[Federal Register Volume 68, Number 104 (Friday, May 30, 2003)]
[Notices]
[Pages 32513-32517]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-13505]



[[Page 32513]]

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FEDERAL RESERVE SYSTEM

[Docket No. R-1152]


Federal Reserve Bank Services; Imputed Investment Income on 
Clearing Balances

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Notice with request for comments.

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SUMMARY: The Board requests comment on a proposal to modify the method 
for imputing priced-service income from clearing balance investments. 
The Federal Reserve Banks impute this income when setting fees and 
measuring actual cost recovery each year.
    Specifically, the Board requests comment on a proposal to impute 
the income from its clearing balance investments on the basis of a 
broader portfolio of investment instruments than used today, selected 
from instruments available to banks and subject to a portfolio 
management framework. Selection of the portfolio mix would be subject 
to a risk-management framework that includes criteria consistent with 
those used by bank holding companies and regulators in evaluating 
investment risk. The Board also requests comment on two different 
implementation methods for imputing this investment income.
    This proposal focuses on the imputed investment of clearing 
balances; it would not change the terms or conditions under which 
depository institutions hold clearing balances. If adopted, the changes 
would be effective for the 2004 fees for Federal Reserve priced 
services.

DATES: Comments must be submitted on or before July 14, 2003.

ADDRESSES: Comments, which should refer to Docket No. R-1152, may be 
mailed to Ms. Jennifer J. Johnson, Secretary, Board of Governors of the 
Federal Reserve System, 20th and C Streets, NW., Washington, DC 20551. 
However, because paper mail in the Washington area and at the Board of 
Governors is subject to delay, please consider submitting your comments 
by e-mail to [email protected] or faxing them to the 
Office of the Secretary at 202/452-3819 or 202/452-3102. Members of the 
public may inspect comments in Room MP-500 between 9 a.m. and 5 p.m. 
weekdays, pursuant to Sec.  261.12, except as provided in Sec.  261.14 
of the Board's Rules Regarding Availability of Information, 12 CFR 
261.12 and 261.14.

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. 
Telecommunications Device for the Deaf (TDD) users may contact 202/263-
4869.

SUPPLEMENTARY INFORMATION:

I. Background

    The Monetary Control Act (MCA) requires Federal Reserve Banks to 
establish fees for ``priced services'' provided to depository 
institutions at a level necessary to recover, over the long run, all 
direct and indirect costs actually incurred and imputed costs.\1\,\2\ 
In addition, the Reserve Banks impute a priced services return on 
capital (profit).\3\ The imputed costs and imputed profit are 
collectively referred to as the private-sector adjustment factor 
(PSAF). Just as the PSAF is used to impute costs that would have been 
incurred and profits that would have been earned had services been 
provided by a private business firm rather than the central bank, the 
Reserve Banks impute income that would have been earned on the 
investment of clearing balances customers hold with the Reserve Banks 
had those balances been held by a private business firm. This imputed 
income, less the costs associated with the clearing balances, is 
referred to as the net income on clearing balances (NICB).
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    \1\ Priced services include primarily check, automated 
clearinghouse, Fedwire funds transfer, and Fedwire securities 
services.
    \2\ Imputed costs include financing costs, taxes, and certain 
other expenses that would be incurred if a private business firm 
provided the services.
    \3\ The return on capital is imputed using the average of the 
results of three economic models, the comparable accounting earnings 
model, the discounted cash-flow model, and the capital asset pricing 
model.
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    Since 2002, the imputed elements of the Reserve Bank pricing 
process reflected in the PSAF and NICB calculations have become more 
integrated. For example, by using a small portion of the investable 
clearing balances as a financing source for the assets used in the 
delivery of priced services, the financing costs embedded in the PSAF 
are reduced. This proposal extends the review of the key features of 
the methods for computing the imputed elements.
    Calculating the PSAF includes projecting the level of priced-
services assets, determining the financing mix used to fund the assets, 
and the rates used to impute financing costs.\4\ Much of the data for 
the PSAF are developed from the ``bank holding company (BHC) model,'' a 
model that contains consolidated financial data for the nation's fifty 
largest (based on deposit balances) BHCs.\5\ As part of this process, a 
core amount of clearing balances is considered stable and available to 
finance long-term assets.\6\
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    \4\ Equity is imputed based on the Federal Deposit Insurance 
Corporation's (FDIC) definition of a ``well-capitalized'' 
institution for insurance premium purposes.
    \5\ The top fifty BHCs are used as the data peer group as they 
are considered to be the private-sector providers of services most 
analogous to the Reserve Bank priced-services activities.
    \6\ The Board classified clearing balances of $4 billion as core 
beginning with the 2002 price-setting. Core balances have not fallen 
below $4 billion since 1992. (66 FR 52617, October 16, 2001)
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    The method for deriving the NICB is reviewed periodically to ensure 
that it is still appropriate in light of changes that may have occurred 
in Reserve Bank priced services activities, accounting standards, 
finance theory, regulatory practices, and banking activity.\7\ The 
current methodology for imputing investment income assumes that the 
Reserve Banks invest all clearing balances, net of imputed reserve 
requirements and the amount necessary to finance long-term assets, in 
three-month Treasury bills. The imputed income on the Treasury-bill 
investments net of the actual earnings credits granted to clearing 
balance holders based on the federal funds rate is considered income or 
expense for priced-services activities. The net income associated with 
clearing balances is one component in pricing decisions and in 
evaluating cost recovery.
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    \7\ In 1994, the Board requested comment on a proposal to modify 
the methodology for imputing clearing balance income. The Board 
proposed replacing the three-month Treasury-bill imputed investment 
with a longer-term Treasury investment based on the earning asset 
maturity structure of the largest BHCs. As a result of issues 
related to interest rate risk raised in the comments, the Board did 
not adopt the proposal. The proposal would have created an asset and 
liability mismatch that created interest rate risk exposure 
inappropriate for Federal Reserve priced services. In addition, 
Federal Reserve priced services would not have assumed the interest 
rate risk associated with longer-maturity investments because the 
imputed return would have been adjusted monthly to reflect current 
rates. (59 FR 42832, August 19, 1994)
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A. Clearing Balances

