Asset Prices and Central Bank Policy

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Behind the Scenes on September 11

• How the Federal Reserve Made Sure that Cash
  Machines and Credit Cards Kept Working

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• Imagine what would have happened if on September
  11 you had gone to the withdraw cash from your
  nearest bank machine, and it was out of order?

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• What the Federal Reserve Does and Where They Do
  It?
• The Payments System How Money Moves
• The Financial Disruptions of September 11
• What the Federal Reserve Did to Make Sure Your
  Cash Machine Still Worked

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What the Federal Reserve Does?

• Objectives
• Low, Stable Inflation
• High, Stable Growth
• Financial System Stability

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What the Federal Reserve Does?

• Day-to-Day Functions
• Bank for the U.S. Government
• Manages the Governments Finance
• Maintains the U.S. Treasurys bank account
• Manages the issuance, transfer and redemption
  of U.S. Treasury debt.
• Using interest rates, controls availability of
  money and credit

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What the Federal Reserve Does?

• Day-to-Day Functions
• Bank for the U.S. Government
• Bank for Foreign Governments Central Banks
• Maintains a bank account for them

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What the Federal Reserve Does?

• Day-to-Day Functions
• Bank for the U.S. Government
• Bank for Foreign Governments
• Bank for the Bankers
• Maintains a deposit account for commercial banks
• Make funds available through discount loans
• Operate a payments system
• Supervise, regulate financial institutions to
  ensure safety and soundness

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Where They Do It

• The Federal Reserve System
• Board of Governors in Washington
• Part of the Federal Government
• Supervisors and Regulators

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Where They Do It

• The Federal Reserve System
• Board of Governors in Washington
• 12 Regional Federal Reserve Banks
• Private non-profit corporations and chartered
  banks
• Overseen by the Board of Governors
• Conduct Federal Reserves Day-to-Day Business

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Where They Do It

• All 12 Regional Banks
• Cash
• Check Clearing
• Electronic Payments, ex. Fedwire
• Discount Lending
• Bank Supervision

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• New York Only
• Auction Treasury Securities
• Foreign Government Services
• Monetary Policy Operations
• Fedwire Large Value Interbank Funds Transfer
  System

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• The Gold Vault
• 250 million ounces
• Over 85 billion at current market prices
• 10 of all the gold that has ever been taken out
  of the ground
• One bar weights about 400 ounces

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The Federal Reserves Balance Sheet

• Used to control money and credit.
• Control over the size
• Unlike you or me, if they want to buy
  something, they just create liabilities to do
  it.

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Open Market Operations

• The Federal Reserve controls the overnight
  interest rate banks charge each other for
  reserves thats the federal funds rate
• They do it by buying and selling securities,
  crediting or debiting commercial bank accounts.
• This adds or drains reserves from the banking
  system.

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The Payments System

• How We Pay for things
• Cash
• Checks
• Electronic Payments
• Credit Cards
• Debit Cards
• Automated Clearing House Transactions (ACH)
• Electronic Funds Transfers

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The Federal Reserves Role in the Payments System
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The Federal Reserves Role in the Payments System

• Supply Cash
• There is 625 billion out there.
• 2200 per U.S. resident.
• 2/3rds of it is in 100 bills
• 15 100 bills per U.S. resident.
• The New York Fed handles 1.5 billion a day.

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The Federal Reserve Bank of New Yorks cash vault
is the largest in the world. It three stories
high and the size of a football field. It holds
5400 pallets of currency.
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The Federal Reserves Role in the Payments System

• Checks
• On an average business day, 170 million move
  through the economy.

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The New York district handles 6 million a day,
with a value of about 10 billion, using
check-sorting machines like this one.
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You Write and Mail Payment
Recipient Deposits it in Their Bank
Step 1
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You Write and Mail Payment
Recipient Deposits it in Their Bank
Bank Transports it To Federal Reserve Processing
Center
Step 2
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You Write and Mail Payment
Recipient Deposits it in Their Bank
Bank Transports it To Federal Reserve Processing
Center
Step 3
Fed flies the check back to your district
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You Write and Mail Payment
Recipient Deposits it in Their Bank
Bank Transports it To Federal Reserve Processing
Center
Your Bank Returns the Check to You
Step 5
Fed flies the check back to your district
Step 4
Your Bank Pick up the Check from the local
processing center
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Checks and Float

• If Their Bank is in a different Federal Reserve
  district from Your Bank,
• Your Banks Federal Reserve account is not
  debited until the check is physically moved to
  that district!
• This is done with airplanes.

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The Federal Reserves Role in the Payments System

• Electronic Payments
• 120 million transactions per day, primarily
  credit and debit cards.
• The Fed Clears the ACH transactions
• Fedwire
• Large-value interbank payments system
• 2 trillion per day in gross payments

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The Fedwire

• On a typical day there will be
• 400,000 to 450,000 transactions
• Valued at 2 trillion
• Most of it between 230pm and 630pm
• And at the end of the day, balances are about
  15 billion

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Interbank Payments

• Banks regularly make payments expecting to be
  paid by someone else later in the day.
• System has substantial interdependence
• Runs on reserves the balances commercial banks
  hold at the Federal Reserve
• Notice that reserve balances are used an average
  of between 100 and 150 times a day!

