Federal Register / Vol. 70, No. 199 / Monday, October 17, 2005 / Notices 60341 

Five commenters suggested that 

certain language be clarified, and 

several of these suggestions have been 

incorporated into the survey document. 

For example, the survey now more 

clearly indicates that checks converted 

to ACH transactions should be 

excluded, clarifies which types of losses 

should be included as check losses, and 

explains the difference between 

electronic check presentment and paper 

check presentment. Additionally, the 

survey document more clearly indicates 

that a respondent should check an 

estimate box if an answer is an estimate, 

or enter ‘‘DK’’ (don’t know) if the 

respondent has volume of the type being 

measured, but is unable to report at least 

an estimate. 

Board of Governors of the Federal Reserve 

System, October 11, 2005. 

Jennifer J. Johnson, 

Secretary of the Board. 

[FR Doc. 05–20663 Filed 10–14–05; 8:45 am] 

BILLING CODE 6210–01–P 

FEDERAL RESERVE SYSTEM 

Formations of, Acquisitions by, and 

Mergers of Bank Holding Companies 

The companies listed in this notice 

have applied to the Board for approval, 

pursuant to the Bank Holding Company 

Act of 1956 (12 U.S.C. 1841 et seq.) 

(BHC Act), Regulation Y (12 CFR Part 

225), and all other applicable statutes 

and regulations to become a bank 

holding company and/or to acquire the 

assets or the ownership of, control of, or 

the power to vote shares of a bank or 

bank holding company and all of the 

banks and nonbanking companies 

owned by the bank holding company, 

including the companies listed below. 

The applications listed below, as well 

as other related filings required by the 

Board, are available for immediate 

inspection at the Federal Reserve Bank 

indicated. The application also will be 

available for inspection at the offices of 

the Board of Governors. Interested 

persons may express their views in 

writing on the standards enumerated in 

the BHC Act (12 U.S.C. 1842(c)). If the 

proposal also involves the acquisition of 

a nonbanking company, the review also 

includes whether the acquisition of the 

nonbanking company complies with the 

standards in section 4 of the BHC Act 

(12 U.S.C. 1843). Unless otherwise 

noted, nonbanking activities will be 

conducted throughout the United States. 

Additional information on all bank 

holding companies may be obtained 

from the National Information Center 

website at www.ffiec.gov/nic/. 

Unless otherwise noted, comments 

regarding each of these applications 

must be received at the Reserve Bank 

indicated or the offices of the Board of 

Governors not later than November 10, 

2005. 

A. Federal Reserve Bank of Atlanta 

(Andre Anderson, Vice President) 1000 

Peachtree Street, N.E., Atlanta, Georgia 

30303: 

1. Flint Community Bancshares, Inc., 

Albany, Georgia; to become a bank 

holding company by acquiring 100 

percent of the voting shares of Flint 

Community Bank, Albany, Georgia (in 

organization). 

2. SBT Bancorp, Inc., Clarkesville, 

Georgia; to become a bank holding 

company by acquiring 100 percent of 

the voting shares of Southern Bank & 

Trust, Clarkesville, Georgia (in 

organization). 

B. Federal Reserve Bank of 

Minneapolis (Jacqueline G. King, 

Community Affairs Officer) 90 

Hennepin Avenue, Minneapolis, 

Minnesota 55480-0291: 

1. Citizens Development Company, 

Billings, Montana; to merge with 

Midwest Bancorporation, Billings, 

Montana, and thereby indirectly acquire 

Clarke County State Bank, Osceola, 

Iowa; Farmers and Merchants State 

Bank, Iroquois, South Dakota; and 

Farmers State Bank, Stickney, South 

Dakota. 

2. Citizens Development Company, 

Billings, Montana; to merge with United 

Bancorporation, Billings, Montana, and 

thereby indirectly acquire Lincoln 

County Bank, Merrill, Wisconsin; 

United Bank, Osseo, Wisconsin; Bank of 

Poynette, Poynette, Wisconsin; and 

Cambridge State Bank, Cambridge, 

Wisconsin. 

C. Federal Reserve Bank of Kansas 

City (Donna J. Ward, Assistant Vice 

President) 925 Grand Avenue, Kansas 

City, Missouri 64198-0001: 

1. Nebraska Bankshares, Inc., Farnam, 

Nebraska; to acquire up to 100 percent 

of the voting shares of First State Bank 

(also known as Holbrook Exchange 

Company, Holbrook, Nebraska (in 

organization). 

Board of Governors of the Federal Reserve 

System, October 12, 2005. 

Jennifer J. Johnson, 

Secretary of the Board. 

[FR Doc. E5–5691 Filed 10–14–05; 8:45 am] 

BILLING CODE 6210–01–S 

FEDERAL RESERVE SYSTEM 

[Docket No. OP–1229] 

Federal Reserve Bank Services Private 

Sector Adjustment Factor 

AGENCY: Board of Governors of the 

Federal Reserve System. 

ACTION: Notice. 

