Request for Public Comment on Proposal to Modify Method for Imputing  Priced-Service Income from Clearing
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Request for Public Comment on Proposal to Modify Method for Imputing Priced-Service Income from Clearing


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Federal Reserve Bank of Dallas2200 N. PEARL ST.DALLAS, TX 75201-2272June 19, 2003Notice 03-32TO: The Chief Executive Officer of eachfinancial institution and others concernedin the Eleventh Federal Reserve DistrictSUBJECTRequest for Public Comment on Proposal toModify Method for Imputing Priced-Service Income from Clearing-Balance InvestmentsDETAILSThe Board of Governors of the Federal Reserve System has requested public comment ona proposal to modify the method for imputing priced-service income from clearing balance invest-ments. Federal Reserve Banks impute this income when setting fees and measuring actual costrecovery each year.Specifically, the Board proposes to impute the income from its clearing balanceinvestments on the basis of a broader portfolio of investment instruments than used today, selectedfrom instruments available to banks and subject to a portfolio management framework. Selection ofthe portfolio mix would be subject to a risk-management framework that includes criteria consistentwith those used by bank holding companies and regulators in evaluating investment risk. The Boardalso requests comment on two different implementation methods for imputing this investmentincome.This proposal focuses on the imputed investment of clearing balances; it would notchange the terms or conditions under which depository institutions hold clearing balances. If adopted,the changes would be effective for the 2004 fees for Federal Reserve priced ...



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Federal Reserve Bank of Dallas 2200 N. PEARL ST. DALLAS, TX 752012272
June 19, 2003
Notice 0332
TO:The Chief Executive Officer of each financial institution and others concerned in the Eleventh Federal Reserve District SUBJECT Request for Public Comment on Proposal to Modify Method for Imputing PricedService Income from ClearingBalance Investments DETAILS
The Board of Governors of the Federal Reserve System has requested public comment on a proposal to modify the method for imputing priced-service income from clearing balance invest-ments. Federal Reserve Banks impute this income when setting fees and measuring actual cost recovery each year.
Specifically, the Board proposes to impute the income from its clearing balance investments on the basis of a broader portfolio of investment instruments than used today, selected from instruments available to banks and subject to a portfolio management framework. Selection of the portfolio mix would be subject to a risk-management framework that includes criteria consistent with those used by bank holding companies and regulators in evaluating investment risk. The Board also requests comment on two different implementation methods for imputing this investment income.
This proposal focuses on the imputed investment of clearing balances; it would not change the terms or conditions under which depository institutions hold clearing balances. If adopted, the changes would be effective for the 2004 fees for Federal Reserve priced services.
The Board must receive comments by July 14, 2003. Please address comments to Jennifer J. Johnson, Secretary, Board of Governors of the Federal Reserve System, 20th Street and Constitu-tion Avenue, N.W., Washington, DC20551. Also, you may mail comments electronically to All comments should refer to Docket No. R-1152.
For additional copies, bankers and others are encouraged to use one of the following toll-free numbers in contacting the Federal Reserve Bank of Dallas: Dallas Office (800) 333-4460; El Paso BranchIntrastate(800) 592-1631,Interstate(800) 351-1012; Houston BranchIntrastate(800) 392-4162,Interstate(800) 221-0363; San Antonio BranchIntrastate(800) 292-5810.
 2  ATTACHMENT A copy of the BoardÕs notice as it appears on pages 32513Ð17, Vol. 68, No. 104 of the Federal Registerdated May 30, 2003, isattached..
For more information, please contact Gregory Evans, Manager, at (202) 452-3945, or Brenda Richards, Senior Financial Analyst, at (202) 452-2753, Division of Reserve Bank Operations andPayment Systems, at the Board of Governors.Paper copies of this notice or previous Federal Reserve Bank notices can be printed from our web site
Federal Register/ Friday,68, No. 104/ NoticesMay 30, 2003/ Vol.
