[Federal Register Volume 66, Number 200 (Tuesday, October 16, 2001)]
[Notices]
[Pages 52617-52623]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-25833]


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FEDERAL RESERVE SYSTEM

[Docket No. R-1095]


Federal Reserve Bank Services; Private Sector Adjustment Factor

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Notice.

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SUMMARY: The Board has approved modifications to the method for 
calculating the Private Sector Adjustment Factor (PSAF), which imputes 
the costs that would have been incurred and profits that would have 
been earned had the Federal Reserve Banks' priced services been 
provided by a private firm. The Board considered several alternatives 
for calculating components of the PSAF and is modifying the current 
method for imputing debt and equity, enhancing the method for 
determining the target rate of return on equity, and continuing to use 
the fifty largest bank holding companies' financial data as a proxy for 
Federal Reserve priced-services activities. In a change from the 
proposal and current practice, the peer group will be selected based on 
total deposits rather than the size of asset balances. The revised 
method will be used to determine the PSAF and fees for Federal Reserve 
priced services beginning with the 2002 price setting.

FOR FURTHER INFORMATION CONTACT: Gregory L. Evans, Manager (202/452-
3945) or Brenda L. Richards, Sr. Financial Analyst (202/452-2753), 
Division of Reserve Bank Operations and Payment Systems. For users of 
Telecommunication Device for the Deaf (TDD) only, please call 202/263-
4869. Copies of a research paper describing the theoretical basis and 
detailed application of each of the models (``The Federal Reserve 
Banks' Imputed Cost of Equity Capital'') may be obtained from the Board 
through the Freedom of Information Office (202/452-3684) or at the 
Board's web site at http://www.federalreserve.gov/boarddocs/press/boardacts/2000/200012212/researchpaper.pdf.

SUPPLEMENTARY INFORMATION:

I. Background

    As required by the Monetary Control Act of 1980, fees for Federal 
Reserve priced services provided to depository institutions are set at 
a rate to recover all direct and indirect costs of providing the 
services actually incurred and imputed costs. Imputed costs include 
financing costs, return on equity (also referred to as profit), taxes, 
and certain other expenses that would be incurred if a private business 
firm provided the services. The imputed costs and imputed profit are 
collectively referred to as the private-sector adjustment factor 
(PSAF). In a comparable fashion, revenue is imputed and netted with 
actual related direct costs through the net income on clearing balances 
(NICB) calculation.
    Calculating the PSAF involves projecting the level of priced-
services assets and determining the financing mix used to fund them and 
the rates used to impute financing costs. In the current method, the 
financing rates, the combination of financing types, and an income tax 
rate are based on data developed from the ``bank holding company (BHC) 
model,'' a model that contains consolidated financial data for the 
nation's fifty largest (based on asset balances) BHCs. Imputed taxes 
are captured using a pre-tax return on equity (ROE). The current 
methodology assumes that the Reserve Banks invest all clearing balances 
net of imputed reserve requirements in three-month Treasury bills. The 
net earnings or expense attributable to the imputed Treasury-bill 
investments and actual earnings credits granted to clearing balance 
holders based on the federal funds rate are considered income or 
expense for priced-services activities. The net income or expense is 
referred to as net income on clearing balances (NICB).
    To evaluate the effect of changes that may have occurred in Reserve 
Bank priced-service activities, accounting standards, finance theory, 
regulatory practices, and banking activity, the Board periodically 
reviews the methods for calculating the PSAF and the NICB. To ensure 
that the method remains current and consistent with sound business 
management, the Board requested comments on a proposal to modify 
certain elements of the calculations (65 FR 82360, December 28, 2000). 
Specifically, the Board requested comment on the following changes to 
the PSAF:
     Imputed debt and equity: The Board proposed initially 
designating $4 billion of clearing balances as core deposits for 
potential use as a financing source for priced-services assets, thereby 
reducing the funds available for imputing investment income. The Board 
also proposed imputing equity at the minimum requirements for a well-
capitalized institution as defined by the FDIC for purposes of 
assessing insurance premiums.
     Target return on equity (ROE): The Board proposed 
enhancing the method for determining the target rate of return on 
equity by combining the rate resulting from the current BHC model, one 
example of the comparable accounting earnings model (CAE), with rates 
derived from a discounted cash flow (DCF) model and a capital asset 
pricing model (CAPM). The Board proposed a risk-free rate and using 
specific data for determining the average risk premium for the market 
and the beta in the CAPM. For the DCF, the Board proposed using 
commercially available consensus forecasts to measure future dividends 
and long-term growth rates. The Board also proposed equal weights 
within the CAE model, weights based on market capitalization for the 
DCF and CAPM models, and a combined ROE measure based on equal 
weighting of the results of the three models.
     Peer group: The Board proposed continuing the current 
practice of selecting the largest fifty BHCs based on asset balance 
size as the Reserve Bank peer group.

