The Federal Reserve’s role in banking: What you need to know

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Ever wonder who's pulling the strings behind the U.S. economy? Meet the Federal Reserve, often called the Fed. This powerful institution keeps the United States economy stable and healthy by regulating and supervising the financial system, including banks.

The Fed's actions impact your wallet more than you might realize. Let's break down how this organization works and which Fed actions you should keep an eye on.

What is the Federal Reserve?

The Federal Reserve serves as the central bank of the United States. Broadly speaking, its goal is to help the economy run smoothly. The Fed consists of three key structures:

1. A seven-member Board of Governors
2. 12 Federal Reserve banks operating in specific regions of the country
3. The Federal Open Market Committee (FOMC)

Why do we need a Federal Reserve?

Before the Fed’s creation, the U.S. was the only major financial power without a central bank — and it showed. During economic panics, the government had to turn to wealthy individuals like J.P. Morgan for emergency cash.

After a series of bank runs and financial panics in the late 19th and early 20th centuries, President Woodrow Wilson signed the Federal Reserve Act into law in 1913 to stabilize the banking system.

The Fed’s primary functions

A lot goes into making the economy run smoothly. The Fed has five primary functions:

1. Monetary policy: The Fed aims to keep inflation in check (targeting about 2% annually) while promoting maximum employment. It does this primarily by adjusting the federal funds rate, which influences economic interest rates.
2. Financial system stability: The Fed monitors domestic and international financial markets to identify potential risks. It also works with other regulatory agencies to address systemic issues that could threaten economic stability.
3. Regulation of financial institutions: The Fed sets rules for banks to follow, ensuring they maintain enough capital and manage risks appropriately. This helps prevent bank failures and protects consumers' deposits.
4. Payment systems oversight: From check processing to electronic fund transfers, the Fed plays a crucial role in ensuring that money moves safely and efficiently through the financial system.
5. Consumer protection and community development: The Fed researches consumer financial issues, enforces consumer protection laws, and supports community development initiatives to promote fair and transparent financial services.

How the Fed oversees banks

The Fed monitors everything from small regional banks to the world's largest financial institutions. Its approach to banking policy is both narrow and wide. The central bank supervises and regulates individual banks to ensure they operate safely and legally. It also monitors the broader financial system and identifies risks, such as unhealthy lending practices.

Regulation

While Congress creates laws that banks must follow, the Fed introduces rules for enforcing those laws. For example, the Fed might specify how much capital banks need to hold relative to their assets or set guidelines for lending practices.

Supervision

The Fed conducts regular exams of banks, similar to a physical at the doctor's office. These exams assess a bank's overall health and can result in penalties if a bank operates unsafely or illegally. Banks then respond to the report with their plan to address any weaknesses, and examiners from the Fed later assess progress.

The Fed also conducts annual stress tests for larger banks, requiring banks to respond to hypothetical adverse conditions like severe recessions. This helps the Fed know which banks are vulnerable and also helps the Fed set capital requirements — more on that below.

The Fed's influence on bank lending and deposits

The FOMC meets eight times yearly to assess the economy and adjust monetary policy. Most notably, these meetings determine whether to raise, lower, or maintain the federal funds rate — the benchmark financial institutions use to set interest rates for credit cards, loans, savings accounts, and more.

When the Fed raises its federal funds rate, banks generally follow suit, making it more expensive to borrow money. The Fed uses this strategy to influence consumer spending and borrowing behavior.

For example, between 2021 and 2022, inflation soared to 7.1%. To combat this, the Fed raised interest rates 11 times between 2022 and 2023. This made borrowing more expensive but helped bring inflation down to 2.5% by 2024, though with some side effects.

The Fed's actions have a ripple effect throughout the economy:

• Higher rates can slow economic growth and reduce inflation
• Lower rates can stimulate borrowing and economic activity
• Changes in rates affect everything from mortgage rates to credit card APRs to yields on savings accounts

Federal Reserve services for banks and consumers

As stated in its five key objectives, part of the Federal Reserve’s job is to oversee efficient and safe payment systems. Here are a few services the Fed provides to banks and consumers to facilitate easy, secure transactions:

• Check processing and ACH transactions: The Fed clears millions of checks and electronic payments daily, ensuring that money moves efficiently between banks and accounts.
• Wire transfers: The Fedwire system allows for same-day, large-value wire transfers between financial institutions.
• Instant payments: The new FedNow service, launched in 2023, enables real-time payments between individuals and businesses 24/7. For example, customers of different banks using this service can instantly transfer money to each other’s accounts.

The Fed's role in banking crises

The Fed adjusts interest rates as a standard business, but during banking crises, the Fed has several levers designed to prevent disaster.

• Emergency lending programs: The Fed can lend directly to businesses and financial institutions to provide liquidity during times of stress. For example, during the COVID-19 pandemic, the Fed created several lending facilities to support various sectors of the economy.
• Loosening regulations: In times of crisis, the Fed might relax certain rules to give banks more flexibility. For instance, during the pandemic, the Fed temporarily eliminated the rule limiting savings account withdrawals to six per month.
• The discount window: This is the Fed's standing offer to lend to banks that need short-term liquidity. While banks typically avoid using it due to the stigma associated with needing emergency funds, it serves as an essential backstop for the banking system.

What banking customers should know about the Fed

After holding rates at 20+ year highs for over a year, the Fed cut its federal funds rate by half a percentage point in September 2024. Experts expect more rate cuts in the future, depending on how the economy reacts.

For consumers, this means yields on savings accounts will likely fall. Chris Cybulski, certified financial planner, advises: "Make sure your money has a purpose by asking these questions: When do I need this money? Is it worth my time to chase a slightly better yield? What if I take on more risk and lose part of my principal? If you focus on your goals, risk, and timelines, you can avoid much of the broader market noise."

One option to consider is certificates of deposit (CDs). Melissa Caro, a certified financial planner, suggests: "Looking at longer CD terms is worthwhile now. But make sure your personal situation warrants losing liquidity for that period to avoid early withdrawal penalties."

As interest rates change, consider these strategies:

• Monitor your variable-rate savings accounts and credit cards
• Consider locking in fixed rates on loans if rates are low
• Look for opportunities to refinance existing debt
• Be cautious about taking on new debt when rates are high

The bottom line

The Fed's primary goal is maintaining a stable banking system. Its actions directly impact banks and your savings, making it crucial to understand the Fed's basic functions and stay informed about its decisions, especially adjustments to the federal funds rate.

By understanding how the Fed works, you can make more informed financial decisions, whether saving, borrowing, or investing. Keep an eye on Fed announcements and consider how they might affect your financial strategy. You can stay up to date on FOMC meetings and other Fed actions by checking the Fed’s newsroom.

Editorial disclosure: Opinions expressed are author's alone, not those of any bank, credit card issuer, or other entity. This content has not been reviewed, approved, or otherwise endorsed by any of the entities included in the post.