The Federal Reserve System carries numerous responsibilities in regulating the banking and the monetary systems. However, its role becomes even more important when it comes to resolving financial crises. Resolving Financial Crises: The Role of Fed in Banking System Introduction The Federal Reserve System is known to be “the bank for bankers”. The system is connected with numerous responsibilities and obligations, which regulate the monetary and the banking systems. However, hardly anyone ever thinks about the Fed’s role in resolving financial crises.
This is why it is important to review the Fed’s responsibilities when financial crises occur. The importance of financial stability to national economic performance We often make a serious mistake, when discussing the role and position of the Fed in the U. S. banking and monetary systems: “the process of transferring funds from savers to investors through the banking system and through capital markets is so seamless and efficient that we often take it for granted” (Browne, 2001).
However, the overall performance of the Fed is ultimately aimed at maintaining the economic stability of the country and its population. The real understanding of the Fed’s role in the national financial system comes only when several countries with different financial systems are being compared. The new economic structures, emerging in Asia, Africa and Eastern Europe make it clear that the national economic performance is directly connected to and depends on the effectiveness of the monetary and banking systems.
Thus, the Fed’s importance in resolving crises should not be underestimated. According to the recent researches, the countries which lack sound financial structures, and do not possess stable financial regulations, are more prone to economic crises of various origins (Apel, 2003). This is where the role of the Fed is really appreciated. In addition, “when the intermediation process no longer functions effectively and when falling asset prices undermine household and firm balance sheets”, the Fed becomes an even more valuable tool of banking and monetary systems’ regulation (Apel, 2003).
It is crucial to understand that economic crises cause several different impacts onto the economic performance in general. First, the cost of borrowings considerably increases. Second, the availability of credit can become minimal. As a result of these processes, customers face the shortage of spending and employment contraction. Third, asset prices directly impact the amount of wealth; as a result, consumer confidence suffers, too. During the last decade, an increasing number of countries have experienced persistent financial crises. These crises sometimes caused irreversible effects onto national economic systems.
This is why the Fed’s policymakers have faced the challenge of combining traditional crisis management measures with the newest institutional reforms, to address the threats of financial crises. The role of the Fed in the U. S. banking and monetary systems The most visible Fed’s responsibility is developing and realizing the monetary policy of the U. S. “As the nation’s central bank, the Federal Reserve regulates the creation of money and of liquidity more generally” (Ashdown, 2002). From the limited perspective, the role of the Fed is viewed as the mere tool of crisis regulation.
However, the functionality and importance of the Federal Reserve in the national banking system is much broader. Moreover, its role is much more important, than one may think at first sight. First, the Federal Reserve deals with setting interest rates for federal funds. This is one of the means to regulate the national monetary policy. Interest rates’ regulation is crucial to maintain the stability of prices and low inflation. The stability of prices is the determining factor for the sustainable economic development; price stability fosters economic growth and maintains consumer confidence.
Price stability is crucial for high employment rates. The Fed can immediately respond to numerous economic disturbances if it operates in the stable price environment (Schwarz, 2007). The stability of prices causes the Fed’s flexibility in resolving financial crises. The events of 9/11 have become the bright example of the Fed’s importance in maintaining economic stability. Such events usually lead to economic recession, if financial systems do not react in timely manner. The Fed was able to preserve stability of financial markets even under the threat of repetitive terrorist acts.
The second Fed’s responsibility is in regulating numerous financial responsibilities. “The Fed’s mission in this regard is to ensure a safe and sound, as well as competitive, banking system in the country” (Schwarz, 2007). This does not matter, whether the Fed is involved into regulating the economic relations with national banks, or with international financial institutions, but in any activity the Fed is primarily aimed at maintaining sustainable financial development of the national economy.
The Fed’s direct responsibility is providing financial services to the federal government and the related depository institutions. The Fed is involved into clearing checks and regulating certain forms of electronic payments. Currency circulation is also one of the Fed’s responsibilities. There are several means of lending money to the U. S. financial institutions. The Fed either uses the discount window, or applies lending strategies to the economic subjects which found themselves in stressed financial situation as a result of economic breakdowns.
The Fed works with both state and private financial objects, creating a solid system of financial relations with all economic players. The national Treasury is also supported by the Fed in managing its software solutions, and supporting the stability of its performance. The Federal Reserve System has a mix of public and private responsibilities. Monetary policy and bank regulation are clearly public responsibilities. Financial services to the banks and the Treasury have mixed public-private aspects, particularly given that a number of purely private firms compete with the Fed. Browne, 2001) The role of the Fed in resolving financial crises has been evolving through the last decade. The development of software solutions and the stability of the overall financial system have made it easier to maintain stable economic growth, and to avoid serious financial market crises. The current banking system operates in a well structured manner, and timely responds to economic and financial challenges. There are several aspects, through which the evolution of the Fed’s financial role can be viewed.
First, the Fed has currently turned into the conjunction of skills and knowledge of professional financial specialists (Apel, 2003). The Fed promotes standardization of financial services across its banks to eliminate significant differences in operations, and to promote better understanding between the banks and the customers. This understanding is one of the solid foundations in eliminating and resolving financial crises in the country. However, standardization should not be viewed as the goal in itself. In its ultimate forms, standardization is a negative feature of any financial system.