II. Priced Services Balance Sheet

    Table 1 represents the elements of the priced-services balance 
sheet and how they will be derived. All actual assets and liabilities 
presented on the priced-services balance sheet are based on projected 
average daily balances.

III. Summary and Analysis of Comments

    The Board received ten responses to its request for comment, 
including responses from two Reserve Banks. Overall, eight commenters 
supported and two commenters opposed the Board's proposal. Those 
supporting the proposal represented credit unions, smaller depository 
institutions, and Reserve Banks. The Association of Bank Couriers and 
Fiserv, Inc. opposed the proposal. The Board received no comments from 
large banks or bank holding companies.
    Those supporting the proposal believe that the proposed changes to 
the PSAF methodology are appropriate and will provide a better basis on 
which to impute the expenses and income used in setting Federal Reserve 
fees. Those in opposition object to using clearing

[[Page 52618]]

balances to finance priced services assets, the imputed equity level, 
certain aspects of the economic models, and the basis for selection of 
a peer group.

A. Imputed Debt and Equity

    Currently short-term debt, long-term debt, and equity are imputed 
to the extent necessary to finance short-term and long-term assets 
without consideration of the Reserve Banks' clearing balance 
liability.\1\ The cost for debt financing is determined using the 
short- and long-term debt rates from the BHC model. The apportionment 
of long-term asset financing between long-term debt and equity is based 
on the debt-to-equity ratio derived from the BHC model. The Board 
believes that these practices unnecessarily impute larger amounts of 
certain assets and liabilities and equity along with their related 
income and expenses to priced services. Considering the growth in the 
size of clearing balances since the inception of the NICB and the 
stable nature of the majority of the balances, the Board believes that 
rather than incur additional debt costs, a private business firm would 
use a portion of these balances to finance its capital needs.
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    \1\ Depository institutions may hold both reserve and clearing 
balances with the Federal Reserve Banks. Reserve balances are held 
pursuant to regulatory requirements and are separate from the 
Reserve Banks' priced-services activities. Clearing balances, based 
on contractual agreements with Reserve Banks, are held to settle 
transactions arising from use of Federal Reserve priced services. In 
some cases, depository institutions hold clearing balances in excess 
of contractual agreements.
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    In its request for comment, the Board proposed that initially $4 
billion of clearing balances be designated as ``core'' and that these 
core balances be made available to finance long-term assets. The use of 
core clearing balances will effectively eliminate debt and reduce 
imputed investments in Treasury securities. The Board requested comment 
on whether this was a reasonable use of these balances, and asked that 
commenters who opposed initially establishing the $4 billion as core 
balances to suggest an alternative portion of the balances and a method 
for deriving the acceptable balance. In addition, the Board proposed 
basing the Reserve Bank priced-services equity balance on that required 
by the FDIC to be considered a well-capitalized institution.
    One commenter challenged the Federal Reserve's statutory authority 
to integrate the PSAF and NICB calculations. Two commenters, including 
the commenter who challenged the Board's statutory authority, objected 
to the proposed use of core clearing balances to fund long-term assets. 
Another commenter stated that the $4 billion was too conservative and 
offered an alternative method for its calculation. Two commenters 
supported the Board's proposal to evaluate the balance of the core 
deposits annually, and one expressed support for the proposal provided 
that clearing balance requirements were not adjusted to facilitate the 
use of this core balance.
    The basis for the objection of two commenters to the use of core 
clearing balances was essentially that clearing balances are short-term 
liabilities and should be used to finance only short-term assets. One 
comment stated that the Federal Reserve controls these balances based 
