[Federal Register Volume 71, Number 56 (Thursday, March 23, 2006)]
[Notices]
[Pages 14694-14701]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 06-2790]


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FEDERAL RESERVE SYSTEM

[Docket No. OP-1164]


Federal Reserve Currency Recirculation Policy

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Final policy.

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SUMMARY: The Board is revising the Federal Reserve's cash services 
policy to reduce depository institutions' overuse of Federal Reserve 
Bank currency processing services, which could affect approximately 150 
to 225 depository institutions with high-volume currency operations. 
The Board is adding two elements to the policy: (1) A custodial 
inventory program that provides an incentive to depository institutions 
to hold $10 and $20 notes in their vaults to meet customers' demand, 
and (2) a fee to depository institutions that deposit fit $10 or $20 
notes at a Reserve Bank and order the same denomination, above a de 
minimis amount, during the same business week. In general, the Federal 
Reserve expects depository institutions to recirculate to their 
customers fit currency deposited with them and to deposit only excess 
or unfit currency with Reserve Banks. The Reserve Banks will amend 
section 3.3 of Operating Circular 2 to implement the provisions of the 
final policy.

DATES: Implementation Timeframe: Reserve Banks expect to begin 
accepting requests to participate in the custodial inventory program in 
May 2006, with program operations beginning in July 2006. Reserve Banks 
expect to begin assessing recirculation fees in July 2007. Reserve 
Banks' Cash Product Office will provide notice of the specific dates at 
least sixty days in advance on the Federal Reserve Financial Services 
Web site at http://www.frbservices.org.

FOR FURTHER INFORMATION CONTACT: Eugenie E. Foster, Manager (202/736-
5603) or John D. Sparrow, Jr., Senior Financial Services Analyst (202/
452-3597), Cash Section, Division of Reserve Bank Operations and 
Payment Systems, Board of Governors of the Federal Reserve System; for 
users of the Telecommunications Device for the Deaf (TDD) only, (202/
263-4869).

SUPPLEMENTARY INFORMATION: 

I. Background

The Problem

    The Federal Reserve Banks (Reserve Banks) supply genuine (new and 
fit) currency and coin to depository institutions to meet the public's 
cash demand.\1\ Historically, Reserve Banks also removed unfit notes 
from circulation and served as intermediaries among depository 
institutions, accepting deposits from those with a surplus of fit notes 
and providing currency to those with a shortfall. Depository 
institutions, in turn, acted as intermediaries among their customers, 
recirculating currency from merchant customers, for example, to meet 
the currency demands of households and other customers.
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    \1\ Fit notes are of acceptable quality for circulation, whereas 
unfit notes are unacceptable. For example, unfit notes are often 
soiled, torn, or defaced. New notes are previously uncirculated 
notes that Reserve Banks issue.
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    These traditional patterns have been changing as depository 
institutions have used fewer fit notes deposited by their customers to 
fill other customers' orders. Today, depository institutions often 
order currency directly from Reserve Banks to stock automated teller 
machines (ATMs) and fill customer orders, depositing notes received 
from their customers directly with Reserve Banks.
    Further, actions taken by many depository institutions to reduce 
their required reserves have allowed them to reduce their holdings of 
vault cash.\2\ Depository institutions with vault cash in excess of 
that needed to satisfy reserve requirements have an incentive to 
economize on holdings of currency in their vaults.\3\ Efforts to 
economize on holdings of currency have led some depository institutions 
to increase the size and frequency of their deposits of currency to and 
orders of currency from Reserve Banks.
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    \2\ Depository institutions can satisfy their reserve 
requirements with vault cash, or with reserve balances held at a 
Reserve Bank either directly or through a pass-through 
correspondent. Since the mid-1990s, however, many depository 
institutions have sharply reduced their reserve requirements by 
sweeping balances held by retail customers in deposit accounts that 
are reservable into accounts that are not reservable. For some 
institutions, the reduction in required reserves left them with more 
vault cash than necessary to meet requirements.
    \3\ Vault cash holdings do not earn interest. If, however, an 
institution deposits currency with a Reserve Bank, it receives 
credit to its account at the Federal Reserve. The depository 
institution can then earn a positive return on those funds by 
lending them to another institution, such as in the federal funds 
market.
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    Reserve Banks' order and deposit activity during 2004 shows that 
deposits of 7.2 billion fit $10 and $20 notes were followed or preceded 
by orders of the same denomination by the same institution in the same 
business week in the same geographic area.\4\ This pattern suggests 
that some depository institutions are relying on Reserve Banks to 
process a substantial amount of currency that the depository 
institutions should normally have recirculated to their customers. 
Further, this activity is concentrated primarily in approximately 40 
depository institutions with large currency businesses.\5\ Underpinning 
depository institutions' decisions to use--and overuse--Reserve Bank 
currency processing services is the fact that Reserve Banks offer basic 
currency processing services without charge. The Board believes that to 
minimize the societal cost of providing currency to the public, 
depository institutions should resume their traditional role of 
supplying fit currency from their customers' deposits to meet other 
customers' needs before turning to Reserve Banks to obtain currency.
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    \4\ This amounts to approximately 39 percent of notes deposited 
in these denominations, or approximately 19 percent of total 
deposits to Reserve Banks in 2004.
    \5\ Approximately 40 of the Reserve Banks' more than 8,000 
currency customers are responsible for approximately 90 percent of 
cross-shipping activity.
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Current Policy

