[Federal Register Volume 67, Number 216 (Thursday, November 7, 2002)]
[Notices]
[Pages 67834-67858]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-28116]


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FEDERAL RESERVE SYSTEM

[Docket No. R-1133]


Federal Reserve Bank Services

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Notice.

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SUMMARY: The Board has approved the fee schedules for Federal Reserve 
priced services and electronic connections and a private-sector 
adjustment factor (PSAF) for 2003 of $171.7 million. These actions were 
taken in accordance with the requirements of the Monetary Control Act 
of 1980, which requires that, over the long run, fees for Federal 
Reserve priced services be established on the basis of all direct and 
indirect costs, including the PSAF.

DATES: The new fee schedules become effective January 2, 2003.

FOR FURTHER INFORMATION CONTACT: For questions regarding the fee 
schedules: Joseph Baressi, Financial Services Analyst, (202/452-3959); 
William Driscoll, Financial Services Analyst, check payments, (202/452-
3117); Edwin Lucio, Financial Services Analyst, ACH payments, (202/736-
5636); Gregory Cannella, Financial Services Analyst, Fedwire funds 
transfer, Fedwire securities, and noncash collection services, (202/
530-6214); Marybeth Butkus, Senior Financial Services Analyst, special 
cash services, (202/452-3917); or Amy Pierce, Senior IT Analyst, 
electronic connections, (202/736-5675), Division of Reserve Bank 
Operations and Payment Systems. For questions regarding the PSAF: 
Brenda Richards, Senior Financial Analyst, (202/452-2753) or Gregory 
Evans, Manager, Financial Accounting, (202/452-3945), Division of 
Reserve Bank Operations and Payment Systems. For users of 
Telecommunications Device for the Deaf (TDD) only, please call 202/263-
4869. Copies of the 2003 fee schedules for the check service are 
available from the Board, the Federal Reserve Banks, or the Reserve 
Banks' financial services Web site at http://www.frbservices.org.

SUPPLEMENTARY INFORMATION:

I. Priced Services

A. Discussion

    Over the period 1992 through 2001, the Reserve Banks recovered 99.8 
percent of their total costs for providing priced services, including 
special project costs, imputed expenses, and targeted after-tax profits 
or return on equity (ROE).\1\
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    \1\ Imputed costs, such as taxes that would have been paid and 
return on equity that would have been provided had the services been 
furnished by a private business firm, are referred to as the 
private-sector adjustment factor (PSAF). The ten-year recovery rate 
is based upon the pro forma income statements for Federal Reserve 
priced services published in the Board's Annual Report. Beginning in 
2000, the PSAF included additional financing costs associated with 
pension assets attributable to priced services. This ten-year cost 
recovery rate has been computed as if these costs were not included 
in the PSAF calculations prior to 2000. If these costs were included 
in the calculations, and assuming that the Reserve Banks would not 
have made any contemporaneous cost or revenue adjustments, the 10-
year recovery rate would be 98.7 percent.
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    Table 1 summarizes the priced services' actual, estimated, and 
budgeted cost recovery rates for 2001, 2002, and 2003 respectively. 
Cost recovery is estimated to be 92.2 percent in 2002 and budgeted to 
be 94.4 percent in 2003. The aggregate cost-recovery rates are heavily 
influenced by the performance of the check service, which accounts for 
approximately 85 percent of the total cost of priced services. The 
electronic services (FedACH, Fedwire funds transfer, Fedwire 
securities, and national settlement) account for approximately 15 
percent of costs, while noncash and special cash services represent a 
de minimis amount.

[[Page 67835]]



                                Table 1.--Pro Forma Cost and Revenue Performance
                                                  [$ millions]
----------------------------------------------------------------------------------------------------------------
                                                                                                    5  Recovery
              Year                  1a  Revenue      2b  Total     3  Net income  4c  Target ROE    rate after
                                                      expense          (ROE)                        target ROE
                                  ..............  ..............           [1-2]  ..............       [1/(2+4)]
---------------------------------
2001............................           960.4           901.9            58.5           109.2           95.0%
2002 (Estimate).................           912.9           898.0            14.8            92.5           92.2%
2003 (Budget)...................           933.7           883.9            49.8           104.7          94.4%
----------------------------------------------------------------------------------------------------------------
a Includes net income on clearing balances (NICB). Clearing balances, net of imputed reserve requirements and
  balances used to finance priced-services assets, are assumed to be invested in three-month Treasury bills.
  NICB equals the income from this imputed investment less earnings credits granted to clearing balance holders
  at the federal funds rate.
b The calculation of total expense includes operating expenses and imputed expenses. Imputed expenses include
  taxes, FDIC insurance, Board of Governors priced services expenses, the cost of float, and interest on imputed
  debt, if any. Credits related to the accounting for pensions under FAS 87 are also included.
c Target ROE is the ROE included in the PSAF.

    Table 2 presents an overview of the 2001 actual, budgeted 2002, 
estimated 2002, and projected 2003 cost recovery performance by 
category of priced service.

                                     Table 2.--Priced Services Cost Recovery
                                                    [Percent]
----------------------------------------------------------------------------------------------------------------
                 Priced service                     2001 Actual     2002 Budget    2002 Estimate    2003 Budget
----------------------------------------------------------------------------------------------------------------
All services....................................            95.0            96.4            92.2            94.4
Check...........................................            93.9            95.5            90.9            93.0
ACH.............................................           103.7           101.4           102.5           101.6
Fedwire funds transfer..........................            99.5           101.1            95.9           104.1
Fedwire securities..............................            90.2           100.4            98.7           104.9
Noncash collection..............................           111.9            94.3            93.1           110.3
Special cash....................................           103.3           103.4            91.1            77.5
----------------------------------------------------------------------------------------------------------------

