1) Describe the functions performed by the Federal Reserve Banks. 2) The FOMC ha
ID: 2698403 • Letter: 1
Question
1) Describe the functions performed by the Federal Reserve Banks.
2) The FOMC has instructed the FRBNY Trading Desk to purchase $750 million in U.S. Treasury securities. The Federal Reserve has current;y set the reserve requirement at 10 percent of transaction deposits. Assume U.S. banks withdraw all excess reserves and give out loans.
a. Assume also that borrowers eventually return all of these funds to their banks in the form of transaction deposits. What is the full effect of this purchase on bank deposits and the money supply?
b. What is the full effect of this purchase on bank deposits and the money supply if borrowers return only 90 percent of these funds to their banks in the form of transaction deposits?
3) What are the major sources of funds for commercial banks in the United States? What are the major uses of funds for commercial banks in the United States? For each of your answers, specify where the item appears on the balance sheet of a typical commercial bank.
4) What are the differences between community banks, regional banks, and money center banks? Contrast the business activities, locations, and markets of each of the bank groups.
5) What were the reasons for the crisis of the savings institutions industry in the late 1970s and early 1980s?
6) Why did commercial banks pursue legal action against the credit union industry in the late 1990s? What was the result of this legal action?
Explanation / Answer
1. Functions
The Federal Reserve System provides the government with a ready source of loans and serves as the safe depository for federal monies. The Federal Reserve is also a low-cost mechanism for transferring funds and is an inexpensive agent for meeting payments on the national debt and government salaries. The Federal Reserve Banks were created as instrumentalities to carry out the policies of the Federal Reserve System.
The Federal Reserve Banks issue shares of stock to member banks. However, owning Federal Reserve Bank stock is quite different from owning stock in a private company. The Federal Reserve Banks are not operated for profit, and ownership of a certain amount of stock is, by law, a condition of membership in the system. The stock may not be sold or traded or pledged as security for a loan; dividends are, by law, limited to 6% per year.
The dividends paid to member banks are considered partial compensation for the lack of interest paid on member banks' required reserves held at the Federal Reserve. By law, banks in the United States must maintain fractional reserves, most of which are kept on account at the Federal Reserve. Historically, the Federal Reserve did not pay interest on these funds. The Federal Reserve now has authority, granted by Congress in the Emergency Economic Stabilization Act (EESA) of 2008, to pay interest on these funds.
A major responsibility of The Federal Reserve is to oversee their banking and financial systems. Overseeing the banking and financial systems of a bank is crucial in a society.[8]
Confidence in the soundness of the banking and financial systems is what mobilizes a society's savings, allows the savings to be channeled into productive investments, and encourages economic growth.
3. The primary sources of funds are deposits and borrowed funds. Small banks rely more heavily on
transaction, savings, and retail time deposits, while large banks tend to utilize large, negotiable
time deposits and nondeposit liabilities such as federal funds and repurchase agreements. The
supply of nontransaction deposits is shrinking, because of the increased use by small savers of
higher-yielding money market mutual funds.
major uses : Loans and investment securities continue to be the primary assets of the banking industry.
Commercial loans are relatively more important for the larger banks, while consumer, small
business loans, and residential mortgages are more important for small banks. Each of these
types of loans creates credit, and to varying extents, liquidity risks for the banks. The security
portfolio normally is a source of liquidity and interest rate risk, especially with the increased use
of various types of mortgage-backed securities and structured notes. In certain environments,
each of these risks can create operational and performance problems for a bank.
4. Community banks typically have assets under $1 billion and serve consumer and small business customers in local markets. In 2006, 93.4 percent of the banks in the United States were classified as community banks. However, these banks held only 12.4 percent of the assets of the banking industry. In comparison with regional and money-center banks, community banks typically hold a larger percentage of assets in consumer and real estate loans and a smaller percentage of assets in commercial and industrial loans. These banks also rely more heavily on local deposits and less heavily on borrowed and international funds.
Regional banks range in size from several billion dollars to several hundred billion dollars in assets. The banks normally are headquartered in larger regional cities and often have offices and branches in locations throughout large portions of the United States. Although these banks provide lending products to large corporate customers, many of the regional banks have developed sophisticated electronic and branching services to consumer and residential customers. Regional banks utilize retail deposit bases for funding, but also develop relationships with large corporate customers and international money centers.
Money center banks rely heavily on nondeposit or borrowed sources of funds. Some of these banks have no retail branch systems, and most money center banks are major participants in foreign currency markets. These banks compete with the larger regional banks for large commercial loans and with international banks for international commercial loans. Most money center banks have headquarters in New York City.
5. The savings and loan crisis of the 1980s and 1990s (commonly dubbed the S&L crisis) was the failure of about 747 out of the 3,234 savings and loan associations in the United States. A savings and loan or "thrift" is a financial institution that accepts savings deposits and makes mortgage, car and other personal loans to individual members—a cooperative venture known in the United Kingdom as a Building Society. "As of December 31, 1995, RTC estimated that the total cost for resolving the 747 failed institutions was $87.9 billion." The remainder of the bailout was anticipated to be paid for by charges on saving and loan accounts.
William K. Black wrote that Paul Volcker as Chairman of the Federal Reserve helped create a criminogenic environment for the Savings and Loans in 1979 by doubling the interest rate (to reduce inflation): S&Ls made long-term loans at fixed interest using short-term money. When the interest rate increased, the S&Ls could not attract adequate capital and became insolvent. Rather than admit to insolvency, some CEOs of S&Ls became "reactive" control frauds by inventing creative accounting strategies that turned their businesses into Ponzi schemes that looked highly profitable, thereby attracting more investors and growing rapidly, while actually losing money. The push of the Reagan administration for deregulation made it harder to detect such fraud. This had two effects: it meant that the fraud continued longer and substantially increased the economic losses involved, and it attracted "opportunistic" control frauds who were looking for businesses they could subvert into Ponzi schemes. For example, Charles Keating paid $51 million from Michael Milken's junk bond operation for Lincoln Savings and Loan, which at the time had a negative net worth exceeding $100 million.
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