Standardization should be combined with the reasonable incorporation of financial specialties. These approaches are supported and encouraged by the Federal Reserve. In such financial environment, the banks are able to combine their stability with efficiency of their financial operations. The Fed is cutting by more than half the number of Reserve bank sites around the country that process checks. The Fed is contracting its paper-processing facilities because people are writing fewer checks in favor of using credit cards, debit cards and other forms of electronic payment. Ramirez, 2000) The Fed’s importance in resolving financial crises has increased with the Fed becoming more public and open to the nation. The Fed regularly issues press releases, in which it delineates the major directions of its financial policies, their benefits, and their importance for the improved economic performance of the national financial institutions. The financial policy decisions are made public; they are discussed with the public, and are reported to the Congress. This publicity often becomes the means to justify the Fed’s financial decisions (Browne, 2001).
As a result, the Fed builds the trust of the national business players, and is able to preserve this trust (confidence) when it needs to act during financial crises. What lessons have we learnt from the recent financial crises? Each financial crisis is unique; as a result, the Fed has to advise the appropriate anti-crisis methods each time it faces the challenge of financial instability. There are no universal methodologies in eliminating the causes and the consequences of financial crises. It is crucial to analyze the lessons we have learnt from the latest financial upheavals.
Financial market regulation must be dynamic, not static, and must adapt to a changing financial environment. It is unrealistic to believe that a regulatory framework designed for a particular financial structure will continue to be effective when that structure changes. (Browne, 2001) Contemporary financial environment is characterized by extremely rapid changes. This is why financial structures should be able to timely react to such changes. The U. S. currently faces the situation, in which the institutional investors’ importance is constantly increased.
This importance is what calls for the implementing long-term changes into the methods of financial market regulation. The recent financial crises have proved that there is consistent interrelation between the regulation and the regulated financial subjects (Ramirez, 2000). The Fed regulates the financial institutions’ activity; these regulations change the financial behavior, which in its turn requires further changes in the Fed’s financial regulation. The Fed has displayed the extreme flexibility of its financial decisions in the latest financial upheavals.
Regulations do not serve the ultimate goal in resolving financial crises: the banks have learned to adjust to the ever changing financial conditions, which sometimes presuppose the need to change, or even to avoid regulations. The combination of flexibility and regulatory approaches turns the Fed into the major decision-maker when financial crises should be stopped or prevented. Financial crisis creates severe challenges to the overall financial performance of the Federal Reserve. The Fed is involved into the process of intermediation between the private banks and state financial institutions.
It directly regulates the amount and the availability of lending on financial market. There are numerous reasons of why the state financial institutions are not able to distinguish the insolvent institutions from the liquidity impaired entities. In such situations, the Fed is to control the anti-crises regulatory process, in order not to make it too restrictive (Ramirez, 2000). The Fed’s goal is to objectively evaluate the threats and the exact conditions of the specific financial crisis.
Financial crises push the state towards applying the worse-case scenarios, which are not always appropriate, and may even cause the worsening of the financial situation. Evidently, applying the worse-case scenarios means exercising restrictive regulatory measures (Ramirez, 2000). Regulation of lending is one of the most effective measures the Fed can apply in eliminating the economic consequences of financial crises; however, in pressured financial conditions even well capitalized banks may keep from expanding their lending activities.
This is why the role of the Fed is to convince the banks in the need and effectiveness of increased lending during the time when the crisis persists. Intermediation has traditionally been one of the most important Fed’s activities in the banking and monetary system of the U. S. The Fed’s role is to diversify the system of financial intermediation between various financial institutions. Moreover, the banking system was always considered the major intermediation source. “Troubles in the banking system can considerable decrease the intermediation abilities with far-reaching macroeconomic consequences” (Apel, 2003).
In this situation, the Fed is called for diversifying the sources of intermediation in the national financial system. Such diversification is required, if the Fed wants to make the national financial structure more robust. The 1990-1991 problems with intermediation, and with the availability of bank lending to small businesses have resulted in the slow economic recovery, and can be taken as a serious lesson in resolving financial crises.
Resolving financial crises: Implications for the Fed. The increasing interconnectedness of financial institutions and markets has highlighted the need to ensue that diverse federal, state, international, and private financial organizations work together to effectively contain and resolve financial disruptions. The Federal Reserve leads crisis containment efforts because of their financial resources, access, and expertise, with its distinct and complementary leadership role. (Ashdown, 2002) The discussed changes in the Fed’s activity, approaches, and regulations create significant implications for the role of the Fed in managing financial crises.
The crisis conditions in which the Fed currently operates suggest that the use of discount window is no longer the best approach in resolving financial crises. The Fed finds itself in the situation when it cannot exercise the flexibility of its crisis management to the fullest. There are several reasons of why the Fed cannot use the discount window anymore. First, contemporary financial regulations (FDICIA, in particular) limit lending procedures to the banking and monetary institutions which ultimately fail (Schwarz, 2007). Second, in normal financial conditions banks do not display their desire to use the benefits of the discount window.