    The Federal Reserve's current cross-shipping policy is described in 
the

[[Page 14695]]

Reserve Banks' Operating Circular 2, Cash Services, which states:

    If you deposit fit currency with us, you may not order currency 
of the same denomination within five business days prior to or 
following the deposit of that denomination. This practice, known as 
``cross-shipping,'' is not permitted at the depositing office level. 
When practicable, cross-shipping should be minimized or eliminated 
at the depositing institution level.\6\
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    \6\ Federal Reserve Operating Circular 2, January 2, 1998, 
section 3.3. http://www.frbservices.org/Cash/index.cfm.

    The current policy has proven ineffective in reducing or preventing 
cross-shipping. For example, this policy does not provide sufficient 
guidance to depository institutions or Reserve Banks with respect to 
the circumstances under which cross-shipping should not occur. More 
fundamentally, the only tool that Reserve Banks currently have to 
enforce the policy is to deny currency services to depository 
institutions that do not comply with the operating circular 
requirement. Denial of service would be highly disruptive to the 
businesses of both the depository institutions and their customers. 
Also, in the past, Reserve Banks did not have systematic tools for 
monitoring the quality of specific currency deposits, making the 
process of identifying cross-shipping cumbersome and costly.

2003 Proposed Recirculation Policy

    To provide incentives for depository institutions to adopt, from a 
societal point of view, the least costly means of recirculating 
currency to their customers, in October 2003 the Board proposed 
revising the current policy by adding two inter-related components: A 
custodial inventory program, and a fee that would be assessed on 
deposits of cross-shipped currency (``2003 proposed policy'').\7\
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    \7\ See 68 FR 59176, October 14, 2003.
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    To mitigate the costs associated with holding currency long enough 
to facilitate its recirculation, the Board proposed allowing depository 
institutions to transfer to a custodial inventory no more than 25 
percent of the value of their total holdings in the $5 through $20 
denominations.\8\ To be eligible to hold a custodial inventory, the 
2003 proposed policy required a depository institution to be capable of 
recirculating at least 200 bundles of currency in the eligible 
denominations per week in a Reserve Bank zone or sub-zone, in order to 
justify the administrative costs and the risks to Reserve Banks of 
allowing depository institutions to hold Reserve Bank currency in their 
vaults.\9\
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    \8\ A custodial inventory is currency owned by a Reserve Bank 
but located within a depository institution's secured facility and 
segregated from the depository institution's currency.
    \9\ A bundle of currency is a standard package of 1,000 notes. A 
zone is the area to which a Reserve Bank office provides currency 
services. Under the 2003 proposed policy, Reserve Banks could 
establish sub-zones for large metropolitan areas that are located a 
significant distance from the nearest Reserve Bank office. Deposits 
and orders by institutions with branches and vaults in a sub-zone 
would have been assessed cross-shipping fees separately from the 
institutions' activities in the rest of the zone.
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    To provide further incentive for depository institutions to 
recirculate currency, the Board also proposed establishing a 
recirculation fee. The fee would reflect Reserve Banks' costs that vary 
with the quantity of currency processed. The 2003 proposal indicated 
that, based on Reserve Banks' costs at the time, the fee would be $5 to 
$6 per bundle of cross-shipped currency. Depository institutions would 
pay the fee if they cross-ship $5, $10, and $20 notes above a de 
minimis exemption level of 1,000 bundles of currency cross-shipped per 
quarter.\10\
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    \10\ The 2003 proposed policy initially excluded $1 notes while 
Reserve Banks worked with the banking industry with the goal of 
achieving net savings comparable to those that Reserve Banks could 
realize by including $1 notes in the policy. If this collaborative 
effort failed to yield comparable savings, the 2003 proposal would 
have then included $1 notes in the policy.
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Summary and Analysis of Public Comments

