explaining the federal reserve system

since the option at this point was for someone to buy out the failing firm, the only question was who? it was still unclear at this point how much debt bear sterns was in, so many of the big wall street firms were wary of taking on this risk. this is where the federal reserve bank of ny stepped in. (here's where it gets a little like a economics class, but don't worry, it's really easy!)

the federal reserve system is the central banking system in the united states. it's primary purpose is to formulate monetary policy and it is run by a board of 7 federally appointed governors (of which Ben Bernanke is the chairman) and regional reserve bank presidents. there are 12 reserve banks districts scattered throughout the country.

the federal reserve system has a couple tools with which to "formulate monetary policy": reserve requirements, open market operations, and the discount rate. let's start with the first one.

reserve requirements
this one is easy; the federal reserve's board of governors mandates that banks cannot dip below a certain percent of their total debt in assets. this usually hovers around 10% for the size of the banks we're talking about. this just means that a bank has to have reserves of at least 10% of what they owe, and if they don't, need to borrow money to get to the 10% mark. so if you owe $100, you always need to have at least $10 in reserves.

open market operations
all open market operations are governed by the federal open market committee (the FMOC has been in the news a lot lately- "the fed cut interest rates"- that's who they are talking about), which is made up of the board of governors, the president of the federal reserve bank of new york (proving once again that NYC is the center of the world!) and a rotating cast of 5 of the other 11 reserve bank presidents. the FMOC governs open market operations by setting a price at which banks can lend to each other to maintain those reserves. for example, if one bank needs to make a loan to a client (let's say a mortgage for example) they will dip into their reserves for the cash for the loan. in order to maintain the federally mandated level of money in reserves, they need to borrow from another bank. the nominal* interest rate for that transaction is what the FMOC can determine and it is called "the federal funds rate" and what they mean when they say "the fed cut the interest rate" in the news. what does decreasing or increasing this interest rate do, and why such a big fuss about it?

first of all, when you decrease an interest rate, you make it easier for people to borrow money from one another (think about how much more willing people are to get student loans, with 7% interest rates, verses credit cards, with 20% interest rates), thereby increasing liquidity in the market (liquidity is basically a complicated word for cash, or access to cash). therefore, when the FMOC loosens these rates it is signaling to banks that they should be more willing to lend money to clients (giving small business loans, mortgages, etc) and spend money because it will be cheaper to borrow what you just lent/spent. when they tighten the interest rate, they are trying to curb access to liquidity and tighten up the market. you could write many, many papers (and i'm sure they have been written) about the fed funds rate and it's correlation to various market factors. but that's the basic gist: rate goes up, the fed is tightening the market and it will be harder for everyone to access cash, rate goes down, fed is encouraging lending/spending and liquidity is pumped into the market.

discount rate
the discount rate (sometimes also talked about as the discount window) is the interest rate at which banks can borrow directly from the federal reserve bank. it is very rare for the bank to borrow directly from the federal reserve, primarily because this rate is usually a bit higher that the fed funds rate and means that no one else is willing to lend to this bank. it is mostly used in short-term liquidity emergencies.the board of governors determines the discount rate and unlike my confusing caveat below, can actually set a real rate because banks borrow directly from the system.

in the case of bear stearns, no one bank wanted to take on all of bear's still unknown debts, so the federal reserve bank of new york stepped in an made the deal safer for JP Morgan.

*because the FMOC can't actually regulate interest rates between banks, the actual interest rates banks pay to one another will fluctuate. the nominal rate is the target interest rate and the actual "effective" interest rates are the weighted average of all the transactions between banks. okay, that was super confusing, but just basically remember that finance is all about perception, and this interest rate stuff is just about signaling a direction the FMOC wants the economy to go in.
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