treasury.

5. Education Visit the website of the Chicago Federal Reserve at www.
chicagofed.org/news_and_conferences/conferences_and_events/2008_
international.cfm. Review recent seminars on international banking and
see what seminars are planned for the future. Be prepared to discuss how
the seminars reflect past, current, and future concerns of the industry.
6. Current Events During the third quarter of 2007, the international
value of the dollar fell. During that time, one euro could buy $1.4065.
Prior to that time, one euro could not buy more than $1.4. One result of
the falling dollar value was that products manufactured in America were
less expensive to citizens of countries whose currency was strong relative
to the dollar. This increased American exports. Research the current in-
ternational value of the dollar relative to the euro. List it below. Also list
how the dollar’s international value affects the overall economy.

chapter 3 assessment
Chapter Summary
3.1 Structure of the Federal Reserve System
A. The Chair oversees the Federal Reserve Board, which oversees the
12 District Reserve Banks, which monitor and serve the member banks.
a. adverse feedback B. The Fed is the U.S. government’s bank, a bank for banks, and a su-
loop pervisory organization.
b. balance of
payments 3.2 Monetary and Fiscal Policy
c. Call report A. Monetary policy adjusts bank reserves and influences interest rates for
d. CAMELS economic stability. The Federal Reserve is the author of monetary policy.
e. charter
f. District Reserve B. Fiscal policy is the Congress and President’s way to control the economy.
Bank 3.3 Consumer Protection
g. Equal Credit
A. Four main laws (TILA, ECOA, FCRA, and FDCPA) provide the
Opportunity Act
(ECOA) foundation for consumer protection in lending.
h. Fair Credit B. Banks are required to document their compliance with all applicable
Reporting Act state and federal regulations.
i. Fair Debt Collec-
3.4 Role in Determining Banks’ Financial Health
tion Practices Act
(FDCPA) A. The Fed, the FDIC, OTS, and OCC share oversight duties.
j. Federal Open B. Quarterly Call reports summarize banks’ performance.
Market Commit-
tee (FOMC) 3.5 International Banking and the Federal Reserve System
k. Federal Reserve A. The Fed supervises U.S. banks with offices abroad and foreign banks
System Open with offices in the U.S.
Market Account B. The Fed and the Treasury work to keep the dollar strong.
(SOMA)
l. fixed exchange
C. Multiple organizations foster international economic development.
rate
m. flexible exchange Vocabulary Builder
rate Choose the term that best fits the definition. Write the letter of the answer
n. Government in the space provided. Some terms may not be used.
Accountability
Office (GAO) ___ 1. A report banks are required to complete quarterly that reflects
o. member bank their performance
p. ROCA score ___ 2. A rating of how well a foreign bank is able to provide appropriate
q. Strength of Sup- guidance, oversight, and financial backing to its U.S. offices
port Assessment ___ 3. A record of all the exchanges of goods and services that occur be-
(SOSA) tween two countries for a specified time period
r. System to Esti-
mate Examina- ___ 4. Protects consumers from unfair collection techniques
tions Ratings ___ 5. Guarantees that all information about a loan is provided in writing
(SEER) ___ 6. When the monetary valuation of one country’s currency is tied to
s. Taylor rule the valuation of another country’s currency
t. Truth in Lending ___ 7. The government body that makes decisions about discount interest
Act (TILA) rates
u. U.S. Treasury Ex-
change Stabiliza- ___ 8. A theory about using short-term interest rates to achieve the goals
tion Fund (ESF) of a central bank
___ 9. Legal approval to operate a business as a bank

Review Concepts
10. Name the four organizational components of the Federal Reserve
System.
11. What four functions does the Federal Reserve perform?
12. Describe the structure and purpose of the FOMC.
13. How does Keynesian economics relate to fiscal policy?
14. Explain the role of an adverse feedback loop in the recent credit crisis.
15. How does the balance of payments impact a flexible exchange rate?
16. Why is it significant which government agency issued a bank’s

charter?
17. How does the SEER report help regulators?
Chapter 3 Assessment 93
18. Why is the government interested in helping private investors aid
banks that are struggling?
19. Describe the membership and objectives of the IMF.
20. Why did the U.S. transition from a fixed exchange rate to a flexible
exchange rate?
Apply What You Learned

21. What is the advantage of distancing the Federal Reserve System from
politics?
22. Why is inflation a constant concern of the Federal Reserve Board?
23. Describe the differences between monetary and fiscal policy.
24. As of August 2008, the Australian dollar was worth $0.8815 U.S. dollars
and the Indian rupee was worth $42.9057. How many Australian dollars
and Indian rupees would a U.S. dollar have bought at that time?