    1. 2002 Estimated Performance--In 2002, the Reserve Banks estimate 
that they will recover 92.2 percent of the costs of providing priced 
services, compared with the budgeted recovery rate of 96.4 percent. The 
Reserve Banks expect to recover fully actual and imputed expenses, 
earning net income of $14.8 million, which is $77.7 million less than 
the budgeted net income, or ROE, of $92.5 million. The shortfall from 
the 2002 budget is largely driven by declining check volume. The 
Reserve Banks estimate that check revenue in 2002 will be $45.3 million 
below budget. Though the Reserve Banks have taken steps to reduce check 
operating costs, these reductions are largely offset by increases in 
non-operating factors.
    Forward-processed check volume in 2002 was budgeted to be 2.9 
percent higher than in 2001. The Reserve Banks now estimate, however, 
that 2002 volume will be 1.8 percent lower than in 2001. Even this 
estimate may be optimistic, as processed check volume through August 
2002 is 3.4 percent below 2001 volume for the same period. The 
deterioration in the Reserve Banks' check volume appears to be 
consistent with nationwide trends away from check use and toward 
greater use of electronic payment methods. The Federal Reserve System's 
recent retail payments research shows that the number of checks written 
in the United States appears to have been declining since the mid-
1990s.\2\ Lower volumes in 2002 may also have been influenced by slower 
growth in the overall economy.
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    \2\ Gerdes, Geoffrey R. and Jack K. Walton II, ``The Use of 
Checks and Other Noncash Payment Instruments in the United States,'' 
Federal Reserve Bulletin, August 2002, pp. 360-374. (This article is 
available on line at www.federalreserve.gov/pubs/bulletin/default.htm). During the late 1990s, the volume of checks processed 
by the Reserve Banks rose, albeit slowly, which implies that the 
proportion of interbank checks cleared through the Reserve Banks 
increased.
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    2. 2003 Projected Performance--For 2003, the Reserve Banks project 
a priced services cost recovery rate of 94.4 percent, with net income 
of $49.8 million, as compared to target net income, or ROE, of $104.7 
million. The primary factor affecting 2003 cost recovery is the 
continued check volume decline.
    The primary risks to the Reserve Banks' ability to achieve their 
budget targets are (1) cost overruns in the check modernization 
projects, (2) significantly lower-than-projected returns on pension 
assets, and (3) a steeper decline in the Reserve Banks' check volume 
than the projected 2.8 percent annual decline.\3\ To address the 
apparent continuing decline in check volumes, the Reserve Banks are 
developing a business and operational strategy that will position the 
service to achieve its financial and payment system objectives over the 
long term.
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    \3\ Check modernization is a multiyear initiative to standardize 
the processing of checks at all Reserve Banks, adopt a common 
platform for processing and researching check-adjustment cases, 
create a national system for archiving and retrieving check images, 
and deliver check services to depository institutions using web 
technology. Check modernization should improve the operational 
efficiency and cost-effectiveness of the Reserve Banks' check 
services once fully implemented. It will also improve the 
consistency, quality, and uniformity of the check services that 
Reserve Banks deliver to their customers and allow new services to 
be developed and deployed more quickly.
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    3. 2003 Pricing--The following summarizes the Reserve Banks' 
changes in fee structures and levels for priced services:
Check
    [sbull] The Reserve Banks are raising fees for forward-collection 
check products 2.5 percent, return check products 4.0 percent, and 
payor-bank check products 4.8 percent compared with January 2002 fees.

[[Page 67836]]

    [sbull] Since 1996, the price index for check services has 
increased 31 percent.\4\
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    \4\ The price index estimates are based on a chained Fisher 
ideal price index. This index is not adjusted for quality changes in 
Federal Reserve priced services. Data elements used in calculating 
the index include explicit fee revenue from priced services and 
volumes associated with those services. For 2003, the year-over-year 
percentage change in the index is based on a comparison of the 2003 
projections with the 2002 estimates for priced services revenues and 
volumes. The price index is calculated based on 1994-2001 actual, 
2002 estimated, and 2003 projected revenues and volumes.
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FedACH
    [sbull] The Reserve Banks will (1) Retain current per-item 
origination fees for items in large files, (2) reduce per-item 
origination fees for items in small files from $0.004 to $0.003, and 
(3) reduce per-item receipt fees (for all items) from $0.0035 to 
$0.0025.\5\
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    \5\ Files containing fewer than 2,500 items are small; files 
with 2,500 or more items are large.
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    [sbull] The ACH price index has decreased 61 percent since 1996.
Fedwire Funds Transfer and National Settlement Services \6\
    [sbull] The Reserve Banks will reduce fees in all volume tiers: 
from $0.31 to $0.30 per transfer if less than 2,501 transfers per 
month, from $0.22 to $0.20 per transfer if between 2,501 and 80,000 
transfers per month, and from $0.15 to $0.10 per transfer if more than 
80,000 transfers per month.
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    \6\ The name of the net settlement service was changed to 
national settlement service effective August 2002.
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    [sbull] The price index for Fedwire funds transfer and national 
settlement services has decreased 60 percent since 1996.
Fedwire Securities Service
    [sbull] The Reserve Banks will reduce the on-line transfer 
origination and receipt fees from $0.66 to $0.40.
    [sbull] The price index for the Fedwire securities service has 
decreased 34 percent since 1996.
    4. 2003 Price Index--The price index for electronic payment 
services (ACH, Fedwire funds transfer and national settlement, Fedwire 
securities, and electronic check) and electronic connections is 
projected to decline 5 percent in 2003. By contrast, the index for 
paper-based payment services (check, special cash, and noncash 
collection) is expected to increase about 3 percent in 2003. The 
overall 2003 price index for all Federal Reserve priced services is 
projected to increase less than 1 percent. Since 1996, the overall 
price index has declined by about 2 percent. Figure 1 compares the 
Federal Reserve's price index for priced services with the GDP price 
deflator.
[GRAPHIC] [TIFF OMITTED] TN07NO02.004

B. Check

    Table 3 shows the actual 2001, estimated 2002, and projected 2003 
cost-recovery performance for the check service.

[[Page 67837]]



                             Table 3.--Check Pro Forma Cost and Revenue Performance
                                                  [$ millions]
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                                                                                                     5  Recovery
                                                                2  Total      3  Net     4  Target    rate after
                      Year                        1  Revenue    expense       income        ROE       target ROE
                                                                              (ROE)
                                                 ...........  ...........        [1-2]  ...........    [1/(2+4)]
------------------------------------------------
2001...........................................        793.2        754.4         38.9         90.2        93.9%
2002 (Estimate)................................        760.0        758.3          1.7         78.2        90.9%
2003 (Budget)..................................        789.0        758.7         30.3         89.4        93.0%
----------------------------------------------------------------------------------------------------------------

    1. 2001 Performance--The check service recovered 93.9 percent of 
total costs in 2001, including imputed expenses and targeted ROE, which 
was below the targeted recovery rate of 97.6 percent. The volume of 
checks collected decreased 0.5 percent from 2000 levels, partly because 
of a decline in fine-sort volumes as banks presented more checks 
directly. Revenue grew from 2000 levels primarily because of price 
increases, but revenue was $22 million below the budgeted amount. Costs 
exceeded the budgeted amount by $18.5 million because of lower-than-
budgeted pension credits, somewhat offset by lower-than-budgeted check 
modernization costs.
    2. 2002 Performance--Through August 2002, the check service has 
recovered 93.0 percent of total costs, including imputed expenses and 
targeted ROE. For the full year, the Reserve Banks expect to recover 
all direct and indirect costs of providing check services and a modest 
portion of the targeted return on equity. Specifically, the Reserve 
Banks estimate that the check service will recover 90.9 percent of its 
total costs for the full year compared with the budgeted 2002 recovery 
rate of 95.5 percent, amounting to a $39 million shortfall.\7\ The 
lower-than-budgeted recovery rate is primarily due to lower-than-
budgeted revenues. Service revenue is estimated to be $57 million below 
budget, due to lower-than-expected volume in forward-collection, 
return-collection, and electronic check products. Additionally, in the 
current low-interest-rate environment, depository institutions select 
lower-priced, later-availability check products. Major factors are 
summarized in Table 4.
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    \7\ The cost-recovery estimate does not reflect reduced 
depreciation expense for some check-sorting equipment of 
approximately $1 million, resulting from a recent System re-
evaluation of the useful life of such equipment.

