Introduction to Finance

Personal Financial Planning

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96
C H A PT E R 4 Federal Reserve System
the depository institutions of the nation. Each Reserve Bank serves as a clearinghouse for all 
depository institutions in its district, provided that they agree to pay the face value on checks 
forwarded to them for payment. Today, nearly all the checks processed for collection by Federal 
Reserve Banks are received as electronic check images. 
Let’s illustrate how the check-clearing process traditionally took place through Reserve 
Banks. Assume that the owner of a business in Sacramento, California, places an order for 
merchandise with a distributor in San Francisco. The order is accompanied by a check drawn 
on the owner’s bank in Sacramento. The distributor deposits the check with its bank in San 
Francisco, at which time the distributor receives a corresponding credit to its account with the 
bank. The distri-butor’s bank will send the check to the Reserve Bank of its district, also loc-
ated in San Francisco. The Reserve Bank will forward the check to the bank in Sacramento on 
which the check was drawn. The adjustment of accounts is accomplished at the Reserve Bank 
through an alternate debit and credit to the account of each bank involved in the transaction. 
The San Francisco bank, which has honored the check of its customer, will receive an increase 
in its reserves with the Reserve Bank, while the bank in Sacramento will have its reserves 
decreased by a corresponding amount. The bank in Sacramento will then reduce the account 
of the business on which the check was written. Notice that the exchange takes place without 
any transfer of currency. 
Check Clearance Among Federal Reserve Districts 
If an order was also 
placed by the Sacramento fi rm with a distributor of goods in Chicago, the check would be 
subject to an additional step in being cleared through the Fed. The Chicago distributor, like 
the San Francisco distributor, deposits the check with the bank of its choice and, in turn, re-
ceives an increase in its account. The Chicago bank deposits the check for collection with the 
Reserve Bank of Chicago, which forwards the check to the Reserve Bank of San Francisco. 
The Reserve Bank of San Francisco, of course, then presents the check for payment to the 
bank on which it was drawn. Thus, there are two routes of check clearance: the 
intradistrict 
settlement
, in which the transaction takes place entirely within a single Federal Reserve dis-
trict, and the 
interdistrict settlement
, in which there are relationships between banks of two 
Federal Reserve districts.
As described, Reserve Banks are able to minimize the actual fl ow of funds by increas-
ing or decreasing reserves of the participating depository institutions. In the same way, the 
Interdistrict Settlement Fund eliminates the fl ow of funds between the Reserve Banks needed 
to make interdistrict settlements. The Interdistrict Settlement Fund in Washington, D.C., has 
a substantial deposit from each of the Reserve Banks. These deposit credits are alternately 
increased or decreased, depending on the clearance balance of the day’s activities on the part 
of each Reserve Bank. At a certain hour each day, each Reserve Bank informs the Interdistrict 
Settlement Fund by direct wire of the amount of checks it received the previous day that were 
drawn upon depository institutions in other Federal Reserve districts. The deposit of each 
Reserve Bank with the Interdistrict Settlement Fund is increased or decreased according to the 
balance of the day’s check-clearance activities.