Federal Reserve Bank Services Private Sector Adjustment Factor, 15481-15495 [E9-7473]

Agencies

• FEDERAL RESERVE SYSTEM

[Federal Register Volume 74, Number 64 (Monday, April 6, 2009)]
[Notices]
[Pages 15481-15495]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E9-7473]


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FEDERAL RESERVE SYSTEM

[Docket No. OP-1354]


Federal Reserve Bank Services Private Sector Adjustment Factor

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Notice and request for public comment.

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SUMMARY: The Board requests comment on proposed modifications to its 
method for calculating the private-sector adjustment factor (PSAF). The 
PSAF is part of the Board's calculation, as required by the Monetary 
Control Act of 1980 (MCA), to establish the fees that Federal Reserve 
Banks (Reserve Banks) charge for certain financial services provided to 
depository institutions (DIs). Consideration of a new PSAF methodology 
was prompted by the reduction in clearing balances held by DIs at 
Reserve Banks following the Board's recent implementation of the 
payment of interest on required reserve balances and excess balances 
held at Reserve Banks, as well as by long-term changes in the structure 
of the market for providing payment services to DIs. The existing PSAF 
calculation model, which is built upon a correspondent bank framework, 
is driven primarily by the level of clearing balances held by DIs at 
Reserve Banks. The expected continued reduction in clearing balances 
will make the current PSAF calculation methodology less meaningful. 
Accordingly, the Board requests comment on the prospective need to 
change its methodology and its proposal to replace the current 
correspondent bank model for calculating the PSAF with a publicly 
traded firm model as described in this notice. If approved, use of this 
new model could be reflected in priced services fees as early as 2010.

DATES: Comments must be submitted on or before May 29, 2009.

ADDRESSES: You may submit comments, identified by Docket No. OP-1354, 
by any of the following methods:
     Agency Web Site: https://www.federalreserve.gov. Follow the 
instructions for submitting comments at https://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm.
     Federal eRulemaking Portal: https://www.regulations.gov. 
Follow the instructions for submitting comments.
     E-mail: regs.comments@federalreserve.gov.
     FAX: 202/452-3819 or 202/452-3102.
     Mail: Jennifer J. Johnson, Secretary, Board of Governors 
of the Federal Reserve System, 20th Street and Constitution Avenue, 
NW., Washington, DC 20551.
    All public comments are available on the Board's Web site at https://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as submitted, 
except as necessary for technical reasons. Accordingly, your comments 
will not be edited to remove any identifying or contact information. 
Public comments may also be viewed electronically or on paper in Room 
MP-500 of the Board's Martin Building (20th and C Streets, NW.) between 
9 a.m. and 5 p.m. on weekdays.

FOR FURTHER INFORMATION CONTACT: Gregory L. Evans, Deputy Associate 
Director (202/452-3945), Brenda L. Richards, Manager (202/452-2753), 
Jonathan Mueller, Senior Financial Analyst (202/530-6253), or Rebekah 
Ellsworth, Financial Analyst (202/452-3480); Division of Reserve Bank 
Operations and Payment Systems. Telecommunications Device for the Deaf 
(TDD) users may contact 202/263-4869.

SUPPLEMENTARY INFORMATION:

I. Background

    Under MCA, the Federal Reserve Banks must charge fees to DIs for 
certain financial services, known collectively as ``priced services,'' 
so as to recover, over the long run, all direct and indirect costs 
actually incurred in providing these services as well as the imputed 
costs that would have been incurred had the services been provided by a 
private-sector firm.1 2 MCA specifically identifies certain 
imputed costs that must be recovered via priced services fees, 
including taxes and return on equity (profit).
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    \1\ These priced services include the check, automated 
clearinghouse, Fedwire[reg] Funds, and Fedwire[reg] Securities (for 
activity not related to Treasury securities) services.
    \2\ 12 U.S.C. 248a(c)(3).
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    To set priced services fees in accordance with the requirements of 
MCA, the Board not only must estimate all actual direct and indirect 
costs incurred in providing priced services but also must impute costs 
that the Reserve Banks do not incur but would incur as private-sector 
entities. In determining a methodology for imputing these costs, the 
Board recognizes that there is no perfect private-sector proxy for the 
Reserve Bank priced services, but seeks a methodology that is 
theoretically sound and represents a reasonable approximation of the 
costs the Reserve Banks would incur if operating as private-sector 
providers. Because of the similarity between the services provided by 
Reserve Banks and many of the services offered by private-sector 
correspondent banks, the Board historically has derived these imputed 
costs, collectively known as the PSAF, and offsetting imputed revenue, 
known as net income on clearing balances (NICB), using a correspondent 
bank model. The PSAF and NICB are estimated annually, and the resulting 
net cost is incorporated each year when

[[Page 15482]]

setting priced services fees and measuring cost recovery.\3\
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    \3\ In 2008, actual direct and indirect costs represented 
approximately 88 percent of total priced services costs and the PSAF 
represented the remaining 12 percent. The PSAF constituted an 
estimated $108.3 million of the overall costs recovered by priced 
services activities, and was offset by approximately $101.7 million 
of NICB.
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The Clearing Balance Program

    The Reserve Bank clearing balance program was developed in 
connection with the implementation of MCA's requirement to establish 
fees for priced services. This program allows DIs to hold at Reserve 
Banks an agreed-upon level of clearing balances which serve several 
purposes, including facilitating settlement of transactions, protecting 
against overnight overdrafts, and paying for priced services through 
the generation of earnings credits. The Reserve Bank clearing balance 
program is largely modeled after similar programs offered by private-
sector correspondent banks, wherein respondent banks maintain balances 
with their correspondents for some or all of the purposes listed above.
    Under the Reserve Bank clearing balance program, a participating DI 
agrees to set and maintain a targeted minimum average clearing balance, 
known as the DI's contractual clearing balance, over a set period. A DI 
may hold balances in excess of its contractual clearing balance and is 
charged for deficiencies below the contracted minimum.
    A DI accrues credits, known as earnings credits, on its contractual 
clearing balances (not on excess balances) held at a Reserve Bank at a 
rate currently equal to 80 percent of the 13-week moving average of the 
annualized coupon equivalent yield of the three-month Treasury bill. 
Earnings credits can only be applied toward priced services fees, and 
unused credits expire if not used within one year.