SUMMARY: The Board has approved 

modifications to the method for 

calculating the private sector adjustment 

factor, which imputes the costs that 

would have been incurred and profits 

that would have been earned, including 

the return on equity capital, had the 

Federal Reserve Banks’ priced services 

been provided by a private sector 

business. When setting prices in 2006, 

the Board will use only the capital asset 

pricing model to determine the target 

return on equity capital. Rather than 

continuing the long-standing process of 

identifying a peer group to calibrate the 

target return on equity capital, the 

return on equity capital will be based on 

the rate of return for the equity market 

as a whole. The Board’s method for 

setting the level of equity capital 

imputed to priced services would 

continue to be based on the Federal 

Deposit Insurance Corporation 

guidelines for a well-capitalized 

depository institution for insurance 

premium purposes. In addition, the 

Board will continue using the financial 

data from the top fifty bank holding 

companies by deposit balance to 

determine the priced-services effective 

tax rate each year. 

DATES: This revised method will be used 

to calculate the targeted return on equity 

capital beginning with the 2006 price 

setting. 

FOR FURTHER INFORMATION CONTACT: 

Gregory L. Evans, Assistant Director 

(202/452–3945), Brenda L. Richards, 

Manager (202/452–2753), or Jonathan 

Mueller, Financial Analyst (202/530–

6291); 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 that the Board establish fees for 

‘‘priced services’’ provided to 

depository institutions to recover, over 

the long run, all direct and indirect 

costs actually incurred as well as 

imputed costs that would have been 

incurred, including financing costs, 

taxes, and certain other expenses, and 

the return on equity (profit) that would 

have been earned, if a private business 

60342 Federal Register / Vol. 70, No. 199 / Monday, October 17, 2005 / Notices 

1Equity is imputed based on the FDIC definition 

of a ‘‘well-capitalized’’ 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; and (2) a ratio of Tier 1 capital to riskweighted assets of 6 percent or greater; and (3) a 

leverage ratio of Tier 1 capital to total assets of 5 

percent or greater. The Federal Reserve pricedservices balance sheet total capital has no 

components of Tier 1 or total capital other than 

equity; therefore, requirements 1 and 2 are 

essentially the same measurement. 

2Rather than estimate a separate tax expense, the 

Board targets a pretax ROE that would provide 

sufficient income to fulfill its income tax 

obligations. To the extent that the actual 

performance results are greater or less than the 

targeted ROE, income taxes are adjusted 

accordingly. 

3The previous review of the PSAF was completed 

in 2001 and changes were implemented for the 

2002 PSAF (66 FR 52617, October 16, 2001). 

4 During the development of this proposal, the 

Federal Reserve worked with a consulting firm 

specializing in capital allocation and risk 

management and four finance professors from U.S. 

academic institutions to obtain information about 

current private-sector practices. 

firm provided the services. The imputed 

costs and imputed profit are collectively 

referred to as the private sector 

adjustment factor (PSAF). 

The method for calculating the PSAF 

includes determining the book value of 

Federal Reserve assets and liabilities to 

be used in providing priced services 

during the coming year. The Board’s 

method involves developing an 

estimated Federal Reserve pricedservices pro forma balance sheet using 

actual priced-services assets and 

liabilities. The remaining elements on 

the balance sheet, such as equity, are 

imputed as if these services were 

provided by a private-sector business. 

Equity is imputed at a level necessary to 

satisfy the Federal Deposit Insurance 

Corporation (FDIC) requirement for a 

well-capitalized depository institution.1

A target return on equity capital 

(ROE) is estimated and applied to the 

dollar amount of equity capital on the 

pro forma balance sheet to determine 

the priced-services cost of equity. For 

the past few years, the ROE has been 

calculated by averaging the results of 

three analytical models: The comparable 

accounting earnings (CAE) model, the 

discounted cash flow (DCF) model, and 

the capital asset pricing model (CAPM). 

The top fifty bank holding companies 

(BHCs) based on deposit balances serve 

as the peer group for Federal Reserve 

priced services and the peer group’s 

financial data are used to estimate the 

target ROE. 

The Board uses historical BHC 

accounting information to compute a 

target ROE in the CAE model. The ROE 

for an individual BHC in the peer group 

is calculated as the ratio of the firm’s net 

income to its book value of equity and 

is averaged with the ROEs of the peer 

group BHCs to determine the total peer 

group ROE. The CAE ROE is calculated 

as the average of the peer group ROEs 

over the last five years. The DCF model 

takes a forward-looking approach to 

estimating ROE. It assumes that a firm’s 

stock price is equal to the discounted 

present value of all expected future 

dividends. The CAPM captures the riskreturn relationship that rational 

investors require in efficient markets. 

The underlying theory of the model 

assumes that investors demand a 

premium for bearing risk; that is, the 

higher the risk of the entity, the higher 

its expected return must be to attract 

investors. 

The PSAF also includes imputed 

income taxes by using a targeted pretax 

ROE.2 The PSAF tax rate is the median 

of the rates paid by the fifty BHCs in the 

peer group over the past five years. 

Finally, the PSAF includes an estimated 

share of the Board of Governors’

expenses incurred to oversee Reserve 

Bank priced services, imputed sales tax, 

and an imputed assessment for FDIC 

insurance. 

The methodology underlying the 

PSAF is reviewed periodically to ensure 

that it is appropriate and relevant in 

light of Reserve Bank priced-services 

activities, accounting standards, finance 

theory, and regulatory and business 

practices.3 In addition, the Board seeks 

to balance the cost, complexity, and 

accuracy of the PSAF methodology in 

implementing theoretically sound 

approaches. 

