[Federal Register Volume 68, Number 208 (Tuesday, October 28, 2003)]
[Notices]
[Pages 61413-61418]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-27124]


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FEDERAL RESERVE SYSTEM

[Docket No. R-1152]


Federal Reserve Bank ServicesImputed Investment Income on 
Clearing Balances

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Notice.

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SUMMARY: The Board has approved modifications to the method for 
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. The Reserve Banks will impute 
the income from clearing balance investments on the basis of a broader 
portfolio of investments than used previously, selected from those 
available to banks. The Reserve Banks will impute an investment return 
expressed as a constant annual spread over the rate used to determine 
the cost of clearing balances. The constant annual spread will be 
determined based on an underlying imputed investment portfolio. 
Selection of the portfolio investment mix will be subject to a risk-
management framework that includes criteria consistent with those used 
by banks, bank holding companies, and regulators in evaluating 
investment risk. The revised method will be used to impute investment 
income on clearing balances beginning in January 2004.

FOR FUTHER 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

[[Page 61414]]

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 the 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 that 
customers hold with the Reserve Banks as if those balances had been 
held with a correspondent bank. 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.
    \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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    Calculating the PSAF includes projecting the level of priced-
services assets, determining the financing mix used to finance 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. As part of 
this process, a core amount of clearing balances is considered stable 
and available to finance long-term assets.
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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.
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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.\5\ The 
current method for imputing investment income assumes that the Reserve 
Banks invest all clearing balances, net of imputed reserve requirements 
and the amount used to fund priced-services 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 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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    \5\ In 1994, the Board requested comment on a proposal to modify 
the method 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.6 7 Reserve balances are held 
pursuant to a regulatory requirement and are not a result of an 
institution's use of priced services.\8\ 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.\9\ At year-
end 2002, depository institutions held more than $10 billion in 
clearing balances at Reserve Banks.
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    \6\ Clearing balances were introduced when Reserve Banks 
implemented the MCA.
    \7\ Clearing balances, unless otherwise indicated, refer to 
total clearing balances, including contracted balances and balances 
in excess of the contracted amount, held by depository institutions 
with the Federal Reserve Banks.
    \8\ Regulation D, 12 CFR part 204.
    \9\ Many depository institutions also set their contracted 
clearing balance level to generate earnings credits needed to pay 
fees assessed for Reserve Bank priced services.
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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, 
and to pay fees assessed by the correspondent bank. Reserve Banks and 
some correspondent banks establish a contracted 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. Historically, earnings credits provided by the Reserve Banks 
have been based on the federal funds rate. In May 2003, the Board 
requested comment on whether it should consider modifications to the 
Reserve Banks' earnings credit rate in the future, and, if so, what 
factors should be considered in the evaluation.\10\ One commenter 
stated that the Federal Reserve should evaluate the appropriateness of 
its earnings credit rate as part of its overall pricing of services, 
including a review of private sector practice. The Board recently 
changed the earnings credit rate to be based on a discounted three-
month Treasury bill rate, which is now more consistent with market 
practice.\11\
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    \10\ 68 FR 32513, May 30, 2003.
    \11\ More specifically, the earnings credit rate will be 90 
percent of a rolling 13-week average of the annualized coupon 
equivalent yield of three-month Treasury bills in the secondary 
market. See companion notice, Federal Reserve Bank Services, 
elsewhere in today's Federal Register.
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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.\12\ 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. Income is currently imputed based on the assumption 
that all available clearing balances are invested in three-month 
Treasury bills.13 14
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    \12\ Decisions about monetary policy investment transactions are 
not motivated by profit objectives; therefore, the actual investment 
results are not applicable to priced-service activities.
    \13\ 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 ($407 million in 2004) are 
not available for investment.
    \14\ The Board chose three-month Treasury bills as the imputed 
investment vehicle in 1982 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 correspondent 
bank. In addition to providing a short-term earnings rate consistent 
with creating a matched asset and liability structure with the 
short-term liabilities, the three-month Treasury bill yield data are 
easily verified by outside observers with publicly available data.
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    Historically, most of the net income on clearing balances was the 
result of imputed earnings on excess balances held, which have no 
associated cost. The practice of imputing clearing balance investments 
in three-month Treasury bills while paying earnings credits at the 
federal funds rate resulted in an average interest rate spread of 
negative 18 basis points over the past twenty years with a standard 
deviation over the same period of 23 basis points and ranged from 23 to 
-58 basis points.\15\
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    \15\ 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.