Calculating the PSAF

    The Board's method for calculating the PSAF begins with developing 
a pro forma priced services balance sheet based on the projected 
average book value of Reserve Bank assets and liabilities to be used in 
providing priced services during the coming year.\4\ Additional 
elements on the priced services balance sheet are imputed as if the 
priced services were provided by a hypothetical private-sector 
correspondent bank. For example, a private-sector correspondent bank 
would be able to use the balances that its respondents deposit with it 
as a funding source for investments. Accordingly, the Board imputes 
investment income on clearing balances held at Reserve Banks based on 
an imputed portfolio of interest-bearing assets. Similarly, because 
private-sector correspondent banks are required to hold some portion of 
their deposit balances as vault cash or as balances at a Reserve Bank, 
the Board imputes a reserve requirement as a percentage of clearing 
balances. The imputed investment of clearing balances and the imputed 
reserve requirement both appear as assets on the priced services 
balance sheet.
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    \4\ The 2007 priced services balance sheet can be found in the 
Federal Reserve Board's 2007 Annual Report at https://www.federalreserve.gov/boarddocs/rptcongress/annual07/sec2/c3.htm#nl12.
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    The liability and equity components of the priced services balance 
sheet consist of clearing balances, short- and long-term liabilities 
related to providing priced services, imputed debt (if necessary), and 
imputed equity. The level of clearing balances on the priced services 
balance sheet increases or decreases at the discretion of the DIs 
maintaining those balances and provides a source of long-term financing 
for priced services assets.\5\ Using the correspondent bank model 
results in imputed debt only when core clearing balances, long-term 
liabilities, and equity on the priced services balance sheet are not 
sufficient to fund long-term assets; or when an interest rate 
sensitivity analysis indicates that a 200 basis point change in 
interest rates would change the percentage of priced services costs 
recovered (cost recovery) more than 2 percentage points. To satisfy the 
FDIC requirement for a ``well-capitalized'' institution, equity is 
imputed at 5 percent of total assets.\6\
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    \5\ Using clearing balances as a financing source is consistent 
with private-sector correspondent banks' use of their respondent 
balances to fund short- and long-term assets. In the correspondent 
bank model only the portion of clearing balances that has remained 
stable over time (core clearing balances), historically set at $4 
billion, is used to fund long-term assets on the priced services 
balance sheet.
    \6\ Equity is imputed based on the FDIC definition of a well-
capitalized depository institution for insurance premium purposes. 
The FDIC requirements for a well-capitalized depository institution 
are (1) a ratio of total capital to risk-weighted assets of 10 
percent or greater, (2) a ratio of Tier 1 capital to risk-weighted 
assets of 6 percent or greater, and (3) a leverage ratio of Tier 1 
capital to total assets of 5 percent or greater. Because the total 
capital on the priced services balance sheet has no components of 
Tier 1 or total capital other than equity, requirements 1 and 2 are 
essentially the same measurement. In addition, because risk-weighted 
assets have historically been considerably below actual assets on 
the priced services balance sheet, typically only requirement 3 has 
been binding for the priced services.
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    The imputed costs of the PSAF are derived from the priced services 
balance sheet. A target return on equity (ROE) rate is estimated and 
applied to the equity on the priced services balance sheet to determine 
the cost of equity. The ROE rate is estimated using the capital asset 
pricing model (CAPM), which calculates a firm's required ROE rate as 
the sum of a risk-free rate of return and a risk premium. In this 
model, the risk premium is the product of a firm-specific sensitivity 
factor, known as beta, which expresses the correlation of the firm's 
returns to the return of the market as a whole, and the expected return 
of the market in excess of the risk-free rate. In the PSAF calculation, 
the risk-free rate of return is based on the three-month Treasury bill 
rate, and the expected market risk premium is the average of the 
monthly returns of the market as a whole in excess of the risk-free 
rate over the most recent 40 years.\7\ The priced services beta of 1.0 
assumes that, over time, priced services returns will be perfectly 
correlated with those of the overall market.
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    \7\ Data on market returns are based on the French data series, 
which is the standard data series used to estimate the market risk 
premium (https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html).
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    Given that Federal corporate income tax rates are graduated, State 
income tax rates vary, and various credits and deductions can apply, 
the correspondent bank model does not include an actual income tax 
expense. Instead, the Board targets a pretax ROE that would provide 
sufficient income for the priced services to fulfill their imputed 
income tax obligation. The imputed income tax rate used to calculate 
the pretax ROE is the median of the rates paid over the past five years 
by the top 50 bank holding companies (BHCs) ranked by deposit balances, 
adjusted to exclude any investment in tax-free municipal bonds. The 
PSAF also includes the estimated share of Board expenses that supports 
the priced services, imputed sales tax, and an imputed FDIC insurance 
assessment based on current FDIC rates and the level of clearing 
balances held at Reserve Banks.

Calculating NICB

    The correspondent bank model includes imputed revenue, known as 
NICB, which is calculated each year along with the imputed costs of the 
PSAF. The NICB calculation assumes that, similar to a correspondent 
bank, the priced services would invest clearing balances, net of the 
imputed reserve requirement and balances used to finance priced 
services assets, in interest-bearing assets. To impute investment 
income, a rate of return

[[Page 15483]]

equal to the yield on the three-month Treasury bill plus a constant 
spread is applied to the level of clearing balances available for 
investment on the priced services balance sheet. The constant spread is 
derived annually from a portfolio of investments comparable to the 
investment holdings of BHCs.\8\ The NICB calculation nets this imputed 
investment income against the actual cost of earnings credits, which 
represent the cost to the Reserve Banks of holding clearing 
balances.\9\
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    \8\ These investments include short-term Treasury securities, 
government agency securities, commercial paper, long-term corporate 
bonds, and money market funds. For additional details on the 
calculation of the constant spread, refer to the notice of approval 
of modifications to the method for calculating the PSAF, 68 FR 
61413-61418 (Oct. 28, 2003).
    \9\ Because clearing balances are voluntary, set by priced 
services customers, and held for clearing transactions or offsetting 
priced services fees, they are directly related to the priced 
services. The cost associated with holding clearing balances, 
therefore, is appropriately attributed to the priced services.
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Calculating Cost Recovery

