[Federal Register Volume 70, Number 199 (Monday, October 17, 2005)]
[Notices]
[Pages 60341-60347]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 05-20660]


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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.

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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

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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 priced-services 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\
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    \1\ Equity 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 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. The Federal Reserve priced-
services 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.
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    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 risk-return 
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.
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    \2\ Rather 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.
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    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.
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    \3\ The previous review of the PSAF was completed in 2001 and 
changes were implemented for the 2002 PSAF (66 FR 52617, October 16, 
2001).
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    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\
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    \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.
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    <bullet> Imputed ROE models: The Board requested comment on 
calculating a target ROE based only on the CAPM, rather than the 
current three-model method.
    <bullet> 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.
    <bullet> 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.
    <bullet> 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

[[Page 60343]]

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.
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    \5\ R.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).
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    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 short-term 
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\
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    \6\ The 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.
    \7\ The 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.
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    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.
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    \8\ APT 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.
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    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 risk-free 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:

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[GRAPHIC] [TIFF OMITTED] TN17OC05.001


CAPM requires judgment in determining
    <bullet> 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.
    <bullet> 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.
    <bullet> 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 risk-free interest 
rate.\9\ In its request for comment, the Board noted that there are 
competing views about whether a short-term 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 long-term 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 
long-term 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.
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    \9\ For the 2005 PSAF, the Board used the one-year Treasury bill 
rate as the risk-free rate.
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    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 short-term 
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 private-sector 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\
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    \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.
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(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.

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    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.
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    \11\ According 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).
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    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 forty-year 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.
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    \12\ This 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 html)
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(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 priced-services 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 priced-services 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.
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    \13\ BHC 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.
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    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

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``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 market-value 
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 five-year estimation period to recognize changes in 
the banking industry. The third commenter suggested using a two-year 
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 
well-capitalized depository institution, using a tax rate based on the 
top fifty BHCs by deposit balance continues to be an applicable and 
reasonable approach.
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    \14\ Other taxes are included in priced-services actual or 
imputed costs.
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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 long-term 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-to-year 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 priced-services equity at 
five percent of total assets is too low to cover operational risks and 
suggested that the Board compare the Reserve Banks' capital

[[Page 60347]]

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.
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    \15\ These commenters suggested that the Board participate in a 
future industry benchmarking study.
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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.
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    \16\ For 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%.

                                            Table.--PSAF Illustration
                                                 [$ in millions]
----------------------------------------------------------------------------------------------------------------
                                            Pretax ROE
                                             (percent)     x      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.
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    \17\ FRRS 9-1558.
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    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:
    <bullet> Use CAPM as the sole analytical method for developing the 
after-tax target ROE.
    <bullet> Within the CAPM framework for estimating the after-tax ROE
    [cir] 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.
    [cir] Use a rolling forty-year average of monthly returns to 
estimate the market risk premium rather than taking the average since 
1927.
    [cir] 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.
    <bullet> 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.
    <bullet> 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