The Federal Reserve Act of 1913 provided the United States with a central banking system. The Federal Reserve System dominates US banking, is a strong influence in the affairs of commercial banks, and exercises virtually unlimited control over the money supply. The Federal Reserve Bank system is an independent government organization, with important posts appointed by the President and approved by the Senate.
Each of the 12 federal reserve districts contains a federal reserve bank. A board of nine directors presides over each reserve bank. Six are elected by the member banks in the district: of this group, three may be bankers; the other three represent business, industry, or agriculture. The Board of Governors of the Federal Reserve System (usually known as the Federal Reserve Board) appoints the remaining three, who may not be officers, directors, stockholders, or employees of any bank and who are presumed therefore to represent the public.
The Federal Reserve Board regulates the money supply and the amount of credit available to the public by asserting its power to alter the rediscount rate, by buying and selling securities in the open market, by setting margin requirements for securities purchases by altering reserve requirements of member banks in the system, and by resorting to a specific number of selective controls at its disposal. The Federal Reserve Board's role in regulating the money supply is held by economists of the monetarist school to be the single most important factor in determining the nation's inflation rate.
Member banks increase their reserves or cash holdings by rediscounting commercial notes at the federal reserve bank at a rate of interest ultimately determined by the Board of Governors. A change in the discount rate, therefore, directly affects the capacity of the member banks to accommodate their customers with loans. Similarly, the purchase or sale of securities in the open market, as determined by the Federal Open Market Committee, is the most commonly used device whereby the amount of credit available to the public is expanded or contracted. The same effect is achieved in some measure by the power of the Board of Governors to raise or lower the reserves that member banks must keep against demand deposits. Credit tightening by federal authorities in early 1980 pushed the prime rate-the rate that commercial banks charge their most creditworthy customers-above 20% for the first time since the financial panics of 1837 and 1839, when rates reached 36%. As federal monetary policies eased, the prime rate dropped below 12% in late 1984; as of 2000 it was below 10%. In mid-2003 the federal funds rate was reduced to 1%, a 45-year low.
The financial sector is dominated by commercial banks, insurance companies, and mutual funds. There was little change in the nature of the sector between the 1930s, when it was rescued through the creation of regulatory bodies and deposit insurance, and the 1980s, when the market was deregulated. In the 1980s, the capital markets underwent extensive reforms. The markets became increasingly internationalized, as deregulationallowed foreign-owned banks to extend their operations. There was also extensive restructuring of domestic financial markets-interest-rate ceilings were abolished and competition between different financial institution intensified, facilitated by greater diversification.
Commercial and investment banking activities are separated in the United States by the Glass Steagall Act, which was passed in 1933 during the Great Depression. Fears that investment banking activities put deposits at risk led to a situation where commercial banks were unable to deal in non-bank financial instruments. This put them at severe commercial disadvantage, and the pressure for reform became so strong that the Federal Reserve Board has allowed the affiliates of commercial banks to enter a wide range of securities activities since 1986. Attempts to repeal the act were unsuccessful until November 1999, when the Gramm-Leach-Bliley Act (also known as the Financial Modernization Act) was passed by Congress. The Gramm-Leach-Bliley Act repeals Glass-Steagall and allows banks, insurance companies, and stock brokers and mutual fund companies to sell each other's products and services; these companies are also now free to merge or acquire one another.
The expansion and diversification in financial services was facilitated by information technology. Financial deregulation led to the collapse of many commercial banks and savings and loan associations in the second half of the 1980s. In the 1990s, change has continued in the form of a proliferation of bank mergers; with the passage in 1999 of Gramm-Leach-Bliley, further consolidation of the industry was predicted.
Prior to 1994 the banking system was highly fragmented; national banks were not allowed to establish branches at will, as they were subject to the banking laws of each state. Within states, local banks faced similar restraints on their branching activities. In 1988, only 22 states permitted statewide banking of national banks, while 18 allowed limited banking and ten permitted no branches. Consequently in 1988 over 60% of US commercial banks had assets of less the $150 million, while only 3% had assets valued at $500 million or more.
Such regulation rendered US banks vulnerable to merger and acquisition. Acquisitions have generally taken place through bank holding companies, which then fall under the jurisdiction of the Federal Reserve System. This has allowed banks to extend their business into non-bank activities such as insurance, financial planning, and mortgages, as well as opening up geographical markets. The number of such holding companies is estimated at 6,500. These companies are believed to control over 90% of total bank assets.
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 removed most of the barriers to interstate bank acquisitions and interstate banking. The new act allowed banks to merge with banks in other states although they must operate them as separate banks. In addition, banks are allowed to establish branches in neighboring states. Restrictions on branching activity were lifted as of June 1997. The legislation allowed banks to lessen their exposure to regional economic downturns. It also ensured a continuing stream of bank mergers. Liberalization has encouraged a proliferation of in-store banking at supermarkets. International Banking Technologies, Inc., reported that the number of supermarket bank branches rose to 7,100 in 1998, up from 2,191 in 1994. In the mid-1990s, the number of supermarket branch banks grew at an annual rate of around 30%, but growth from 1997 to 1998 slowed to just over 10%.
Under the provisions of the Banking Act of 1935, all members of the Federal Reserve System (and other banks that wish to do so) participate in a plan of deposit insurance (up to $100,000 for each individual account as of 2003) administered by the Federal Deposit Insurance Corporation (FDIC).
Savings and loan associations are insured by the Federal Savings and Loan Insurance Corporation (FSLIC). Individual accounts were insured up to a limit of $100,000. Savings and loans failed at an alarming rate in the 1980s. In 1989 the government signed legislation that created the Resolution Trust Corporation. The RTC's job is to handle the savings and loans bailout, expected to cost taxpayers $345 billion through 2029. Approximately 30 million members participated in thousands of credit unions chartered by a federal agency; state-chartered credit unions had over 20 million members.
The International Monetary Fund reports that in 2001, currency and demand deposits—an aggregate commonly known as M1—were equal to $1,595.5 billion. In that same year, M2—an aggregate equal to M1 plus savings deposits, small time deposits, and money market mutual funds—was $6,961.2 billion. The money market rate, the rate at which financial institutions lend to one another in the short term, was 3.89%. The discount rate, the interest rate at which the central bank lends to financial institutions in the short term, was 1.25%.
When the New York Stock Exchange (NYSE) opened in 1817, its trading volume was 100 shares a day. On 17 December 1999,1.35 billion shares were traded, the record high for shares traded in a single day. Record-setting trading volume occurred for 1999 as a whole, with 203.9 billion shares traded (a 20% increase over 1998) for a total value of $8.9 trillion, up from $7.3 trillion in 1998. In 1996, 51 million individuals and 10,000 institutional investors owned stocks or shares in mutual funds traded on the NYSE. The two other major stock markets in the United States are the American Stock Exchange (AMEX) and the NASDAQ (National Association of Securities Dealers). The NASD (National Association of Securities Dealers) is regulated by the SEC (Securities and Exchange Commission).