    The Board incorporates the PSAF and NICB into the projected and 
actual annual cost recovery calculations for Reserve Bank priced 
services. Cost recovery measures the percentage of priced services 
costs, including the PSAF, recovered through priced services fees and 
NICB. In the fall of each year, the Board projects the PSAF and NICB 
for the following year using the most recent clearing balance and rate 
data available (typically July data) during the process of establishing 
priced services fees. The Board also estimates cost recovery for the 
coming year using projected direct and indirect costs, revenue, and the 
net imputed cost generated from the estimated PSAF and NICB.
    When calculating actual cost recovery for the priced services at 
the end of each year, the Board historically has used the estimated 
PSAF derived during the price-setting process with only minimal 
adjustments for actual rates or balance levels.\10\ \11\ The Board 
adopted this approach because the PSAF largely represents the fixed 
financing costs associated with the assets on the priced services 
balance sheet, which is updated annually. This method has proven to be 
reasonable and transparent without being unduly complex or burdensome. 
The Board updates NICB, however, to reflect actual interest rates and 
clearing balance levels throughout the year when calculating actual 
priced services cost recovery. Actual NICB, therefore, can vary from 
the projected amount used to determine priced services fees for a given 
year. For example, while the projected and actual PSAF for 2007 
remained substantially unchanged at $132.5 million, actual 2007 NICB 
decreased from its $139.6 million projection to $133.8 million.
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    \10\ Although the largest portion of the PSAF, the target ROE, 
is fixed, two minor elements of the PSAF calculation are variable. 
The first adjusts the imputed income tax expense for the difference 
between the projected and actual priced services net income by 
applying the imputed effective income tax rate to any difference. 
The second recalculates the imputed FDIC assessment using actual 
clearing balance levels and assessment rates.
    \11\ In light of the uncertainty about the long-term effect that 
paying interest on required reserve and excess balances held at 
Reserve Banks will have on the level of clearing balances, the Board 
will adjust the PSAF used in the actual cost-recovery calculation 
for 2009 using the actual clearing balance levels maintained 
throughout 2009.
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The Interdependence of Clearing Balances, the PSAF, and NICB

    Changes in clearing balance levels directly affect the imputed 
costs and income that factor into priced services fees and cost 
recovery. Clearing balances not only represent the largest component of 
the priced services balance sheet but also drive the calculation of 
nearly all imputed elements included in priced services fees, including 
the financing costs, the cost of equity, and NICB. For example, 
clearing balances provide a major source of short- and long-term 
funding for the assets on the priced services balance sheet, 
representing 74 percent of total financing in 2007. Clearing balances 
thus reduce total imputed financing costs by eliminating the need to 
impute more costly forms of financing, such as debt.\12\ Clearing 
balances, in the form of imputed investments, also represent a 
significant portion of total priced services assets. Total assets, in 
turn, determine the level of imputed equity and the resultant imputed 
cost of that equity. In addition, the level of clearing balances 
influences the amount of funds available for investment in the imputed 
portfolio of investments and the cost of earnings credits, both of 
which are principal factors in the NICB calculation. These three 
elements--financing costs, the cost of equity, and NICB--are included 
in the net imputed cost that is recovered through priced services fees. 
Any change in the level of clearing balances, therefore, has a 
significant effect on the PSAF, NICB, and cost recovery.
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    \12\ Historically, debt financing rates have been higher than 
the earnings credit rate, making debt a more costly source of 
financing for the priced services balance sheet. For the week ended 
February 11, 2009, the earnings credit rate paid on clearing 
balances held by DIs at the Reserve Banks was 0.09 percent versus 
5.21 percent for the bond rate on Moody's Aaa-rated corporate bonds 
for the week ended February 13, 2009 (see https://www.federalreserve.gov/releases/h15/20090105/).
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Interest on Balances Held at Reserve Banks

    Title II of the Financial Services Regulatory Relief Act of 2006 
granted the Reserve Banks authority to pay earnings (interest) on 
balances maintained by or on behalf of DIs at Reserve Banks. 
Originally, this authority was to become effective in 2011. Section 128 
of the Emergency Economic Stabilization Act of 2008, enacted on October 
3, 2008, made the authority effective upon enactment. On October 6, 
2008, the Board published an interim final rule amending Regulation D 
(Reserve Requirements of Depository Institutions). The interim rule 
directed the Reserve Banks to pay explicit interest on balances held at 
Reserve Banks to satisfy reserve requirements (required reserve 
balances) and on balances held in excess of both required reserve 
balances and contractual clearing balances (excess balances), effective 
October 9, 2008.\13\
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    \13\ 73 FR 59482-59486 (Oct. 9, 2008), as amended by 73 FR 
65506-65507 (Nov. 4, 2008), 73 FR 67713-67714 (Nov. 17, 2008), and 
73 FR 78616 (Dec. 23, 2008).
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    The Board has observed a significant decline in the level of 
clearing balances held at Reserve Banks following the implementation of 
interest on required reserve balances and excess balances and 
anticipates that this trend will continue. The daily average level of 
clearing balances over the two-week reserve maintenance period ending 
October 8, 2008 was $7.7 billion. As shown in figure 1, by the reserve 
maintenance period ending February 11, 2009, the daily average level of 
clearing balances had fallen to $4.6 billion. Over this period, the 
rate of interest paid on both required reserve balances and excess 
balances maintained at Reserve Banks was generally higher than the 
earnings credit rate paid on clearing balances.\14\ The interest rate 
on required reserve balances and excess balances as of March 2009 is 25 
basis points, which is the top of the targeted range for the Federal 
funds rate and higher than the concurrent earnings credit rate for 
clearing balances. When the target Federal funds rate exceeds the 
earnings credit rate (the typical historical

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scenario), and absent a significant preference by DIs for implicit 
interest on clearing balances over explicit interest on excess balances 
held at Reserve Banks, DIs will likely continue to reduce clearing 
balances in favor of increasing excess balances to receive higher, 
explicit returns.
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    \14\ The recent plateau in clearing balance levels may be due to 
the small difference (often of less than 15 basis points) between 
the rates earned on excess balances and clearing balances in the 
current low interest rate environment. In a more normal rate 
environment, the absolute value of this difference will increase, 
giving DIs more incentive to shift from maintaining contractual 
clearing balances to maintaining interest-earning excess balances.
[GRAPHIC] [TIFF OMITTED] TN06AP09.000