    Depository institutions may hold both reserve and clearing balances 
with the Federal Reserve Banks.\8\ Reserve balances are held pursuant 
to a regulatory requirement and are not a result of an institution's 
use of priced

[[Page 32514]]

services.\9\ Clearing balances were introduced when Reserve Banks 
implemented the MCA of 1980, which required the Federal Reserve to 
price its payment services and broadened direct access to those 
services to include institutions that previously did not have a Federal 
Reserve balance requirement. Clearing balances are held to settle 
transactions arising from use of Federal Reserve priced services for 
institutions that either do not hold reserve balances or find their 
reserve balances inadequate to settle their transactions. At year-end 
2002, depository institutions held more than $10 billion in clearing 
balances at Reserve Banks.
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    \8\ ``Clearing balances,'' unless otherwise indicated, refers to 
total clearing balances including contracted balances and balances 
in excess of the contracted amount, held by depository institutions 
with the Federal Reserve Banks.
    \9\ Regulation D, 12 CFR part 204.
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    Clearing balances held at Reserve Banks are similar to compensating 
balances held by respondent banks at correspondent banks. Respondent 
banks hold compensating balances to support the settlement of payments, 
as well as for other purposes. Reserve Banks and some correspondent 
banks establish a contractual balance level that the account holder 
must maintain on average over a specified period. Both Reserve Banks 
and correspondent banks provide compensation in the form of earnings 
credits to the holders of clearing or compensating balances. Earnings 
credits provided by the Reserve Banks are based on the federal funds 
rate and the contracted level of clearing balances. Reserve Bank 
earnings credits are not paid on any clearing balances held in excess 
of the contracted amount, they can only be used to pay fees for priced 
services, and they must be used within one year or they are forfeited. 
Correspondent banks use a similar approach to calculate earnings 
credits as compensation for respondent balances. Correspondent bank 
earnings credits are determined based on a variety of rates, including 
Treasury bill, federal funds, and others. Recognizing that Reserve 
Banks may compensate for balances at a different rate than 
correspondent banks, the Board requests comment on whether the Board 
should consider modifications to the Reserve Banks' earnings credit 
rate in the future, and, if so, what factors should be considered in 
the evaluation.