In May, the Board requested 

comments on potential modifications to 

the following elements of the PSAF ROE 

methodology (70 FR 29512, May 23, 

2005).4

• Imputed ROE models: The Board 

requested comment on calculating a 

target ROE based only on the CAPM, 

rather than the current three-model 

method. 

• CAPM parameters: The Board 

requested comment on the appropriate 

method for establishing the risk-free rate 

and the measure of market risk, 

commonly referred to as the beta, 

including the peer group, estimation 

period, weighting approach, and the 

assumption that the priced-services beta 

is equal to 1.0. 

• Income tax rate calculation: 

Although the Board did not specifically 

request comment on the tax rate 

calculation, if the Board were to assume 

a beta equal to 1.0 for priced services 

and a peer group is no longer needed, 

the Board would need to identify a 

method to determine a comparable tax 

rate for the PSAF. 

• Broader issues and future industry 

and regulatory changes: The Board 

requested comment on whether the ROE 

target should be set every year or over 

a multi-year period and whether the 

ROE methodology should be adjusted to 

take business changes into 

consideration. Given that the 

competition to the Reserve Banks’

priced services will increasingly be 

market utilities rather than 

correspondent banks as the check 

service becomes more electronic, the 

Board requested comment on the 

implications that this trend would have 

on determining the priced-services peer 

group. The Board also requested 

comment on the potential effect on the 

PSAF of proposals developed by the 

Basel Committee on Banking 

Supervision (Basel II) to improve capital 

adequacy regulations. 

II. Summary and Analysis of Comments 

The Board received ten responses to 

its request for comment. Six responses 

were from banks or BHCs, and one 

response each was received from a 

savings and loan, a payments processing 

company, a banking association, and a 

Reserve Bank. Overall, the comments 

were mixed regarding the theory, use, 

and components of the current and 

considered PSAF ROE methodology. 

A. Imputed Return on Equity Models 

The target ROE for Reserve Bank 

priced-services activities is established 

at the organization level rather than by 

developing an ROE for each service or 

Reserve Bank. Conceptually, the ROE is 

developed with a shareholder’s 

perspective in mind and considers 

whether shareholders are adequately 

compensated in the form of average 

equity returns given the overall risk of 

the business activities. The current 

three-economic-model approach 

incorporates different inputs and melds 

different outlooks when determining a 

target ROE. The source of data for the 

CAE model is peer-group historical 

accounting information and the peer 

group CAE ROE is averaged over five 

years to avoid any large fluctuations. 

The DCF approach uses BHC peer group 

stock prices, along with analyst 

projections of future dividends and 

long-term dividend growth rates, to 

estimate ROE. The CAPM uses peer 

group and market equity returns to 

estimate a risk premium, which is 

added to the return on a risk-free asset 

to estimate ROE. 

Because the CAPM is widely accepted 

and used more in practice than the CAE 

and DCF methods, the Board requested 

comment on replacing the current 

method of averaging the results of three 

Federal Register / Vol. 70, No. 199 / Monday, October 17, 2005 / Notices 60343 

5R.F. Bruner, K.M. Eades, R.S. Harris, and R.C. 

Higgins, 1998 ‘‘Best Practices in Estimating Cost of 

Capital: Survey and Synthesis,’’ Financial Practice 

and Education, and J.R. Graham, and C.R. Harvey, 

2001 ‘‘The Theory and Practice of Corporate 

Finance: Evidence from the Field,’’ Journal of 

Financial Economics, find that CAPM is the 

dominant model for estimating cost of equity. In 

addition, most textbook treatments of equity cost of 

capital calculations are based on the CAPM model 

(for example see http://www.Damodaran.com). 

6The earnings credit rate is 80 percent of the base 

rate, which is the coupon equivalent yield of the 13- 

week rolling average of the three-month Treasury 

bill. The investment rate is the base rate plus a 

constant spread, which is determined by a portfolio 

that is similar to one held by a BHC. 

7The NICB calculation assumes that Reserve 

Banks invest clearing balances net of imputed 

reserve requirements and balances used to finance 

priced-services assets. Based on the net clearing 

balance level, Reserve Banks impute a constant 

spread, determined by the return on a portfolio of 

investments, over the three-month Treasury bill 

rate. 

8APT incorporates various capital market and 

macro-economic data to estimate a target ROE. 

Instead of one measure of market risk, APT includes 

many. Each beta measures the sensitivity of a firm’s 

returns to a separate underlying factor, such as 

short-term real interest rates, inflation, default risk, 

and industrial production. 

models with a simple CAPM-only 

method.5 Specifically, the CAE model 

has continued to wane in use and the 

effectiveness of the DCF model has been 

questioned based on research findings 

that analysts’ dividend projections can 

be biased. 

Generally, commenters supported 

using the CAPM-only method to 

calculate a target ROE because it is 

simple and theoretically the best model. 

Some suggested keeping the current 

three-model approach or using a 

modified version of the current 

approach. None of the comments 

supported the DCF model; however, 

three commenters noted that the CAE 

model, or other accounting-based 

information, could be a useful way to 

validate the results and assumptions of 

CAPM. One commenter opposed using 

only the CAPM because it would create 

volatility in Federal Reserve pricing. 

