Although the Fed is supposed to be an independent body, and its decisions are not ratified by the President or Congress, there is often a large degree of consultation and cooperation between the bodies.

Federal Reserve Board

The Federal Reserve System is run by a board of governors and the Chairman. The Federal Reserve Board includes seven members and all members, including the Chairman, are appointed by the President of the United States, confirmed by the Senate and serve automatically on the FOMC. While the Board's functions and responsibilities overlap with the FOMC, the Board establishes key policies, like the discount rate and the reserve requirements.

FOMC

The Federal Open Market Committee (FOMC) determines monetary policy. The committee includes a seven-member board of governors and five reserve bank presidents. While four of these five seats rotate among reserve presidents in one-year terms, the president of the New York Federal Reserve Bank has a permanent seat on the committee. The eight annual meetings of the FOMC are closed to the public, but minutes and vote records are made available after the meetings.

Federal Reserve Banks

There are 12 regional Federal Reserve banks that assist in controlling the money supply and executing Fed policy. The 12 banks are located in Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas City, Minneapolis, New York, Philadelphia, Richmond, St. Louis and San Francisco. Perhaps not surprisingly, the New York Federal Reserve bank is the largest of the 12, in terms of assets.

The Federal Reserve banks act as depositories for federal money and act as payment agents for government transactions. These banks play a role in distributing currency to commercial U.S. banks, make loans to smaller member banks and oversee the regulation of commercial banks in their region.

Fed Operations

The Fed can alter the money supply through open market operations, that is, buying or selling government securities. When the Fed wishes to increase the money supply, it goes into the market and buys bonds from banks; those banks can then lend out that cash. On the flip side, the Fed can sell bonds to these banks and drain money from the market.

Second, the Fed can change the reserve requirements for banks. As previously mentioned, the money supply is tied directly to the percent of deposits that banks hold as reserves. If the reserve rate is increased, the money supply decreases, and vice versa. Banks do not always loan out the maximum amount that they are allowed to, and alterations to the reserve requirement can create instability in the banking sector, to say nothing of taking some time to go into effect. Consequently, this is not an especially commonly used method by the Federal Reserve.

Lastly, the Federal Reserve can impact the money supply through interest rates. The Fed does not directly determine what an individual borrower pays for a mortgage or new car loan, but interest rates, by and large, flow from whatever the Fed charges. Consequently, if the Fed raises rates, those rates typically work down through all levels of banking and ultimately result in higher lending rates, and less lending activity.

The Fed is also a lender of last resort within the banking system, a regulator and a data gathering and analysis operation.

Controversies About the Fed System

The validity and utility of the Federal Bank is certainly not universally accepted. There has always been a debate about the constitutionality of a national bank, and the extent to which the federal government plans or controls the economy through that bank. Throughout the bank's history there have also been frequent criticisms of particular Fed policies. Some argue that the Fed's monetary policy is too tight and creating unemployment and others argue that monetary policy is too loose, and stokes inflation and dollar depreciation.

Contrary to the experience of bank panics every decade in the 1800s, throughout most of which the U.S. did not have a central bank, some believe that the Fed cannot adequately manage the monetary policy of the country and actually increases instability. Likewise, while some believe that the Fed is too willing to accommodate political administrations and allows asset bubbles to inflate and continue, others believe the Fed interferes too much in the economy of the United States.

Central Banks Around the World

Despite the controversy around the role, or even the existence, of the Federal Reserve System, most developed countries in the world now have functional central banks. As is the case with the U.S. Federal Reserve, most central banks have responsibility for executing monetary policy and overseeing the banking system. There are certainly differences from country to country in how the central banks operate and the extent to which they are independent of, or beholden to, the ruling administration. One additional notable difference is that some central banks explicitly target a certain inflation rate and base their policy decisions on that target. While some argue that this approach sacrifices economic growth for stability, it does lend predictability to the interest rate outlooks.

The Banking System: Non-Bank Financial Institutions. Savings and Loans

Credit Unions

Credit unions are another alternative to regular commercial banks. Credit unions are almost always organized as not-for-profit cooperatives. Like banks and S&Ls, credit unions can be chartered at the federal or state level. Like S&Ls, credit unions typically offer higher rates on deposits and charge lower rates on loans, in comparison to commercial banks.

In exchange for a little added freedom, there is one particular restriction on credit unions; membership is not open to the public, but rather restricted to a particular membership group. In the past, this has meant that employees of certain companies, members of certain churches, and so on, were the only ones allowed to join a credit union. In recent years, though, these restrictions have been eased considerably, very much over the objections of banks.

Private Banks

While there used to be a significant number of independent private banks operating in the United States, the independent dedicated private bank is all but extinct. Private banks are increasingly part of larger commercial banks and international financial institutions. Almost every nationally known bank and financial services firm has a division that caters to wealthy clients.

Private banks target high net-worth individuals and do not encourage, or in many cases accept, people of lesser means opening accounts. Private banks look to provide a host of services beyond simple checking and savings accounts. Wealthy individuals often spend considerable resources sheltering their incomes and assets from the tax collector; tax planning, as well as the creation and sale of tax-minimizing investment projects, is a major service of private banks.