                                  Table 4.--Check 2002 Budget vs. 2002 Estimate
                                              [millions of dollars]
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                                                                      Budget         Estimate        Variance
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Operating revenue...............................................           820.0           763.3           -56.7
NICB............................................................           -14.7            -3.3           -11.4
                                                                 -----------------
    Total revenue...............................................           805.3           760.0           -45.3
                                                                 =================
Operating costs.................................................           692.2           681.0            11.3
Check modernization.............................................           106.2           101.4             4.8
Pension credits.................................................           -66.6           -41.0           -25.7
PSAF............................................................           111.2            95.1            16.1
 
    Total cost..................................................           843.0           836.4             6.5
                                                                 =================
Net revenue.....................................................           -37.7           -76.5           -38.8
Recovery rate (percent).........................................            95.5            90.9  ..............
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    Reserve Banks expect lower-than-budgeted pension credits to offset 
estimated local cost reductions of $27 million. The estimated full-year 
recovery rate is lower than the rate through August as severance 
expenses are recognized and data processing and data communications 
charges increase during the fourth quarter.
    The volume of checks handled by the Reserve Banks has declined (as 
shown in table 5) reflecting a broader market trend in which the number 
of checks written each year appears to be declining, as discussed in a 
recent Federal Reserve check study.\8\ Year-to-date forward-collection 
check product volume through August, excluding electronic fine sort 
volume, declined 3.6 percent, compared with the 0.6 percent increase 
for the similar period last year.\9\ For the full year 2002, the 
Reserve Banks estimate that forward-processed volume will decline 1.8 
percent, compared with a budgeted 2.9 percent growth rate. (The decline 
is due to lower local volumes, partly offset by higher nonlocal 
volumes, from both large and small banks.) The full-year rate of 
decline is less than the decline to date because of recent volume 
growth in several Districts. There is some risk, however, that the 
full-year rate of decline may exceed the estimate. Return-check volume 
has declined 3.8 percent through August 2002, and full-year volume is 
expected to decline 4.7 percent, as depository institutions seek 
alternative ways to return checks at

[[Page 67838]]

lower cost because of the Reserve Banks' continuing price increases for 
return products.
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    \8\ Gerdes, Geoffrey R. and Jack K. Walton II, ``The Use of 
Checks and Other Noncash Payment Instruments in the United States,'' 
Federal Reserve Bulletin, August 2002, pp. 360-374.
    \9\ Electronic fine-sort is a service offered by two Reserve 
Banks that allows depository institutions to exchange fine-sort 
information electronically with paper checks to follow. Presentment 
occurs when the paper checks are delivered.

                                  Table 5.--Paper Check Product Volume Changes
                                                    [percent]
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                                                                                   Year-to-date
                                                                   Budgeted 2002  change through  Estimated 2002
                                                                      change        August 2002       change
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Total forward-collection a......................................             3.6            -3.6            -1.7
    Forward-processed...........................................             2.9            -3.4            -1.8
    Fine-sort a.................................................            13.1            -6.5             0.0
Returns.........................................................            -2.3            -3.8           -4.7
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a These rates exclude electronic fine-sort volume. Including the electronic fine-sort product, fine-sort volume
  growth was budgeted to increase 8.7 percent in 2002 and is now estimated to increase 9.0 percent.

    Reversing a trend over the past few years, electronic check volumes 
have declined. Recent data are summarized in table 6. Reserve Banks 
provide payor banks with electronic check data or images for about 38 
percent of the checks they collect. Year-to-date 2002 image volumes 
have declined about 5 percent, to approximately 884 million check 
images, which represents about 8.4 percent of all checks collected by 
the Reserve Banks. The decline in image volume, compared with the 
target growth of 25.6 percent, is likely due to delays in implementing 
FedImage services.\10\ The Board believes that Reserve Banks' estimates 
for electronic check service volume for the full year, which reflect a 
higher rate of growth than experienced through August, may be somewhat 
optimistic.
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    \10\ The rollout of Reserve Bank FedImage services has taken 
longer than expected due to complexities associated with developing 
the application.

                           Table 6.--Electronic Check Product Share and Volume Changes
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                                                                                                     Share of
                                                                   Volume change                      checks
                                                                  through August  Estimated 2002     collected
                                                                       2002           change      through August
                                                                     (percent)       (percent)         2002
                                                                                                     (percent)
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Electronic check presentment....................................            -2.4            -0.2            23.0
    Truncation..................................................            -6.1            -5.6             5.3
    Non-truncation..............................................            -0.2             1.5            17.6
Electronic check information....................................           -10.4            -8.8             6.7
Images..........................................................            -4.8             1.9             8.4
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    3. 2003 Pricing--For the coming year, the Reserve Banks will 
continue to focus on check modernization initiatives to standardize 
check processing across all Reserve Bank offices. The Reserve Banks 
will incur significant transition costs associated with these 
initiatives, at least through 2003 (costs in 2003 are discussed below). 
These initiatives, however, are expected to reduce steady-state 
production costs and improve service over the long term.
    In 2003, fees for all check products are increasing 2.8 percent on 
a volume-weighted basis compared with current fees, as shown in table 
7.\11\ Forward-collection fee increases of 2.5 percent are composed of 
an increase in forward-processing cash letter fees of 10 percent and 
per-item fee increases of 1.5 percent. The average volume-weighted fees 
for payor bank services will increase 4.8 percent compared with current 
fees. Fees for electronic check products are increasing faster than 
fees for paper check products because the Reserve Banks are instituting 
more consistent fees for these products that better reflect the value 
they provide to depository institution customers.
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    \11\ This discussion evaluates volume-weighted changes in the 
direct fees for check products. The price index, discussed earlier, 
evaluates the average change in costs that would be incurred by a 
customer purchasing an average market basket of Federal Reserve 
check products.

                       Table 7.--2003 Fee Changes
                                [percent]
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                                                                   Fee
                            Product                              change
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Total check service...........................................       2.8
Forward-collection............................................       2.5
Returns.......................................................       4.0
Payor bank services...........................................       4.8
    Electronic check presentment..............................       7.1
    Electronic check information..............................       7.3
    Image services............................................       4.0
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    Table 8 summarizes ranges of selected check fees for 2002 and 2003, 
and shows 2003 price changes in bold type.