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[[Page 61415]]

    Given that a simple change to federal funds investments would have 
simultaneously eliminated the interest rate spread and reduced the 
volatility, as expressed by the standard deviation, to zero, the Board 
believed that the Reserve Banks' imputed investment income method may 
have imputed an inappropriately low NICB to priced services.\16\ 
Correspondent banks and BHCs invest in a much wider array of 
investments than those imputed by the Federal Reserve, including loans, 
Treasury securities with longer maturities, government agency 
securities, government-sponsored enterprise securities, federal funds, 
commercial bonds, commercial paper, money market mutual funds, asset-
backed securities, foreign currencies, repurchase agreements, and 
derivatives. As a result, the Board requested comment on a proposal to 
expand imputed investment options within a risk management framework 
similar to that used by banks, BHCs, and regulators in evaluating 
investment risk. To implement the proposal, the Board requested comment 
on two methods.
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    \16\ While reducing interest rate risk, a change in investment 
from Treasury bills to Federal funds would, in theory, increase 
credit risk. As a practical matter, however, banks have not incurred 
losses due to default in federal funds transactions.
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II. Summary and Analysis of Comments

    The Board received two responses, both from Reserve Banks, to its 
request for comment. Although the Federal Reserve worked with private-
sector representatives in developing the methods on which the Board 
requested comment, the Board received no comments from the banking 
industry. Both commenters favor changing the method used for imputing 
investment income and believe that a new method more consistent with 
the practices of BHCs will provide a better basis on which to impute 
income used in setting Federal Reserve fees.

A. Investments

    Because the BHCs are a proxy for providers of priced-services 
activities, options for Reserve Bank clearing balance investments 
should be comparable to those available to BHCs. In principle, all of 
the investments available to BHCs could be appropriate clearing balance 
investments. In its request for comment, the Board proposed limiting 
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.\17\ 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 and unrealized gains and losses on imputed 
mutual fund investments would be incorporated in the total return and 
recorded as net earnings. The Board requested comment on whether this 
investment strategy was appropriate.
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    \17\ 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. See companion 
notice, Federal Reserve Bank Services, elsewhere in today's Federal 
Register.
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    Both commenters considered it reasonable to expand the imputed 
investment options. To limit discretion allowed in ``managing'' the 
portfolio and on the array of allowable investments, one commenter 
suggested that the investments be selected from a relatively narrow set 
of assets with readily observable market values. The second commenter 
suggested choosing investments with average or lower than average risk 
characteristics and recommended that the set of fixed-income 
investments be limited to those that are investment grade.
    The Board has concluded that in constructing an imputed portfolio, 
investments will be selected from those allowable to banks and BHCs and 
will employ a buy-and-hold strategy for those investments with a stated 
maturity. Mutual fund gains and losses will be incorporated in the 
total return and recorded as net earnings. When investing in fixed-
income instruments, only those of investment grade will be imputed.

B. Risk-Management Framework

    The Board considered the comparability of the imputed investments 
with investments of a similar private-sector entity, and requested 
comment on establishing a risk-management framework to limit the 
imputed investments to prudent levels in accordance with sound business 
practice and regulatory constraints. To address these risks, the 
exposure to any one type of risk would be limited and measured in terms 
of earnings or equity at risk. The Reserve Banks currently use three 
risk measures in calculating the PSAF that address liquidity, interest 
rate, and credit risk. In its request for comment, the Board proposed 
incorporating these measures, while adopting a specific constraint on 
credit risk, and adding a measure to address the longer-term effects of 
interest rate risk. In addition, the Board requested comment on any 
other risk-management criteria that should be considered.
1. Liquidity Risk
    Although clearing balances are short term in nature, the Board 
previously determined that a portion of clearing balances remained 
stable and initially established $4 billion as available to fund long-
term assets used in the delivery of priced services, rather than 
invested only in short-term assets.\18\ Neither commenter objected to 
making the portion of core clearing balances not used to fund priced 
services assets available for investment in longer-term instruments. 
The Board believes that limiting the use of clearing balances to fund 
longer-term assets to only that portion that is deemed core clearing 
balances effectively manages liquidity risk.
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    \18\ 66 FR 52617, October 16, 2001.
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2. Interest Rate Risk
    In considering interest rate risk, one must evaluate the effect on 
earnings should the rate used to determine the cost of funds and the 
investment yield on those funds change at different intervals. To 
evaluate the risk of funding longer-term assets with short-term 
liabilities at rates that do not change concurrently and the resulting 
earnings volatility, the Board adopted the interest rate sensitivity 
analysis measure as part of its PSAF method. As adopted, this measure 
requires that longer-term investment of clearing balances be managed so 
that a 200-basis-point change in the rates for both the yield on all 
relevant priced services assets and the cost of all relevant priced 
service liabilities would not affect earnings, measured by the overall 
priced services recovery rate, by more than 200 basis points.
    In requesting comment, the Board proposed adopting 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 
resulting from a change in interest rates. The comparison shows the 
change in present values as a proportion of equity.\19\ The Board