Investment and Merchant Banks

While investment banks may be called "banks," their operations are far different than deposit-gathering commercial banks. Complicating matters further, many major commercial banks bought investment banks, and some investment banks have reorganized themselves as commercial banks, in many cases to make themselves eligible for government-funded bailouts.

Investment banks are principally involved in underwriting debt and equity offerings, trading securities, making markets and providing corporate advisory services. Investment banks are also active counterparties in a variety of derivative transactions. Confusing matters further, some investment banks, including those without true bank subsidiaries, will engage in bank-like activity. It is not uncommon for investment banks to provide bridge loans and stand-by financing commitments for mergers and acquisitions.

Generally speaking, investment banks are subject to less regulation than commercial banks. While investment banks operate under the supervision of regulatory bodies, like the Securities and Exchange Commission, FINRA, and the U.S. Treasury, there are typically fewer restrictions when it comes to maintaining capital ratios or introducing new products.

Merchant banking has changed more than perhaps any other category of banking. Merchant banks used to exist to finance international trade, providing financing, letters of introduction and credit, for ocean-going voyages. Merchant banks then evolved into something more like what private equity is today; very few institutions call themselves "merchant banks" today.

Shadow Banks

The housing bubble and subsequent credit crisis brought attention to what is commonly called "the shadow banking system." This is a collection of investment banks, hedge funds, insurers and other non-bank financial institutions that replicate some of the activities of regulated banks, but do not operate in the same regulatory environment.

The shadow banking system funneled a great deal of money into the U.S. residential mortgage market during the bubble. Insurance companies would buy mortgage bonds from investment banks, which would then use the proceeds to buy more mortgages, so that they could issue more mortgage bonds. The banks would use the money obtained from selling mortgages, to write still more mortgages.

Many estimates of the size of the shadow banking system suggest that it had grown to match the size of the traditional U.S. banking system by 2008.

Apart from the absence of regulation and reporting requirements, the nature of the operations within the shadow banking system created several problems. Specifically, many of these institutions "borrowed short" to "lend long." In other words, they financed long-term commitments with short-term debt. This left these institutions very vulnerable to increases in short-term rates and when those rates rose, it forced many institutions to rush to liquidate investments and make margin calls. Moreover, as these institutions were not part of the formal banking system, they did not have access to the same emergency funding facilities.

Islamic Banks

Islamic banks exist to fill the need for financial services that are compliant with Islamic rules concerning interest. Sharia law forbids the charging, or acceptance, of interest or other fees related to borrowing money. In the place of interest, Islamic banks make use of profit sharing arrangements, "safekeeping" agreements, joint ventures, leasing and cost-plus accounting to extend credit in a way that is compliant with Sharia.

As an example, an Islamic bank would not loan money to someone who wished to borrow a house or car. Instead, the bank might buy the asset itself, agree to resell it to the would-be borrower at a higher price and take the payments in installments. In practice, then, it is almost identical to how a regular mortgage or equipment loan works, as most mortgage borrowers pay equal fixed amounts for the duration of the loan, but there is no formal interest involved.

Many Islamic countries have regular banks operating in their borders, but this is nevertheless a growth market. If nothing else, many of these businesses are creative in how they establish workable business models that comply with rules on interest, and so on. Not surprisingly, Iran, Saudi Arabia, Malaysia, and UAE are among the leading nations in terms of assets managed by Islamic financial institutions.

Industrial Banks

Industrial banks are a special category of financial institution that exists for very specific purposes. Industrial banks are financial institutions owned by non-financial institutions.

As they are able to lend money, industrial banks are often used by their parent companies to facilitate financing for customers. Not all of these banks engage in lending; sometimes companies create industrial banks, simply to improve payment settlement efficiency and to reduce the costs of managing working capital accounts.

Conclusion

Banking systems have been with us for as long as people have been using money. Banks and other financial institutions provide security for individuals, businesses and governments, alike. Let's recap what has been learned with this tutorial:

In general, what banks do is pretty easy to figure out. For the average person banks accept deposits, make loans, provide a safe place for money and valuables, and act as payment agents between merchants and banks.

Banks are quite important to the economy and are involved in such economic activities as issuing money, settling payments, credit intermediation, maturity transformation and money creation in the form of fractional reserve banking.

To make money, banks use deposits and whole sale deposits, share equity and fees and interest from debt, loans and consumer lending, such as credit cards and bank fees.

In addition to fees and loans, banks are also involved in various other types of lending and operations including, buy/hold securities, non-interest income, insurance and leasing and payment treasury services.

History has proven banks to be vulnerable to many risks, however, including credit, liquidity, market, operating, interesting rate and legal risks. Many global crises have been the result of such vulnerabilities and this has led to the strict regulation of state and national banks.

However, other financial institutions exist that are not restricted by such regulations. Such institutions include: savings and loans, credit unions, investment and merchant banks, shadow banks, Islamic banks and industrial banks.

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