B. Imputed Investment of Clearing Balances

    The Reserve Banks impute income on the clearing balance investments 
rather than using the actual results from monetary policy investment 
activities.\10\ The imputation of clearing balance income is analogous 
to assuming that the priced-services enterprise, which is essentially a 
``monoline'' bank offering only payment services, also includes a 
treasury function.
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    \10\ Decisions about monetary policy investment transactions are 
not motivated by profit objectives; therefore, the actual investment 
results are not applicable to priced-service activities.
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    Income is currently imputed based on the assumption that all 
available clearing balances are invested in three-month Treasury 
bills.\11\ The Board chose three-month Treasury bills as the imputed 
investment vehicle because, at that time, the yield was considered to 
approximate the return that would be realized had clearing balance 
funds been held and invested by a private business firm. In addition to 
providing a short-term earnings rate consistent with creating a matched 
asset and liability structure with the short-term liabilities, the 
ninety-day Treasury-bill yield data are easily verified by outside 
observers with publicly available data.
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    \11\ Clearing balances needed to meet an imputed reserve 
requirement (10 percent of clearing balances) and to ``fund'' assets 
used in the production of priced services ($504 million in 2003) are 
not available for investment.
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II. Discussion

    Table 1 presents the spread of the three-month Treasury bill rate 
compared to the federal funds rate for the past twenty years. As the 
table shows, the current practice of imputing clearing balance 
investments in three month Treasury-bills while paying earnings credits 
at the federal funds rate has resulted in an average negative interest 
rate spread of 27 basis points over the past twenty years with an 
average standard deviation over the same period of 28 basis points.\12\ 
The spread of the earnings rate imputed on clearing balances versus the 
rate for the cost of earnings credits has ranged from 8 basis points to 
-88 basis points over that period.\13\ As a result of the average 
negative spread, most of the net income on clearing balances recognized 
during these years was the result of imputed earnings on excess 
balances held, which have no associated cost.
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    \12\ The standard deviation measures the variance around the 
average and indicates the level of volatility of the rates. Two-
thirds of the time the actual yield will fall in the range of the 
average plus or minus one standard deviation. Ninety-five percent of 
the time the actual yield is expected to fall in the range of the 
average plus or minus two standard deviations.
    \13\ Although not represented here because of simplifying 
assumptions, some of the volatility in actual NICB is a result of 
changes in rates and changes in contracted and excess clearing 
balance levels.

                   Table 1.--Spread From Federal Funds
------------------------------------------------------------------------
                                                                T-bills
                             Year                              (current)
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1983.........................................................      -0.23
1984.........................................................      -0.27
1985.........................................................      -0.27
1986.........................................................      -0.50
1987.........................................................      -0.72
1988.........................................................      -0.88
1989.........................................................      -0.79
1990.........................................................      -0.29
1991.........................................................       0.08
1992.........................................................       0.08
1993.........................................................       0.05
1994.........................................................      -0.05
1995.........................................................      -0.15
1996.........................................................      -0.13
1997.........................................................      -0.28
1998.........................................................      -0.38
1999.........................................................      -0.26
2000.........................................................      -0.30
2001.........................................................      -0.06
2002.........................................................       0.01
                                                              ----------
Average......................................................      -0.27
                                                              ----------
Standard deviation...........................................       0.28
------------------------------------------------------------------------

    Although basic finance theory suggests a direct relationship 
between risk and earnings where earnings increase, on average, with the 
amount of risk incurred, a minor change to the current imputed 
investments could significantly increase earnings and decrease 
volatility. For example, investing in a simple portfolio of overnight 
loans to financial institutions (federal funds) would simultaneously 
eliminate the interest rate spread and reduce the volatility, as 
expressed by the standard deviation, to zero.\14\ The results of an 
investment in federal funds demonstrate that the current investment 
assumption imputes less income than could be easily achieved with a 
low-risk alternative. Consequently, the Board believes that the current 
method may impute an inappropriately low NICB to priced services. The 
Board notes that financial institutions, such as correspondent banks 
and bank holding companies (BHCs), invest in a much wider array of 
instruments than that imputed by the Federal Reserve, including loans, 
Treasury securities with longer maturities, government agency 
securities, federal funds, commercial bonds, commercial paper, money 
market mutual funds, asset-backed securities, gold, foreign

[[Page 32515]]

currencies, repurchase agreements, and derivatives.
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    \14\ While reducing interest rate risk, a change in investment 
from Treasury bills to federal funds would increase credit risk. As 
a practical matter, however, banks have not incurred losses due to 
default in federal funds transactions.
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    The Board requests comment on a proposal to impute the income on 
clearing balances from a broader portfolio of acceptable investment 
instruments, allocated within the constraints imposed by criteria used 
by BHC and regulators to evaluate investment risk. The Board also 
requests comment on two different implementation methods for imputing 
investments and the related income.