[[Page 61416]]

requested comment on whether a risk tolerance of a change of 8 percent 
of equity resulting from a 200-basis-point-rate change is 
appropriate.\20\ One commenter agreed that the introduction of EVE is 
appropriate given the current supervisory guidelines for the BHC peer 
group and stated that the proposed constraint is appropriate.
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    \19\ 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.
    \20\ Large BHCs typically manage the EVE measure within a risk-
tolerance range of 5 to 10 percent. More information on measurement 
of interest rate risk can be found at http://www.federalreserve.gov/boarddocs/supmanual/trading/trading.pdf pdf.
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    The Board received no 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 will adopt the EVE measure and set the risk tolerance at a 
change of 8 percent of equity resulting from a 200-basis-point-rate 
change. In addition, the earnings at risk tolerance will be maintained 
as a prudent constraint on the imputed investments.
3. Credit Risk
    The overall level of credit risk compared with the level of equity 
is measured by the ratio of risk-adjusted assets to capital.\21\ 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 or more 
for tier one capital.\22\ Only tangible equity capital (tier one 
capital) is imputed to Reserve Bank priced services; therefore, the two 
measures are the same. The current investment in three-month Treasury 
bills carries a risk weight of zero. As a result, the balance sheet 
underlying the 2003 PSAF showed that the priced services risk-based 
capital ratio is nearly 33 percent for both measures.\23\ 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. To manage credit risk, the Board 
requested comment on whether either of two options for establishing a 
minimum risk-adjusted total capital ratio adequately limits imputed 
investment risk. The first option would maintain the ratio of total 
capital to risk-adjusted assets at a level equal to or greater than 
that maintained by the fifty largest BHCs, which has remained near 12 
percent between 1997 and 2002. Under the second option, the risk-based 
capital ratio would be maintained equal to or greater than the minimum 
required by the FDIC for a well-capitalized institution, which is 
currently 10 percent.
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    \21\ 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 investing in 
instruments other than Treasury securities.
    \22\ http://www.fdic.gov.
    \23\ 66 FR 67834, November 7, 2002.
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    One commenter noted that the current priced services risk-based 
capital ratio is not representative of that of its peers and supported 
a change to a ratio within the range of 10 to 12 percent and provided 
empirical data suggesting that the FDIC minimum is within the range of 
risk-based capital ratios for the top 50 BHCs. The Board has concluded 
that imputed investments will be limited to those that result in 
priced-services activities maintaining a risk-based capital ratio equal 
to or greater than the minimum required by the FDIC for a well-
capitalized institution, which is currently 10 percent.
    In responding to whether other risk management criteria should be 
considered, one commenter suggested that, because of rapidly changing 
risk management practices, the Board regularly review BHC peer group 
risk management practices. Because the priced services risk-based 
capital ratio will be based on FDIC requirements, it will be reviewed 
each year to determine the ratio necessary to meet the regulatory 
capital requirements. The Board has concluded that all four risk 
constraints will be included in the framework used to select 
investments on which to impute priced-services income.

C. Implementation Methods

    The Board requested comment on two alternative methods to impute 
clearing balance investment income based on the proposed conceptual 
framework. Both methods emerge from an underlying imputed portfolio of 
investments. The first method proposed constructing a specific 
portfolio of hypothetical investments, tracking its yield, and 
ascribing the income to priced-services activities (the actual return 
method). The second method proposed using average hypothetical 
portfolio returns, expressed as a constant spread over the three-month 
Treasury bill rate, as the basis for future investment performance and 
ascribing the income to priced services activities (the constant annual 
spread method).
1. Constructing a Portfolio
    To construct a hypothetical portfolio, the Reserve Banks would 
select from the investment options described earlier that are available 
to banks and BHCs, based on an allocation method that uses historical 
data to create an optimized portfolio. Historical data are used to 
create the optimized portfolio to avoid any perception that the Federal 
Reserve is signaling future monetary policy actions or is otherwise 
projecting future economic conditions or interest rate environments. 
This optimized portfolio is the basis for the investment allocation 
within the risk-management framework that maximizes the spread of the 
rate of return on the portfolio over the Treasury bill rate.\24\ To 
avoid the administrative complexities of incorporating realized capital 
gains and losses in the imputed investment results for fixed-term 
investments, such as corporate bonds, the Board proposed to impute 
these investments as held to maturity.\25\
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    \24\ A ten-year period was selected because the data are 
available and the period includes a variety of interest rate 
environments.
    \25\ 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.
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    To impute the pricing-year's investment income, the Board proposed 
using this portfolio method to create a pricing-year imputed portfolio 
of investments for the actual return method or to create a ten-year 
average portfolio performance for the constant annual spread method.
    To create a pricing-year imputed portfolio of investments to 
implement the actual return method, the Board proposed assuming that 
the pricing-year portfolio is the most current optimized portfolio for 
the most current ten-year period. For example, the 2004 pricing-year's 
imputed portfolio yield would be the yield obtainable in 2004 from the 
optimum portfolio allocated based on the optimized portfolio's 
investment return performance from 1994 through 2003.
    To create ten years of optimized portfolio actual returns to 
average for implementing the constant annual spread method, the Board 
proposed creating the optimized portfolio for each year in the most 
recent ten-year period. For example, the 2004 pricing-year's constant 
annual spread would be based on the actual investment return 
performance from 1993 through 2002. The optimized portfolio for 1993 
would be based on historical investment return performance from 1983 
through 1992, the portfolio for 1994 would be based on performance from 
1984 through 1993, and so on.
    The key difference in the implementation methods is how the