                                          Table 8.--Selected Check Fees
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                                        Current fee ranges                       2003 fee ranges
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              Items:                        (per item)                             (per item)
 
Forward-processed:
    City..........................  $0.005 to 0.079...........  $0.005 to 0.080

[[Page 67839]]

 
    RCPC..........................  0.003 to 0.350............  0.003 to 0.340
Forward fine-sort:
    City..........................  0.005 to 0.021............  0.005 to 0.021
    RCPC..........................  0.005 to 0.036............  0.005 to 0.036
Qualified returned checks:
    City..........................  0.08 to 0.80..............  0.08 to 0.80
    RCPC..........................  0.10 to 1.10..............  0.10 to 1.10
Raw returned checks:
    City..........................  1.50 to 5.00..............  1.50 to 5.00
    RCPC..........................  1.30 to 5.00..............  1.30 to 5.00
    Consolidated shipment a.......  0.004 to 0.036............  0.004 to 0.036
           Cash letters:                 (per cash letter)                      (per cash letter)
 
Forward-processed b...............  2.00 to 36.00.............  2.00 to 37.00
Forward fine-sort.................  4.00 to 14.00.............  6.00 to 14.00
Returned checks: raw/qualified....  2.25 to 14.00.............  2.00 to 16.00
       Payor bank services:         (Fixed) (per item)          (Fixed) (per item)
 
MICR information..................  2-15 0.0030-0.0170          5-15 0.0030-0.0150
Electronic presentment............  1-12 0.0005-0.0130........  2-15 0.0005-0.0110
Truncation........................  2-7 0.0020-0.0180.........  2-7 0.0020-0.0180
Image capture.....................  2-15 0.0020-0.0170........  2-15 0.0020-0.0150
Image delivery....................   Varies c 0.0020-0.0080...   Varies c 0.0020-0.0080
Image archive.....................  N/A 0.0010-0.0060.........  N/A 0.0007-0.0060
Image retrieval...................  N/A 0.25-5.00.............  N/A 0.30-5.00
----------------------------------------------------------------------------------------------------------------
Note: Bold indicates change from 2002 prices.
a Per-item fees for consolidated shipments include a half mill surcharge due to higher fuel costs.
b Cash letter fees for forward-processed items transported by the Reserve Banks include a fifty-cent surcharge
  due to higher fuel costs.
c Fixed fee varies by media type.

    4. 2003 Projected Cost Recovery--For 2003, the Reserve Banks 
project that the check service will recover 93.0 percent of total 
costs, including imputed expenses, costs associated with the check 
modernization project, and targeted ROE. In total, the Reserve Banks 
expect to recover all direct and indirect costs of providing check 
services, but only a portion of targeted return on equity.
    Total adjusted costs before taxes are projected to increase 
approximately $6.8 million, or 0.8 percent, from estimated 2002 
expenses.\12\ These costs for 2003 include $102.8 million in costs for 
the four check modernization projects, representing an increase of $1.5 
million over the 2002 estimate. Budgeted 2003 local costs, aside from 
local check modernization costs and offsets, are $18.2 million lower 
than 2002 estimated costs, a 3.1 percent reduction, which slightly 
exceeds the projected percentage decline in forward-processed volume.
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    \12\ This estimate does not reflect reduced depreciation expense 
for check sorting equipment of approximately $3.5 million, resulting 
from a recent System re-evaluation of the useful life of such 
equipment.
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    Total check revenue is projected to increase $29 million, or 3.8 
percent, from the 2002 estimate due to increased fees for payor-bank 
products and return-check products. (Increases in fees for forward-
collection products are projected to be more than offset by lower 
volumes and shifts to lower-priced products due to low interest rates.) 
In 2003, revenues from paper-based services, electronic services, and 
other operating and imputed revenues are expected to represent about 83 
percent, 12 percent, and 5 percent, respectively, of the check 
service's budgeted $789.0 million in revenue.
    In 2003, forward-processed check volume is projected to be 14.4 
billion, a decrease of 2.7 percent compared with the 2002 estimate, 
with the decline coming mostly from large banks, perhaps partly due to 
their customers' shift to electronic payment instruments. Fine-sort 
check volume is expected to continue to decline by 41 million checks, 
or 3.7 percent, from the 2002 estimate. Total returns are projected to 
be 166 million, a decrease of 2.3 percent compared with the 2002 
estimate.
    The Reserve Banks expect an increase in payor-bank service volumes. 
The Reserve Banks project electronic presentment volume to increase 5.5 
percent in 2003 and truncation volume to increase 0.9 percent. Image 
services volume is projected to grow 8.4 percent in 2003, compared with 
an estimated 2002 increase of 1.9 percent. Image volume growth is 
expected to be driven by the increased functionality of FedImage 
services (for example, electronic access to archived check images using 
web technology). MICR information volume is projected to increase 0.2 
percent in 2003, compared with a 9 percent decline estimated for 2002.
    The Board believes that the greatest risks to achieving the 
projected cost-recovery rate for the check service of 93.0 percent are 
(1) challenges in meeting System volume projections and related revenue 
projections, (2) challenges in reducing local costs as budgeted, (3) 
potential downward revisions to priced pension credits, and (4) 
potential check modernization cost overruns.

C. Automated Clearinghouse (ACH)

    Table 9 presents the actual 2001, estimated 2002, and projected 
2003 cost-recovery performance for the commercial ACH service.

[[Page 67840]]



                              Table 9.--ACH Pro Forma Cost and Revenue Performance
                                                  [$ millions]
----------------------------------------------------------------------------------------------------------------
                                                                                                    5  Recovery
              Year                  1  Revenue       2  Total      3  Net income   4  Target ROE    rate after
                                                      expense          (ROE)                        target ROE
                                  ..............  ..............           [1-2]  ..............       [1/(2+4)]
---------------------------------
2001............................            79.4            67.7            11.8             8.9          103.7%
2002 (Estimate).................            70.8            62.6             8.2             6.5          102.5%
2003 (Budget)...................            69.9            61.2             8.7             7.5          101.6%
----------------------------------------------------------------------------------------------------------------

    1. 2001 Performance--In 2001, the ACH service recovered 103.7 
percent of total expenses, including imputed costs and targeted ROE, 
compared with a targeted recovery rate of 101.3 percent. Commercial ACH 
volume was 16.2 percent higher than 2000 volume, compared with the 11.1 
percent increase originally projected for 2001. The Reserve Banks 
changed their prices on October 1, 2001, to reflect better the cost 
structure of the ACH service, which is characterized by high fixed and 
low variable costs. The Reserve Banks decreased per-item fees for 
large-volume files and increased monthly fixed fees, thereby lowering 
overall fees to large and medium-sized customers. Also on October 1, 
the Reserve Banks implemented pricing agreements with other ACH 
operators for interoperator ACH transactions. Under the new 
interoperator agreements, the Reserve Banks stopped charging per-item 
fees to depository institutions that are customers of other ACH 
operators. Instead, the Reserve Banks and the other ACH operators began 
to charge each other fees for interoperator transactions. Thus, for ACH 
items originated by a Reserve Bank customer but sent to a customer of 
another ACH operator, the Reserve Banks now pay a fee to the other 
operator and no longer assess per-item fees to that ACH operator's 
customer.
    2. 2002 Estimate--The Reserve Banks estimate that the ACH service 
will recover 102.5 percent of total expenses in 2002, compared with the 
budgeted recovery rate of 101.3 percent. The difference from targeted 
recovery rate is mainly due to higher-than-projected volume. The $5.1 
million year-over-year expense decrease results primarily from 
consolidating the twelve Districts' ACH customer support operations 
into two offices. On February 1, 2002, the Reserve Banks reduced fees 
to reflect lower operating costs following the consolidation. Despite 
this price reduction, total revenue is projected to be $4.3 million or 
6.5 percent above the 2002 budget figure.
    The Reserve Banks estimate that their 2002 commercial ACH volume 
will be 9.1 percent higher than experienced in 2001, which is 20.3 
percent higher than budgeted. Year-to-date through August 2002, the 
Reserve Banks' ACH volume increased 10.8 percent from the same period 
in 2001. The full-year projection reflects the Reserve Banks' 
expectation that some large depositors will continue to shift some 
volume to another ACH operator, or at least split their transactions 
between the Federal Reserve and another operator.
    3. 2003 Pricing--The Reserve Banks project that the ACH service 
will recover 101.6 percent of its costs in 2003 including imputed 
expenses and targeted ROE. For the third time since January 2001, the 
Reserve Banks are reducing fees, which would decrease revenue by 1.3 
percent from the 2002 estimate. The fee to originate items in files 
with fewer than 2,500 transactions will be reduced from $0.004 to 
$0.003, and the receipt fee for all items will be reduced from $0.0035 
to $0.0025. These changes should reduce costs for low-to medium-volume 
customers. Assuming constant volume, the lower fees would reduce 
revenue by $5.4 million. The Reserve Banks expect a 3.7 percent 
increase in transaction volume, reflecting growth of at least that 
amount in nationwide use of ACH transactions, however, which would 
offset somewhat the revenue effect from the lower fees. The Board 
believes that the Reserve Banks' volume and revenue projections are 
reasonable.