    The expected continued decline in clearing balance levels could 
have significant implications for the imputed costs that factor into 
the Board's price-setting methodology. If clearing balance levels 
decline significantly, the priced services balance sheet will shrink 
dramatically, and the priced services will lose a major source of both 
funding and income. A continued reduction in clearing balance levels 
will decrease the similarities between the financial characteristics of 
the priced services and private-sector correspondent banks. 
Specifically, with low to zero clearing balance levels, it will be more 
difficult to draw the analogy between correspondent banks, whose 
balance sheets include large levels of deposit balances and related 
accounts, and the Reserve Bank priced services. Similarly, markedly 
reduced clearing balance levels will call into question the use of the 
FDIC's regulatory structure for well-capitalized depository 
institutions as a determinant of equity capital on the priced services 
balance sheet and will potentially nullify the calculation of an FDIC 
insurance assessment based on clearing balance levels. All of these 
factors challenge the continued applicability of a PSAF model based on 
a correspondent bank framework.
    The potential for such circumstances, in conjunction with the 
ongoing changes in the nature of priced services competitors discussed 
below, has prompted the Board to consider changes to its approach to 
imputing the costs that MCA requires to be recovered through priced 
services fees. If approved, these changes could be effective as early 
as the 2010 pricing process. In determining the appropriate timing of 
such changes, the Board will consider trends in the level of clearing 
balances held at Reserve Banks and the extent to which the nature of 
the Reserve Banks' competitors, particularly in the check service, 
shifts away from correspondent banks.
    The Board requests comment on the following:
    If the explicit interest rate for required reserve balances and 
excess balances continues to be higher than the implicit rate paid on 
clearing balances in the form of earnings credits, is it reasonable to 
assume that DIs will continue to reduce or eliminate their level of 
contractual clearing balances in favor of holding additional excess 
balances? If not, why might DIs choose to maintain their clearing 
balances?
    Will DIs raise and lower the level of clearing balances they hold 
at Reserve Banks depending on whether the earnings credit rate is above 
or below the rate on excess balances?
    Are there any reasons why the Board should maintain its clearing 
balance program if demand for clearing balances continues to decline 
significantly?

Trends in the Banking and Payment Systems Industries

    As noted above, when implementing the priced services provisions of 
MCA in the early 1980s, the Board identified private-sector 
correspondent banks as the most appropriate peer group for the priced 
services in adopting key elements of the policy. The Board

[[Page 15485]]

considered correspondent banks to be a reasonable proxy for private-
sector providers of priced services because they are the primary 
competitors of the Reserve Banks' check service, which historically has 
comprised more than 80 percent of the cost of Reserve Bank priced 
services activities. In doing so, the Board recognized that BHCs offer 
diverse services that extend well beyond the payment services that are 
provided by the Reserve Banks, and that these services largely drive 
BHC financial results; however, given that Reserve Banks and BHCs both 
hold customer balances that facilitate payment services, the Board 
considered it a reasonable comparison.
    Recently, however, the analogy between private-sector correspondent 
banks and the priced services has become less applicable. The payment 
systems industry has sharply decreased its use of traditional check 
services and increased its use of electronic payment services. As a 
result, user-owned utilities, the Reserve Banks' typical competitors in 
electronic payment services, have increasingly replaced correspondent 
banks as the predominant competitors of the Reserve Banks in providing 
priced services. These user-owned utilities include such entities as 
the Clearing House Interbank Payment System (CHIPS), which is the 
primary competitor for Fedwire[reg] funds transfer services, and the 
Electronic Payments Network (EPN), which is the only private-sector 
automated clearinghouse (ACH) operator. Both of these entities are part 
of a larger cooperative, The Clearing House Payments Company, LLC 
(TCH), which is owned entirely by its principal users. Unlike private-
sector correspondent banks, user-owned utilities do not hold overnight 
balances for their participants. As paper check processing volumes 
continue to decline and the check service becomes more electronic, 
utilities will likely increasingly be key competitors of the Reserve 
Banks in providing priced services. These trends, in conjunction with 
the potential continued significant decline in clearing balances 
resulting from the ability of DIs to receive explicit interest on 
balances held at Reserve Banks, raise questions about the continued 
appropriateness of the correspondent bank model as the basis for the 
imputed costs that factor into the Board's pricing methodology.