[[Page 61417]]

investment return is imputed for cost-recovery measurement purposes for 
the pricing year. Imputing the return under the actual return method 
requires applying the investment yields during the pricing year to the 
imputed investments. The constant annual spread method, however, 
simplifies the process during the year by applying the historical ten-
year average portfolio spread over the current three-month Treasury 
bill rate.\26\
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    \26\ A calculation of the optimized portfolio return will still 
be necessary, however, to factor into future pricing-years' constant 
annual spread.
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2. Imputing the Actual Return
    The data in the table show the results of selecting an optimized 
portfolio for each year as described above and imputing the return as 
if the portfolio were held during that year.\27\ The investments were 
chosen to optimize the return while placing a 35 basis point constraint 
on the standard deviation of the spread. Over the ten-year period, the 
asset mix is composed primarily of commercial paper or one-year 
Treasury notes and money market mutual funds. When holding clearing 
balance levels constant as in this example, fluctuations experienced 
using the actual return method reflect both variance in the Treasury 
bill rate and variance in the spread between the portfolio yield and 
the Treasury bill rate. The actual standard deviation associated with 
the actual return method over the ten-year period is greater than the 
23 basis point standard deviation associated with the current imputed 
investment method. The actual standard deviation of the portfolio 
spreads is also greater than the 35 basis point standard deviation 
applied to select each year's optimum portfolio. The ten-year average 
NICB generated in this example would have been $106.4 million with a 
standard deviation of $42.2 million.
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    \27\ To eliminate fluctuations in implementation method results 
related to changes in clearing balances in the table, all clearing 
balance amounts are held constant throughout the analysis period. To 
construct the optimized portfolio, balances are held at the levels 
estimated for 2002 price-setting; investable balances are $5.473 
million and balances on which earnings credits are paid are $5.892 
million. To impute the results for each year, the balances are held 
at the 2004 level; investable balances are $10.302 million and 
balances on which earnings credits are paid are $9,711.

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                          Actual return method
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                                    Spread over  3-
              Year                   month T-bill      NICB  (millions)
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1993............................                0.29               $78.4
1994............................               -0.19                43.1
1995............................                0.60               152.3
1996............................                0.18               101.2
1997............................                0.67               151.4
1998............................                0.37               118.4
1999............................               -0.37                35.4
2000............................                0.35               129.2
2001............................                0.44               111.7
2002............................                1.12               142.6
    Average 10-year.............                0.35               106.4
                                 =====================
    Standard deviation 10-year..                0.42               $42.2
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3. Imputing the Constant Annual 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. \28\ These representatives observed that 
construction of a risk-management framework and hypothetical portfolio 
appeared unduly complex for imputing income from hypothetical 
investments and suggested that a constant basis point calculation could 
be simpler and provide similar results. They suggested that the NICB 
calculation impute investment income based on a clearing balance 
investment yield expressed as a constant spread over the rate used to 
determine the clearing balance cost of funds. The representatives 
observed that this approach might be easier to understand, administer, 
and monitor.
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    \28\ The advisory group included participants from the American 
Bankers Association, the Independent Community Bankers of America, 
and the Association of Corporate Credit Unions.
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    Using a constant spread over the three-month Treasury bill rate to 
impute the income from investing clearing balances would, by 
definition, not reflect the actual variability within the year between 
the investment rate of return and the Treasury bill rate that would 
occur with the actual return method. Although investment income imputed 
using a constant annual spread would vary with fluctuations in the 
three-month Treasury bill rate, finance theory suggests that a discount 
to the constant annual rate might be required to earn the consistency 
during the year that is produced by a constant spread method.
    Unfortunately, historical mutual fund data needed to calculate NICB 
under the constant annual spread method are not available.\29\ 
Conceptually, however, the averaging of the basis-point spreads in the 
constant annual spread method will reduce the basis-point fluctuations 
that otherwise would have occurred. Removing the fluctuations in the 
return related to the actual variability between the investment yield 
rate of return and the Treasury bill rate that would occur with the 
actual return method generates a higher return in some years than would 
have been experienced with the actual return method and a lower return 
in others.
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    \29\ In order to model the results that the constant annual 
spread method would have produced for years prior to 2004, returns 
for years prior to 1993 would need to be simulated. Those simulated 
portfolios would, in turn, be based on optimum portfolios that 
include years prior to 1983, the earliest year for which required 
data are available.
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    Both commenters preferred the actual return method over the 
constant annual spread method. The commenters noted that the actual 
return method is more transparent and more representative of BHC 
practices. One commenter stated that the need to demonstrate that the 
constant annual spread would be achievable with the actual portfolio 
would result in the same level of effort as the actual return method.
    The Board agrees with the industry representatives that the 
constant annual spread method reduces some complexity associated with 
the imputation process during the pricing