D. Fedwire Funds Transfer and National Settlement

    Table 10 presents the actual 2001, estimated 2002, and projected 
2003 cost-recovery performance for the funds transfer and national 
settlement services.

         Table 10.--Fedwire Funds and National Settlement Service Pro Forma Cost and Revenue Performance
                                                  [$ millions]
----------------------------------------------------------------------------------------------------------------
                                                                                                    5  Recovery
              Year                  1  Revenue       2  Total      3  Net income   4  Target ROE    rate after
                                                      expense          (ROE)                        target ROE
                                  ..............  ..............           [1-2]  ..............       [1/(2+4)]
---------------------------------
2001............................            63.8            56.7             7.1             7.4           99.5%
2002 (Estimate).................            56.0            53.0             3.0             5.5           95.9%
2003 (Budget)...................            51.9            44.5             7.4             5.4          104.1%
----------------------------------------------------------------------------------------------------------------

    1. 2001 Performance--The funds transfer and national settlement 
service recovered 99.5 percent of total costs in 2001, including 
imputed expenses and targeted ROE, below the targeted recovery rate of 
101.2 percent. Expenses for 2001 were $1.6 million (2.5 percent) more 
than original budget projections, primarily because of higher-than-
anticipated Federal Reserve Information Technology costs, while service 
revenue was only $0.6 million (1.0 percent) more than original budget 
projections.
    2. 2002 Performance--Through August 2002, the funds transfer and

[[Page 67841]]

national settlement services recovered 100.0 percent of total costs, 
including imputed expenses and targeted ROE. For full-year 2002, the 
Reserve Banks estimate that the funds transfer and national settlement 
services will recover 95.9 percent of total expenses, compared with a 
targeted recovery rate of 101.1 percent. The underrecovery is 
attributed to several factors, including lower pension credits, an 
unbudgeted FedLine for Web project, and a FedLine for Windows write-
off. Funds transfer volume through August has decreased 0.5 percent 
relative to the same period in 2001. For the full year, the Reserve 
Banks estimate a 0.5 percent volume decrease, compared with a budgeted 
decline of 1.1 percent.
    3. 2003 Fedwire Funds Transfer Pricing--The Reserve Banks are 
maintaining the current thresholds for volume-based discounts but 
reducing the per-transfer fees for each threshold. Specifically, the 
Reserve Banks are lowering the transfer fee for the first volume tier 
(<=2,500 transfers per month) $0.01 from $0.31 to $0.30 (3.0 percent), 
lowering the transfer fee for the second volume tier (2,501-80,000 
transfers per month) $0.02 from $0.22 to $0.20 (9.1 percent), and 
lowering the transfer fee for the third volume tier (80,000 
transfers per month) $0.05 from $0.15 to $0.10 (33.3 percent). The 
average (volume-weighted) per-transfer price would decline from its 
current level of $0.2009 to $0.1679 (16.4 percent). In addition, the 
Reserve Banks are retaining the off-line surcharge at its current 
level.
    Reserve Banks project that the Fedwire funds transfer service will 
recover 104.1 percent of total costs in 2003, including imputed 
expenses and targeted ROE. Total costs are expected to decline $8.6 
million (14.7 percent) from the 2002 estimate because of lower data 
communications charges and the full-year effect of savings from the 
consolidation of local on-line operations support.\13\ Volume for 2003 
is expected to remain flat compared with the 2002 estimate. The Reserve 
Banks project total funds transfer revenue to decline by $4.1 million 
(7.4 percent) in 2003 from the 2002 estimate primarily because of the 
effect of the 2003 price reductions, which is partially offset by 
increases in electronic connection revenue and NICB. The Board believes 
that the Reserve Banks' projections for 2003 funds transfer volume and 
revenue are reasonable.
    4. 2003 National Settlement Service Pricing--Continued 
consolidations among check clearinghouses in 2003 that use the national 
settlement service are expected to decrease transaction volume. The 
Reserve Banks expect this decrease to be offset by volume from new 
customers such as securities exchanges and card networks. On balance, 
the Reserve Banks are retaining the current national settlement service 
fees for 2003. In addition, the Reserve Banks will retain the monthly 
$60 minimum account maintenance fee per arrangement. The Reserve Banks 
expect settlement entry and file volumes to remain stable in 2003 
compared with the 2002 estimate.
---------------------------------------------------------------------------

    \13\ Specifically, the Reserve Banks consolidated on-line funds 
transfer operations to two sites and consolidated computer interface 
testing. The consolidation began in September 2001 and was completed 
in May 2002.
---------------------------------------------------------------------------

E. Fedwire Securities Service \14\

    Table 11 presents the actual 2001, estimated 2002, and projected 
2003 cost-recovery performance for the Fedwire securities service.\15\
---------------------------------------------------------------------------

    \14\ Includes purchase and sale activity.
    \15\ The Reserve Banks provide securities transfer services for 
securities issued by the U.S. Treasury, federal government agencies, 
government-sponsored enterprises, and certain international 
institutions. The priced component of this service, reflected in 
this memorandum, consists of revenues, expenses, and volumes 
associated with the transfer of all non-Treasury securities. For 
Treasury securities, the U.S. Treasury assesses fees for the 
securities transfer component of the service. The Reserve Banks 
assess a fee for the funds settlement component of a Treasury 
securities transfer, this component is not treated as a priced 
service.