    Twenty-four entities provided comments on the 2003 proposed policy, 
including twenty financial institutions and organizations representing 
financial institutions; two armored carriers; a currency processing 
equipment manufacturer; and a member of Congress. Several broad themes 
emerged from the comments. The most frequent comment, made in various 
ways by fourteen commenters, reflected concern that the policy would 
lead to deterioration in the quality of currency in circulation. 
Thirteen commenters asserted that the policy favored depository 
institutions with certain types of operations or currency volumes over 
others. Twelve commenters expressed concern that the policy would 
increase their costs; seven commenters expected that depository 
institutions would pass these costs on to customers. Nine commenters 
responded negatively to various aspects of including one-dollar notes 
in the policy. Nine commenters sought more information about the 
requirements of the custodial inventory program.
Quality
    Many commenters expressed concern that the 2003 proposed policy 
would adversely affect the quality of currency in circulation because 
the fee would create an incentive to reduce cross-shipping, but would 
not necessarily cause the depository institutions to sort fit from 
unfit notes before paying them to customers.\11\ Depository 
institutions, therefore, could choose to recirculate unfit notes to 
their customers to avoid the risk of incurring fees in the event that 
they deposit fit notes with Reserve Banks. Reserve Banks, however, 
believe that many depository institutions have or will invest in 
automated fitness-sorting equipment, particularly for processing $20 
notes, to ensure proper functioning of their ATMs.
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    \11\ One commenter from the automatic merchandising industry 
noted that ``[i]f the recirculation policy degrades the quality of 
currency so that a mere \1/2\ of 1% of the industry's estimated $30 
billion of annual sales are lost, the result will be $150 million of 
lost sales.''
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    Nonetheless, some depository institutions may recirculate unfit 
notes, leading to a decline in the overall quality of notes in 
circulation. Consequently, the final policy requires Reserve Banks to 
adopt and implement a currency quality policy before the recirculation 
fee takes effect. The quality policy will define the threshold level of 
quality for each denomination that is ``fit for commerce;'' identify a 
framework for monitoring quality; and specify actions Reserve Banks 
would take to adjust the quality of currency in circulation to avoid 
significant inconvenience to the public, or increased risk of 
recirculating counterfeit notes.
    The ``fit-for-commerce'' standard will have two components, which 
may differ by denomination: (1) A minimum fitness threshold based on 
consumer acceptance and the technical tolerances of machines that 
handle currency, and (2) a maximum allowable incidence of below-
threshold notes remaining in circulation. The goals of the standard 
will be the following:
     The public remains confident that currency supplied by 
depository institutions and merchants is genuine and readily usable in 
subsequent transactions.
     Currency in circulation is of sufficiently good condition 
that users can determine it is genuine by using the currency's security 
features.\12\
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    \12\ The public's ability to recognize the security features of 
currency can diminish if notes are heavily soiled, torn, worn, or 
crumpled.

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[[Page 14696]]

