The Federal Reserve is strange. In an age of populism and polarized politics, America’s central bank maintains a technocratic and nonpartisan reputation. Despite operating with a level of independence and impact that rivals the Supreme Court, the Fed’s decisions are subject to surprisingly little public scrutiny. And while government deficits are expanding, the Fed actually manages to turn a profit for taxpayers. But the strangest part of the Fed, by some margin, is its bizarre structure that blends public and private elements to create an institution that is sort of part of the government, but not really.
The Fed’s odd structure has been the inspiration for a number of fun conspiracy theories that allege the bank is part of a secret cabal of financiers controlling the American financial system for their own benefit. These theories are usually cooked up by people discovering that most forms of money can be viewed as debt, and who proceed to become very upset at that fact. Like all good conspiracies, though, this one is based in truth. The Federal Reserve Banks really are private corporations, and commercial banks serve as their shareholders.
There are twelve geographically distributed Reserve Banks around America, with the most powerful one being found in New York1. The Banks are the operating arms of the Fed, and work with a stick in one hand and a carrot in the other. While they regulate and supervise commercial banks in their regions, the Banks provide the same institutions with valuable financial services2. The Banks form the private half of the Fed’s hybrid model, with the Board of Governors, a federal agency, serving as the public half3.
Together, the Banks and the Board form the committee which ultimately decides American monetary policy. To critics, this structure gives private interests an enormous influence over the financial system, both through regulatory and monetary policy levers. But these criticisms (and the resulting conspiracies) miss that basically none of the words used to describe the structure of the Reserve Banks mean what they normally do. The Federal Reserve Bank of St. Louis and Bank of America are both private corporations with shareholders in the same way that caffeine and cocaine are both addictive stimulants. Describing different things with the same words does not make them equal.
Consider the ‘shareholders’ of the Reserve Banks. Commercial banks, like Wells Fargo or Citigroup, have to buy stock in their regional Reserve Bank in order to participate in the Federal Reserve system4. Unlike traditional stock ownership, being a shareholder of a Reserve Bank confers no control rights, and banks are mandated to purchase an amount proportional to their total capital. Further, banks cannot sell their stock or use it as collateral for another purchase. For a commercial bank, purchasing Reserve Bank stock is more like paying membership dues than acquiring equity in a company.
Reserve Bank stock still has some features of traditional ownership. For instance, shareholders (that is, commercial banks) can elect six of the nine members of each Reserve Bank’s board of directors. This board appoints a Reserve Bank President, who, since they often wield a vote on monetary policy, can have significant influence5. Still, only three of the directors that shareholders elect can be employees or officers of a commercial bank, and these directors are not allowed to cast a vote to elect the Reserve Bank President. This leaves commercial banks with essentially no power over the operations of the Reserve Bank. As a final government backstop, the Board of Governors must approve all Reserve Bank Presidents before they can take office.
Reserve Bank stock also pays a dividend, which is often decried as a government handout to Wall Street. Admittedly, this is the aspect of the Reserve Bank structure with the worst public optics. For years, this dividend was fixed at a 6% annual rate, which looked increasingly generous as interest rates fell around the world. In 2016, the dividend rule was modified so that the largest banks now earn the lower of 6% or the yield on a ten-year Treasury. While the cessation of all dividends on Reserve Bank stock is likely to be an eventual result of targeted Wall Street outrage, making banks hold unremunerated assets that are ineligible for sale would essentially be levying an additional tax. A better policy would be to fix the dividend for all banks at the yield of a ten-year Treasury. In any case, ordinary stock grants the owner a claim on the residual profits of a company, after all fixed claims are paid. In the case of Reserve Banks, any profits are turned over to the Treasury, to the benefit of taxpayers.
The Fed’s unique structure is a vestige of the competing interests that influenced the design of the system at its origin. After the Panic of 1907, which nearly turned into an economic collapse, most policymakers and financiers agreed on the need for a central bank to provide liquidity in times of crisis. What they disagreed on was who should control the decision-making process of the bank. Wall Street believed that private bankers were best suited to run the central bank. The government sought to keep control in Washington. Midwestern farmers and other populist agitators (à la Jacksonian democracy) rejected all centralized control in the hands of Eastern interests, and pushed for a system made up of autonomous regional banks. In 1913, the Federal Reserve system, which appeased everyone but satisfied no one, was put into place. Reforms after the Great Depression and the Global Financial Crisis have reduced the autonomy of the Reserve Banks and the power of private interests, resulting in the system that stands today.
Ultimately, the Fed’s hybrid model is an illusion. Materially, almost all power is in the hands of the government-appointed Board. Over the last century, the government has accumulated more control over the Federal Reserve system, at the expense of private interests. Similarly, the Fed has achieved greater independence within the government, at the expense of political interests. The Reserve Banks are private in a rational sense, but not an empirical one. In other words, the Reserve Banks are private, but not in any way that actually matters.
1. Considering the New York Fed oversees Wall Street banks, this is probably unsurprising, but people underestimate how powerful the New York Fed is compared with other Reserve Banks. The NY Fed is the bank tasked with conducting open market operations, including quantitative easing. Securities held by the Fed, like Treasuries and MBS, are held in the NY Fed’s System Open Market Account (SOMA). Moreover, The NY Fed is the primary contact for foreign central banks, since the bank is responsible for conducting FX operations on behalf of the Fed and stores gold on behalf of foreign governments. Finally, the NY Fed President has a permanent seat on the FOMC and serves as the committee’s vice chair.
2. These services mainly include check clearing and managing electronic fund transfers. Reserve Banks also manage Fedwire, which processes large, real-time transfers between member banks. Reserve Banks charge commercial banks fees for these services.
4. Getting access to the Federal Reserve system grants commercial banks the option to borrow at the Fed’s discount window during times of crisis, although this benefit is less important now that the Fed has expanded their lender of last resort role to nearly the entire financial system through an alphabet soup of lending and repo programs. Perhaps more importantly, joining the system allows banks to use the Federal Funds market to settle transactions with other member banks. Joining the Federal Reserve system is compulsory for nationally chartered banks, but not state chartered ones.
5. The twelve-member Federal Open Market Committee (FOMC) is comprised of five Reserve Bank presidents and the whole seven-member Board of Governors. The New York Fed President has a permanent seat on the FOMC, while other Presidents serve one-year rotating terms. The FOMC ultimately dictates monetary policy, including adjusting target interest rates and determining how to proceed with large-scale asset purchases.
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