A. Investment Instruments

    As noted in the Background section, the top fifty BHCs (based on 
deposits) were selected as the closest private-sector peer group for 
Reserve Bank priced services. Because the BHCs are a proxy for 
providers of priced-services activities, options for Reserve Bank 
priced services clearing balance investments should be comparable to 
those available to bank holding companies. In principle, all of the 
investment instruments available to bank holding companies could be 
appropriate clearing balance investments. The Board requests comment on 
whether investment options for Federal Reserve priced services should 
include all investment instruments permitted by regulators for bank 
holding companies.
    In practice, the Federal Reserve proposes to limit its imputed 
investments to federal funds; investments suitable for a buy-and-hold 
strategy, such as Treasury securities, government agency securities, 
commercial paper, and municipal and corporate bonds; and money market 
and mutual funds.\15\ For investments with a fixed term, this strategy 
eliminates capital gains and losses from the investment returns and 
simplifies the recognition and reporting of imputed investment income. 
Realized gains and losses on imputed mutual fund investments would be 
incorporated in the total return and recorded as net earnings. The 
Board requests comment on whether this investment strategy is 
appropriate.
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    \15\ Mutual fund investments would be selected from those that 
are publicly available and widely held. The specific funds used for 
imputing income would be disclosed during the price setting process 
so that performance could be tracked and replicated.
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B. Risk-Management Framework

    To ensure that the imputed investments are indeed comparable to the 
investments of a similar private-sector entity, the Board believes that 
a risk-management framework should be established to limit the imputed 
investments to prudent levels in accordance with sound business 
practice and regulatory constraints. The exposure to any one type of 
risk, measured in terms of earnings or equity at risk, would be 
limited. The Reserve Banks currently use two risk measures in 
calculating the PSAF that manage liquidity and interest rate risk. The 
Board requests comment on two additional measures that would be part of 
the risk-management framework for the imputed investment of clearing 
balances, one to manage the longer-term effects of interest rate risk 
and another to manage credit risk. In addition, the Board requests 
comment on any other risk-management criteria that should be 
considered.
1. Liquidity Risk
    While clearing balances are contractually short term in nature, a 
portion of clearing balances can be considered as core deposits that 
are expected to remain stable over time. When it made changes to the 
PSAF method, the Board determined that core clearing balances, which it 
initially established at $4 billion, should be available to finance 
long-term assets used in the delivery of priced services, rather than 
invested only in short-term assets. (66 FR 52617, October 16, 2001) 
Limiting the use of clearing balances to finance long-term assets to 
only that portion that is deemed core clearing balances effectively 
manages liquidity risk. The Board proposes that the portion of core 
clearing balances not used to finance priced services assets be 
available for imputed investment in longer-term instruments. The Board 
requests comment on whether using core clearing balances for imputed 
longer-term investments is appropriate.
2. Interest Rate Risk
    One aspect of interest rate risk arises when the cost of funds and 
the investment yield on those funds change at different intervals. 
Financing longer-term assets with short-term liabilities at rates that 
do not change concurrently could create unacceptable earnings 
volatility. The Board adopted a method to address interest rate risk as 
part of the recent change in the PSAF methodology. This method 
addresses the risk to earnings in a changing rate environment by 
requiring that longer-term investment of clearing balances be managed 
so that a 200-basis-point change in the rates for the yield on all 
relevant priced services assets--currently the three-month Treasury 
bill rate--and the cost of all relevant priced service liabilities--the 
federal funds rate--would not affect the overall priced services 
recovery rate by more than 200 basis points. The Board intends to 
maintain this risk tolerance as a prudent constraint on the imputed 
investments.
    The Board proposes to adopt a second measure of interest rate risk, 
known as economic value of equity (EVE), for use in conjunction with 
the earnings at risk measure. The EVE measure, which is used by BHCs 
and regulators, compares the present value of interest-bearing assets 
and liabilities in the current rate environment with the prospective 
present value given a change in interest rates; the comparison shows 
the change in present values as a proportion of equity. EVE is used as 
a complement to the interest rate sensitivity analysis already adopted 
to evaluate the effects of long-term mismatches between assets and 
liabilities on the value of an entity; the interest rate sensitivity 
analysis captures the risk to near-term earnings. Large BHCs typically 
manage the EVE measure within a risk-tolerance range of 5 to 10 
percent.\16\ The Board proposes to adopt a risk tolerance of a change 
of 8 percent of equity for a 200-basis-point-rate change. The Board 
requests comment on whether these two measures of interest rate risk, 
earnings at risk and equity at risk, are together sufficient measures 
for monitoring and controlling interest rate risk. The Board also 
requests comment on whether a constraint on the EVE measure limiting 
the effect of a 200 basis point rate change to a change of eight 
percent of equity is an appropriate risk tolerance level.
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    \16\ More information on measurement of interest rate risk can 
be found at http://www.occ.treas.gov/handbook/irr.pdf.
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3. Credit Risk
    Credit risk results from the possibility that the issuer of a bond 
or other borrower cannot repay its obligations as promised. Criteria 
for managing credit risk are necessary when investment instruments 
other than Treasury securities are used. The overall level of credit 
risk compared with the level of equity is measured by the ratio of 
risk-adjusted assets to capital. The FDIC uses two risk-based capital 
measures as criteria in defining a ``well capitalized'' institution for 
insurance premium purposes. One requires a risk-based capital ratio of 
10 percent or more for total capital and the other requires a risk-
based ratio of 6 percent for tier one capital.\17\ Only tangible equity 
capital (tier one capital) is imputed to Reserve Bank priced services; 
therefore, the two measures are the same for priced services. Because 
the current investment