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Payments Flows on a Normal Day
Bank A Bank B Bank C Opening Balance
50 50 0 Closing Balance 50
25 25
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Recap

• A primary objective of the Federal Reserve is to
  maintain stability of the financial system
• Day-to-day this means ensuring that the financial
  system has the capacity to shift funds around
• This payments system requires liquidity in the
  form of commercial bank deposits at the Federal
  Reserve

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Recap

• Federal Reserve Operations are done in New York
• The Check Clearing System Requires Airplanes
• The Interbank Payment System is Highly
  Interdependent

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September 11, 2001
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¼ Mile




½ Mile

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Trading pit at the New York Mercantile Exchange
in New York City that appeared in the movie
Trading Places with Eddie Murphy and Dan
Ackroyd.
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The Disruptions

• Lower Manhattan became inaccessible
• No power
• No communication
• All nonmilitary aircraft in the U.S. were
  grounded.

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The Federal Reserve Response

• At 1145 am, 3 hours after the attacks began, the
  Federal Reserve Board issued the following
  statement

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The Disruption

• Suddenly, banks could not be sure that they were
  going to receive anticipated payments.
• Caution meant that they would not make payments
  if they didnt have to.
• Some banks couldnt make payments at all.
• The technical problems in securities transfer
  were particularly severe.

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Payments Flows When Payments are Disrupted
Bank BCant Send Payments
75 at 1200pmCant Be Sent
50 at 1000am
Bank C
Bank A
50 at 100 pmCant Be Sent
Bank A Bank B Bank C Opening Balance
50 50 0 Closing Balance 0
100 0
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Payments Flow Disruptions

• Some of the Biggest Banks were unable to send out
  payments.
• Small banks use big banks as their bankers.
• Big banks receive and send out lots of payments.
• Remember there are 400,000 payments a day just
  over the Fedwire!

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The Risk

• A bank that makes payments but doesnt receive
  them runs the risk of depleting their reserve
  account.
• If a bank runs out of reserves, they cant
  operate any more.
• This would eventually filter down to us!
• The Federal Reserve knows this, and so they take
  precautions.

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¼ Mile




½ Mile

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Bank of New York

• Things were bad enough that on September 14 they
  issued a statement
• The Bank of New York Company, Inc., one of the
  world's largest securities servicing and cash
  processing institutions, said today that
  virtually all of its systems are up and running
  in the aftermath of the terrorist attacks on New
  York City. The Bank said that its headquarters as
  well as some of its operational facilities in
  lower Manhattan have had to be moved temporarily
  to alternate locations. The Bank has
  longstanding contingency plans to carry on
  business in an emergency and said it is open for
  business in New York City, across the country and
  around the world.

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Federal Reserve Contingencies

• Fedwire Several backup sites.
• Discount Loans All 12 banks can do
  them. Boston took over the New York banks.
• Open Market operations New York only!
• There is a backup site
• There werent back up people
• The people slept in the building on the night of
  September 11 so they could be there on September
  12.

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Federal Reserve Actions

• Normal Day
• Open market operations Buy 3 to 5 billion
  in securities
• Discount loans Borrowing is virtually zero
• Float 500 million
• No Foreign Exchange Operations

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Federal Reserve Reaction

• Liquidity was added by
• Open market operations Buy securities,
  paying with reserves
• Discount loans Banks come and asked
• Float The planes didnt fly
• European Central Bank exchanged euros for dollars
  (temporarily)

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Outstanding Term and Overnight RPs around
September 11 billions of dollars
Overnight RPs
Term RPs

9/5 9/11
9/17 9/19
10/3
We
Tu Mo We
We
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Impact of Key Autonomous Factors on the Supply of
Fed Balances around September 11 in billions of
dollars
Foreign Exchange Swaps
Float
Foreign Central Bank Deposits

9/5 9/11
9/17 9/19
10/3
We Tu
Mo We
We
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Total Fed Balances around September 11 billions
of dollars
Borrowed Balances
Non Borrowed Balances

9/5 9/11
9/17 9/19
10/3
We
Tu Mo We
We
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Extraordinary Additions to Banking System Reserves
ECB Cooperation
Bank Borrowing
Planes Grounded
Fed Actions
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The Results

• The contingency planning paid off.
• Everyone knew that liquidity needed to be added,
  and there were people with the means to do it.
  Banks were able to make payments
• If the Federal Reserve hadnt done its job, we
  all would have noticed.

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I would like to acknowledge the help of my
friends at the Federal Reserve Bank of New York,
Dino Kos, Spence Hilton and Peter Bakstansky,
for explanations, data and photographs.