FEDERAL RESERVE SYSTEM:of the data for the PSAF are developed FOR FURTHER INFORMATION CONTACT Gregory L. Evans, Manager (202/452from the‘‘bank holding company (BHC) 3945) or Brenda L. Richards, Sr.model,’’a model that contains [Docket No. R–1152] Financial Analyst (202/4522753); consolidatedfinancial data for the Federal Reserve Bank Services;Division of Reserve Bank Operationsnations fifty largest (based on deposit 5 Imputed Investment Income onAs part of this process,balances) BHCs.and Payment Systems. Clearing Balancesa core amount of clearing balances isTelecommunications Device for the Deaf (TDD) users may contact 202/2634869. consideredstable and available to AGENCY:Board of Governors of the6 finance long-term assets. SUPPLEMENTARY INFORMATION: Federal Reserve System. The method for deriving the NICB is I. Background ACTION:Notice with request for reviewed periodically to ensure that it is comments. The Monetary Control Act (MCA) still appropriate in light of changes that requires Federal Reserve Banks to may have occurred in Reserve Bank SUMMARY:The Board requests comment establish fees for‘‘priced services’’priced services activities, accounting on a proposal to modify the method for provided to depository institutions at a standards, finance theory, regulatory imputing priced-service income from level necessary to recover, over the long 7 practices, and banking activity.The clearing balance investments. The run, all direct and indirect costs actually current methodology for imputing Federal Reserve Banks impute this 1 2 incurred and imputed costs., In investment income assumes that the income when setting fees and measuring addition, the Reserve Banks impute a Reserve Banks invest all clearing actual cost recovery each year. priced services return on capital balances, net of imputed reserve Specifically, the Board requests 3 (profit). Theimputed costs and requirements and the amount necessary comment on a proposal to impute the imputed profit are collectively referred to finance long-term assets, in three-income from its clearing balance to as the private-sector adjustment factor month Treasury bills. The imputed investments on the basis of a broader (PSAF). Just as the PSAF is used to income on the Treasury-bill investments portfolio of investment instruments than impute costs that would have been net of the actual earnings credits granted used today, selected from instruments incurred and profits that would have to clearing balance holders based on the available to banks and subject to a been earned had services been provided federal funds rate is considered income portfolio management framework. by a private business firm rather than or expense for priced-services activities. Selection of the portfolio mix would be the central bank, the Reserve Banks The net income associated with clearing subject to a risk-management framework impute income that would have been balances is one component in pricing that includes criteria consistent with earned on the investment of clearing decisions and in evaluating cost those used by bank holding companies balances customers hold with the recovery. and regulators in evaluating investment Reserve Banks had those balances been risk. The Board also requests comment held by a private business firm. ThisA. Clearing Balances on two different implementation imputed income, less the costs methods for imputing this investment Depository institutions may hold both associated with the clearing balances, is income. reserve and clearing balances with the referred to as the net income on clearing 8 This proposal focuses on the imputed Federal Reserve Banks.Reserve balances (NICB). investment of clearing balances; it balances are held pursuant to a Since 2002, the imputed elements of would not change the terms or regulatory requirement and are not a the Reserve Bank pricing process conditions under which depository result of an institutions use of priced reflected in the PSAF and NICB institutions hold clearing balances. If calculations have become more adopted, the changes would be effective ‘‘well-capitalized’’institution for insurance integrated. For example, by using a for the 2004 fees for Federal Reservepremium purposes. small portion of the investable clearing5 The top fifty BHCs are used as the data peer priced services. balances as a financing source for thegroup as they are considered to be the private-sector DATES:Comments must be submitted on assets used in the delivery of pricedproviders of services most analogous to the Reserve or before July 14, 2003.Bank priced-services activities. services, the financing costs embedded 6 The Board classified clearing balances of $4 ADDRESSES:Comments, which should in the PSAF are reduced. This proposal billion as core beginning with the 2002 price-refer to Docket No. R1152, may be extends the review of the key features of setting. Core balances have not fallen below $4 mailed to Ms. Jennifer J. Johnson, the methods for computing the imputedbillion since 1992. (66 FR 52617, October 16, 2001) Secretary, Board of Governors of the 7 elements.In 1994, the Board requested comment on a proposal to modify the methodology for imputing Federal Reserve System, 20th