Although ROE targets taken directly 

from results produced by a CAPM-only 

approach are more volatile than those 

generated under the current 

methodology primarily due to the 

CAPM’s sensitivity to the short-term 

risk-free rate, the Board believes that the 

degree of volatility is representative of 

ROEs that would be expected of a 

private-sector service provider. In 

addition, the imputed net income on 

clearing balances (NICB) for priced 

services is also sensitive to short-term 

interest rate changes because the spread 

between the earnings rate and the cost 

of clearing balances increases as shortterm rates increase.6 In a changing 

interest rate environment these two 

factors move in directions that offset 

each other. Both the target ROE and 

NICB would increase and decrease 

together as interest rates rise and fall, 

respectively. Thus, the effect on net 

income and service prices of these two 

factors combined becomes more stable 

than under the current ROE calculation 

methodology.7

Several commenters offered 

alternative models or adjustments that 

could be considered when calculating a 

target ROE. Three commenters 

suggested that the Board could use an 

Arbitrage Pricing Theory (APT) model, 

other multi-factor models, or adjust the 

CAPM beta for differences in leverage 

between the peer group and Federal 

Reserve priced services. Although not 

discussed in the request for comment, 

the Board considered whether APT and 

other multi-factors models, along with 

making adjustments for leverage, to 

estimate a target ROE would lead to a 

materially different ROE over the 

‘‘simple’’ CAPM ROE.8 In multi-factor 

models and models adjusting for 

differences in leverage, subjective 

judgments and assumptions must be 

made about the factors to include and 

the future behavior of the factors. 

Incorporating the additional factors and 

making subjective and complex 

adjustments did not produce materially 

different ROEs from those resulting from 

using a single factor CAPM. 

Overall, the Board believes that 

CAPM is a methodology widely used in 

financial industry practice. The Board 

recognizes that many firms use financial 

models, such as CAPM, as a starting 

point when estimating a target ROE and 

make subjective adjustments based on 

current or expected trends affecting the 

firm’s profitability. Because the Board 

strives to have a PSAF methodology that 

is consistent with private-sector practice 

and that can be replicated by the public, 

the CAPM-only approach is reasonable 

because it is a well-known, generally 

accepted, and theoretically sound model 

that is simple and transparent compared 

to other approaches. The Board, 

therefore, will use the CAPM-only 

approach to estimate a target ROE. 

B. CAPM Parameters 

In its request for comment, the Board 

considered whether the current CAPM 

methodology should be modified to 

reflect better the goals of the MCA, and 

current professional and academic 

practice. CAPM’s basic principle is that 

the required rate of return on a firm’s 

equity is equal to the return on a riskfree asset plus a risk premium. The risk 

premium is a measurement of the 

expected excess return on a market 

portfolio of equities over a risk-free rate 

(the expected market risk premium) and 

the correlation of the firm’s returns to 

the market returns (beta). These 

principles are captured in the following 

formula: 

60344 Federal Register / Vol. 70, No. 199 / Monday, October 17, 2005 / Notices 

9For the 2005 PSAF, the Board used the one-year 

Treasury bill rate as the risk-free rate. 

10 Initially, the risk-free rate will be based on the 

NICB investment rate. The NICB investment rate is 

based on the coupon equivalent yield of the 13- 

week rolling average of the three-month Treasury 

bill in the secondary market, from which a constant 

spread is applied. 

CAPM requires judgment in 

determining 

• The risk-free interest rate or the rate 

of return on an investment with no or 

low risk, typically measured using a 

Treasury security rate. 

• The method, data, and period used 

for estimating the beta. The beta 

measures the market risk of a particular 

company relative to the risk of the 

overall market. 

• The market risk premium, which 

estimates the additional return investors 

require to forgo the safety of investing 

in no or low-risk assets to bear the 

higher risk of investing in a specific 

asset. 

(1) Risk-Free Rate (Investment Horizon) 

Consistent with the theory of CAPM, 

the Board currently uses the rate on a 

short-term Treasury security as the riskfree interest rate.9 In its request for 

comment, the Board noted that there are 

competing views about whether a shortterm or long-term risk-free rate is more 

appropriate in the CAPM. One point of 

view is that a short-term risk-free rate is 

appropriate because it is consistent with 

the time horizon of investors in liquid 

securities markets. This approach also is 

consistent with the yearly price-setting 

for Federal Reserve services. Another 

point of view advocates using a longterm risk-free rate, such as the ten-year 

Treasury bond rate, because it more 

closely matches the duration of physical 

investments, the duration of stock 

market indexes used to estimate a beta, 

and the investment horizon of a longterm investor. It may also be considered 

to be more in line with the MCA’s 

requirement for the Federal Reserve to 

recover all costs of providing its services 

over the long run. In this approach, a 

target ROE should represent the return 

that the firm expects to achieve on 

average over the fluctuations of the 

business cycle. When considering what 

risk-free rate term to use, generally the 

time horizon of the investor is matched 

with term of the risk-free security. If 

investment in the Reserve Banks’

activities is assumed to be long term, 

this approach would support using the 

yield on a longer-term Treasury 

instrument as the risk-free rate in the 

CAPM to calculate the Reserve Banks’

priced-services target ROE. 