     Currency in circulation is usable in automated currency 
handling equipment.\13\
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    \13\ Automated currency handling equipment includes, for 
example, vending machines, fare card machines, and currency sorting 
machines.
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     There is an appropriate balance between the public's note 
handling costs and Reserve Banks' costs to maintain the fit-for-
commerce standard.
    Some commenters mentioned the need for a clear and useable standard 
for fit notes. To assist depository institutions with the standard, 
Reserve Banks published guidelines in 2004 for distinguishing between 
notes that are fit and unfit for further circulation.\14\ Over time, 
the Federal Reserve expects to continue to refine these guidelines to 
reflect changing industry practices, technology, and the overall 
quality of currency in circulation.
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    \14\ See http://www.frbservices.org/Cash/pdf/FRB_Fitness_
Standards.pdf.
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Equity
    Some commenters expressed concern that the 2003 proposed policy 
would favor depository institutions with certain currency volumes over 
others. The most frequent comment came from institutions with high-
volume currency operations that suggested the de minimis exemption 
would favor institutions with low-volume currency operations because 
the latter's activity is likely to fall below the exemption threshold. 
These respondents argued that the de minimis exemption would allow 
institutions with low-volume currency operations to obtain fit and new 
currency less expensively from Reserve Banks than from correspondent 
depository institutions, putting the correspondent institutions at a 
competitive disadvantage. Institutions with medium-volume currency 
operations argued that they were likely to be most disadvantaged by the 
policy because (1) their activity exceeds the exemption threshold; (2) 
they do not have the economies of scale to invest in high-speed 
processing equipment as depository institutions with large currency 
volumes do; and (3) they do not have sufficient volume to qualify for 
the custodial inventory program. Institutions with low-volume currency 
operations stated that although their activity generally does not 
exceed the exemption threshold, the policy would nonetheless have a 
negative effect on them through the increased costs their correspondent 
banks would pass along to them. Several respondents also commented on 
the disproportionate effect of the 2003 proposed policy on depository 
institutions that have a number of relatively small vaults widely 
dispersed across a Federal Reserve service zone. Transportation costs, 
they argued, as well as the complexities of managing multiple 
inventories, would be more burdensome for depository institutions in 
this position than for those that have fewer, more centralized vaults.
    The Board has structured the elements of the final policy, 
including the custodial inventory program and the recirculation fee, to 
balance the goal of providing incentives to curtail overuse of Reserve 
Bank services while minimizing the administrative burden of enforcing 
the policy on institutions with de minimis cross-shipping activity. The 
custodial inventory proof-of-concept program, discussed later in this 
notice, demonstrated that a depository institution vault with as little 
as $5 million in daily average vault cash might qualify for the 
program. Under the final policy, a depository institution can meet the 
eligibility threshold for the custodial inventory program based on 
either cross-shipping volume or evidence of internal recirculation, or 
a combination of the two.\15\ Data provided by the depository 
institutions that participated in the proof-of-concept program suggest 
that some depository institutions may recirculate significant volumes 
of currency in normal circumstances. If depository institutions satisfy 
half of their customer orders with currency from internal sources, such 
as deposits from other customers, Reserve Banks estimate that, under 
the final policy, only thirteen depository institutions would incur 
fees greater than $5,000 per year and the largest fee that any affected 
depository institution would incur would be less than $15,000 per year. 
If depository institutions satisfy two-thirds of their customer orders 
with currency from internal sources, Reserve Banks estimate that all 
depository institutions either would recirculate enough currency to 
meet the minimum recirculation requirement for a custodial inventory or 
would incur no fees because they would not exceed the de minimis 
exemption. Depository institutions with highly dispersed inventories 
may decide to consolidate some operations or manage their inventories 
more effectively under the policy, in order to minimize costs.
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    \15\ A depository institution can meet the threshold for a 
custodial inventory site by providing deposit and payment records 
demonstrating that it currently recirculates at least 200 bundles of 
currency weekly among its customers. ``Internal recirculation'' 
refers to satisfying customer orders with currency from internal 
sources, such as deposits from other customers, rather than cross-
shipping.
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Increased Costs to Depository Institutions
    Many commenters asserted that the 2003 proposed policy would 
increase their costs, but provided almost no information on specific 
costs that depository institutions might incur. Some commenters 
indicated that the proposed policy would affect profit margins for 
their currency businesses and that it would increase expenses for high-
speed sorting equipment, third-party vendor arrangements, new software, 
and transportation. Reserve Banks projected additional expenses that 
depository institutions might incur to comply with the policy, 
including the purchase of new currency processing equipment and the 
associated labor and maintenance costs, and concluded that the Reserve 
Bank savings from processing a lower volume of currency will exceed the 
increased costs to depository institutions.
    Commenters also asserted that the 2003 proposed policy did not 
address the root cause of cross-shipping--the opportunity costs 
associated with holding additional currency in their vaults long enough 
to facilitate its recirculation. In response, the Board adjusted the 
custodial inventory cap in the final policy as described below.
Custodial Inventory Program
    A number of commenters sought more information about the 
requirements of the custodial inventory program. Following the notice 
of the 2003 proposed policy, but before the implementation of the 
proof-of-concept program, Reserve Banks published more detailed 
information about the custodial inventory program, including an 
executive summary, a manual of procedures, and a uniform agreement.\16\
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    \16\ See http://www.frbservices.org/Cash/
CustodialInventoryProgram.html.
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    Five commenters expressed concern that the inventory cap in the 
2003 proposed policy was too restrictive. Most of the custodial 
inventory proof-of-concept participants agreed, finding that the cap 
limited their ability to hold enough currency in the custodial 
inventory to satisfy customer orders. As a result, the participants 
were able to reduce, but not fully eliminate, cross-shipping. 
Accordingly, as described below, the Board has adjusted the inventory 
cap in the final policy.