II. The Proposed PSAF Model

The Publicly Traded Firm Model

    The Board seeks to replace the current correspondent bank model 
with a model that is transparent, consistent with current financial 
theory and practice, and conceptually sound as a basis for efficient 
pricing in the market of payment services. To achieve these objectives, 
and given the difficulty in identifying and obtaining data for an 
applicable peer group, the Board proposes to replace the correspondent 
bank model with a ``publicly traded firm model'' for calculating the 
imputed costs that factor into priced services fees and cost recovery. 
This model recognizes the shift, in the priced services' financial 
characteristics and competitors, away from correspondent banks, as well 
as the difficulties inherent in a user-owned utility model as discussed 
below, and instead compares the priced services to the entire market of 
U.S. publicly traded firms.
    Under the publicly traded firm model, the asset side of the priced 
services balance sheet would reflect only the projected portion of 
actual Reserve Bank assets used to provide priced services; no 
additional assets would be imputed. Any residual clearing balances 
maintained by DIs at Reserve Banks would not be included in the priced 
services balance sheet or in the calculation of the PSAF. Consequently, 
imputed investments and NICB would be zero by definition, and the 
priced services would impute additional equity and debt to meet the 
funding need on the priced services balance sheet. The publicly traded 
firm model would not include an imputed FDIC assessment, because the 
priced services' peer group would no longer be limited to private-
sector correspondent banks and because, as noted above, any residual 
clearing balances would not be included in the priced services balance 
sheet or in the PSAF calculation. The imputed capital structure, debt 
and equity financing rates, and effective income tax rate would be 
based on data for the U.S. market as a whole and would be calculated 
using the various market data sources and time frames discussed below. 
The time frame selected for each of these imputed elements was chosen 
to minimize volatility in the PSAF from year to year. A one-year time 
frame was selected for elements that historically have been more 
stable; a five-year average was selected when data were more volatile 
historically or when changes in that element would have a larger impact 
on the PSAF.\15\ When averaging data for individual U.S. firms, the 
model would use value-weighted rather than equal-weighted averages.\16\
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    \15\ Although MCA's requirement for cost recovery over the long 
run allows the Board to set fees to over- or underrecover costs in a 
given year to minimize price volatility, volatility in imputed costs 
makes the pricing process more complex. As a result, the Board has 
typically preferred to adopt PSAF methodologies that provide for 
stable rather than volatile imputed costs.
    \16\ Value-weighted averages assign equal weight to each dollar, 
while equal-weighted averages assign equal weight to each firm. The 
Board opted to use value-weighted averages to reflect more 
accurately the financial characteristics of the market as a whole 
rather than those of the ``average'' firm in the market.
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    The priced services imputed capital structure would be based on the 
most recent full-year value-weighted average capital structure (that 
is, total long-term debt to total long-term debt plus equity) of all 
U.S. publicly traded firms included in a commercially available 
financial database. The Board initially proposes using Standard & 
Poor's Compustat[supreg] database as the source for the capital 
structure and effective income tax rate of all U.S. publicly traded 
firms. The Standard & Poor's Compustat[supreg] database contains 
information on more than 6,000 U.S. publicly traded firms, which 
approximate the entirety of the U.S. market. Because of the timing of 
the price-setting process and the availability of relevant data, there 
would be a two-year lag in the data used in the PSAF calculation: for 
example, 2010 priced services fees, set in late 2009, would be based 
upon full-year 2008 data.\17\ Table 1 shows the value-weighted average 
capital structures for all U.S. publicly traded firms in the Standard & 
Poor's Compustat[supreg] database from 2003 to 2007. In 2007, based on 
the foregoing, the value-weighted average capital structure was 54 
percent.
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    \17\ The two-year lag in the data used to calculate certain 
imputed costs in the PSAF is characteristic of the current model as 
well and is due in large part to the timing of the price-setting 
process.

[[Page 15486]]



                 Table 1--Capital Structure (Capitalization Ratio) of U.S. Publicly Traded Firms
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                                                                                     Five-year       Standard
      2003             2004            2005            2006            2007           average        deviation
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          55%              53%             53%             52%             54%             53%            1.0%
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Source: Standard & Poor's Compustat[supreg] data.

    Because the PSAF resulting from the publicly traded firm model is 
not highly sensitive to capital structure and because the value-
weighted average capital structure does not vary significantly from 
year to year, the Board believes that a one-year time frame is 
appropriate when imputing the priced services capital structure. This 
conclusion is supported both by financial theory, which states that 
changes in capital structure should not significantly affect the value 
of a firm, and by sensitivity analysis as shown in attachment 1.\18\
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    \18\ F. Modigliani and M.H. Miller (1958), ``The Cost of 
Capital, Corporation Finance, and the Theory of Investment,'' 
American Economic Review, 48, pp. 261-97. The Modigliani-Miller 
Theorem states that under some conditions and in an efficient market 
the value of a firm is unaffected by how that firm is financed.
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    The imputed effective income tax rate would be the five-year mean 
of the value-weighted average ratios of current tax expense to total 
net income for all U.S. publicly traded firms in the financial 
database. Table 2 shows the annual value-weighted average effective tax 
rates for all U.S. publicly traded firms in the Standard & Poor's 
Compustat[supreg] database from 2003 to 2007. For that period, the 
five-year mean of these tax rates was 24 percent. A five-year mean 
would be used because of the volatility of the annual effective tax 
rate from year to year and the sensitivity of the PSAF to this input, 
as shown in attachment 1.

                            Table 2--Effective Tax Rate of U.S. Publicly Traded Firms
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                                                                                     Five-year       Standard
      2003             2004            2005            2006            2007           average        deviation
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          19%              23%             27%             24%             29%             24%            3.4%
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Source: Standard & Poor's Compustat[supreg] data.

    The imputed long-term debt financing rate under the publicly traded 
firm model would be the five-year mean of an estimated average annual 
bond yield for the market as a whole. The Board proposes to use a five-
year mean when imputing a long-term debt financing rate to be 
consistent with the treatment of the tax rate (both of these inputs are 
cost-related) and to reduce year-to-year volatility in the PSAF.\19\
---------------------------------------------------------------------------

    \19\ Although attachment 1 shows low levels of volatility in the 
average Moody's bond rates from 2003 to 2007, this stability has not 
been the historic norm. Given the PSAF's sensitivity even to small 
changes in the debt financing rate, the Board plans to use a five-
year average to minimize volatility in the PSAF.
---------------------------------------------------------------------------

    The Board initially proposes calculating the imputed long-term debt 
rate as the five-year mean of the Aaa and Baa Moody's bond yields 
published on the Federal Reserve Board's H.15 Statistical Release.\20\ 
The inclusion of only investment-grade debt is based on analysis of 
data on approximately 1,400 publicly traded firms in the Compustat 
database for which bond rating data are available.\21\ Given that the 
majority of outstanding debt for this population was investment grade, 
the Board considered an average investment-grade bond yield to be a 
reasonable proxy for the imputed priced services long-term debt 
financing rate. The Board considered two averaging techniques to 
determine the average investment-grade bond yield, which provided 
nearly identical results. Of these two approaches, the five-year mean 
of the Aaa and Baa Moody's bond yields was more simple and 
transparent.\22\ Table 3 shows the annual average yield from 2003 to 
2007 using this methodology. For this period, the five-year mean was 
6.0 percent.
---------------------------------------------------------------------------

    \20\ https://www.federalreserve.gov/releases/H15/data.htm. 
Moody's Aaa and Baa bond ratings represent the upper and lower 
limits of the range of investment-grade bonds.
    \21\ While the firms in this sample included only approximately 
20 percent of publicly traded firms in the database, they 
represented more than 85 percent of the assets and debt of the 
complete population of over 6,000 firms. Analysis of data for this 
sample from 2003 to 2007 showed that 82 percent of outstanding long-
term debt (which represents over 70 percent of the outstanding long-
term debt for all firms in the database during that period) was 
investment grade.
    \22\ Alternatively, the Board could calculate an average 
investment-grade bond yield using five-year average annual bond 
yields for each investment grade, weighted by the relative 
proportion of debt outstanding for each grade in the population of 
approximately 1,400 firms. For 2003 to 2007, the weighted average 
bond yield using this technique differed from the five-year mean of 
the Aaa and Baa Moody's bond yields by 2 basis points.

