The Federal Reserve Act of 1913 established the Federal Reserve System as the country’s central bank. The act made the Federal Reserve an independent, decentralized bank to better ensure that monetary policy would be based on a broad economic perspective from all regions of the country. The Federal Reserve System consists of the Board of Governors located in Washington, D.C., and 12 Reserve Banks, with 25 branches, located throughout the nation. Each Reserve Bank is a federally chartered corporation with a Board of Directors representing the public and member banks in its district. Under the Federal Reserve Act, Reserve Banks are subject to the general supervision of the Board. The Board is a federal agency, responsible for maintaining the stability of financial markets, supervising financial and bank holding companies and state-chartered banks that are members of the Federal Reserve and the U.S. operations of foreign banking organizations, and overseeing the operations of the Reserve Banks. The Board has delegated some of these responsibilities, including bank examinations, to the Reserve Banks, which also provide payment services, such as check clearing and wire transfers, to depository institutions and government agencies. In 2001, there were approximately 25,000 staff in the Federal Reserve with about 93 percent of these employees working at the Reserve Banks. From 1995 to 2001, Federal Reserve employment decreased by 482 employees. Employment for 2002 is projected to grow by 314, largely because of plans to increase security staff. Figure 1 shows Federal Reserve employment from 1995 to 2001. In the 1996 report, we noted that the Federal Reserve is self-financed, and that the income it collects but does not use to fund its operations is turned over to the U.S. Treasury. In 2001, the Federal Reserve had a total income of $31.9 billion and expenses of approximately $2.1 billion; it subsequently transferred $27.1 billion to the U.S. Treasury. Since 1993, the operating expenses of the Federal Reserve have increased an average of 4.2 percent per year (2.2 percent when adjusted for inflation). According to its 2002 Budget Review, the Federal Reserve’s operating expenses are budgeted at $2.8 billion, an increase of 4.5 percent from the estimated 2001 expenses. Figure 2 shows the Federal Reserve’s operating expenses from 1993 to 2001. Our 1996 report identified several inefficiencies in the Federal Reserve’s policies and practices that had increased the cost of providing its services, including its costs for travel, personnel benefits, and contracting and procurement. Many of these inefficiencies related to the decentralized nature of the Federal Reserve, which allowed each Reserve Bank to set many of its own policies, and to the absence of traditional cost-minimizing forces, such as competition or appropriations, that are commonplace in entities that are either purely private or public sector in nature. With this in mind, we suggested that the Federal Reserve could do more to increase its cost consciousness and ensure that it is operating as efficiently as possible. The 1996 report concluded that major cost reductions ultimately depended on the Federal Reserve’s carefully reexamining its mission, structure, and work processes. The report identified areas that had potential for reducing the Federal Reserve’s costs. The recommendations from the report fall into four broad categories: systemwide mission and management issues, control and oversight mechanisms, cost of specific Federal Reserve administrative functions, and charging banks for the costs associated with bank examinations. In 1996, we noted that the Federal Reserve faces major challenges in its mission and lines of business, particularly in services to depository institutions and government agencies and in bank supervision. These challenges included (1) increased competition from the private sector and increasing difficulties in recovering costs in priced services; (2) increasingly widespread use of electronic transactions in the financial services industry; and (3) continuing rapid consolidation of the banking industry, which could affect both the need for and the distribution of bank examination staff. Because these areas accounted for the largest part of the Federal Reserve’s expenses and staffing, we believed that addressing these challenges effectively would likely result in major changes in how the Federal Reserve operated. The Federal Reserve’s strategic plans and programs under development at the time of the 1996 report generally focused on individual divisions, Reserve Banks, or functions. While these plans served an important purpose in defining the direction of these Federal Reserve entities, we also believed that the emerging issues and challenges facing the Federal Reserve would necessitate strategic planning focused on the system as a whole. We also found that each of the Reserve Banks administered various functions independently, rather than as a single entity that could operate more efficiently or possibly command more advantageous prices. These findings led to the recommendations in figure 3. Since 1996, the Federal Reserve has consolidated the management of the services provided by the individual Reserve Banks, particularly payment services. For example, payment system products and new technologies are now managed on a systemwide basis. The Federal Reserve also has undertaken an assessment of its role in providing payment services. In January 1998, the Committee on the Federal Reserve in the Payments Mechanism, chaired by the Vice Chair of the Board of Governors, issued its report entitled The Federal Reserve in the Payments Mechanism. The study examined the payment services