                  Table 11.--Fedwire Securities Service Pro Forma Cost and Revenue Performance
                                                  [$ millions]
----------------------------------------------------------------------------------------------------------------
                                                                                                    5 Recovery
              Year                   1 Revenue        2 Total      3 Net income    4 Target ROE     rate after
                                                      expense          (ROE)                        target ROE
                                  ..............  ..............           [1-2]       [1/(2+4)]
---------------------------------
2001............................            19.7            19.5             0.2             2.3           90.2%
2002 (Estimate).................            23.2            21.3             1.9             2.2           98.7%
2003 (Budget)...................            20.6            17.4             3.2             2.2          104.9%
----------------------------------------------------------------------------------------------------------------

    1. 2001 Performance--The Fedwire securities service recovered 90.2 
percent of total costs in 2001, including imputed expenses and targeted 
ROE, below the target recovery rate of 95.6 percent. Total costs for 
2001 were $0.9 million (4.4 percent) more than budgeted, and service 
revenue was approximately $0.3 million (1.4 percent) less than 
budgeted. The lower revenue was due to the delay in the scheduled 
addition of Ginnie Mae securities to the service caused by the events 
of September 11. Total securities transfer volume increased 18.8 
percent from the 2000 level.
    2. 2002 Performance--Through August 2002, the Fedwire securities 
service recovered 98.7 percent of total costs, including imputed 
expenses and targeted ROE. For full-year 2002, the Reserve Banks 
estimate that the Fedwire securities service will also recover 98.7 
percent of total costs, compared with a targeted recovery rate of 100.4 
percent. The underrecovery is attributed to several factors, including 
unbudgeted costs associated with the postponed addition and testing of 
Ginnie Mae securities, the FedLine for the Web project, and a write-off 
associated with the FedLine for Windows project.
    Through August 2002, total Fedwire securities transfer volume has 
increased 22.5 percent compared with volume during the same period in 
2001. For the full year, the Reserve Banks estimate that total Fedwire 
securities volume will increase 25.4 percent from 2001, compared with a 
budgeted 21.0 percent increase. The increased volume is primarily due 
to the addition of Ginnie Mae securities to the Fedwire securities 
service earlier this year. Higher-than-anticipated mortgage refinancing 
activity has also contributed to the overall increase in volume.
    3. 2003 Pricing--The Reserve Banks are reducing the on-line 
transfer origination and receipt fee $0.26 from $0.66 to $0.40 (39.4 
percent) and lowering the per-issue, per-account

[[Page 67842]]

maintenance fee $0.01 from $0.41 to $0.40 (2.4 percent). The Reserve 
Banks are retaining the off-line surcharge and account maintenance fee 
at their current levels. In addition, the Reserve Banks implemented a 
new automated claim adjustment processing feature to support automated 
claim adjustments related to failed securities transactions, interim 
accounting for securities with an accrual date different than the 
record date, and repurchase agreement tracking.\16\ Phased in during 
the past year, this new feature allows participants to add information 
to transfer messages that the Fedwire securities service can use to 
calculate cash payments owed to counterparties involved with related 
transfers. Only participants that use this functionality (currently 
fewer than 100) will be charged a fee. The Reserve Banks are 
establishing a $0.38 fee per automated claim adjustment entry.
---------------------------------------------------------------------------

    \16\ The new feature is currently available only for mortgage-
backed securities; functionally for Treasury securities and other 
agency debt may be incorporated later.
---------------------------------------------------------------------------

    With the consolidation of operational support for processing joint 
custody collateral, costs for this labor-intensive product can be 
clearly identified and explicitly recovered by a new surcharge. The 
Reserve Banks, therefore, are establishing a $22.00 surcharge per 
customer-initiated joint custody account withdrawal, effective July 
2003.
    After many years of declining volume, the business of executing 
orders for the purchase and sale of Fedwire-eligible securities by the 
Reserve Banks will be discontinued as of year-end 2002. Banking 
industry consolidation and the availability of discount brokerage 
services have reduced significantly the need for the Reserve Banks to 
continue this accommodation for customers. The purchase and sale 
activity represents less than 0.5 percent of the costs and revenues of 
the securities service line.
    The Reserve Banks project that the Fedwire securities service will 
recover 104.9 percent of costs in 2003, including imputed expenses and 
targeted ROE. Total costs are expected to decline $3.9 million (16.5 
percent) from the 2002 estimate, primarily due to lower data 
communication charges, and the full-year impact of savings from the 
consolidation of local on-line operations support.\17\ The Board 
believes that the 2003 cost projections are reasonable.
---------------------------------------------------------------------------

    \17\ Specifically, the Reserve Banks consolidated on-line 
securities operations to two sites, joint custody collateral 
processing to one site, and consolidated computer interface testing. 
The consolidation began in September 2001 and was completed in May 
2002.
---------------------------------------------------------------------------

    The Reserve Banks project that the volume of agency securities 
transfers in 2003 will increase 4.3 percent from the 2002 estimate and 
total revenue will decrease 11.2 percent from the 2002 estimate. The 
volume increase is primarily due to the full-year effect of adding 
Ginnie Mae securities to the service.\18\ The Board believes the 2003 
securities volume and revenue projections are reasonable.
---------------------------------------------------------------------------

    \18\ Ginnie Mae securities were added to the Fedwire securities 
service in March 2002.
---------------------------------------------------------------------------

F. Noncash Collection Service

    Table 12 lists the actual 2001, estimated 2002, and projected 2003 
cost-recovery performance for the noncash collection service.

                      Table 12.--Noncash Collection Pro Forma Cost and Revenue Performance
                                                  [$ millions]
----------------------------------------------------------------------------------------------------------------
                                                                                                    5  Recovery
              Year                  1  Revenue       2  Total      3  Net Income   4  Target ROE    rate after
                                                      expense          (ROE)                        target ROE
                                  ..............  ..............           [1-2]  ..............       [1/(2+4)]
---------------------------------
2001............................             2.0             1.6             0.4             0.2          111.9%
2002 (Estimate).................             1.6             1.5             0.0             0.2           93.1%
2003 (Budget)...................             1.9             1.6             0.4             0.2          110.3%
----------------------------------------------------------------------------------------------------------------

    1. 2001 Performance--The noncash collection service recovered 111.9 
percent of total expenses in 2001, including imputed expenses and 
targeted ROE, exceeding the targeted recovery rate of 102.5 percent. 
Volume for 2001 declined 20.7 percent from 2000 levels, compared with a 
budgeted decline of 20.9 percent, and revenue declined 16.8 percent 
from 2000 levels, compared with a budgeted decline of 17.7 percent. 
Total costs for 2001 decreased 19.5 percent over 2000 levels, compared 
with a 12.4 percent budgeted decline.
    2. 2002 Performance--Through August 2002, the noncash collection 
service recovered 105.5 percent of its costs. For full-year 2002, the 
Reserve Banks estimate that the noncash collection service will recover 
93.1 percent of costs, including imputed expenses and targeted ROE, 
compared with the targeted recovery rate of 94.3 percent. This drop in 
the recovery rate for the year is primarily due to a 26.4 percent 
decrease in the average volume for the remaining four months of the 
year, compared with the first eight months of the year. The Board 
believes that full-year cost recovery will be higher than the Reserve 
Bank estimate.
    3. 2003 Pricing--As the number of outstanding physical municipal 
securities continues to decline, the volume of coupons and bonds 
presented for collection also declines. New issues of bearer municipal 
securities effectively ceased in 1983 when the Tax Equity and Fiscal 
Responsibility Act of 1982 removed tax advantages for investors. To 
simplify the pricing structure in a small and rapidly declining 
business, the Reserve Banks are eliminating the practice of charging 
variable cash letter and coupon envelope prices and establishing a 
single price regardless of deposit size. Specifically, the Reserve 
Banks are establishing a single fee per cash letter of $13.00 and a 
single fee per coupon envelope of $4.50. In addition, the Reserve Banks 
are implementing a $15.00 increase (75.0 percent), from $20 to $35, in 
the return-item fee and a $15 increase (38.0 percent), from $40 to $55, 
in the bond-collection fee. The Reserve Banks project that the noncash 
collection service will recover 110.3 percent of total costs, including 
imputed expenses and targeted ROE, in 2003. The Board believes that the 
Reserve Banks' projections are reasonable.

