Understanding the Fed: Five Things You Should Know About Financial Stability

The Federal Reserve is the central bank of the United States. But that doesn't mean it's the kind of bank where you get cash from an ATM, borrow money for a home, or keep a safe deposit box.

As the central bank, the Fed is tasked with a variety of responsibilities that, as a whole, promote the health, safety, and prosperity of the US economy and financial system. While commercial banks provide financial services directly to the public, the Fed provides services to commercial banks. That's why some people describe the Fed as the bank for banks.

The Federal Reserve System is a nonpolitical institution that includes 12 independent regional Reserve Banks, located around the country, as well as the Federal Reserve Board of Governors in Washington, DC. Each Reserve Bank brings unique data and perspectives from their regions to the Board of Governors, so the economic experiences of all Americans are represented in the formation of monetary policy.

The Fed performs five main functions. They include:

• setting the nation's monetary policy;
• promoting financial system stability;
• supervising and regulating financial institutions;
• fostering a safe, efficient, and accessible payments system; and
• promoting consumer protection and community development.

Today, we're highlighting financial stability and five key things we think everyone should know about this work. Keep an eye out for future stories on the other functions. We'll link them to the list above as they're available.

1. How the Federal Reserve defines financial stability

Financial stability exists when banks, nonbank financial institutions, and financial markets are able to channel resources and credit to households and businesses at the lowest cost possible. Ideally, this balance will occur even in times of economic stress.

The Fed monitors vulnerabilities in four areas and communicates results to the Board of Governors and the Federal Open Market Committee, the body that sets the short-term interest rate. The four areas are asset prices in relation to economic fundamentals; excessive borrowing by consumers and businesses; excessive leverage within the financial sector; and the ability of financial institutions to withstand a run on deposits.

2. Great Recession triggered major regulatory reform

Congress enacted legislation to reduce risk in the US banking and financial system in response to the global economic recession of 2007 to 2009. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 is described as the most significant regulatory reform since the Great Depression.

The Dodd-Frank Act allowed for various measures intended to enhance the safety and security of the banking and financial system. In addition to federal monitoring of individual financial institutions, such as banks, Dodd-Frank expanded monitoring to include the entire financial system for purposes of identifying threats that could destabilize the US economy. In addition, banks were restricted from trading with their own funds. The Act increased regulations of financial products and introduced new consumer protection programs.

In the years since Congress passed the Dodd-Frank Act, the Fed and its partners have written and enforced regulations intended to protect the safety and soundness of the nation's financial institutions and system. The purpose of the Fed's regulations is to keep pace with innovations in the financial marketplace through enhanced supervision, ensure financial institutions have adequate capital reserves to absorb shocks, and help provide for the orderly liquidation of failed banks.

3. Monitoring risk across the financial system

The Fed monitors the banking and financial system, as a whole, with the goal of preventing the failure of one firm from destabilizing the entire financial system. The Fed watches for riskiness of systemically important financial institutions, known colloquially as "too big to fail," as well as their linkages to other financial institutions. The Fed determines if any mitigation is needed.

Such system monitoring is a component of the Dodd-Frank Act. The Act enabled rules and tools for this role in macroprudential regulation. Previously, the Fed had focused its supervisory responsibilities on individual institutions, or microprudential regulation, as was envisioned in the preamble of the 1913 Federal Reserve Act that established the central bank.

4. Stress testing key financial institutions

US firms large enough to pose risk to the nation's financial stability, if they weakened or failed, are required to submit to an annual stress test conducted by the Fed. In addition, these firms must conduct company-run stress tests twice a year and report findings to the Federal Reserve.

The Fed's stress test looks across a nine-quarter horizon. The test projects the institution's balance sheets, real world assets (such as bonds and real estate) and net income, along with the resulting post-stress capital levels and regulatory capital ratios. The results inform any efforts regulators may take to lower the firm's risk of failure, reduce systemic impact if a firm does fail, and alert the Fed's policymakers about potential risks to the broader economy.

5. Domestic and international cooperation and coordination

The Fed works with partners in the US and abroad to promote financial stability around the world. The premise of the Fed's international work is that financial and economic instability in one country can spill across borders.

Nationally, the Fed chair serves on the 15-member Financial Stability Oversight Committee (FSOC), which is chaired by the secretary of the Treasury. The Dodd-Frank Act established the FSOC to identify risks to the financial stability of the US, promote market discipline, and respond to emerging threats to the US financial system.

Internationally, the Fed engages primarily with two entities to monitor the global financial system and promote sound policies. The Basel Committee on Banking Supervision, part of the Bank of International Settlements (BIS), includes representatives of about 60 central banks from countries that together make up about 95 percent of world gross domestic product. The Financial Stability Board is hosted by the BIS and promotes global financial stability.

More about the Atlanta Fed's role in promoting financial stability

The Federal Reserve Bank of Atlanta supports the Federal Reserve System's efforts to promote stability in the financial system. It supervises banks and financial institutions across the Sixth District (which comprises Alabama, Florida, and Georgia and parts of Louisiana, Mississippi, and Tennessee) to ensure they comply with rules and guidelines intended to prevent failures that could harm customers. It looks for signs of systemic risk across the financial system to avoid the type of financial crisis that emerged in 2007.

The Atlanta Fed's Center for Financial Innovation and Stability focuses on research involving financial innovation and stability. The annual Financial Markets Conference, the Bank's signature policy and research event, brings together experts on financial stability and shines a light on potential risks to the financial system. The Atlanta Fed's economists and the Regional Economic Information Network add to the wealth of real-time data the Sixth District provides to the Fed System to promote financial system stability.

Want to know more about financial stability?

If you'd like to take a deeper dive into the world of financial stability, check out The Fed Explained: What the Central Bank Does, which details the structure, responsibilities, and work of the US central banking system.