and C Calculating the PSAF includes clearing balance income. The Board proposed Streets, NW., Washington, DC 20551. projecting the level of priced-services replacing the three-month Treasury-bill imputed However, because paper mail in the assets, determining the financing mixinvestment with a longer-term Treasury investment Washington area and at the Board ofbased on the earning asset maturity structure of the used to fund the assets, and the rates Governors is subject to delay, please4largest BHCs. As a result of issues related to interest used to impute financing costs.Much rate risk raised in the comments, the Board did not consider submitting your comments by adopt the proposal. The proposal would have e-mail toPriced services include primarily check, 1 created an asset and liability mismatch that created automated clearinghouse, Fedwire funds transfer, regs.comments@federalreserve.govorinterest rate risk exposure inappropriate for Federal and Fedwire securities services. Reserve priced services. In addition, Federal faxing them to the Office of the 2 Imputed costs include financing costs, taxes, Reserve priced services would not have assumed Secretary at 202/4523819 or 202/452and certain other expenses that would be incurred the interest rate risk associated with longer-maturity 3102. Members of the public may if a private business firm provided the services. investments because the imputed return would inspect comments in Room MP500have been adjusted monthly to reflect current rates.The return on capital is imputed using the 3 between 9 a.m. and 5 p.m. weekdays, average of the results of three economic models, the(59 FR 42832, August 19, 1994) 8 comparable accounting earnings model, the ‘‘Clearing balances,’’unless otherwise indicated, pursuant to§261.12, except as provided discounted cash-flow model, and the capital asset refers to total clearing balances including in§261.14 of the Boards Rules pricing model. contracted balances and balances in excess of the Regarding Availability of Information, 4 Equity is imputed based on the Federal Depositcontracted amount, held by depository institutions 12 CFR 261.12 and 261.14.Insurance Corporationwith the Federal Reserve Banks.s (FDIC) definition of a
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9 services. Clearingbalances wereincome is analogous to assuming thatTABLE1.—SPREADFROMFEDERALintroduced when Reserve Banksthe priced-services enterprise, which is FUNDSimplemented the MCA of 1980, whichessentially a‘‘monoline’’bank offering required the Federal Reserve to price its only payment services, also includes aTbills Year payment services and broadened direct(current) treasury function. access to those services to include Income is currently imputed based on 1983 ..............................................¥0.23 institutions that previously did not have the assumption that all available 1984 ..............................................¥0.27 a Federal Reserve balance requirement. clearing balances are invested in three-1985 ..............................................¥0.27 Clearing balances are held to settle 11 month Treasury bills.The Board1986 ..............................................¥0.50 transactions arising from use of Federal chose three-month Treasury bills as the1987 ..............................................¥0.72 Reserve priced services for institutions 1988 ..............................................¥0.88 imputed investment vehicle because, at that either do not hold reserve balances 1989 ..............................................¥0.79 that time, the yield was considered to or find their reserve balances inadequate 1990 ..............................................¥0.29 to settle their transactions. At year-endapproximate the return that would be 1991 ..............................................0.08 2002, depository institutions held morerealized had clearing balance funds 1992 ..............................................0.08 than $10 billion in clearing balances atbeen held and invested by a private 1993 ..............................................0.05 Reserve firm. In addition to providing 1994 ..............................................¥0.05 Clearing balances held at Reserve a short-term earnings rate consistent 1995 ..............................................¥0.15 Banks are similar to compensating with creating a matched asset and 1996 ..............................................¥0.13 balances held by respondent banks at liability structure with the short-term 1997 ..............................................¥0.28 correspondent banks. Respondent banks liabilities, the ninety-day Treasury-bill1998 ..............................................¥0.38 hold compensating balances to support yield data are easily verified by outside1999 ..............................................¥0.26 the settlement of payments, as well as 2000 ..............................................¥0.30 observers with publicly available data. for other purposes. Reserve Banks and 2001 ..............................................¥0.06 some correspondent banks establish aII. Discussion 2002 ..............................................0.01 contractual balance level that the Table 1 presents the spread of the account holder must maintain onAverage ........................................