G. Special Cash Services

    Special cash services represent a small portion (less than one 
tenth of one percent) of overall priced services provided by the 
Reserve Banks to

[[Page 67843]]

depository institutions. In 2002, special cash services included 
wrapped coin, nonstandard packaging of currency orders and deposits, 
and registered mail shipments of currency and coin. The two offices 
that offered registered mail shipments discontinued this service in 
2002. The one office that currently offers wrapped coin will 
discontinue this service in 2003. In 2004, nonstandard packaging of 
currency will be the only remaining special cash service. Table 13 
presents the actual 2001, estimated 2002, and projected 2003 cost-
recovery performance for special cash services.

                         Table 13.--Special Cash Pro Forma Cost and Revenue Performance
                                                  [$ millions]
----------------------------------------------------------------------------------------------------------------
                                                                                                    5 Recovery
              Year                   1 Revenue        2 Total      3 Net income    4 Target ROE     rate after
                                                      expense          (ROE)                        target ROE
                                  ..............  ..............           [1-2]  ..............       [1/(2+4)]
---------------------------------
2001............................             2.3             2.1             0.2             0.1          103.3%
2002 (estimate).................             1.4             1.4            -0.1             0.1           91.1%
2003 (budget)...................             0.4             0.5             0.0             0.1           77.5%
----------------------------------------------------------------------------------------------------------------

    1. 2001 Performance--In 2001, special cash services recovered 103.3 
percent of total expenses, including imputed expenses and targeted ROE, 
compared with a targeted recovery rate of 104.4 percent.
    2. 2002 Performance--Through August 2002, special cash services 
recovered 103.2 percent of total expenses, including imputed expenses 
and targeted ROE. For full-year 2002, the Reserve Banks estimate that 
recovery for special cash services will decline to 91.1 percent, 
compared with a targeted recovery rate of 103.8 percent. The estimated 
underrecovery is due primarily to the Kansas City and Helena offices 
discontinuing registered mail shipments of currency in 2002. Kansas 
City discontinued this service in August 2002 primarily because of 
rising insurance and postage rates. In response to these increasing 
costs, the office increased the surcharge for registered mail 
shipments, which resulted in a significant volume decline, though 
Kansas City will continue to incur support costs for the remainder of 
the year. Helena discontinued the registered mail service in October 
2002 and will continue to incur support charges for the remainder of 
the year. In addition, coin-wrapping volume in Helena is down 23.0 
percent from its 2002 budgeted volumes.
    3. 2003 Pricing--For 2003, the Reserve Banks project that special 
cash services will recover 77.5 percent of costs, including imputed 
expenses and targeted ROE. Relative to 2002 estimates, total costs are 
projected to decrease $0.9 million, or 60.0 percent, and revenue is 
expected to decrease $0.9 million, or 67.6 percent. Helena will 
discontinue the coin-wrapping service in 2003 and expects coin-wrapping 
volumes to decline significantly during the transition period, though 
it will continue to incur support costs through the end of 2003. The 
Board believes that the Reserve Banks' projections are reasonable.

II. Private-Sector Adjustment Factor

A. Background

    Each year, as required by the Monetary Control Act of 1980, the 
Reserve Banks set fees for priced services provided to depository 
institutions. These fees are set to recover, over the long run, all 
direct and indirect costs and imputed costs, including financing costs, 
return on equity (profit), taxes, and certain other expenses that would 
have been incurred if a private business firm provided the services. 
These imputed costs are based on data developed in part from a model 
comprising consolidated financial data for the nation's fifty largest 
bank holding companies (BHCs).\19\ The imputed costs and imputed profit 
are collectively referred to as the PSAF. In a comparable fashion, 
investment income is imputed and netted with related direct costs 
associated with clearing balances to estimate net income on clearing 
balances (NICB).
---------------------------------------------------------------------------

    \19\ The peer group of the fifty largest bank holding companies 
is selected based on total deposits.
---------------------------------------------------------------------------

    1. Private Sector Adjustment Factor--The method for calculating the 
financing and equity costs in the PSAF requires determining the 
appropriate levels of debt and equity to impute and then applying the 
applicable financing rates. This process requires developing a pro 
forma priced services balance sheet using actual Reserve Bank assets 
and liabilities associated with priced services and imputing the 
remaining elements that would exist if the Reserve Banks' priced 
services were provided by a private sector business firm.
    The amount of the Reserve Banks' assets that will be used to 
provide priced services during the coming year is determined using 
Reserve Bank information on actual assets and projected disposals and 
acquisitions. The priced portion of mixed-use assets is determined 
based on the allocation of the related depreciation expense. The priced 
portion of actual Reserve Bank liabilities consists of balances held by 
Reserve Banks for clearing priced services transactions (clearing 
balances), estimated based on historical data, and other liabilities 
such as accounts payable and accrued expenses.
    Long-term debt is imputed only when core clearing balances and 
long-term liabilities are not sufficient to fund long-term assets or if 
the interest rate risk sensitivity analysis indicates that estimated 
risk will exceed a change in cost recovery of more than two percentage 
points.\20\, \21\ Short-term debt is imputed only when 
clearing balances not used to finance long-term assets and short-term 
liabilities are not sufficient to fund short-term assets. Equity is 
imputed to meet the FDIC definition of a well-capitalized institution, 
which is currently 5 percent of total assets and 10 percent of risk-
weighted assets.
---------------------------------------------------------------------------

    \20\ A portion of clearing balances is used as a funding source 
for priced services assets. Long-term assets are partially funded 
from an initial core amount of $4 billion clearing balances. Core 
clearing balances are considered the portion of the balances that 
has remained stable over time without regard to the magnitude of 
actual clearing balances.
    \21\ The PSAF methodology includes an analysis of interest rate 
risk sensitivity, which compares rate-sensitive assets with rate-
sensitive liabilities and measures the effect on cost recovery of a 
change in interest rates of up to 200 basis points.
---------------------------------------------------------------------------

    a. Financing Rates--When needed to impute short-and long-term debt, 
the debt rates are derived based on these elements in the BHC model. 
Equity financing rates are based on the average

[[Page 67844]]

of the return on equity (ROE) results of three economic models using 
data from the BHC model.\22\
---------------------------------------------------------------------------

    \22\ The pre-tax return on equity (ROE) is determined using the 
results of the comparable accounting earnings model (CAE), the 
discounted cash-flow model (DCF), and the capital asset pricing 
model (CAPM). Within the CAPM and DCF models, the ROE is weighted 
based on market capitalization, and within the CAE model, the ROE 
calculation is equally weighted. The results of the three models are 
averaged to impute the PSAF pre-tax ROE.
---------------------------------------------------------------------------