The Board specifically requested 

comment on whether a short-term or 

longer-term risk-free rate is more 

appropriate for estimating a target ROE, 

and if using a long-term risk-free rate 

less a term premium adjustment to 

reflect an expected average short-term 

risk-free rate over a ten-year horizon is 

reasonable. 

Comments received were varied in 

regards to the term of the risk-free rate 

to use in the CAPM. One commenter 

supported the current practice to use a 

short-term rate and match the term of 

the risk-free rate with the frequency of 

the Federal Reserve pricing. One 

commenter suggested using a five-year 

Treasury rate. Three commenters 

supported using a long-term risk-free 

rate to better meet the long-term cost 

recovery objectives of the MCA, to 

reduce year-to-year volatility in the 

ROE, and to adopt a longer-term 

planning horizon. Two of these 

commenters supported the ten-year 

Treasury note rate, while the other 

thought using a ten-year Treasury note 

rate with a term premium adjustment 

was reasonable. 

In considering the arguments for both 

the short- and long-term rates, the Board 

does not believe that one method 

produces conceptually superior results 

over the other; over time they should 

produce the same results, after adjusting 

for term premiums. In practice, a shortterm rate will reduce the volatility of the 

combined target ROE and NICB 

estimates, minimizing the effect that 

changes in interest rates will have on 

prices each year. Given that privatesector businesses use both short- and 

long-term risk free rates and to address 

the CAPM volatility and the potential 

effect on prices, the Board will use a 

short-term rate in the CAPM that is 

consistent with the rate used to 

calculate NICB. This approach should 

decrease the sensitivity to interest rate 

changes of the combined ROE and NICB 

that are factored into the Federal 

Reserve’s pricing.10

(2) Market Risk Premium 

Currently, the Board uses the monthly 

average difference between the market 

return and the return of a one-month 

Treasury bill since 1927 to estimate the 

expected market risk premium (MRP). 

Although the Board did not specifically 

request comment on an appropriate 

MRP, some commenters suggested that 

the Reserve Banks’ current methodology 

does not properly reflect more recent 

equity and bond market conditions and, 

therefore, may be overstated. One 

commenter encouraged the Board to 

investigate using an MRP of 3–6 percent 

because it was the commenter’s sense 

that support for an MRP around 7 

percent may be dwindling. Another 

commenter suggested that the Board 

consider estimating the MRP using a 

shorter time period that corresponds to 

the risk-free rate horizon. 


EN17OC05.001</GPH>
Federal Register / Vol. 70, No. 199 / Monday, October 17, 2005 / Notices 60345 

11According to an article by M.H. Goedhart, T.M. 

Koller, and Z.D. Williams, Number 5, Autumn 2002 

‘‘The Real Cost of Equity,’’ McKinsey on Finance, 

firms employ a variety of equity risk premium 

estimation approaches that have led to varying 

estimates of the equity risk premium from zero 

percent to 8 percent. The article states further that 

most practitioners now use a narrower range of 3.5 

percent to 6 percent (http:// 

www.corporatefinance.mckinsey.com/_downloads/ 

knowledge/mckinsey_on_finance/MoF_Issue_5.pdf). 

12This estimate will be based on the French data 

series, which is the standard data series used to 

estimate the MRP providing monthly return of the 

market over a one-month Treasury bill from 1927 

to present (http://mba.tuck.dartmouth.edu/pages/ 

faculty/ken.french/data_library.html) 

13BHC due-to balances are bank deposits 

reported on the books of the individual institutions 

that make up the BHC, which originate from other 

banks and represent respondent balances held to 

provide transaction processing and settlement 

services. 

In researching this issue, the Board 

found that practitioners and academics 

use different approaches to estimate an 

MRP that they argue produce a more 

realistic estimate than an MRP based on 

the historical average since 1927.11

Different estimates of the MRP using 

historical data are attributable to choices 

made about averaging techniques, the 

term of the Treasury security that serves 

as the basis for the risk-free rate, and the 

historical time period. Choosing among 

the options is essentially a matter of 

weighing conceptual differences. 

In general, there are two broad 

approaches to estimate the MRP. One is 

based on what equity investors have 

earned in the past, while the other is 

based on projections implied by current 

stock prices relative to earnings, cash 

flows, and expected future growth. In 

order to make the PSAF ROE calculation 

publicly replicable, the Board currently 

uses historical returns to estimate an 

expected MRP. When using historical 

data to estimate the MRP, it is important 

that the time span is neither so short 

that it is heavily influenced by atypical 

events nor so long that it captures 

market conditions that have little or no 

relationship to the current market and 

economy. In analyzing historical 

monthly MRP data since 1927, there are 

outlying observations in the years up to 

1940 when compared with other 

observations in the following decades. 

These data suggest that there can be 

fundamental shifts in investor 

expectations over varying historical 

periods considering that different 

generations will have different risk 

tolerances based on changing economic 

and market conditions. The MRP would 

be more appropriately influenced by 

evolving attitudes reflected in realized 

MRPs if it is calculated using a rolling 

average of historical returns rather than 

the current practice of using historical 

returns since 1927. A rolling average 

would better capture changes in 

expectations because less relevant 

historical data would drop out and more 

relevant and recent data would be 

incorporated in the calculation. 

The Board will adopt a rolling fortyyear time horizon to estimate MRP.12

The Board believes that forty years is 

sufficiently long to smooth cyclical 

fluctuations in realized returns, but 

short enough to reflect trends in 

required returns. 

