Although the common notion is that bank reserves consist of vaults filled with cash, vault cash is usually only about one-third of total bank reserves. The bulk of bank reserves are Federal Reserve deposits.

The Fed

The Fed contains of a number of different parts or components. The key ones are:

• Board of Governors: At the top of the Fed is the Board of Governors, seven members led by a Chairman, which establishes rules, regulations, procedures, and policies of the Fed.


• Federal Reserve Banks: Policies and regulations are carried out by Federal Reserve Banks dispersed throughout the economy. The primary work is undertaken by 12 Federal Reserve District Banks, with support provided by 25 Federal Reserve Branch Banks. These 37 Federal Reserve Banks interface and work directly with commercial banks.


• Federal Open Market Committee: The key policy-making arm of the Fed is the Federal Open Market Committee. It includes the seven members making up the Board of Governors plus five Presidents of Federal Reserve Banks. The primary task of the Federal Open Market Committee is to set the course of monetary policy and to control the amount of money in circulation.

The Bank for Banks

If OmniBank is in need of similar banking services, which many banks are, then it can turn to its local Federal Reserve District or Branch Bank. If OmniBank seeks a short-term loan or wants a place to store reserves, then it can turn to its nearby Federal Reserve Bank. While the Federal Reserve System provides a few services to the public (such as buying U.S. Treasury securities), its primarily functions are directed to commercial banks. The Fed is the bank for banks.

One of the key banking services the Fed provides to commercial banks is maintaining a system of accounts, Federal Reserve deposits.

Three Key Roles

• Check Processing: Federal Reserve deposits are an essential component of the clearing or processing checks between banks. A check written by a customer of one bank that is deposited in the account of a customer of another bank is cleared when reserves are transferred between banks. While, in theory, vault cash could be used, and in historical practice it was used, in the modern economy Federal Reserve deposits are the reserves of choice that are used. The Fed simply transfers Federal Reserve deposits from one bank to another. It is quicker, easier, and safer than sending cash from bank to bank all over country.


• Federal Funds Market: Federal Reserve deposits are commonly traded (loaned and borrowed) between commercial banks through what is termed the Federal Funds market. If one commercial banks temporarily has a few more reserves that it needs to meet reserve requirements and another bank temporarily is a little short, then a short-term loan of Federal Reserve deposits (or Federal Funds) can benefit both. This is such a common practice that the Federal Funds rate, the interest rate charged for such loans, is a key benchmark interest rate for the banking system.


• Monetary Policy: An essential function of the Federal Reserve System is monetary policy and control of the money supply. While the Fed could, in principle, control the money supply by printing more Federal Reserve notes which it could then toss from low flying airplanes, in practice, it uses Federal Reserve deposits. By changing the total quantity of Federal Reserve deposits commercial banks have, it can encourage or discourage banks lending, which then affects the amount of checkable deposits and the M1 money supply. With Federal Reserve deposits, the Fed would find monetary policy more difficult to undertake.

The Other Reserve

Vault cash is the paper bills and metal coins that is kept in banks, that is, in bank vaults. This cash is used, quite literally, to "cash" checks and otherwise to satisfy currency withdrawal demands of depositors. Note that vault cash is not part of the official M1 money supply because it is held by banks (not the nonbank public) and thus it is not in circulation.