¥0.27 three-month Treasury bill rate compared average over a specified period. Both to the federal funds rate for the pastStandard deviation ........................0.28 Reserve Banks and correspondent banks provide compensation in the form oftwenty years. As the table shows, the earnings credits to the holders ofcurrent practice of imputing clearing Although basic finance theory clearing or compensating balances.balance investments in three month suggests a direct relationship between Earnings credits provided by theTreasury-bills while paying earnings risk and earnings where earnings Reserve Banks are based on the federalcredits at the federal funds rate has increase, on average, with the amount of funds rate and the contracted level of resulted in an average negative interestrisk incurred, a minor change to the clearing balances. Reserve Bank rate spread of 27 basis points over thecurrent imputed investments could earnings credits are not paid on any past twenty years with an averagesignificantly increase earnings and clearing balances held in excess of the standard deviation over the same perioddecrease volatility. For example, contracted amount, they can only be12 of 28 basis points.The spread of theinvesting in a simple portfolio of used to pay fees for priced services, and earnings rate imputed on clearingovernight loans to financial institutions they must be used within one year or (federal funds) would simultaneously balances versus the rate for the cost of they are forfeited. Correspondent banks eliminate the interest rate spread and earnings credits has ranged from 8 basis use a similar approach to calculate reduce the volatility, as expressed by points to¥88 basis points over that earnings credits as compensation for14 13Thethe standard deviation, to zero. period. Asa result of the average respondent balances. Correspondent results of an investment in federal funds negative spread, most of the net income bank earnings credits are determined demonstrate that the current investment on clearing balances recognized during based on a variety of rates, including assumption imputes less income than these years was the result of imputed Treasury bill, federal funds, and others. could be easily achieved with a low-risk earnings on excess balances held, which Recognizing that Reserve Banks may alternative. Consequently, the Board have no associated cost. compensate for balances at a different believes that the current method may rate than correspondent banks, the impute an inappropriately low NICB to Board requests comment on whether the priced services. The Board notes that Board should consider modifications to 11financial institutions, such as Clearing balances needed to meet an imputed the Reserve Banksearnings credit rate reserve requirement (10 percent of clearingcorrespondent banks and bank holding in the future, and, if so, what factors balances) and to‘‘fund’’assets used in thecompanies (BHCs), invest in a much should be considered in the evaluation. production of priced services ($504 million in 2003) wider array of instruments than that are not available for investment. B. Imputed Investment of Clearingimputed by the Federal Reserve, 12 The standard deviation measures the variance Balancesincluding loans, Treasury securities around the average and indicates the level of with longer maturities, government The Reserve Banks impute income onvolatility of the rates. Two-thirds of the time the agency securities, federal funds, the clearing balance investments ratheractual yield will fall in the range of the average plus commercial bonds, commercial paper, than using the actual results from or minus one standard deviation. Ninety-five 10percent of the time the actual yield is expected tomoney market mutual funds, asset-monetary policy investment activities. fall in the range of the average plus or minus twobacked securities, gold, foreign The imputation of clearing balance standard deviations. 13 Although not represented here because of 9 14 Regulation D, 12 CFR part 204.While reducing interest rate risk, a change in 10simplifying assumptions, some of the volatility in Decisions about monetary policy investmentinvestment from Treasury bills to federal funds actual NICB is a result of changes in rates and transactions are not motivated by profit objectives;would increase credit risk. As a practical matter, changes in contracted and excess clearing balance therefore, the actual investment results are nothowever, banks have not incurred losses due to applicable to priced-service activities.levels. defaultin federal funds transactions.
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currencies, repurchase agreements, and derivatives. The Board requests comment on a proposal to impute the income on clearing balances from a broader portfolio of acceptable investment instruments, allocated within the constraints imposed by criteria used by BHC and regulators to evaluate investment risk. The Board also requests comment on two different implementation methods for imputing investments and the related income.
