What it means
The Act was a response to repeated panics in which basically sound banks failed simply because too many depositors asked for cash at the same time. It created an institution that could lend to banks against good collateral, so a temporary shortage of cash would not turn into a wave of collapses.
The problem it was built to solve was liquidity, not bad lending. The structure it set up was deliberately a compromise between central control and regional independence.
A board based in Washington oversees the system, while twelve regional reserve banks spread across the country carry out much of the operational work and feed in local economic information. That design was politically necessary at the time and still shapes how policy information is gathered.
The Act gave the new system three main capabilities: issuing currency, lending to member banks through what is now called the discount window, and a role in supervising banks. Open market operations, the buying and selling of government securities that dominates policy today, developed later inside the framework the Act created.
Later legislation amended the Act rather than replacing it. Subsequent laws added the modern policy committee arrangements and the goals of maximum employment and stable prices, which is why the Act is best read as a foundation that has been built on repeatedly.
For a business, the practical link is the cost and availability of credit. Policy decisions taken within the structure this Act created set the base cost of money, which flows through to overdraft pricing, loan margins and the discount rate used in investment appraisal.
A company that never speaks to a central banker still feels every decision one makes. One nuance worth knowing concerns ownership.
Member banks hold stock in their regional reserve bank, but that stock behaves nothing like ordinary equity, since it carries no control over policy and pays a dividend fixed by statute.
In practice
Real-world examples.
Example
A treasury manager at a manufacturer holds a $5,000,000 revolving facility priced at a floating reference rate plus a fixed margin. When policy tightening over a year lifts the reference rate by 0.75 percentage points, her interest cost rises by 5,000,000 x 0.0075 = $37,500 even though her margin never changed.
Example
A regional bank facing an unexpected deposit outflow borrows overnight from the discount window against its loan book rather than selling assets at a loss. The facility exists because the Act created a lender of last resort, and the bank is trading normally again within a fortnight.
Example
A finance director explaining a rise in the company's weighted average cost of capital to the board points to the policy rate rather than to anything the company did. She reprices the capital projects hurdle rate from 11% to 13% and defers two of the five projects on the list.
Case study
Seen in the real world.
Two Rivers Savings Bank is an illustrative, fictional community bank serving a farming region. A drought caused local businesses to draw down deposits far faster than the bank's loan book could be converted into cash, leaving it short of funds within weeks.
Rather than selling long-dated securities into a weak market and crystallising a loss, the bank pledged part of its agricultural loan portfolio and borrowed from its regional reserve bank. It repaid the borrowing over the following quarter as the harvest cash came in.
The fictional case shows the Act's central idea in action. A bank with good assets but no immediate cash is a liquidity problem rather than a solvency problem, and the point of the structure created in 1913 was to stop the first from becoming the second.
Watch out
Common mistakes.
- Describing the Federal Reserve as simply a government department, when the Act deliberately created a hybrid of a central board and regionally owned reserve banks.
- Assuming the Act set out the modern employment and inflation goals, when those were added by later legislation built on the same foundation.
- Thinking the Act's purpose was to manage interest rates, when its original focus was a flexible currency, a lender of last resort and improved bank supervision.
Questions
People also ask.
Why was the Act passed in 1913 specifically?
It followed a series of banking panics in the preceding decades that showed the system had no reliable source of emergency cash when depositors withdrew at once.
What is the discount window?
It is the facility through which eligible banks borrow short term from their regional reserve bank against collateral, which is one of the original tools the Act created.
Does the Act matter to a small business today?
Indirectly but considerably, because the institution it created influences the interest rate on business borrowing and the willingness of banks to lend at all.
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