(3) Beta 

Conceptually, the Reserve Banks’

priced services should target the ROE 

that the market would require of a 

private firm with the same risk profile. 

The beta should be based on a 

comparable peer group of companies 

providing these same services and 

having the same risk profiles as pricedservices activities. When the peer group 

is identified, the most relevant and 

appropriate methods to use for the beta 

can be determined and applied to 

estimate the market risk of priced 

services. 

Peer Group 

When it requested comment, the 

Board acknowledged that BHCs are not 

a perfect proxy for Reserve Bank pricedservices activities. Some BHCs provide 

similar services through their 

correspondent banking activities, 

including payment and settlement 

services. BHCs also hold respondent 

(‘‘due-to’’) balances, which are similar 

to depository institution balances held 

by Reserve Banks, and have publicly 

available financial information.13 As a 

result, BHCs have been considered the 

most reasonable proxy for a peer group. 

A major drawback to using BHCs as the 

proxy is that they offer diverse services 

with different risk profiles that reach 

well beyond the payment services that 

are provided by the Reserve Banks, such 

as consumer and corporate lending and 

investment services. Currently, the top 

50 BHCs by deposit balance are used as 

the priced-services peer group, and 

since the inception of MCA, the peer 

group has always consisted of BHCs. 

In its request for comment, the Board 

considered looking at the level of a 

BHC’s involvement in correspondent 

banking activity, its capital structure, 

and its solvency ratings to refine the 

BHC peer group to match better the 

Federal Reserve priced-services 

activities and reduce the effect on the 

ROE of these noncomparable services in 

which BHCs are involved. The Board 

specifically requested comment on two 

alternatives to choosing a suitable peer 

group. The first alternative focused on 

continuing to select the top fifty 

publicly traded BHCs based on deposit 

balance. The Board requested comment, 

however, on adding filters to the 

selection process to focus on capital 

structure, risk-weighted asset ratios, and 

solvency ratings. The Board also 

requested comment on the efficacy of 

cross matching the top 50 BHCs by 

deposit balance with the top 50 BHCs by 

due-to balances. The Board believed 

that this additional selection criterion 

could improve the peer group selection 

by narrowing the group to include only 

those BHCs that are more involved in 

transaction processing and settlement 

services. 

Only one of the commenters who 

specifically responded to the questions 

concerning the proposed peer group 

selection criteria supported the 

continued use of BHCs as an 

appropriate peer group for the Reserve 

Banks’ payments services. Two 

commenters suggested that reliance on 

BHCs as a peer group would most likely 

overstate a target ROE for the Reserve 

Banks because of the overall nature and 

diversity of the businesses in which 

BHCs engage. Another commenter 

argued that the payments business is 

riskier than other BHC business lines 

and that using BHCs would understate 

the target ROE. This commenter 

suggested eliminating BHCs altogether 

and exclusively using non-bank 

payments processing companies as the 

peer group. Other suggested approaches 

included screening out firms whose risk 

profile has been heavily influenced by 

specific events such as severe credit 

losses and acquisitions; developing a 

target ROE based on specific BHC 

product line information (segment data); 

and broadening the peer group to 

include a core group of payment 

processing companies along with BHCs. 

Finding a comparable peer group has 

been one of the more challenging 

aspects of targeting an ROE for Reserve 

Bank priced services. Over the years, the 

Board has considered a number of ways 

to refine the peer group to provide a 

better basis for imputing the profits that 

would have been earned had the 

Reserve Banks’ priced-services activities 

been provided by a private-sector 

business. Earlier efforts examined 

whether segment data within BHCs 

could be used to match more closely 

priced-services activity, or whether 

other companies such as service bureaus 

and processing firms would be a 

suitable proxy for the Reserve Banks’

priced-services activity. Using BHC 

segment data or service bureau financial 

information presented certain obstacles. 

There is no standard definition of 

60346 Federal Register / Vol. 70, No. 199 / Monday, October 17, 2005 / Notices 

14Other taxes are included in priced-services 

actual or imputed costs. 

‘‘segment’’ for use in financial reporting. 

As a result, segments may be reported 

based on any combination of customer 

type, product, or service provided. It is 

often impossible to determine in which 

BHC segments activities comparable to 

priced-services activities are included. 

As a result, information is not reliable, 

complete or consistent across BHCs. 

Service bureaus also provide diverse 

services, many of which are not 

comparable to those of Reserve Banks, 

and they typically do not provide 

settlement services, which represent a 

significant aspect of the Reserve Banks 

payments processing activity. 

Beta Estimation Period and Weighting 

In the current method, the beta is 

estimated from a rolling ten-year period 

of monthly stock returns for each BHC 

in the peer group. The returns of each 

BHC in the peer group are then marketvalue weighted and compared with the 

overall market returns. In its request for 

comment, the Board considered 

calculating the beta using monthly 

returns from the market over a rolling 

five-year period rather than a rolling 

ten-year period. The Board also 

requested comment on whether value 

weighting produces an appropriate beta 

for the Reserve Banks’ priced-services 

activities and if equal-weighting, or an 

alternative weighting process, would 

produce a better beta estimate for 

priced-services. 