                           Table 3--Average of Annual Moody's Aaa and Baa Bond Yields
----------------------------------------------------------------------------------------------------------------
                                                                                     Five-year       Standard
      2003             2004            2005            2006            2007           average        deviation
----------------------------------------------------------------------------------------------------------------
         6.2%             6.0%            5.7%            6.0%            6.0%            6.0%            0.2%
----------------------------------------------------------------------------------------------------------------

    Using an average investment-grade bond yield as the imputed priced 
services long-term debt financing rate, however, does not take into 
account the effect of non-investment-grade debt on the average bond 
yield for the market as a whole. Inclusion of non-investment-grade debt 
would result in a somewhat higher imputed long-term debt financing 
rate. Accordingly, the Board could also calculate an average bond yield 
for U.S. publicly traded firms using five-year average yields for each 
bond rating, weighted by the relative

[[Page 15487]]

proportion of debt outstanding in the market at each bond rating.\23\
---------------------------------------------------------------------------

    \23\ The relative proportions of outstanding debt would be based 
on the most recent five years of Standard & Poor's Compustat[reg] 
data for which bond rating data are available.
---------------------------------------------------------------------------

    If short-term assets exceed short-term liabilities on the priced 
services balance sheet, short-term debt would be imputed at the average 
of the three-month AA and A2/P2 nonfinancial commercial paper rates as 
published on the Federal Reserve Board's Commercial Paper Release.\24\ 
This methodology is simple, transparent, consistent with the proposed 
approach to calculating the long-term debt financing rate, and based on 
publicly available data.
---------------------------------------------------------------------------

    \24\ https://www.federalreserve.gov/releases/cp/. AA and A2/P2 
ratings for commercial paper approximate the same credit ratings as 
Moody's Aaa and Baa ratings for bonds. Since 2002, the priced 
services short-term funding need has been met by clearing balances, 
eliminating the need to impute short-term debt.
---------------------------------------------------------------------------

    The Board considered other data sources for each of the imputed 
elements discussed above. These sources include the Flow of Funds 
Federal Reserve Board Statistical Release for capital structure, 
general corporate income tax rates as found on Internal Revenue Service 
(IRS) Form 1120 for the effective tax rate, and the ratio of ``interest 
and related expense'' to total debt for all publicly traded U.S. firms 
in the Standard & Poor's Compustat[reg] database for the long-term debt 
financing rate.\25\ In each case, the Board considered the source set 
forth in the current proposal to be the superior alternative. The Flow 
of Funds release does not include data on U.S. publicly traded 
financial firms and provides only approximate market-value equity data. 
Use of the general corporate income tax rate published by the IRS would 
inappropriately exclude the effect of State and local taxes. A long-
term debt financing rate calculated from the Standard & Poor's 
Compustat[reg] database would be artificially high because of the 
inclusion of ``related expense,'' which includes items such as interest 
on deposits held at DIs, in the interest expense measure used in the 
numerator.
---------------------------------------------------------------------------

    \25\ Current corporate income tax rates can be found in the 2008 
instructions for IRS Form 1120 at https://www.irs.gov/pub/irs-pdf/i1120.pdf.
---------------------------------------------------------------------------

    Under the publicly traded firm model, the imputed ROE rate would 
continue to be calculated using the CAPM with a beta of 1.0 and a 40-
year average historical market premium. Given the sensitivity of the 
PSAF to the risk-free rate used in the CAPM, and because short-term 
Treasury bill rates are generally more sensitive to interest rate 
changes than longer-term rates, the Board considered replacing the 
current short-term risk-free rate with a longer-term risk-free rate. As 
shown in attachment 1, changes in the risk-free rate used in the 
calculation of the target ROE rate affect the PSAF more than any other 
imputed element. In 2005, the Board decided to use a three-month 
Treasury bill rate as the risk-free rate to impute the target ROE 
because this rate was consistent with that used to calculate NICB and 
would help minimize volatility in the net imputed cost caused by 
changes in interest rates.\26\ With the elimination of NICB under the 
proposed publicly traded firm model, however, using a longer-term 
Treasury rate, such as the 10-year Treasury bond rate, may be an 
appropriate way to minimize volatility in the calculation of the target 
ROE rate. A longer-term rate more closely matches the duration of stock 
market indexes used to estimate a beta, the expected life of the assets 
on the priced services balance sheet, and the investment horizon of a 
long-term investor.
---------------------------------------------------------------------------

    \26\ 70 FR 60347 (Oct. 17, 2005). NICB is based on an average 
three-month Treasury bill rate, while the target ROE CAPM 
calculation uses a current three-month Treasury bill rate for the 
risk-free rate.
---------------------------------------------------------------------------

    Table 4 compares certain components for 2009 derived under the 
publicly traded firm model with the same components as derived under 
the baseline case.\27\ Using the elements discussed above, the publicly 
traded firm model returns a PSAF of $55.4 million compared with a 
baseline PSAF of $62.2 million (NICB of $48.8 million, net imputed cost 
of $13.4 million).
---------------------------------------------------------------------------

    \27\ The baseline PSAF of $62.2 million, projected NICB of $48.8 
million, and net imputed cost of $13.4 million are the Board-
approved projected 2009 values using the correspondent bank model. 
73 FR 65329-65340 (Nov. 3, 2008).
---------------------------------------------------------------------------

    The baseline net imputed cost reflects clearing balance levels and 
interest rates as of July 2008. The correspondent bank model is highly 
sensitive to both of these variables. For example, using the lower 
clearing balance levels and interest rates from February 2009, 
projected 2009 NICB is less than half the amount that was projected for 
pricing purposes, leading to an increase in the 2009 net imputed cost. 
If clearing balances continue to decline, the variance between the PSAF 
calculated using the proposed methodology and the net imputed cost 
using the correspondent bank model will likely be significantly smaller 
than noted above. In contrast, as interest rates rise, the income 
generated on each dollar of clearing balances in the NICB calculation 
of the correspondent bank model will increase. Rising interest rates, 
however, will widen the spread between the interest rate on excess 
balances and the earnings credits rate, giving DIs more incentive to 
shift from maintaining clearing balances to maintaining additional 
excess balances. This expected reduction in clearing balances will 
reduce NICB, counteracting the effect of higher per-dollar earnings and 
likely leading to a net decrease in NICB. Consequently, rising interest 
rates could cause an overall increase of the net imputed cost of the 
correspondent bank model throughout the year. This increase could 
substantially shrink the variance between the PSAF of the proposed 
model and the net imputed cost of the current model.