A. Investment Instruments
As noted in the Background section, the top fifty BHCs (based on deposits) were selected as the closest private-sector peer group for Reserve Bank priced services. Because the BHCs are a proxy for providers of priced-services activities, options for Reserve Bank priced services clearing balance investments should be comparable to those available to bank holding companies. In principle, all of the investment instruments available to bank holding companies could be appropriate clearing balance investments. The Board requests comment on whether investment options for Federal Reserve priced services should include all investment instruments permitted by regulators for bank holding companies. In practice, the Federal Reserve proposes to limit its imputed investments to federal funds; investments suitable for a buy-and-hold strategy, such as Treasury securities, government agency securities, commercial paper, and municipal and corporate bonds; and money market and 15 mutual funds.For investments with a fixed term, this strategy eliminates capital gains and losses from the investment returns and simplifies the recognition and reporting of imputed investment income. Realized gains and losses on imputed mutual fund investments would be incorporated in the total return and recorded as net earnings. The Board requests comment on whether this investment strategy is appropriate.
B. RiskManagement Framework
To ensure that the imputed investments are indeed comparable to the investments of a similar private-sector entity, the Board believes that a risk-management framework should be established to limit the imputed
15 Mutual fund investments would be selected from those that are publicly available and widely held. The specific funds used for imputing income would be disclosed during the price setting process so that performance could be tracked and replicated.
investments to prudent levels in accordance with sound business practice and regulatory constraints. The exposure to any one type of risk, measured in terms of earnings or equity at risk, would be limited. The Reserve Banks currently use two risk measures in calculating the PSAF that manage liquidity and interest rate risk. The Board requests comment on two additional measures that would be part of the risk-management framework for the imputed investment of clearing balances, one to manage the longer-term effects of interest rate risk and another to manage credit risk. In addition, the Board requests comment on any other risk-management criteria that should be considered.
1. Liquidity Risk
While clearing balances are contractually short term in nature, a portion of clearing balances can be considered as core deposits that are expected to remain stable over time. When it made changes to the PSAF method, the Board determined that core clearing balances, which it initially established at $4 billion, should be available to finance long-term assets used in the delivery of priced services, rather than invested only in short-term assets. (66 FR 52617, October 16, 2001) Limiting the use of clearing balances to finance long-term assets to only that portion that is deemed core clearing balances effectively manages liquidity risk. The Board proposes that the portion of core clearing balances not used to finance priced services assets be available for imputed investment in longer-term instruments. The Board requests comment on whether using core clearing balances for imputed longer-term investments is appropriate.
2. Interest Rate Risk
One aspect of interest rate risk arises when the cost of funds and the investment yield on those funds change at different intervals. Financing longer-term assets with short-term liabilities at rates that do not change concurrently could create unacceptable earnings volatility. The Board adopted a method to address interest rate risk as part of the recent change in the PSAF methodology. This method addresses the risk to earnings in a changing rate environment by requiring that longer-term investment of clearing balances be managed so that a 200-basis-point change in the rates for the yield on all relevant priced services assetscurrently the three-month Treasury bill rateand the cost of all relevant priced service liabilitiesthe federal funds ratewould not affect the overall priced