[[Page 32516]]

in three-month Treasury bills carries a risk weight of zero, the 
balance sheet underlying the 2003 PSAF shows that the priced services 
risk-based capital ratio is nearly 33 percent for both measures.\18\ A 
change in investment strategy that includes investments with greater 
risk requires establishing a minimum risk-based total capital ratio 
within which to make investment decisions. As a result, the Board 
proposes to establish a minimum risk-adjusted total capital ratio that 
maintains the ratio of total capital to risk-adjusted assets at a level 
equal to or greater than that maintained by the fifty largest BHCs. 
Between 1997 and 2002 the average risk-adjusted total capital ratio for 
these institutions has remained near 12 percent. Because only tangible 
equity is imputed to priced services, the target ratio for the priced-
services' risk-adjusted assets to tier one capital would be 12 percent, 
well above the average ratio of eight percent maintained by the 
entities in the BHC model. The Board requests comment on whether this 
target ratio adequately limits imputed investment credit risk. The 
Board also requests comment on whether the target ratio should be 10 
percent, the minimum required by the FDIC for a well capitalized 
institution.
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    \17\ http://www.fdic.gov.
    \18\ 67 FR 67834, November 7, 2002.
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C. Implementation Methods

    The Board requests comment on alternative methods to impute 
clearing balance income based on the proposed conceptual framework. The 
first method involves constructing a specific portfolio of hypothetical 
investments, tracking its yield, and ascribing the income to the 
priced-services activities. The second method imputes an investment 
yield expressed as a constant spread over the cost of clearing 
balances, without specifying an underlying portfolio.
1. Constructing a Hypothetical Portfolio
    To construct a hypothetical portfolio, the Reserve Banks would 
select from the investment options described above that are available 
to correspondent banks.
    Selecting the investments and the proportions of the clearing 
balances assigned to each investment requires an allocation method that 
avoids any projections of future economic conditions or interest rate 
environments to address concerns that such forecasts would be viewed as 
a market signal of future monetary policy actions. The Board proposes 
an allocation method that optimizes the portfolio yield within the 
current and proposed risk management framework criteria. This 
allocation would be based on the historical performance of the 
available investment instruments and applied to the upcoming year.
    To avoid the administrative complexities of incorporating realized 
capital gains and losses on an imaginary portfolio in the imputed 
investment results, any investment with a fixed term, such as corporate 
bonds, would be held to maturity.\19\ In addition, the Board proposes 
that adjustments to the portfolio allocation maintain the appropriate 
investment balance to optimize return; however, the amount invested in 
any one instrument could only decrease by the amount of the investment 
maturing that period, or increase by the amount of additional balances 
available for investment.\20\
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    \19\ This results in a ladder approach to determining the 
average yield. For an investment in five-year corporate bonds, for 
example, the average yield would incorporate the yield from bonds 
purchased in increments over the preceding five years.
    \20\ To facilitate public verification of imputed portfolio 
income, the Board would publish the portfolio components and imputed 
investment income on its public website.
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    Hypothetical Portfolio Example. The data in table 2 illustrate the 
results of two hypothetical investment portfolios, both of which meet 
the proposed risk-management framework but have different return and 