Custodial Inventory Proof-of-Concept Program

    Before undertaking a permanent custodial inventory program, the 
Board authorized Reserve Banks to implement a proof-of-concept program. 
This

[[Page 14697]]

program allowed depository institutions to transfer into a custodial 
inventory no more than 25 percent of average closing balances of 
currency at the location in the $5 through $20 denominations. The 
purpose of the proof-of-concept program was to allow Reserve Banks to 
evaluate how custodial inventories influence depository institutions' 
patterns of depositing and withdrawing currency, while allowing 
depository institutions to assess the costs and benefits of 
participating in the program. Consistent with these objectives, the 
Board indicated that it would review the following:
     The extent to which participants significantly reduce 
cross-shipping or recirculate significant amounts of currency.
     The extent to which deposits received from participants 
contain a higher proportion of unfit notes than the average for all 
deposits in the same zones.
     The appropriate inventory cap formula.
     The appropriate eligibility threshold for participation in 
the custodial inventory program.
    Six depository institutions participated in the proof-of-concept 
program. Several institutions participated at more than one location; 
consequently, the program included eleven custodial inventory sites. 
The participants found benefit in the program and expressed an interest 
in continuing their participation. Likewise, Reserve Banks found that 
the program had a measurable effect on the participants' depositing and 
ordering patterns with their respective Reserve Bank offices. In total, 
the eleven participating sites experienced a 34 percent reduction in 
cross-shipping volume in the first quarter of 2005 as compared with the 
first quarter of 2004, although results varied from site to site. There 
was no discernible increase in the proportion of unfit notes deposited 
because the custodial inventory sites generally chose not to make 
investments to fitness-sort their currency over the short duration of 
the program. Many participants indicated to Reserve Banks that if the 
program were made permanent, they would invest in automated fitness-
sorting capability, at least for $20 notes, because they need notes of 
acceptable quality to ensure that their ATMs do not malfunction.
    The proof-of-concept program also allowed Reserve Banks to evaluate 
the proposed inventory cap formula. The program demonstrated that the 
proposed formula does not accommodate intra-week depository institution 
currency flows and, therefore, does not provide effective relief from 
increased opportunity costs that depository institutions could incur if 
they held additional inventory to recirculate to their customers. 
Program participants found that the inventory cap was inflexible in 
accommodating incoming deposits that they otherwise could have used to 
satisfy customer orders. As a result, depository institutions reduced 
but did not fully eliminate cross-shipping.

II. Final Recirculation Policy

Highlights of Changes From the 2003 Proposed Policy

    As a result of the information obtained from public comments and 
through the proof-of-concept program, the Board determined to revise 
its cash services policy. The final policy differs from the 2003 
proposed policy in the following ways:
     It excludes $1 and $5 notes.
     It requires custodial inventory participants to hold one 
day of average daily payments on their own books, but allows them to 
transfer up to the equivalent of four days of average daily payments to 
the custodial inventory, to be held on the books of Reserve Banks.
     The Reserve Banks will determine the average fitness rate 
of an institution's deposits on a monthly, rather than quarterly, basis 
and will apply the rate to the institution's weekly deposits for the 
month in which the fitness rate was observed, not prospectively.
     It reduces the de minimis cross-shipping exemption from 
1,000 bundles to 875 bundles of notes per quarter, consistent with the 
Board's decision to exclude the $5 note from this policy.
    The Reserve Banks will amend section 3.3 of Operating Circular 2 to 
implement the provisions of this final policy.