on the rate it offers to compensate depositors. Another offered that 
banking organizations attribute extended maturities to a portion of 
their core deposits, but the deposits are considered to finance longer-
term financial assets, not prepaid pension assets and long-term fixed 
assets such as buildings, check sorters, and leasehold improvements. 
The commenter stated that these assets are typically financed with 
equity capital and long-term debt. This commenter also expressed 
concern with the proposal's creation of a negative working capital 
position (current assets minus current liabilities) for the priced-
services balance sheet. Support for this concern was based on an 
analysis of six non-bank publicly held payments processors and their 
positive working capital positions.
    One commenter objected to the Board's proposal to impute only the 
equity sufficient to meet the FDIC requirements to be considered a 
well-capitalized institution. The objection is based on the contention 
that this level of equity would not be acceptable and that bank holding 
company management maintains capital well above regulatory minimums. 
The commenter believes that the equity of the Federal Reserve priced 
services balance sheet should be closer to or should match that of 
commercial banks, which they estimate as close to 8 percent.
    The Board has concluded that initially classifying $4 billion as 
core clearing balances to fund long-term priced services assets is a 
practical approach that treats these balances in a way private-sector 
providers would treat them. In addition, the Board has concluded that 
imputing equity based on FDIC requirements to be considered a well-
capitalized institution provides adequate protection against 
uncertainties and is a prudent use of this financing source.
    The Board considered the stability of clearing balances and the 
current level of priced-services assets. The balances have not dropped 
below $4 billion since 1992. In addition, the structure of the current 
priced-services balance sheet requires that only an insubstantial part 
of the balances be used to finance longer-term assets leaving the 
majority of these balances for investment in financial assets. A 
portion of all assets will be financed with equity. In considering how 
private business firms would use these balances, the Board believes 
that cash would be considered a fungible resource, but only after 
considering the interest rate risk presented by financing long-term 
assets at short-term rates. To address this risk and avoid 
inappropriate volatility in earnings, the Board will review the 
interest rate risk of long-term priced-services asset financing each 
year. The Board will evaluate the level of interest rate risk by 
reviewing the ratio of rate-sensitive assets to rate-sensitive 
liabilities and the effect on cost recovery of an increase or decrease 
in interest rates of up to 200 basis points. To control interest rate 
risk within acceptable levels, long-term debt will be imputed when the 
risk is estimated to exceed a change in cost recovery of more than two 
percentage points.
    Although the amount of initial core balances may appear very 
conservative to some commenters, this level is more than sufficient to 
finance the current level of assets. The Board expects to review 
clearing balance trends periodically and the core amount will be 
adjusted if necessary. Consistent with current practice, the size of 
contracted clearing balances established by the Federal Reserve and 
depository institutions will be based on the level necessary for 
clearing and paying for services and will not be changed in order to 
increase the size of core balances in order to finance long-term 
assets.
    The level of clearing balances maintained by depository 
institutions with the Reserve Banks increases or decreases based on the 
funds needed to process transactions. The compensation provided to 
depositors, earnings credits available to apply to future services, is 
based on these contracted balances and the federal funds rate. Although 
the rate is targeted by the Federal Reserve without consideration of 
the cost of earnings credits, it is set by the marketplace demand for 
short-term funds.
    The Board's proposal for financing long-term assets with core 
clearing balances does, as a commenter indicated, create a negative 
working capital position. The commenter believes if the priced-services 
activities

