Question

how does the federal reserve encourage and supervise competition in financial markets?

Answer 1

Supervises the Banking System

The Federal Reserve oversees roughly 5,000 bank holding companies, 850 state bank members of the Federal Reserve Banking System, and any foreign banks operating in the U.S. The Federal Reserve Banking System is a network of 12 Federal Reserve banks that both supervise and serve as banks for all the commercial banks in their region.3

The 12 banks are located in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. The Reserve Banks serve the U.S. Treasury by handling its payments, selling government securities, and assisting with its cash management and investment activities. Reserve banks also conduct valuable research on economic issues.

After the financial crisis of 2008, the Dodd-Frank Wall Street Reform Act strengthened the Fed's power over banks. Dodd-Frank said if any bank became too big to fail, it could be turned over to Federal Reserve supervision and required to have a bigger reserve to protect against losses.

In fact, the Fed was given the mandate to supervise "systematically important institutions," and in 2015, it created the Large Institution Supervision Coordinating Committee.4This committee regulates the 16 largest banks, and most importantly, is responsible for the annual stress test of 31 banks.5These tests determine whether the banks have enough capital to continue making loans even if the system falls apart the same way it did in October 2008.

The law, the Economic Growth, Regulatory Relief, and Consumer Protection Act, rolled back a number of rules for small banks. The Fed can't designate these banks as too big to fail, and these banks no longer have to hold as much in assets to protect against a cash crunch. They also may not be subject to the Fed's "stress tests."7

In addition, smaller banks no longer have to comply with the so-called Volcker Rule. Now banks with less than $10 billion in assets can, once again, use depositors' funds for risky investments.

ENCOURAGEMENT

The Federal Reserve worked closely with the Treasury Department to prevent global financial collapse during the financial crisis of 2008. It created many new tools, including the Term Auction Facility, the Money Market Investor Funding Facility, and Quantitative Easing.

Two decades earlier, the Federal Reserve intervened in the Long Term Capital Management Crisis. Federal Reserve actions worsened the Great Depression of 1929 by tightening the money supply to defend the gold standard.

The Fed performs its functions by conducting monetary policy. The goal of monetary policy is healthy economic growth. That target is a 2%-3% gross domestic product growth rate. It also pursues maximum employment. The goal is the natural rate of unemployment of 4.7% to 5.8%.

The Federal Reserve controls inflation by managing credit, the largest component of the money supply. This is why people say the Fed prints money. The Fed moderates long-term interest rates through open market operations and the fed funds rate.

When there is no risk of inflation, the Fed makes credit cheap by lowering interest rates. This increases liquidity and spurs business growth. That ultimately reduces unemployment. The Fed monitors inflation through the core inflation rate, as measured by the Personal Consumption Expenditures Price Index. It strips out volatile food and gas prices from the regular inflation rate. (Food and gas prices rise in the summer and fall in the winter, and that's too fast for the Fed to manage.)

The Federal Reserve uses what's known as expansionary monetary policy when it lowers interest rates. The intent is to expand credit and liquidity.

Expansionary policy makes the economy grow faster and create jobs. If the economy grows too much, though, it triggers inflation. When that happens, the Federal Reserve raises interest rates as part of contractionary monetary policy. High interest rates make borrowing expensive. Increased loan costs slow growth and lower the likelihood of businesses raising prices.

The Fed has many powerful tools at its disposal. It sets the reserve requirement for the nation's banks, telling them what percentage of their deposits they must actually have on hand each night. The rest can be loaned out.

If a bank doesn't have enough cash on hand at the end of the day, it borrows what it needs from other banks. The funds it borrows are known as the fed funds. Banks charge each other the fed funds rate on these loans.

The FOMC sets the target for the fed funds rate at its monthly meetings. To keep it near its target, the Fed uses open market operations to buy or sell securities from its member banks. It creates credit out of thin air to buy these securities. This has the same effect as printing money. That adds to the reserves the banks can lend and results in the lowering of the fed funds rate. Knowledge of the current fed funds rate is important because this rate is a benchmark in financial markets

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From Mona....