services recovery rate by more than 200 basis points. The Board intends to maintain this risk tolerance as a prudent constraint on the imputed investments. The Board proposes to adopt a second measure of interest rate risk, known as economic value of equity (EVE), for use in conjunction with the earnings at risk measure. The EVE measure, which is used by BHCs and regulators, compares the present value of interest-bearing assets and liabilities in the current rate environment with the prospective present value given a change in interest rates; the comparison shows the change in present values as a proportion of equity. EVE is used as a complement to the interest rate sensitivity analysis already adopted to evaluate the effects of long-term mismatches between assets and liabilities on the value of an entity; the interest rate sensitivity analysis captures the risk to near-term earnings. Large BHCs typically manage the EVE measure within a risk-tolerance range of 16 5 to 10 percent.The Board proposes to adopt a risk tolerance of a change of 8 percent of equity for a 200-basis-point-rate change. The Board requests comment on whether these two measures of interest rate risk, earnings at risk and equity at risk, are together sufficient measures for monitoring and controlling interest rate risk. The Board also requests comment on whether a constraint on the EVE measure limiting the effect of a 200 basis point rate change to a change of eight percent of equity is an appropriate risk tolerance level. 3. Credit Risk Credit risk results from the possibility that the issuer of a bond or other borrower cannot repay its obligations as promised. Criteria for managing credit risk are necessary when investment instruments other than Treasury securities are used. The overall level of credit risk compared with the level of equity is measured by the ratio of risk-adjusted assets to capital. The FDIC uses two risk-based capital measures as criteria in defining a‘‘well capitalized’’institution for insurance premium purposes. One requires a risk-based capital ratio of 10 percent or more for total capital and the other requires a risk-based ratio of 6 percent for tier one 17 capital. Onlytangible equity capital (tier one capital) is imputed to Reserve Bank priced services; therefore, the two measures are the same for priced services. Because the current investment
16 More information on measurement of interest rate risk can be found at handbook/irr.pdf. 17
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in three-month Treasury bills carries aallocation would be based on theyield, and federal funds rates, are held 23 risk weight of zero, the balance sheethistorical performance of the availableconstant in the models for all years. underlying the 2003 PSAF shows thatinvestment instruments and applied to the priced services risk-based capitalTABLE2.—10 YEARYIELD(1993– the upcoming year. ratio is nearly 33 percent for both2002) To avoid the administrative 18 measures. Achange in investment complexities of incorporating realized strategy that includes investments withA B capital gains and losses on an imaginary greater risk requires establishing a portfolio in the imputed investmentAverage spread over fed minimum risk-based total capital ratio results, any investment with a fixed...................... 54 35eral funds within which to make investment Standard deviation ............98 29 term, such as corporate bonds, would be decisions. As a result, the Board 19... $65.0 $48.3Average NICB (millions) held to maturity.In addition, the proposes to establish a minimum risk-NICB standard deviation Board proposes that adjustments to the adjusted total capital ratio that (millions) ........................$87.9 $22.2 portfolio allocation maintain the maintains the ratio of total capital to appropriate investment balance to risk-adjusted assets at a level equal to orExample A shows the results of optimize return; however, the amount greater than that maintained by the fiftyselecting an appropriate portfolio within invested in any one instrument could largest BHCs. Between 1997 and 2002the risk parameters using ten-year only decrease by the amount of the the average risk-adjusted total capitalhistorical yield data. The investments in ratio for these institutions has remainedinvestment maturing that period, or portfolio A were chosen to optimize the near 12 percent. Because only tangibleincrease by the amount of additionalreturn without placing any constraints 20 equity is imputed to priced services, thebalances available for investment.on volatility. The imputed return on the target ratio for the priced-servicesyields a spread over federalrisk- portfolio Hypothetical Portfolio Example. The adjusted assets to tier one capital wouldfunds of 54 basis points. The data in table 2 illustrate the results of be 12 percent, well above the averagecomposition of portfolio A varies over two hypothetical investment portfolios, ratio of eight percent maintained by thethe ten year period, based on the both of which meet the proposed risk-entities in the BHC model. The Boardoptimum investment