[[Page 52619]]

were a private-sector company, regulators would not look favorably on 
this position. A working capital comparison is not typically used in 
analyzing the financial condition of a depository institution. The 
liquidity of a depository institution is commonly reviewed using other 
measures that quantify the amount of cash or liquid assets and other 
funding sources (e.g., borrowings) available to meet expected cash 
demands at given time frames. Regulators define an entity's liquid 
assets as ``those assets which are readily available as cash or which 
can be converted into cash on an ``arm's-length'' basis without 
considerable loss.'' \2\ The Board believes that the priced-services 
assets on the balance sheet, specifically the three-month Treasury 
securities, are sufficient to meet the liquidity needs of priced 
services.
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    \2\ BHC Supervision Manual, December 1992, Section 4010.2.
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    When it requested comment, the Board noted the necessary 
integration of the PSAF and NICB calculations. The imputed income or 
expense resulting from the NICB calculation has historically been and 
will continue to be a part of determining priced-services revenue. 
Integration is necessary to reflect the reduction of clearing balances 
available for investment and the resulting reduction of the imputed 
income. The MCA states that fees must incorporate ``an allocation of 
imputed costs'' and that ``pricing principles shall give due regard to 
competitive factors.'' To consider the PSAF along with the cost of 
earnings credits included in the NICB without including the revenue 
from imputed investments would result in non-competitive pricing.
    In evaluating the need for equity financing, one must consider the 
risk inherent in the assets being financed. Ignoring risk and imputing 
equity equal to the average equity of commercial banks, as proposed by 
one commenter, would be contrary to sound business decision-making. 
Equity dollars, typically the most expensive of financing sources, are 
actively managed by financial institutions. Regulators require a 
minimum level of capital to protect against insolvency or failure by 
offsetting or absorbing potential loses in the value of bank loans and 
investments, to protect against temporary losses of liquidity, and to 
ensure public confidence in the bank's ability to respond to shifts in 
economic conditions. Imputing equity to meet regulatory requirements 
for a well-capitalized institution results in a proposed capital to 
risk-weighted assets ratio of 27.7 percent for the priced-services 
balance sheet. The capital to risk-weighted ratios for the sample fifty 
BHCs are significantly lower, with none being greater than 15 percent. 
This ratio, combined with the liquidity of the imputed Treasury 
investments, is sufficient to protect against potential losses arising 
from changes in economic conditions or shifts in the value of 
investments. In general, the Board believes that a higher leverage 
ratio for BHCs reflects the increased risk experienced by these 
entities because of the financing activity in which they engage and 
that targeting an equity-to-asset ratio somewhat lower than the peer 
group average is appropriate for Federal Reserve priced services.