                                                    Table 4--Comparison of Current and Proposed Model
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                     Balance  sheet
                                         assets      Financing  composition     Financing  cost       Tax rate     Debt rate       PSAF         NICB
                                       (billions)                                                     (percent)    (percent)    (millions)   (millions)
--------------------------------------------------------------------------------------------------------------------------------------------------------
Baseline case: correspondent bank              $9.2  Equity per FDIC         ROE of $46.2 M.......          32.6        \(1)\        $62.2         $48.8
 model.                                               guidelines.
Publicly traded firm model.........             1.3  54% long-term debt,     $40.3M (ROE of                 24            6.0         55.4           0
                                                      46% equity.             $22.3M; debt cost of
                                                                              $18.0M).
--------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ No debt.


[[Page 15488]]

    The Board believes that the publicly traded firm model would be an 
appropriate replacement for the current PSAF model for a variety of 
reasons. The publicly traded firm model is relatively simple to 
calculate and understand, easily replicable by the public, and uses 
objective, publicly-available data for all imputed inputs. Unlike the 
correspondent bank model, the publicly traded firm model is not linked 
to the level of clearing balances held at Reserve Banks. This 
characteristic is important given the uncertainty surrounding future 
clearing balance levels. Substantially lower clearing balances would 
not only affect the funding and income of the priced services but also 
undermine the basis for the use of an FDIC-based regulatory structure 
for depository institutions as a determinate of the priced services 
capital structure. A model that is not dependent on clearing balance 
levels is also appropriate in an environment where clearing balances 
are not relevant to a growing proportion of the Reserve Banks' 
competitors in providing priced services. Another advantage of the 
publicly traded firm model is its independence from a narrowly defined 
peer group, such as private-sector correspondent banks, that may become 
less relevant to the priced services over time. Unlike other models 
considered, the publicly traded firm model does not incorporate data 
from a limited number of comparable firms but rather from the entire 
U.S. market of publicly traded firms. This independence decreases the 
risk of price volatility that could result from changes in the 
characteristics or financial results of a limited peer group. The 
publicly traded firm model also is consistent with financial theory 
regarding capital structure and financing costs and is conceptually 
sound. In addition, the publicly traded firm model is consistent with 
the current approach to calculating the ROE using CAPM with a beta of 
1.0, which compares the priced services to the market as a whole.
    The publicly traded firm model also has a few drawbacks. If some 
level of clearing balances persists at Reserve Banks over the long 
term, excluding these priced-services-related balances from the 
calculation of the PSAF would depart from the Board's past practice of 
including all actual priced services assets and liabilities in the 
calculation of the PSAF and would disregard potential imputed income 
from these balances. A publicly traded firm model also departs from a 
model based specifically on the banking industry. This change in 
direction may conflict with the fact that the priced services are 
provided by Reserve Banks, which are, by definition, banks.
    The Board specifically requests comment on the following:
    Is using the U.S. market as a whole as a basis for the imputed 
capital structure, tax rate, and debt financing rates of the priced 
services reasonable? Is discontinuing the use of a correspondent bank 
model reasonable?
    Are the proposed approaches to imputing the capital structure, 
effective tax rate, and long- and short-term debt financing rates 
appropriate?
    Is it reasonable to include only investment-grade bond yields in 
the calculation of the imputed long-term debt financing rate? If not, 
what approach should the Board take to include other yields or rates in 
the calculation? What publicly-available data sources are best suited 
for obtaining data on non-investment-grade debt?
    Is it reasonable to limit the calculation of the short-term debt 
financing rate to include only rated commercial paper even if the long-
term debt financing rate calculation were expanded to include non-
investment-grade debt, given the expectation that the need for short-
term funding on the priced services balance sheet will be relatively 
small? If not, what approach should the Board take to include other 
rates in the calculation?
    What publicly-available data sources are best suited for 
determining the effective tax rate, capital structure, and short- and 
long-term debt financing rates of the U.S. market?
    Should the Board consider using a longer-term risk-free rate to 
calculate the target ROE to decrease the ROE calculation's sensitivity 
to changes in interest rates?

III. Other PSAF Models Considered

The User-Owned Utility Model

    The Reserve Banks' major competitors in the provision of priced 
services increasingly are user-owned utilities rather than traditional 
correspondent banks. Accordingly, one approach to revise the 
methodology for imputing costs might be to model the priced services 
balance sheet and imputed capital structure, financing rates, tax rate, 
and other applicable costs on a user-owned utility. Under this 
methodology, the priced services balance sheet and imputed costs would 
reflect either the financial characteristics of a peer group of user-
owned utilities currently existing in the market or theoretical 
assumptions about the behavior and characteristics of this type of 
organization.
    A user-owned utility model is conceptually appealing because the 
Reserve Banks' competitors in the Fedwire[supreg] Funds, 
FedACH[supreg], and, to a lesser extent, check services are 
increasingly user-owned utilities. Such a model also recognizes that, 
as clearing balance levels decline, providing priced services to DIs 
that do not maintain clearing balances could more closely resemble the 
operation of a user-owned utility than that of a traditional 
correspondent bank.
    Selecting an appropriate peer group for this approach, however, is 
challenging. User-owned utilities typically provide a diverse array of 
services using various operational approaches. Although choosing a 
narrowly defined peer group of user-owned utilities, specifically one 
consisting of peers that provide services more closely resembling the 
priced services, could provide a more-comparable peer group, this 
approach may also introduce greater volatility in the PSAF because of 
the dependence on data from a small number of firms.
    A user-owned utility peer group could present other problems as 
well. Publicly available financial data on user-owned utilities are 
often not published. For example, CHIPS and EPN provide services that 
compete with the priced services provided by Reserve Banks. These two 
entities, however, are both components of TCH, which does not publicly 
report its financial statements either by product line or in aggregate. 
Although data are more readily available to the public from several 
other user-owned utilities (such as SWIFT and the Depository Trust & 
Clearing Corporation), the services provided by these firms are less 
comparable to those provided by the Reserve Banks.
    Basing this model on theoretical characteristics of user-owned 
utilities rather than on the actual data of a specific peer group could 
also prove challenging. User-owned utilities, by definition, lack 
incentive for profit maximization because the owners of these utilities 
are also their primary customers. Consequently, user-owned utilities 
tend to seek to maximize the benefit afforded to their users by 
providing low-cost services while remaining financially viable. 
Although the assumption that this characteristic could result in a 
lower required rate of return on equity is reasonable, establishing a 
methodology to calculate that rate using the limited economic 
literature available on the subject could be difficult. Further, 
establishing the means to calculate the other requisite imputed 
elements--capital structure,