25. Name four consumer protection laws related to lending.
26. How would it help the banking industry if the amount a private equity
firm could invest in a bank was increased beyond 10 percent?

27. Political Science If inflation is such a concern, why not just sta-
bilize the economy by imposing wage and price controls? Wages and
prices have occasionally been frozen before in emergency situations.
Should wage and price controls be permanently established? Write a
paragraph that summarizes your opinion.
28. Social Studies Choose one of the laws discussed in lesson 3.3,
Consumer Protection. Prepare a detailed report on its history, its provi-
sions, and its effect on the lending industry. Write a three-page report
on what you learn.
29. Current Events Consumer protection also applies to student loans.

In September 2008, the New York Times reported that seven student loan
companies were required to develop a $1.4 million dollar fund to help
educate students and their parents on student loans. The companies were
cited for misleading advertising practices, including sending students mar-
keting materials that looked like they came from the federal government.
Research any new cases where the government intervened to protect con-
sumers’ rights. Prepare a one-page report to summarize your findings.
Chapter 3 Assessment 95

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3 The Federal Reserve

3.1 Structure of the Federal Reserve System

3.2 Monetary and Fiscal Policy

3.3 Consumer Protection

3.4 Role in Determining Banks’ Financial Health

3.5 International Banking and the Federal Reserve System

Chapter 3 The Federal Reserve System 59

3.1 Structure of the Federal Reserve System 61

Alaska and Hawaii

term, but no limit is set on the number of terms.

62 Chapter 3 The Federal Reserve System

Functions of the Fed• • • • • • • • • • • • • • • • • • • • • • •

The Banks’ Bank

3.1 Structure of the Federal Reserve System 63

Proposed Reorganization of the Fed • • • • • • • • • • •

64 Chapter 3 The Federal Reserve System

3.1 Structure of the Federal Reserve System 65

Make Academic Connections

6. Biography One of the most influential Federal Reserve chairs in

66 Chapter 3 The Federal Reserve System

Banking Scene + Identify how fiscal policy

3.2 Monetary and Fiscal Policy 67

Adjusting Monetary Policy

Developing Monetary Policy

68 Chapter 3 The Federal Reserve System

3.2 Monetary and Fiscal Policy 69

70 Chapter 3 The Federal Reserve System

Criticism of Monetary and Fiscal Policies • • • • • • •

3.2 Monetary and Fiscal Policy 71

72 Chapter 3 The Federal Reserve System

3. Explain the Taylor rule.

Make Academic Connections

6. Research A tax rebate was issued in April 2008. Go online to research

3.2 Monetary and Fiscal Policy 73

74 Chapter 3 The Federal Reserve System

Equal Credit Opportunity Act

Fair Credit Reporting Act

3.3 Consumer Protection 75

Fair Debt Collection Practices Act

76 Chapter 3 The Federal Reserve System

3.3 Consumer Protection 77

Housing and Real Estate

Educating the Public on Their Rights

78 Chapter 3 The Federal Reserve System

3.3 Consumer Protection 79

2. How might incomplete disclosure in an advertisement about a car loan

3. Why is it in a bank’s best interest to provide complete disclosure in a lend-

4. Some bankers feel that the banking industry is overregulated. What

Make Academic Connections

80 Chapter 3 The Federal Reserve System

Banking Scene + Review how regulations

Oversight Responsibilities of the FED • • • • • • • • • •

supervising the bank- OTS-Supervised

3.4 Role in Determining Banks’ Financial Health 81

Size and structure of the financial institutions dictate the frequency of

82 Chapter 3 The Federal Reserve System

The Score Card • • • • • • • • • • • • • • • • • • • • • • • • • •

Maintaining Balance in the Banking System

Trust Generates Trust