provided by the Federal Reserve in light of the rapid changes occurring in the financial services and technology sectors. These services include check clearing and automated clearinghouse services such as direct deposits. The committee undertook a fundamental review of the Federal Reserve’s role in the payments system and considered how alternative roles for the Federal Reserve might enhance or undermine the integrity, efficiency, and accessibility of the payments system. It concluded that the Federal Reserve’s current role, or even a slightly enhanced role, in fostering technical change was preferred by most payment system participants. In July 1999, the Federal Reserve formed the Payments System Development Committee (PSDC) to advise the Board and system officials on medium- and long-term public policy issues surrounding developments in the retail payments system. This committee, which includes two Federal Reserve Board Governors, a Reserve Bank President, and a Reserve Bank First Vice President, was intended to follow up on the work of the Committee on the Federal Reserve in the Payments System. PSDC’s work has included the Check Truncation Act, proposed legislation designed to remove certain legal impediments to check truncation and enhance the overall efficiency of the nation’s payments system. It has also worked with payments industry officials to develop standards to facilitate increased use of electronic check processing. The Federal Reserve has introduced new payment products, such as its imaging service, to recognize the increasing role that image-based services are playing in the evolution of the U.S. payments system and the migration toward more electronic payments. The Federal Reserve has also undertaken numerous initiatives to streamline management structures, consolidate operations, and apply emerging technologies to the Reserve Banks’ business processes in order to improve quality and reduce costs. Federal Reserve officials explained that many of their initiatives have the effect of consolidating functions of the Federal Reserve without consolidating the 12 Reserve Banks. For example, in 1999, the Treasury Direct customer support function was consolidated so that only 3 Reserve Banks are providing customer service support to individuals who purchase Treasury securities directly from the Treasury. From 1999 to 2002, the Federal Reserve consolidated several aspects of Fedwire funds and securities transfer operations. Similarly, in 2000, the Treasury Investment Program was implemented, centralizing services that the Federal Reserve provides to the Treasury Tax and Loan Program. The Federal Reserve continues to standardize and centralize the management of computer applications used for common business needs. It has selected a central site to develop and implement a centralized application for the Reserve Bank Planning and Control System. The Federal Reserve estimates that the centralization of applications such as the budget application will result in systemwide savings of $2.6 million over a 5-year period. In 1996, we noted a number of weaknesses in the Federal Reserve’s budgeting and internal oversight processes. In reviewing the budgeting process for both the Board and Reserve Banks, we found that it was based on a current services approach that assumed both that existing functions would be retained and that the budget would continue to grow incrementally. We concluded that such an approach did not adequately support top management in controlling costs and imposing the internal self-discipline necessary for the Federal Reserve to respond effectively to future priorities. We found that internal oversight processes, such as performance measurement, internal audit, and financial audits, either did not support performance evaluation from a systemwide perspective or were becoming increasingly inappropriate in the changing environment. We also noted that the Office of Inspector General was authorized to review the activities of the Board, but not the Reserve Banks. As a result, we concluded that the Federal Reserve might not be making the most use of its resources devoted to Federal Reserve oversight. These findings led to the recommendation in figure 4. In addition to incorporating systemwide business strategies and resource needs into the Federal Reserve Bank budget planning process, the Federal Reserve Banks have changed their cost accounting system and have altered their internal and external auditing practices. The Federal Reserve recognized that its budget process required too much effort and yielded an unrealistic spending outlook. Therefore, the Federal Reserve’s Financial Support Office proposed changes to the budget process in which system budget targets would be based on systemwide guidance rather than on Reserve Bank projections of their expenses. Banks provided their expense information later in the process when their budget development would be further along—an approach that also could help align budget planning with goal-setting for business strategies. In 2001, the Federal Reserve’s Conference of First Vice Presidents recommended incorporating this guidance to align the Reserve Bank budget projections more closely with business strategies. The conference identified “national business leaders,” that is, Federal Reserve staff with responsibility for most Reserve Bank functions. These leaders provide business guidance as input to the Reserve Banks as they prepare their Reserve Bank Budget Outlook. They are responsible for almost 90 percent of the total Reserve Bank spending. (The remaining 10 percent of spending is largely in support of Federal Reserve monetary policy formulation and is not covered by systemwide budget goals.)