mix using the management framework but have requests comment on whether this targetprevious ten yearsyield data. Over this 21 different return and volatility profiles. ratio adequately limits imputedtime, it maintains a fairly consistent In both cases, the 1993 portfolios were investment credit risk. The Board alsoasset mix composed of primarily federal selected from BHC-allowable requests comment on whether the targetfunds, Government National Mortgage investments to maximize return using ratio should be 10 percent, theAssociation (GNMA) mutual funds, actual yield data from 1983 through minimum required by the FDIC for amoney market mutual funds, and 1992. The portfolios were rebalanced well capitalized institution.commercial paper. Hypothetical each subsequent year to optimize the portfolio A, however, has a standard C. Implementation Methods return based on the yield data from the deviation of 98 basis points. The 22 The Board requests comment onprevious ten years.That is, for 2002 standard deviation for hypothetical alternative methods to impute clearingthe portfolio yield reflects the actual portfolio A demonstrates greater balance income based on the proposed2002 yields of assets chosen based on volatility than the Reserve Banks conceptual framework. The first methodeach investments performance from experience with the current three-month involves constructing a specific1992 through 2001. Many variations on Treasury-bill investment, which has a portfolio of hypothetical investments, the frequency of portfolio adjustmentstandard deviation of 28 basis points. tracking its yield, and ascribing the and the length of the period from whichBecause the standard deviation for income to the priced-services activities. to base yield data used in selecting theportfolio A, driven by changes in the The second method imputes an portfolio are possible and finance theoryyield, equates to approximately $88 investment yield expressed as a does not provide clear guidance on themillion in NICB, variability in the NICB constant spread over the cost of clearing optimal approach. The rolling ten-yearcould range from net income of balances, without specifying an portfolios performed as well as or betterapproximately $153 million to a net cost underlying portfolio. than other alternatives examined. Forof approximately $23 million in two-simplicity and comparability, allthirds of the years in which the selected 1. Constructing a Hypothetical Portfolio variables, other than the portfolio mix,portfolio is held. To construct a hypothetical portfolio, Example B shows the results of the Reserve Banks would select from the 19selecting an appropriate portfolio based This results in a ladder approach to investment options described above that determining the average yield. For an investment inon the same criteria used for portfolio A are available to correspondent banks.five-year corporate bonds, for example, the average but constraining the volatility in the Selecting the investments and theyield would incorporate the yield from bonds model to approximately what is purchased in increments over the preceding five proportions of the clearing balances currently experienced with Treasury bill years. assigned to each investment requires an investments. The imputed return is an 20 To facilitate public verification of imputed allocation method that avoids any portfolio income, the Board would publish theaverage yield spread over federal funds projections of future economicportfolio components and imputed investment of 35 basis points, and has income on its public website. conditions or interest rate environments approximately the same volatility as 21 For Tables 2 and 3, the following simplifying to address concerns that such forecasts currently experienced with three-month assumptions apply: (1) All clearing balance would be viewed as a market signal of amounts are held constant throughout the analysisTreasury-bill investments. Over the ten-future monetary policy actions. The year period, the portfolio consists period, (2) total clearing balances are $10.5 billion, Board proposes an allocation method(3) investable balances are $9 billion, and (4) primarily of federal funds, commercial balances eligible for earnings credits are $8.6 that optimizes the portfolio yield within paper, money market mutual funds, and billion. the current and proposed risk 22 A ten-year period was selected for illustration management framework criteria. This23 purposes because the data are available and theFor these reasons, the model results vary from period includes a variety of interest ratethe actual results experienced by Federal Reserve 18 67 FR 67834, November 7, 2002.environments. pricedservices.