Three commenters addressed the beta 

estimation period. One commenter 

supported using a rolling five-year 

period, provided that the year-to-year 

volatility is not significant. Another 

commenter also supported using a fiveyear estimation period to recognize 

changes in the banking industry. The 

third commenter suggested using a twoyear beta estimation period with weekly 

or daily observations to incorporate 

industry changes and the evolution from 

paper to electronic check processing. 

Two commenters addressed the 

weighting of the peer group beta. One 

commenter supported the use of equal 

weighting each BHC’s beta to reduce the 

influence of firms that have large market 

capitalization but a small concentration 

of payments processing activities, and 

added that additional weighting by 

segment results would provide 

additional precision. Another 

commenter stated that value weighting 

is more theoretically sound. 

Beta of 1.0 

In its request for comment, the Board 

noted that some of the difficulties 

associated with selecting a peer group 

and estimating the appropriate peer 

group beta could be eliminated by 

assuming a beta of 1.0 for Reserve Bank 

priced services. Finance literature 

suggests that all betas generally move 

toward 1.0 over time. Experience shows 

this to be the case for correspondent 

banks and other firms that provide 

payments processing services. Assigning 

a beta of 1.0 to a firm assumes that 

investment in the firm’s equity carries 

the same risk as the market, and thus, 

that investors require the same return on 

that firm’s equity as they do on the 

market as a whole. Betas greater than 1.0 

indicate greater sensitivity to market 

changes and betas below 1.0 indicate 

less sensitivity. 

Of the five commenters that addressed 

the beta-equal-to-1.0 assumption, three 

expressed a preference for developing a 

beta based on a peer group. These 

commenters, however, recognized the 

difficulty facing the Reserve Banks in 

finding a comparable peer group and 

recommended that the Board use a 

different peer group to calculate beta. 

One commenter supported the idea of 

setting beta equal to 1.0, indicating that 

this is a reasonable simplifying 

assumption in view of the uniqueness of 

the Reserve Banks’ payments business. 

Another indicated a preference for a 

static beta as opposed to one determined 

using a peer group as a way to minimize 

volatility in ROE targets, but made no 

suggestions for deriving the beta. 

From the comments received and in 

recognition of the many theoretical and 

practical considerations in applying a 

peer group approach as noted earlier, 

the Board will no longer rely on a peer 

group when calculating a target ROE. 

Even though the long-run average of the 

priced-services beta is close to 1.0 under 

the current CAPM methodology, the 

continued use of BHCs as a peer group 

gives a false sense of precision. Instead, 

the Board believes that assuming a static 

beta of 1.0 for the Reserve Banks’

priced-services beta is simple to 

understand, administer, and monitor 

while providing reasonable results. 

C. Income Tax Rate Calculation 

The PSAF captures taxes using a 

targeted pretax ROE.14 The CAPM ROE 

is calculated as an after-tax measure and 

is then converted to a pretax measure. 

Currently, the PSAF tax rate is the 

median of the income tax rates paid by 

the top fifty BHCs by deposit balance 

over the past five years. Although the 

Board will not use a peer group to 

estimate the target after-tax ROE in the 

future, it believes that the current 

approach to derive the income tax rate 

remains reasonable. Because the Reserve 

Banks provide similar services through 

their correspondent banking activities, 

including payment and settlement 

services, and equity is imputed to meet 

the FDIC requirements of a wellcapitalized depository institution, using 

a tax rate based on the top fifty BHCs 

by deposit balance continues to be an 

applicable and reasonable approach. 

D. Broader Issues and Future Industry 

and Regulatory Changes 

The Board requested comment on 

several broader issues, including annual 

and multi-year ROE targets, and future 

industry and regulatory changes. 

Overall, commenters supported 

setting the PSAF annually to correspond 

with the annual setting of prices. One 

commenter suggested that the PSAF be 

computed annually and another noted 

that a multi-year target ROE could 

magnify pricing errors. Two 

commenters noted that firms set longterm ROE goals, and some firms adjust 

targets to reflect short-term events, but 

did not suggest that the Board adopt a 

long-term ROE target. One commenter 

noted that not offsetting past under- and 

over-recoveries is not comparable to the 

private sector and suggested that the 

Board recover past years’ over/under 

recoveries in the future. 

Five commenters suggested setting the 

target ROE by service line. Two 

commenters that supported the use of a 

service line ROE noted that doing so 

may be difficult due to data availability. 

One commenter suggested using a peer 

group consisting of processing 

companies to develop service line ROEs, 

while another commenter suggested 

validating this model with a 

macroeconomic approach. One 

commenter stated that the ROE setting 

process should be consistent year-toyear and did not specifically comment 

on an entity or service-level ROE. 

One commenter suggested that the 

Board consider withdrawing from the 

check business and another commenter 

suggested that the Federal Reserve 

should not be a ‘‘leader in the clearing 

business.’’ Another commenter 

encouraged the Federal Reserve to 

remain a competitive provider of check 

services, even if cost-recovery is not 

achieved. 

The Board also requested comment on 

the longer term effect of changes 

underway in regulatory practices and 

possible implications to the Reserve 

Banks’ priced-services capital structure 

and the PSAF in the future. Two 

commenters noted that setting pricedservices equity at five percent of total 

assets is too low to cover operational 

risks and suggested that the Board 

compare the Reserve Banks’ capital 

Federal Register / Vol. 70, No. 199 / Monday, October 17, 2005 / Notices 60347 

15These commenters suggested that the Board 

participate in a future industry benchmarking 

study. 