B. Imputed Return on Equity

    Currently, the target return on equity is calculated based on the 
ROE results from the BHC model as an average of the ratios of the BHCs' 
net income and average book value of equity. This model can be 
duplicated and is readily accepted in industry practice. Its 
shortcomings, however, are that it uses historical data from the two to 
seven years before the target year to predict future earnings and it is 
based on book rather than market values.
    The Board proposed that the PSAF target ROE be calculated using a 
combination of the current CAE model and two additional economic 
models, a capital asset pricing model and a discounted cash flow model. 
The Board requested comment on the economic models, their elements, the 
proposed methods for weighting and averaging them, and whether they are 
theoretically sound and should be used to calculate the PSAF.
    The response from commenters was mixed regarding the theory, use, 
and components of each of the models. Although most commenters 
supported the use of the three models, the proposed weightings within 
the models, and the averaging of their outcomes, one commenter believes 
that the CAE should be weighted by organization size and another 
believes that it should be weighted by service revenue. One commenter 
criticized the CAE model because it could be distorted by credit losses 
unrelated to BHC processing activities. This same commenter believes 
that the thirty-year Treasury bond rate rather than three-month 
Treasury-bill rate should be used for the risk free rate in the CAPM. 
One commenter believes that the DCF should receive greater weight in 
the computation, while another believes that it is inappropriate to use 
the DCF in the calculation due to a perception that it ignores capital 
appreciation. Although there was support for the use of the CAE and 
CAPM models in the calculation, two commenters objected to using BHCs 
as the comparable group.
    The Board has concluded that the three models will be used to 
calculate its priced-services target ROE and the calculation will be 
based on the proposed method. The models have a solid foundation in 
economic and finance theory and are regularly used in industry 
practice. This approach to calculating the target ROE is based on an 
understanding that each of the three models uses different information 
and has different strengths and weaknesses. Together the three models 
provide a measure that is more reliable, consistent, and forward-
looking than using the CAE model alone. In addition, the proposed 
method brings in factors that affect competitors' return on equity that 
had not been previously considered with the CAE model, such as the 
results of changes in market conditions and risk.
    The Board considered several methods for weighting within the 
models. The Board believes that the best and most common method is to 
weight based on market capitalization in the DCF and CAPM models and to 
maintain the current method of equal weighting for the CAE model. 
Weights based on organization size do not provide a more appropriate 
ROE than that provided with the equally weighted CAE. Weights based on 
service revenue could distort the resulting ROE because service revenue 
includes income from many activities that Reserve Banks do not provide 
and because depository institutions differ in the degree to which they 
use fees or balances to obtain compensation. For example, in comparable 
entities, payment for services can be assessed based on holding 
compensating balances rather than explicit fees. These varied 
approaches to assessing service revenue could affect the comparability 
of this information and could result in an inconsistent ROE measure 
over time.
    The financial results used in the CAE model are obtained from 
publicly-available financial statements based on objective criteria. 
Availability and credibility of the financial data are important 
considerations in determining the structure of and peer group included 
in the model. If the data-gathering process included subjectively 
identifying and adjusting the financial results of each BHC in the 
model for activities that are not exactly comparable to priced 
services, the credibility of the calculation could be diminished. After 
careful consideration

[[Page 52620]]

of the comments, the Board believes that the BHC results as presented 
in audited financial statements provide a reasonable proxy for Federal 
Reserve priced services activities.
    It is standard academic practice to use short-term Treasury rates, 
such as the three-month Treasury bill rate, in the implementation of 
the CAPM model. Any short-term rate chosen must be adjusted based on 
the time horizon of the analysis. A one-year rate is appropriate for 
the PSAF calculation because the implicit horizon of analysis is one 
year. Whether this one-year rate is based on the average of monthly, 
three-month, or one-year Treasury bill rates is insignificant because 
the market for Treasury securities is typically efficient enough to 
remove major pricing anomalies between securities of different 
maturities. This efficiency results in little difference between yields 
in the short term. Adopting a longer-term risk-free rate, such as the 
thirty-year Treasury rate, however, could not be supported given the 
one-year time horizon.
    The contention that the DCF does not consider capital appreciation 
has been refuted in economic literature. The DCF does consider capital 
appreciation in its assumption that dividends will grow over time. The 
present value of a finite stream of dividends plus the present value of 
a future price of the stock is mathematically equal to the present 
value of an infinite stream of dividends.\3\ The Board will include the 
DCF model in the PSAF calculation as proposed and weight it equally 
with the two other models.
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    \3\ Sergei P. Dobrovolsky, The Economics of Corporation Finance, 
(New York: McGraw Hill Book Company, 1971), 81.
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C. Peer Group