    For simplicity, given that federal corporate tax rates are 
graduated, state tax rates vary, and various credits and deductions can 
apply, a specific tax rate is not calculated for Reserve Bank priced 
services. Instead, the use of a pre-tax ROE captures imputed taxes. The 
resulting ROE influences the dollar level of the PSAF and Federal 
Reserve price levels because this is the return a shareholder would 
expect in order to invest in a private business firm. The use of the 
pre-tax return on equity assumes 100 percent recovery of expenses, 
including the targeted return on equity. The recommended PSAF is, 
therefore, based on a matching of revenues and actual and imputed 
costs. Should the pre-tax earnings be greater or less than the targeted 
ROE, the PSAF is adjusted for the tax expense or savings associated 
with the adjusted recovery. The imputed tax rate is the median of the 
rates paid by the BHCs over the past five years adjusted to the extent 
that BHCs have invested in municipal bonds.
    b. Other Costs--The PSAF also includes the estimated priced 
services-related expenses of the Board of Governors and imputed sales 
taxes based on Reserve Bank expenses. An assessment for FDIC insurance, 
when required, is imputed based on current FDIC rates and projected 
clearing balances held with the Federal Reserve.
    2. Net Income on Clearing Balances--The NICB calculation is made 
each year along with the PSAF calculation and is based on the 
assumption that Reserve Banks invest clearing balances net of imputed 
reserve requirements and balances used to finance priced-services 
assets. Based on these net clearing balance levels, Reserve Banks 
impute an investment in three-month Treasury bills. The calculation 
also involves determining the priced services cost of earnings credits 
(amounts available to offset future service fees) on contracted 
clearing balances held, net of expired earnings credits, based on the 
federal funds rate. The rates and clearing balance levels used in the 
NICB estimate are based on the actual rates and balances from the six 
months before the calculation date. Because clearing balances are held 
for clearing priced services transactions, they are directly related to 
priced services. Therefore, the net earnings or expense attributed to 
the imputed Treasury-bill investments and the cost associated with 
holding clearing balances are considered net income for priced services 
activities.

B. Discussion

    The increase in the 2003 PSAF is primarily due to a significant 
increase in clearing balances on which investments in marketable 
securities are imputed and the resulting increase in total assets. 
Because required imputed equity is based on five percent of total 
assets, priced services equity and cost of equity increased.
    1. Asset Base--The total estimated cost of Federal Reserve assets 
to be used in providing priced services is reflected in table 14. Total 
assets have increased $3,664.3 million, or 30.9 percent. Growth of 
$3,416.9 million in imputed investments in marketable securities and 
$365.3 million in imputed reserve requirements, which are based on the 
level of clearing balances, explains the majority of this increase. 
These increases are offset by a decrease of $166.5 million in items in 
process of collection.
    While assets financed through the PSAF such as premises, 
receivables, and prepaid expenses have decreased, most priced service 
assets, including the prepaid pension costs, furniture and equipment, 
and Board of Governors' assets have increased. Table 15 shows that the 
short-term assets funded with short-term payables and clearing balances 
total $103.8 million. This amount represents a decrease of $9.5 
million, or 8.4 percent, from the short-term assets funded in 2002. 
Long-term assets funded with long-term liabilities, equity, and core 
clearing balances are projected to total $1,537.4 million. This amount 
represents an increase of $58.1 million, or 3.9 percent, from the long-
term assets funded in 2002. Growth of $35.9 million in prepaid pension 
costs explains the majority of the increase, while increases in Reserve 
Bank leasehold improvements and long-term prepayments and furniture and 
equipment assets explain an additional $23.5 million. These increases 
are offset by a decrease of $1.3 million in Reserve Bank premises 
assets.
    2. Debt and Equity Costs and Taxes--As previously mentioned, core 
clearing balances from the NICB calculation are available as a funding 
source for priced services assets. Table 15 shows that $503.9 million 
in clearing balances are used to fund priced services assets in 2003. 
The interest rate sensitivity analysis in table 16 indicates that 
potential T-bill and federal funds rate decreases of 200 basis points 
produce a decrease in cost recovery of 0.4 percentage points. The 
established threshold for change to cost recovery is two percentage 
points; therefore, interest rate risk associated with using these 
balances is within acceptable levels and no long-term debt is imputed.
    Table 17 shows the imputed PSAF elements, the pre-tax return on 
equity, and other required PSAF recoveries approved for 2003 and 2002. 
The significant increase in clearing balances from which marketable 
security investments are imputed increases total assets. An increase in 
total assets, and the resulting increase in imputed equity, increases 
expenses associated with the return on equity. Although the pre-tax 
return on equity rate decreased from 22.1 percent for 2002 to 19.4 
percent for 2003, with increased imputed equity, the pre-tax return on 
equity increased $19.6 million. As indicated previously, the pre-tax 
return on equity is calculated using the combined results of three 
models. The effective tax rate used in 2003 also increased to 30.4 
percent from 29.3 percent in 2002.
    3. Capital Adequacy and FDIC Assessment--As shown in table 18, the 
amount of equity imputed for the 2003 PSAF is $775.6 million, an 
increase of $183.3 million from imputed equity of $592.3 million in 
2002. As noted above, equity is based on 5 percent of total assets, as 
required by the FDIC for a well-capitalized institution in its 
definition for purposes of assessing insurance premiums. In both 2003 
and 2002, the capital to risk-weighted asset ratio and the capital to 
total assets ratio both exceed regulatory guidelines. As a result, no 
FDIC assessment is imputed for either year.

III. Analysis of Competitive Effect

    All operational and legal changes considered by the Board that have 
a substantial effect on payments system participants are subject to the 
competitive impact analysis described in the March 1990 policy 
statement ``The Federal Reserve in the Payments System.'' \23\ Under 
this policy, the Board assesses whether the proposed 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

[[Page 67845]]

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.
---------------------------------------------------------------------------

    \23\ Federal Reserve Regulatory Service 7-145.2.
---------------------------------------------------------------------------

    The 2003 fees result in a projected ROE below the target 
established using a model that is based, in part, on the consolidated 
results over time of the largest fifty bank holding companies. To the 
extent that these bank holding companies expect a mature, declining 
business, such as check processing, to have the same return on equity 
as the organization as a whole, the Reserve Banks' underrecovery could 
have an adverse competitive effect. Given the current market 
environment, however, greater fee increases are not likely to 
materially improve the Reserve Banks' cost recovery and might even 
reduce the revenue that the Reserve Banks receive as depository 
institutions seek lower-cost alternatives. Overall, the Board believes 
that the proposed fees are reasonable.
BILLING CODE 6210-01-P

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[[Page 67858]]



    By order of the Board of Governors of the Federal Reserve 
System, October 31, 2002.
Jennifer J. Johnson,
Secretary of the Board.
[FR Doc. 02-28116 Filed 11-6-02; 8:45 am]
BILLING CODE 6210-01-C