16For the 2005 PSAF, the CAE model ROE was 

22.2%, the DCF model ROE was 19.7%, and the 

CAPM ROE was 12.3%, resulting in an average of 

18.1%. 

17FRRS 9–1558. 

structure to that of payment processing 

companies. 

Two commenters suggested that the 

Board adopt a ‘‘cost-plus’’

benchmarking approach from which a 

market rate of return would be 

determined for each business line.15

While there may be benefits to Reserve 

Banks in gaining insights from such a 

study, currently the Board does not 

contemplate incorporating this 

approach into its target ROE calculation. 

Moreover, the Board strives to use only 

data in the public domain to calculate 

the PSAF, and data from the study may 

not be available to the public. 

III. Effects of New PSAF ROE 

Methodology 

Using the 2005 final PSAF for 

illustrative purposes, the data below 

shows the effect of implementing a 

CAPM-only approach with a beta of 1.0 

assumption, a rolling 40-year MRP, and 

the coupon-equivalent three-month 

Treasury bill rate as the risk-free rate. 

Applying the revised approach to the 

2005 PSAF equity level results in a 

$70.2 million decrease. 

TABLE.—PSAF ILLUSTRATION

[$ in millions] 

Pretax ROE 

(percent) × Equity = Cost of equity PSAF 

Three model approach 16 .................................................................. 18.1 $808.0 $146.2 $161.0 

CAPM-only approach ........................................................................ 9.4 808.0 76.0 90.8 

IV. 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.’’ 17 Under this policy, the Board 

assesses whether a change would have 

a direct and material adverse effect on 

the ability of other service providers to 

compete effectively with the Federal 

Reserve in providing similar services 

because of differing legal powers or 

constraints or because of a dominant 

market position of the Federal Reserve 

deriving from such legal differences. If 

the fees or fee structures create such an 

effect, the Board must further evaluate 

the changes to assess whether their 

benefits—such as contributions to 

payment system efficiency, payment 

system integrity, or other Board 

objectives—can be retained while 

reducing the hindrances to competition. 

The Board is changing the PSAF 

methodology to develop an ROE target 

that reflects the return earned by 

private-sector service providers, 

consistent with the requirements of the 

MCA. Finance literature suggests that 

betas move toward 1.0 over time, 

including betas for correspondent banks 

and other firms that provide payments 

processing services. Because there is no 

perfect peer group for the Reserve Bank 

priced-services business, the PSAF ROE 

should be similar to the return of firms 

that provide similar services. 

Consequently, the fees adopted by the 

Reserve Banks should be based on the 

cost and profit targets that are 

comparable with those of other 

providers of services similar to Reserve 

Bank priced services. Accordingly, the 

Board believes that these changes will 

not have a direct and material adverse 

effect on the ability of other service 

providers to compete effectively with 

the Federal Reserve in providing similar 

services. 

V. Paperwork Reduction Act 

In accordance with the Paperwork 

Reduction Act of 1995 (44 U.S.C. ch. 

3506; 5 CFR 1320 Appendix A.1), the 

Board has reviewed the proposal under 

the authority delegated to the Board by 

the Office of Management and Budget. 

No collections of information pursuant 

to the Paperwork Reduction Act are 

contained in the proposal. 

VI. Conclusion 

Based on comments received and 

further consideration of the issues 

around the appropriate method for 

estimating a target ROE, the Board has 

adopted the following PSAF ROE 

methodology: 

• Use CAPM as the sole analytical 

method for developing the after-tax 

target ROE. 

• Within the CAPM framework for 

estimating the after-tax ROE 

Æ Set the risk-free rate equal to a 

short-term Treasury bill rate that is 

consistent with the rate used to 

calculate NICB. This will help to 

minimize volatility in net income from 

changes in interest rates. 

Æ Use a rolling forty-year average of 

monthly returns to estimate the market 

risk premium rather than taking the 

average since 1927. 

Æ Discontinue the practice of 

calculating a peer group beta to be used 

as a proxy for priced services. Instead, 

adopt a beta of 1.0, which approximates 

the return of the overall market. 

• Continue to establish the effective 

income tax rate based on the median tax 

rate of the top 50 BHCs by deposit 

balance over the last five years. 

• Continue to set the overall level of 

equity capital based on the FDIC 

guidelines for a well-capitalized 

depository institution for insurance 

premium purposes. 

By order of the Board of Governors of the 

Federal Reserve System, October 11, 2005. 

Jennifer J. Johnson, 

Secretary of the Board. 

[FR Doc. 05–20660 Filed 10–14–05; 8:45 am] 

BILLING CODE 6210–01–P 

GENERAL SERVICES 

ADMINISTRATION 

Privacy Act of 1974: Republication of 

a System of Records Notice 

AGENCY: General Services 

Administration. 

ACTION: Notice of an updated system of 

records subject to the Privacy Act of 

1974. 

SUMMARY: The General Services 

Administration (GSA) is providing 

notice of a revision to the record system, 

Purchase Card Program (GSA/PPFM4–

10). The system provides control over 

expenditure of funds through the use of 

Federal Government purchase cards. 

The revision includes a new category of 

records, credit data, as required by the