    The Board proposed maintaining the currently used BHC sample of the 
largest fifty, based on the size of asset balances, but asked whether 
this sample size continues to be a reasonable data peer group for 
Reserve Bank priced-services activities. In addition, the Board 
requested commenters' views on whether BHC data could be adjusted to 
resemble more closely the Reserve Bank priced-services activities.
    Two commenters objected to the use of BHCs as the peer group and 
suggested using data processing and check processing organizations as 
the peer group. Two other commenters suggested that fewer BHCs would 
provide an adequate sample for the model and one suggested that a 
subgroup from the top fifty BHCs based on the relative importance of 
certain income accounts to total net income would provide a better 
proxy. One commenter suggested selecting the peer group based on 
service revenue.
    The Board acknowledges that BHCs are an imperfect proxy for Federal 
Reserve priced services. The Board considered several alternatives and 
concluded that the services provided by data processing and check 
processing companies are not sufficiently analogous to priced-services 
activities of the Reserve Banks largely because they do not provide 
settlement services or hold correspondent or clearing balances. 
Although, in some cases it may be a small part of their overall 
business, BHCs do provide similar payment services, including 
settlement, and hold correspondent balances. Like BHCs, data processing 
and check processing companies also derive substantial income from 
lines of business in which Reserve Banks do not engage. In addition, 
obtaining the information for these processing companies necessary to 
compile the data needed in the three economic models would be difficult 
for the Board and for the public.\4\ Use of non-audited financial 
information provided by these entities in the models could diminish the 
credibility of the results and create omissions or inconsistencies. In 
addition, there are significantly fewer data processors and check 
processors than BHCs, which would make it difficult to mitigate the 
effects of extreme financial performance of a few companies in the peer 
group.
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    \4\ One commenter believes that verifiable financial information 
for these entities could be obtained through industry associations. 
This would require the Federal Reserve to rely on data that has not 
been audited and to provide such financial information to the 
public. Further, consensus forecasts, used in the DCF model, are not 
available for entities that are not publicly held.
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    Although reducing the sample size could reduce time and effort 
required for data gathering, the risk that the performance of a few 
BHCs could skew the model's results increases. Selecting the peer group 
based on service revenue would not create a better sample because, as 
noted, service revenue includes income from many activities that 
Reserve Banks do not provide. Further, in comparable entities, payment 
for services can be received based on holding compensating balances 
rather than assessing an explicit fee. These varied approaches to 
assessing service revenue could affect the comparability of this 
information.
    After careful consideration of these and other alternatives, the 
Board concluded that the fifty largest BHCs provide a reasonable peer 
group for priced services. In a change from the proposal and current 
practice, the peer group will be selected based on total deposits 
rather than asset balance size. A peer group based on total deposits 
maintains the focus on the largest banking entities and avoids the 
distortion that could result from including financial holding companies 
on the basis of their other financial service activities and assets 
necessary to provide these services. Because of the changes in BHC 
structure made with the Gramm-Leach-Bliley Act of 1999, BHCs may engage 
more extensively in non-banking service activities than in the past.\5\
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    \5\ Selecting the BHC sample based on total deposits rather than 
assets results in the change of two BHCs in the ranking. As these 
entities become more involved in providing non-banking services, the 
Board anticipates that the sample comparability will become more 
divergent.
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IV. Effects of New PSAF Methodology

    The combination of the current equally-weighted CAE and the market-
weighted DCF and CAPM models produces the following pre-tax ROE (pre-
tax profit as a percent of imputed equity) based on the BHC performance 
data used for the 2001 PSAF:

                        Pre-Tax Return on Equity
                              [In percent]
------------------------------------------------------------------------
                  CAE                       DCF        CAPM     Combined
------------------------------------------------------------------------
23.8...................................       22.1       23.3       23.1
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    From year to year, the combined model for calculating ROE can yield 
a target ROE that is higher or lower than the current method. On the 
average during the period from 1983 to 2001, the combined model yielded 
a pre-tax ROE that is 230 basis points higher than the current method.
    Using core clearing balances as a source of financing for actual 
priced-services assets reduces imputed short- and long-term debt and 
imputed investments in marketable securities. As a result, the income 
and expenses associated with these imputed elements are reduced as 
well. Establishing equity at the level required by FDIC requirements 
for a well-capitalized institution results in setting equity equal to 
five percent of total assets, which is a slight reduction from the 
level planned in 2001 under the current methodology (5.3 percent). 
Applying the new PSAF methodology to the 2001 priced-services balance 
sheet reduces PSAF costs $53.3 million or 26 percent and reduces net 
income on clearing balances $33.8 million or 90 percent. This results 
in a net reduction of costs