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small investments in twenty-year AAAby definition, not reflect the actualIII. Competitive Impact Analysis bonds, GNMA mutual funds, and short-variability between the investment yield All operational and legal changes term corporate bond mutual funds.and the cost of funds that would occur considered by the Board that have a Because the standard deviation forwith the hypothetical portfolio. As substantial effect on payments system portfolio B, driven by changes in thedemonstrated by the variation in the participants are subject to the yield, equates to approximately $22average rate spread and volatility competitive impact analysis described million in NICB, variability in the NICBbetween portfolios A and B, both of in the March 1990 policy statement could range from $70 million to $26which met the risk management ‘‘The Federal Reserve in the Payments million in two-thirds of the years inconstraints, constant spreads of varying 25 System.’’Under this policy, the Board which the selected portfolio is held.amounts could be defended as assesses whether the change would have The Board recognizes that a portfolioappropriate. Further, finance theory a direct and material adverse effect on could be constructed that would havesuggests that a discount to the constant the ability of other service providers to less volatility than hypotheticalrate might be required to essentially buy compete effectively with the Federal portfolio B and that such a portfoliothe consistency that is produced by a Reserve in providing similar services would be expected to have a lower yieldconstant spread method. because of differing legal power or than hypothetical portfolio B. PricedThe Board proposes that if a constant constraints or because of a dominant services management finds the NICBspread is used, it be based upon a market position of the Federal Reserve volatility that has been associated withmethod that reviews allowable deriving from such legal differences. If the current three-month Treasury-billinvestment returns over time and holds the fees or fee structures create such an investment strategy acceptable,the selected investments over time. One effect, the Board must further evaluate however, and would not choose asuch method would be to use the results the changes to assess whether their portfolio with lower volatility if itof one of the hypothetical portfolios benefitssuch as contributions to generated a lower yield. On the otherabove to determine the constant spread payment system efficiency, payment hand, given the multi-year cost recoveryto impute over a future period. system integrity, or other Board Table 3 demonstrates NICB results horizon, priced services management objectivescan be retained while when imputing a constant spread return might choose a portfolio with greater reducing the hindrances to competition. over the ten years from 1993 through volatility than hypothetical portfolio B This proposal is intended to expand 2002 using the average spread of 35 if it generated sufficiently greater yield. the investment instruments assumed in basis points from portfolio B in Table 2. The Board requests comment on the the NICB calculation to resemble more While the average NICB is about the proposed method for selecting and closely investments pursued by bank same, the volatility is decreased adjusting a hypothetical portfolio. In holding companies, the services of significantly. The volatility experienced particular, the Board requests comment which are considered to most closely with the constant spread approach is on whether private sector providers face resemble the services provided by limited to the volatility in the earnings additional market-driven volatility Reserve Banks. Imputed investment on the amount of excess clearing constraints that should be considered decisions would be made within a balance investments due to the change when allocating among imputed assets. framework that incorporates risk-in the federal funds rate, whereas the 2. Imputing a Constant Spreadmanagement measures used in industry volatility associated with hypothetical and regulatory practice. Accordingly, During the development of thisportfolio B also includes the result of the Board believes this proposal will not proposal, the Federal Reserve met withchanges in the spread between the have a direct and material adverse effect a group of representatives from banks,portfolio yield and the federal funds on the ability of other service providers corporate credit unions, and their traderate. to compete effectively with the Federal associations to obtain information about Reserve in providing similar services. 24 institution investment practices.TABLE3.—NICB By order of the Board of Governors of the These representatives commented that[Millions] Federal Reserve System, May 23, 2003. construction of a risk-management Jennifer J. Johnson, framework and hypothetical portfolioPortfolio Constant Year B spread Secretary of the Board. appears unduly complex for imputing income from hypothetical investments[FR Doc. 0313505 Filed 52903; 8:45 am] 1993 ..........................$55.8 $42.3 and suggested that a constant basisBILLING CODE 6210–01–P 1994 ..........................11.4 46.5 point calculation could be simpler and 1995 ..........................67.7 52.4 provide similar results. Because the cost 1996 ..........................29.8 50.5 of clearing balances is based on the50.1 51.01997 .......................... federal funds rate, they suggested that1998 ..........................48.9 50.7 1999 ..........................18.7 49.3 the NICB calculation impute investment 2000 ..........................61.9 53.8 income based on a clearing balance 2001 ..........................56.2 45.4 investment yield expressed as a 2002 ..........................82.5 37.5 constant spread over the federal funds Average ....................48.3 48.0 rate. The representatives commented Standard deviation ....22.2 5.1 that this approach would be easier to understand, administer, and monitor. The Board requests comment on Using a constant spread over the whether a long-run average spread over federal funds rate to impute the income federal funds would be an appropriate from investing clearing balances would, basis on which to impute income and, if so, how to take into account the 24 The advisory group included participants from reduced volatility provided by this the American Bankers Association, the Independent method compared to the hypothetical Community Bankers Association, and the 25 Association of Corporate Credit Unions.portfolio method.FRRS 7145.2.
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