As a result, the Fed is also reluctant to utilize the discount window approaches during financial crises. Otherwise, these steps will indicate the changes in financial behavior, and will cause negative financial expectations among banks and related financial structures. In managing financial crises, the role of the Fed is to determine what tools would work for the benefit of the financial institutions’ majority. The use of the open market operations instead of the discount window has become a regular approach in resolving financial (and economic) crises.
Open market operations increase financial market liquidity, but their use should be reasonable, too. It is stated, that “using open market operations rather than the discount window has potential implications for the overall stance of monetary policy” (Browne, 2001). This is why the Fed must determine the appropriate measures in resolving the financial crises and avoiding far reaching macroeconomic consequences. The Fed is to weigh all pros and cons of using the discount window and the open market operations. This need is justified by the fact that both financial approaches cause serious changes in the monetary policy structure.
Open market operations are utilized to increase the liquidity of the financial market. During the 1990s financial crises in the U. S. , open market operations were utilized against traditional discount window methods (Ashdown, 2002). There is still no clear understanding, whether the Fed may employ open market operations without applying discount window methods. In this case the monetary policy stance definitely changes. How can the state guarantee that the new monetary policy stance does not contradict to the need of increasing liquidity in financial markets?
Simultaneously, how can the state properly identify the limits of the financial market liquidity to avoid excessive inflation processes? The Fed is to answer these questions, and its role in resolving such financial issues is invaluable. Several researches were conducted to identify the real role of the Fed in financial crisis management. Poole (2007) expressed his vision of the Fed’s role in resolving financial crises. In his opinion, the Fed should not do anything when the financial instability strikes. Moreover, the author was trying to prove that the previous financial crises had displayed the minor role of the Fed in resolving them:
The Fed has intervened from time to time. One important ease was the provision of additional liquidity and moral support to the markets when the stock market crashed in 1987. The Fed also provided support to the market at the time of the near failure of Long Term Capital Management in 1998. In both eases the Fed cut the federal funds rate, which provided evidence that Fed was on the job and prepared to provide extra liquidity as needed. (Poole, 2007) The author further stated that the whole Fed’s participation in financial crisis management was at least controversial.
Poole (2007) suggested that the Fed had not provided any financial support to the financial institutions during the major financial upheavals. However, such view is rather limited. The Fed is not involved into providing direct financial support to the banking institutions during crises. The Fed is primarily aimed at creating the necessary financial conditions, in which financial institutions could maintain their stable performance, and to avoid financial failures. Above all, the Federal Reserve is called for ensuring macroeconomic stability and reducing the probability of serious financial crises.
The Fed directs its activity at creating legal barriers against financial instability. It uses numerous financial and monetary tools to decrease the negative impact of financial crises onto the whole economic system of the U. S. In this aspect, the Fed does not have to exercise direct financial support to the failing banking institutions. One must understand that the Fed plays major role in financial crisis management at the national level. Moreover, when the countries and financial systems are developed under the impact of globalization processes, the role of the Fed becomes more important in regulating international financial upheavals.
Evidently, globalization facilitates international cooperation of banking institutions; yet, it also facilitates spreading of the crisis trends in the international financial structure. Even in this case the Fed is not called for offering direct financial support to the institutions in need. It is also important to ensure that the Fed itself remains operational under any financial conditions. It is crucial for the Fed to be always prepared for the liquidity actions, aimed at reviving the financial entities which are close to cease their performance (Apel, 2003).
All business and financial market players are confident that the Fed has sufficient authority to act in crisis situations; as a result, the reliability of the Federal Reserve under financial pressure should be doubtless. Conclusion The Federal Reserve System was created to regulate the banking and monetary policy, and to provide the necessary assistance to financial institutions during financial crises. The Fed traditionally exercised the two effective tools in financial crisis management: the lending increase through the discount window, and the open market operations to increase the liquidity of financial funds.
Cutting the funds rates target has also proved to be a beneficial step in resolving financial issues. The Fed’s role is invaluable when financial institutions face the threat of crises and financial losses. The recent financial crises have created numerous implications for the future Fed’s activity. One must realize that flexibility of the Fed’s regulation is the most important aspect of managing financial crises. Contemporary financial conditions require the Fed to adjust its regulatory frameworks to the new economic and political requirements; it is sometimes appropriate that financial institutions are not regulated at all.
The application of the worst-case scenarios is connected with the excessive regulatory restrictions, under which banks and institutions cannot successfully maintain their financial stability. “The Fed’s role in contributing to general financial stability through a policy of maintaining price stability is also important. Historically, periods of restrictive monetary policy designed to bring inflation down have often been accompanies by failures of many financial firms” (Schwarz, 2007). The Fed is also involved into regulating employment rates and output.
Objectively, the Fed cannot eliminate economic recessions, but it can make them less severe. Technological progress requires the Fed to implement the newest software solutions into its practice. The Fed’s activity in financial crisis management has considerably evolved with time. What is more important, is that the Fed’s activity becomes even more responsible under the impact of the expanding globalization processes, when the Fed’s policies and decisions impact the financial performance of international markets, too.