volatility profiles.\21\ In both cases, the 1993 portfolios were 
selected from BHC-allowable investments to maximize return using actual 
yield data from 1983 through 1992. The portfolios were rebalanced each 
subsequent year to optimize the return based on the yield data from the 
previous ten years.\22\ That is, for 2002 the portfolio yield reflects 
the actual 2002 yields of assets chosen based on each investment's 
performance from 1992 through 2001. Many variations on the frequency of 
portfolio adjustment and the length of the period from which to base 
yield data used in selecting the portfolio are possible and finance 
theory does not provide clear guidance on the optimal approach. The 
rolling ten-year portfolios performed as well as or better than other 
alternatives examined. For simplicity and comparability, all variables, 
other than the portfolio mix, yield, and federal funds rates, are held 
constant in the models for all years.\23\
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    \21\ For Tables 2 and 3, the following simplifying assumptions 
apply: (1) All clearing balance amounts are held constant throughout 
the analysis period, (2) total clearing balances are $10.5 billion, 
(3) investable balances are $9 billion, and (4) balances eligible 
for earnings credits are $8.6 billion.
    \22\ A ten-year period was selected for illustration purposes 
because the data are available and the period includes a variety of 
interest rate environments.
    \23\ For these reasons, the model results vary from the actual 
results experienced by Federal Reserve priced services.

                   Table 2.--10 Year Yield (1993-2002)
------------------------------------------------------------------------
                                                           A        B
------------------------------------------------------------------------
Average spread over federal funds.....................       54       35
Standard deviation....................................       98       29
Average NICB (millions)...............................    $65.0    $48.3
NICB standard deviation (millions)....................    $87.9    $22.2
------------------------------------------------------------------------

    Example A shows the results of selecting an appropriate portfolio 
within the risk parameters using ten-year historical yield data. The 
investments in portfolio A were chosen to optimize the return without 
placing any constraints on volatility. The imputed return on the 
portfolio yields a spread over federal funds of 54 basis points. The 
composition of portfolio A varies over the ten year period, based on 
the optimum investment mix using the previous ten years' yield data. 
Over this time, it maintains a fairly consistent asset mix composed of 
primarily federal funds, Government National Mortgage Association 
(GNMA) mutual funds, money market mutual funds, and commercial paper. 
Hypothetical portfolio A, however, has a standard deviation of 98 basis 
points. The standard deviation for hypothetical portfolio A 
demonstrates greater volatility than the Reserve Banks experience with 
the current three-month Treasury-bill investment, which has a standard 
deviation of 28 basis points. Because the standard deviation for 
portfolio A, driven by changes in the yield, equates to approximately 
$88 million in NICB, variability in the NICB could range from net 
income of approximately $153 million to a net cost of approximately $23 
million in two-thirds of the years in which the selected portfolio is 
held.
    Example B shows the results of selecting an appropriate portfolio 
based on the same criteria used for portfolio A but constraining the 
volatility in the model to approximately what is currently experienced 
with Treasury bill investments. The imputed return is an average yield 
spread over federal funds of 35 basis points, and has approximately the 
same volatility as currently experienced with three-month Treasury-bill 
investments. Over the ten-year period, the portfolio consists primarily 
of federal funds, commercial paper, money market mutual funds, and

