[Federal Register Volume 70, Number 199 (Monday, October 17, 2005)]
[Notices]
[Pages 60341-60347]
From the Federal Register Online via the Government Printing 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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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
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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
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 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)
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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
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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:
Use CAPM as the sole analytical method for developing the
after-tax target ROE.
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.
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