[[Page 15489]]

debt financing rates, and income taxes--using theoretical assumptions 
or academic studies could be similarly challenging.
    The user-owned utility model exhibits some of the same drawbacks of 
the publicly traded firm model that the Board is proposing. For 
example, a user-owned utility model represents the same significant 
departure from a model based specifically on the banking industry. A 
user-owned utility model also would not include residual clearing 
balances, which departs from the Board's past practice of basing the 
PSAF on actual priced services assets and liabilities.
    The Board specifically requests comment on the following:
    Given that user-owned utilities reflect a significant portion of 
the Reserve Banks' competitors in providing priced services, would a 
user-owned utility model be more appropriate? If yes, are there 
approaches the Board should consider that would address the identified 
obstacles?

The Cost-Plus Model

    In 2005, while commenting on proposed changes to the PSAF 
methodology for calculating the ROE, two commenters suggested a cost-
plus model as a simple, straightforward method for calculating the 
PSAF. Accordingly, the Board investigated the possibility of using a 
cost-plus PSAF model based on priced services operating expenses. A 
cost-plus PSAF model would add a markup to the priced services 
operating expenses for the year. The markup would be calculated by 
applying an internal benchmark or market rate of return to the level of 
budgeted priced services operating expenses. Regardless of the method 
used to calculate the markup, residual clearing balances held at 
Reserve Banks would not be included in the calculation of net imputed 
cost, and NICB would therefore be zero by definition.
    Calculating the markup for a cost-plus model requires a data source 
from which to develop the internal benchmark or market rate of return 
to be applied to budgeted operating expenses. In the case of an 
internal benchmark, the Board considered using an average of historical 
PSAF values. Such values, however, would not take current data into 
account and would reflect a correspondent bank model that is 
increasingly inapplicable given recent trends in the payments 
industries and the expected continued decline in the level of clearing 
balances. In addition, a static internal benchmark based on historical 
PSAF values would fail to reflect ongoing changes in the marketplace.
    Alternatively, the Board could base the markup ratio applied to the 
priced services operating expenses on an external benchmark, such as 
the average markup over operating expenses for the U.S. market as a 
whole.\28\ Specifically, the Board could calculate the markup as the 
ratio of pretax income and interest expense to operating expense for 
all U.S. publicly traded firms. This markup could then be applied to 
the projected level of priced services operating expense, including 
imputed operating expenses such as sales tax, to determine the value of 
the imputed profit, debt financing cost, and income taxes to be 
factored into priced services fees. Applying a markup over expenses 
ratio based on value-weighted average data for all publicly traded U.S. 
firms in the Standard & Poor's Compustat[supreg] database to the 2009 
budgeted priced services operating expense yields a projected 2009 PSAF 
of $157.5 million.\29\
---------------------------------------------------------------------------

    \28\ The Board discarded the idea of basing the markup ratio on 
data for more narrowly-defined peer groups because of the challenges 
of comparability and data availability discussed previously.
    \29\ The Board could calculate a markup over expenses ratio 
using two averaging techniques: equal weighting and value weighting. 
The Board believes value weighting is more appropriate because it 
would yield less-volatile results and would better capture the 
characteristics of the market as a whole.
---------------------------------------------------------------------------

    Although a cost-plus model is simple, transparent, and replicable 
by the public, it also has several weaknesses. A cost-plus model based 
on historical PSAF values is static and assumes continued use of the 
current correspondent bank model, which is increasingly inapplicable. 
In addition, basing a cost-plus model on accounting-based values 
captures only book, not market, values of financing and other costs. 
Such a model is also not consistent with current finance theory. As 
with the models discussed previously, a cost-plus model represents a 
departure from a model based specifically on the banking industry.
    The Board specifically requests comment on the following:
    Should the Board consider implementing a cost-plus model?
    Are there other sources of data that the Board should consider 
using to calculate an appropriate markup over operating expenses or 
over another financial characteristic of the priced services?
    Are there other approaches that the Board should consider to 
address the identified obstacles?

Continuation of the Current Correspondent Bank Model

    The Board also considered the continued use of the current 
correspondent bank model to impute costs, with minor modifications. 
Using this model while also paying interest on required reserve 
balances and excess balances would result in a significantly smaller 
priced services balance sheet because of the anticipated decline in 
clearing balances and the associated imputed investment assets. Equity, 
which would still be imputed at the FDIC regulatory minimum for a well-
capitalized depository institution, would shrink because of the 
reduction in size of the overall priced services balance sheet.
    Residual clearing balances would continue to serve as a funding 
source for the priced services. If residual balances were not 
sufficient to meet the funding need, net of equity, on the priced 
services balance sheet, debt would be imputed. The imputed short- and 
long-term debt financing rates would be calculated using the same 
methodologies outlined for the imputed debt financing rates of the 
publicly traded firm model. Using average market debt financing rates 
in the correspondent bank model recognizes that as clearing balances 
fall and debt rises as a percentage of total priced services assets, 
the priced services balance sheet would look increasingly like that of 
a publicly traded firm and less like that of a correspondent bank.\30\ 
An average debt financing rate would also use readily-available public 
data and could be calculated with grea