[[Page 32517]]

small investments in twenty-year AAA bonds, GNMA mutual funds, and 
short-term corporate bond mutual funds. Because the standard deviation 
for portfolio B, driven by changes in the yield, equates to 
approximately $22 million in NICB, variability in the NICB could range 
from $70 million to $26 million in two-thirds of the years in which the 
selected portfolio is held.
    The Board recognizes that a portfolio could be constructed that 
would have less volatility than hypothetical portfolio B and that such 
a portfolio would be expected to have a lower yield than hypothetical 
portfolio B. Priced services management finds the NICB volatility that 
has been associated with the current three-month Treasury-bill 
investment strategy acceptable, however, and would not choose a 
portfolio with lower volatility if it generated a lower yield. On the 
other hand, given the multi-year cost recovery horizon, priced services 
management might choose a portfolio with greater volatility than 
hypothetical portfolio B if it generated sufficiently greater yield.
    The Board requests comment on the proposed method for selecting and 
adjusting a hypothetical portfolio. In particular, the Board requests 
comment on whether private sector providers face additional market-
driven volatility constraints that should be considered when allocating 
among imputed assets.
2. Imputing a Constant Spread
    During the development of this proposal, the Federal Reserve met 
with a group of representatives from banks, corporate credit unions, 
and their trade associations to obtain information about institution 
investment practices.\24\ These representatives commented that 
construction of a risk-management framework and hypothetical portfolio 
appears unduly complex for imputing income from hypothetical 
investments and suggested that a constant basis point calculation could 
be simpler and provide similar results. Because the cost of clearing 
balances is based on the federal funds rate, they suggested that the 
NICB calculation impute investment income based on a clearing balance 
investment yield expressed as a constant spread over the federal funds 
rate. The representatives commented that this approach would be easier 
to understand, administer, and monitor.
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    \24\ The advisory group included participants from the American 
Bankers Association, the Independent Community Bankers Association, 
and the Association of Corporate Credit Unions.
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    Using a constant spread over the federal funds rate to impute the 
income from investing clearing balances would, by definition, not 
reflect the actual variability between the investment yield and the 
cost of funds that would occur with the hypothetical portfolio. As 
demonstrated by the variation in the average rate spread and volatility 
between portfolios A and B, both of which met the risk management 
constraints, constant spreads of varying amounts could be defended as 
appropriate. Further, finance theory suggests that a discount to the 
constant rate might be required to essentially buy the consistency that 
is produced by a constant spread method.
    The Board proposes that if a constant spread is used, it be based 
upon a method that reviews allowable investment returns over time and 
holds the selected investments over time. One such method would be to 
use the results of one of the hypothetical portfolios above to 
determine the constant spread to impute over a future period.
    Table 3 demonstrates NICB results when imputing a constant spread 
return over the ten years from 1993 through 2002 using the average 
spread of 35 basis points from portfolio B in Table 2. While the 
average NICB is about the same, the volatility is decreased 
significantly. The volatility experienced with the constant spread 
approach is limited to the volatility in the earnings on the amount of 
excess clearing balance investments due to the change in the federal 
funds rate, whereas the volatility associated with hypothetical 
portfolio B also includes the result of changes in the spread between 
the portfolio yield and the federal funds rate.

                             Table 3.--NICB
                               [Millions]
------------------------------------------------------------------------
                                                    Portfolio   Constant
                       Year                             B        spread
------------------------------------------------------------------------
1993..............................................      $55.8      $42.3
1994..............................................       11.4       46.5
1995..............................................       67.7       52.4
1996..............................................       29.8       50.5
1997..............................................       50.1       51.0
1998..............................................       48.9       50.7
1999..............................................       18.7       49.3
2000..............................................       61.9       53.8
2001..............................................       56.2       45.4
2002..............................................       82.5       37.5
Average...........................................       48.3       48.0
Standard deviation................................       22.2        5.1
------------------------------------------------------------------------

    The Board requests comment on whether a long-run average spread 
over federal funds would be an appropriate basis on which to impute 
income and, if so, how to take into account the reduced volatility 
provided by this method compared to the hypothetical portfolio method.

III. Competitive Impact Analysis

    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.'' \25\ 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 power 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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    \25\ FRRS 7-145.2.
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    This proposal is intended to expand the investment instruments 
assumed in the NICB calculation to resemble more closely investments 
pursued by bank holding companies, the services of which are considered 
to most closely resemble the services provided by Reserve Banks. 
Imputed investment decisions would be made within a framework that 
incorporates risk-management measures used in industry and regulatory 
practice. 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.

    By order of the Board of Governors of the Federal Reserve 
System, May 23, 2003.
Jennifer J. Johnson,
Secretary of the Board.
[FR Doc. 03-13505 Filed 5-29-03; 8:45 am]
BILLING CODE 6210-01-P