[[Page 61418]]

year. The Board believes that while neither method can exactly simulate 
banking industry practices, the constant annual spread method provides 
a reasonable proxy for the return a BHC would receive with similar 
investments. As a result, the pricing-year administrative burden is 
somewhat reduced with the constant annual spread method.
    The Board has adopted the constant annual return method for 
imputing income on investments for the NICB calculation. Each pricing 
year, the constant annual spread will be determined based on an 
optimized investment portfolio, subject to the risk-management 
framework. The constant annual spread will be determined based on the 
actual return from the optimized investment portfolio in each of the 
most recent ten years. The constant spread will be calculated as the 
difference between the portfolio rate of return and the three-month 
Treasury bill rate. NICB for 2004, using the constant annual spread 
method with a 35 basis point spread shown in the table, is estimated to 
be $52.7 million.\30\
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    \30\ The two-year lag in data is consistent with the PSAF 
method, which uses audited financial statements for the top 50 BHCs 
from this period, and is necessary because complete 2003 actual 
return data are not yet available.
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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.''\31\ 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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    \31\ FRRS 9-1558.
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    These changes are intended to expand the investments assumed in the 
NICB calculation to resemble more closely investments pursued by bank 
holding companies, the services of which are considered to resemble 
most closely 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 these changes will not have a direct 
and material adverse effect on the ability of other service providers 
to compete effectively, due to legal differences, with the Federal 
Reserve in providing similar services.

IV. Method for Imputing Investment Income on Clearing Balances

    The Board has adopted the following modifications to the method for 
imputing investment income on clearing balances:
    [sbull] Investment income for each pricing year will be imputed 
based on the average annual spreads between the investment yields and 
three-month Treasury bill rates that would have been realized on 
investments made in the most recently available 10-year period based on 
portfolios optimized as described below. The selected spread will be 
held for the pricing year.
    [sbull] Imputed investments will be selected from those available 
to banks and BHCs. The imputed portfolio for each year will be 
optimized and subject to a risk management framework. The portfolio 
will be optimized based on the most recent ten-year historical data to 
maximize the return that could have been realized over that entire ten-
year period within the risk management framework.
    The risk management framework consists of the following:
    [sbull] A core amount of clearing balances, currently $4 billion 
less core balances use to fund long-term assets in the PSAF 
calculation, is available to invest in longer-term instruments.
    [sbull] The earnings at risk measure will be used as a constraint 
to manage shorter-term interest rate risk. Assuming a 200 basis point 
change in both the yield on relevant assets and the cost of all 
relevant liabilities, the effect to priced services recovery will be 
limited to a change of 200 basis points.
    [sbull] The EVE measure is adopted as a constraint to manage 
longer-term interest rate risk, subject to a limit on the effect to 
equity of 8 percent resulting from a 200 basis point change in the 
asset yield and clearing balance rates.
    [sbull] Investments will be limited to maintain the FDIC's minimum 
risk-based capital ratio for a well-capitalized institution, which is 
currently 10 percent.

    By order of the Board of Governors of the Federal Reserve 
System, October 23, 2003.
Jennifer J. Johnson,
Secretary of the Board.
[FR Doc. 03-27124 Filed 10-27-03; 8:45 am]
BILLING CODE 6210-01-P