Elements of the Final Policy

Denominations Subject to the Policy
    The final policy applies only to $10 and $20 notes. In its 2003 
proposal, the Board initially excluded $1 notes, pending the outcome of 
a collaborative effort between the Reserve Banks and the banking 
industry to find a means of achieving net savings comparable with those 
that Reserve Banks could realize by including $1 notes in the policy. 
Because of the relatively low incidence of counterfeiting and the low 
value of $1 notes, depository institutions handle them differently from 
higher denominations to minimize their costs. Many depository 
institutions do not piece-count a substantial proportion of the $1 
notes they receive today; thus, the additional costs to comply with a 
recirculation policy for $1 notes would be significantly greater than 
the costs for higher denomination notes. Reserve Banks worked with 
depository institutions to consider a variety of options, such as 
extending the cross-shipping restriction for $1 notes from one to four 
weeks or providing an exchange program to allow depository institutions 
to trade fit $1 notes with each other within geographic markets. After 
thorough analysis, however, the Reserve Banks concluded that none of 
the options would increase depository institution recirculation of $1 
notes without unwarranted societal costs. The Board concluded that 
including $1 notes in the final policy also would likely lead to a 
significant decline in the quality of these notes in circulation. The 
final policy, therefore, excludes $1 notes.
    Reserve Banks have also learned that it is unlikely that depository 
institutions would fitness-sort or authenticate $5 notes before 
recirculating them because of the relatively low incidence of 
counterfeiting and the low value of this denomination. Therefore, the 
quality of $5 notes in circulation would likely decline if these notes 
were included in the policy. Thus, as with the $1 note, the Board 
concluded that the options to increase depository institutions' 
recirculation of $5 notes would result in unwarranted societal costs. 
The final recirculation policy, therefore, also excludes $5 notes.
    Finally, the final policy excludes $50 and $100 notes because of 
the risk that depository institutions might recirculate high-
denomination counterfeit notes. These notes are a relatively minor 
component of cross-shipped currency.
Custodial Inventory
Inventory Cap
    Reserve Banks analyzed three alternative formulas for the final 
custodial inventory cap: Increasing the cap from 25 percent to 70 
percent of average closing balances of eligible denominations during 
the previous week; imposing an end-of-week inventory cap with no cap on 
intra-week deposits; or requiring a depository institution to hold a 
minimum amount of currency on its own books before it could deposit 
notes into a custodial inventory. Each of these cap methodologies would 
allow depository institutions to reduce significantly (and 
theoretically eliminate) cross-shipping, while mitigating the 
opportunity costs they would incur by holding currency long enough to 
recirculate it. Reserve Banks concluded, however, that the

[[Page 14698]]