[[Page 52621]]

to priced services of $19.5 million or slightly more than 2 percent of 
total actual and imputed costs, including the target ROE of $138.2 
million.\6\ Table 2 illustrates the effects of the changes on the 
various elements of the PSAF and NICB calculations.
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    \6\ Under this proposal, priced-services revenue would be $944.7 
million and expenses would be $951.5 million, resulting in a 
budgeted cost recovery of 99.3 percent as compared to 98 percent 
under the 2001 prices.
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V. Competitive Impact Analysis

    All operational and legal changes considered by the Board that have 
a substantial effect on payment system participants are subject to the 
competitive impact analysis described in the March 1990 policy 
statement ``The Federal Reserve in the Payments System.''\7\ Under this 
policy, the Board assesses whether the change would have a direct and 
material adverse effect on the ability of other service providers to 
compete effectively with the Federal Reserve in providing similar 
services because of differing legal powers or constraints or because of 
a dominant market position of the Federal Reserve deriving from such 
legal differences. If the fees or fee structures create such an effect, 
the Board must further evaluate the changes to assess whether their 
benefits--such as contributions to payment system efficiency, payment 
system integrity, or other Board objectives--can be retained while 
reducing the hindrances to competition.
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    \7\ FRRS 7-145.2.
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    Because the PSAF includes costs (with an adjustment for NICB net 
revenues or expenses) that must be recovered through fees for priced 
services, changes made to the method may have an effect on fees. This 
proposal is intended to refine the PSAF to resemble more closely the 
costs and profits of other service providers as required by the MCA. 
Consequently, the fees adopted by the Reserve Banks should be based on 
the costs and profit targets that are more comparable with those of 
other providers. Accordingly, the Board believes this proposal will not 
have a direct and material adverse effect on the ability of other 
service providers to compete effectively with the Federal Reserve in 
providing similar services.

VI. Conclusion

    The Board has adopted the following modifications to the method for 
calculating the private sector adjustment factor (PSAF):
     An initial core amount of $4 billion of clearing balances 
will be available to finance priced-services assets. In the current 
environment, this eliminates the need to impute long-term debt. An 
interest risk sensitivity analysis will be performed each year and the 
Board will impute long-term debt if the results of the analysis 
indicate that an increase or decrease in interest rates of up to 200 
basis points results in a reduction in cost recovery of more than two 
percentage points. In addition, the Board will annually review clearing 
balance trends and the core amount will be adjusted, if necessary.
     Equity will be imputed to meet the FDIC definition of a 
well-capitalized institution in its classification for assessing 
insurance premiums. Currently, this is five percent of total assets.
     The target return on equity will be determined using the 
results of three economic models.

--The results of the current CAE model will be combined with the 
results of the capital asset pricing model and the discounted cash 
flows model.
--A short-term Treasury-bill rate will be used as the risk-free rate 
and historical stock market data with a rolling ten-year period will be 
used in implementing the CAPM model.
--Commercially available consensus forecasts will be used to determine 
the expected future dividends and long-term growth rates in the DCF 
model.
--Within the CAPM and DCF models, the ROE will use weights based on 
market capitalization and within the CAE model, the ROE calculation 
will be based on equal weights. The results of the three models will 
then be averaged to derive the PSAF ROE.

     A peer group of the fifty largest bank holding companies 
based on total deposits will be used in each of the models.
     The revised method will be used to determine the 2002 PSAF 
and fees for Federal Reserve priced services.