formula requiring a participating depository institution to hold one 
day of average daily payments on its own books would cause the least 
disruption to Reserve Banks' internal currency operations. The final 
policy, therefore, requires each participant to hold on its own books 
one day of average daily payments in $10 and $20 notes, representing 
the amount needed by the depository institution to satisfy normal 
business needs for those denominations.\17\ To enhance the incentive to 
recirculate currency during the week, the final policy allows each 
participant to hold additional currency for recirculation as follows. 
After satisfying the one-day requirement, a participant may transfer up 
to the equivalent of four days of average daily payments in $10 and $20 
notes from its own vault to the custodial inventory.
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    \17\ Average daily payments is defined as the total dollar 
amount of $10 and $20 notes that the depository institution paid to 
its customers during an appropriate, previous five-busines-day 
period in the zone of a custodial inventory site, divided by five. 
Reserve Banks will perform this calculation on a weekly basis, based 
on data from the most recent, appropriate period.
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Minimum Recirculation Requirement
    The Board determined that depository institutions must demonstrate, 
initially and periodically thereafter, that each vault in which they 
seek to operate a custodial inventory can recirculate a minimum of 200 
bundles of $10 and $20 notes per week in a Reserve Bank zone or sub-
zone to qualify for a custodial inventory.\18\ An institution can meet 
this requirement in the following ways:
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    \18\ Because the expected increase in recirculation from 
reducing the minimum requirement would be insignificant while the 
cost to administer the program would increase appreciably, the Board 
did not adjust the minimum recirculation requirement to reflect the 
exclusion of the $5 note from the final policy.
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    (1) An institution that cross-ships at least 200 bundles of $10 and 
$20 notes per week in a zone or sub-zone would meet the recirculation 
threshold and, therefore, qualify for a custodial inventory, provided 
that each vault in which the institution seeks to operate a custodial 
inventory will be able to recirculate at least 200 bundles of $10 and 
$20 notes per week.
    (2) An institution can show for the prospective custodial inventory 
vault that it recirculates among its customers at least 200 bundles of 
$10 and $20 notes weekly in the zone or sub-zone.
    (3) An institution can also meet the threshold through a 
combination of cross-shipping activity and recirculation among its 
customers, totaling at least 200 bundles of $10 and $20 notes in the 
zone or sub-zone.
    Reserve Banks will review annually the minimum bundles required to 
support a custodial inventory. Reserve Banks estimate that between 150 
and 225 depository institution sites may meet the criteria to 
participate in the custodial inventory program.
Recirculation Fee
Fee Level
    Because the Board expects that custodial inventories alone would 
not substantially increase recirculation and reduce cross-shipping, it 
is approving a recirculation fee to provide further incentive for 
depository institutions to recirculate currency. The fee will be 
standard nationally and will reflect Reserve Banks' costs that vary 
with the quantity of currency received, processed, and paid out. 
Reserve Banks will review the changes to those costs annually and will 
adjust the fee accordingly. Based on current levels of Reserve Bank 
costs, the fee would be approximately $5 per bundle of cross-shipped 
currency. Reserve Banks will assess the fee to depository institutions 
that deposit fit $10 and $20 notes and order the same denomination 
within the same business week in a Reserve Bank zone or sub-zone.\19\ 
The fee will not be assessed on deposits of unfit or surplus fit 
currency.\20\ Under certain unusual circumstances, such as the release 
of a new note design, Reserve Banks may waive the fee.
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    \19\ Reserve Banks will compare each institution's weekly 
deposits of fit currently in a zone or sub-zone with their weekly 
orders to determine the amount of currency the institution cross-
shipped. The lesser of fit deposits and orders is the amount cross-
shipped. For example, if an institution deposited to a Reserve Bank 
1,250 bundles of fit $20 notes in a week and ordered 1,000 bundles 
of $20 notes the same week, the amount cross-shipped is 1,000 
bundles.
    \20\ Surplus fit currency is defined as fit currency that is not 
needed by the depository institution within the business week of its 
deposit.
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    The recirculation fee is not subject to the pricing requirements of 
the Monetary Control Act (MCA). The MCA applies to ancillary currency 
and coin services such as transportation and coin wrapping, but not to 
services ``of a governmental nature, such as the disbursement and 
receipt of new or fit coin and currency.'' \21\ Only the Reserve Banks 
can issue and ultimately redeem currency. The Board determined, in the 
development of its principles for priced services, that ``currency and 
coin processing (paying, receiving, and verifying both coin and 
currency, and issuing, processing, canceling, and destroying currency) 
are governmental functions and would not be considered priced services 
subject to MCA.'' \22\ The recirculation fee is a recovery of costs 
incurred by the Reserve Banks resulting from overuse of governmental 
services by certain institutions. The recirculation fee also should 
lower the overall societal costs of currency processing and 
distribution.
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    \21\ 126 Cong. Rec. S3168 (March 27, 1980) (statement of Senator 
Proxmire).
    \22\ 45 FR 56893 (Sept. 4, 1980).
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Average Fitness Rate Calculation
    The Board has revised the average fitness rate calculation, used in 
determining the amount of currency cross-shipped, so that Reserve Banks 
will apply a contemporaneous fitness rate to each institution's 
deposits.\23\ Under the final policy, Reserve Banks will determine the 
average fitness rate of an institution's deposits on a monthly, rather 
than quarterly, basis and will apply the rate to the institution's 
weekly deposits for the month in which the fitness rate was observed, 
not prospectively. For example, if the notes processed from an 
institution's deposits in a zone or sub-zone in January include 80 
percent fit currency, the Reserve Bank would multiply that 
institution's weekly deposits during January by 80 percent to determine 
how much fit currency the institution deposited each week of the month. 
The Reserve Bank would then compare the institution's weekly deposits 
of fit currency to their weekly orders in the zone or sub-zone to 
determine the amount of currency the institution cross-shipped. At the 
end of each quarter, the Reserve Bank will assess the recirculation fee 
for each bundle of currency cross-shipped above the de minimis 
exemption.
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    \23\ Under the 2003 proposed policy, Reserve Banks would have 
determined the number of fit notes deposited as a percentage of 
total notes deposited during each quarter and then applied the 
average quarterly fitness rate by zone or sub-zone to an 
institution's deposits during the following quarter to determine how 
much currency it cross-shipped.
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De minimis Exemption
    The final policy exempts de minimis levels of cross-shipped 
currency from the recirculation fee. Consistent with the Board's 
decision to exclude the $5 note, the final policy reduces the de 
minimis exemption to 875 bundles of notes per quarter from the level of 
1,000 bundles per quarter in the 2003 proposed policy. Reserve Banks 
will review annually the number of bundles for the de minimis 
exemption.
    Using the initial de minimis amount, depository institutions will 
not pay a recirculation fee for the first 875 bundles of $10 and $20 
notes crossed-shipped in a zone or sub-zone each quarter. The de 
minimis exemption has