                                     Table 1.--Priced-Services Balance Sheet
                                        [Projected average daily balance]
----------------------------------------------------------------------------------------------------------------
              Assets                         Type                  Description            Method for computing
----------------------------------------------------------------------------------------------------------------
Required reserves.................  Imputed..............  Intended to simulate        10 percent of total
                                                            commercial bank reserve     clearing balances.
                                                            requirements.
U.S. Treasury securities..........  Imputed..............  Represents the portion of   Total liabilities plus
                                                            clearing balances not       equity less other
                                                            required for reserves or    assets.
                                                            to finance other actual
                                                            or imputed priced-service
                                                            assets.
Short-term assets.................  Actual...............  Accounts receivable,
                                                            prepaid assets expenses,
                                                            and materials and
                                                            supplies reported on the
                                                            Federal Reserve Banks'
                                                            balance sheets that are
                                                            attributed to priced
                                                            services.
Cash items in process of            Actual...............  Transactions credited to
 collection.                                                the accounts of
                                                            depository institutions,
                                                            but not yet collected by
                                                            the Federal Reserve Banks
                                                            that are attributed to
                                                            priced services.
Pension assets....................  Actual...............  Prepaid pension costs
                                                            reported on the Federal
                                                            Reserve Banks' balance
                                                            sheets that are
                                                            attributed to priced
                                                            services.
Long-term assets..................  Actual...............  Premises, furniture and
                                                            equipment, leases, and
                                                            leasehold improvements
                                                            reported on the Federal
                                                            Reserve Banks' and Board
                                                            of Governors balance
                                                            sheets that are
                                                            attributed to priced
                                                            services.
----------------------------------------------------------------------------------------------------------------


[[Page 52622]]


                                     Table 1.--Priced-Services Balance Sheet
                                                   [continued]
----------------------------------------------------------------------------------------------------------------
      Liabilities and equity                 Type                  Description            Method for computing
----------------------------------------------------------------------------------------------------------------
Core clearing balances............  Actual...............  The portion of clearing     Total clearing balances
                                                            balances considered         required for financing
                                                            stable and available to     long-term assets.
                                                            finance long-term priced-   Maximum core amount
                                                            service assets.             initially set at the
                                                                                        lesser of $4 billion,
                                                                                        which is the estimated
                                                                                        amount of actual
                                                                                        contracted clearing
                                                                                        balances that have
                                                                                        historically been
                                                                                        stable, or the maximum
                                                                                        amount available based
                                                                                        on an analysis of
                                                                                        interest rate risk
                                                                                        sensitivity.
Non-core clearing balances........  Actual...............  Deposits of financial       Equal to total clearing
                                                            institutions maintained     balances used for
                                                            at Federal Reserve Banks    financing long-term
                                                            for clearing                assets
                                                            transactions. Available
                                                            to finance short-term
                                                            priced service assets..
Short-term payables...............  Actual...............  The portion of sundry
                                                            items payable, earnings
                                                            credits due depository
                                                            institutions, and accrued
                                                            expenses unpaid reported
                                                            on the Federal Reserve
                                                            Banks' balance sheets
                                                            that is attributed to
                                                            priced services.
Deferred credits..................  Actual...............  The value of checks
                                                            deposited with the
                                                            Federal Reserve Banks,
                                                            but not yet credited to
                                                            the accounts of the
                                                            Reserve Banks' depositors.
Postemployment/Postretirement       Actual...............  The portion of post-
 liability.                                                 retirement benefits due
                                                            reported on the Federal
                                                            Reserve Banks' balance
                                                            sheets that is attributed
                                                            to priced services.
Long-term debt....................  Imputed..............  An amount imputed when      Equal to the larger of
                                                            equity and core clearing    zero or long-term and
                                                            are not sufficient to       pension assets
                                                            finance long-term priced-   postemployment/
                                                            services assets.            postretirement
                                                                                        liability, core clearing
                                                                                        balances, and equity.
Equity............................  Imputed..............  The minimum level of        The greater of five
                                                            equity necessary to meet    percent of total assets
                                                            FDIC requirements for a     or 10 percent of risk-
                                                            weighted well-capitalized   weighted assets.
                                                            institution.
----------------------------------------------------------------------------------------------------------------

BILLING CODE 6210-10-P

[[Page 52623]]

[GRAPHIC] [TIFF OMITTED] TN16OC01.001


    By order of the Board of Governors of the Federal Reserve 
System, October 9, 2001.
Jennifer J. Johnson,
Secretary of the Board.
[FR Doc. 01-25833 Filed 10-15-01; 8:45 am]
BILLING CODE 6210-01-C