[[Page 14699]]

three purposes. First, the exemption compensates for minor differences 
between currency fitness determinations made by depository institutions 
and Reserve Banks in processing these notes.\24\ Second, the exemption 
limits the effect of the policy on institutions whose small scale of 
currency operations may not justify investments in sorting equipment. 
Third, the exemption allows depository institutions that experience 
unanticipated swings in customer demand to order or deposit currency 
without incurring a fee. The exemption will not have a material effect 
on Reserve Bank processing volumes, but will reduce or eliminate the 
cost of the policy for a large number of depository institutions.
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    \24\ Because Reserve Banks will assess the recirculation fee for 
all fit notes cross-shipped above the de minimis exemption, 
depository institutions will have an incentive to ensure that their 
fitness determinations are comparable with those of Reserve Banks.
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    A Reserve Bank will apply the de minimis exemption to currency that 
a depository institution cross-ships in a zone or sub-zone during each 
quarter.\25\ All or part of an exemption that a depository institution 
did not use during a quarter will expire at the end of that quarter. 
Reserve Banks will apply the exemption against depository institutions' 
total volumes of cross-shipped $10 and $20 notes within a zone or sub-
zone, not against each individual denomination. Because of the de 
minimis exemption, Reserve Banks estimate that only between 100 and 150 
depository institutions may be subject to the recirculation fee.
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    \25\ De minimis exemptions may not be transferred from one zone 
or sub-zone to another.
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Cost-Benefit Analysis of the Final Recirculation Policy

Estimate of Avoided Reserve Bank Costs
    During 2004, Reserve Banks processed 36.2 billion notes, with total 
costs of approximately $344 million. This number includes 17.8 billion 
$10 and $20 notes, 7.2 billion of which depository institutions cross-
shipped. Curtailing current cross-shipping and its expected future 
growth would reduce Reserve Banks' expenses by enabling them to scale 
down currency processing operations and delay future capital 
investments in equipment and facilities. Reserve Banks estimate that by 
implementing the final recirculation policy, they could avoid currency 
processing costs of approximately $250 million over the next ten years 
on a net present value basis.\26\
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    \26\ Reserve Banks estimated the net present value based on 2004 
expense data, using a discount rate of 3.9 percent, as advised by 
OMB Circular No. A-94, Appendix C, to approximate the nominal 
interest rate. The estimate includes costs that vary with the volume 
of currency processed, including labor, materials, and equipment. 
The amount by which Reserve Banks are able to reduce costs would 
depend on the actual decline in volumes because of the recirculation 
policy. This decline would depend on the extent to which (1) 
depository institutions elect to pay the fee instead of 
recirculating; (2) depository institutions take full advantage of 
the de minimis exemption; and (3) depository institutions alter 
their handling of denominations that are not covered by the policy.
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Estimate of Reserve Banks' and Depository Institutions' Costs
    Reserve Banks would incur approximately $1 million per year in 
operating costs to administer the custodial inventory program, 
including managing the overall program and auditing the custodial 
inventories. Reserve Banks estimate that during the first year of the 
program their costs would total approximately $2.5 million because of 
expenses for training and site inspections. The net present value of 
these costs over the next ten years is approximately $10 million.
    Depository institutions will likely incur some costs to operate 
custodial inventories. For example, depository institutions may have to 
modify their facilities to segregate Reserve Bank currency or to 
enhance their physical security, perhaps by installing surveillance 
equipment. They may also have to enhance physical- and procedural-
access controls and engage in additional sorting and other handling of 
the notes held in a custodial inventory. While depository institutions 
provided no specific cost estimates, Reserve Banks project these costs 
to be minimal.
    Reserve Banks believe that many depository institutions have made 
or plan to make the capital investments necessary to reduce or 
eliminate cross-shipping. Reserve Banks estimate that the depository 
institutions' costs to comply with the recirculation policy, including 
labor costs, would be approximately $10-15 million per year over the 
next ten years, assuming that depository institutions fitness-sort $10 
and $20 notes and make the majority of their remaining compliance 
expenditures in the first two years of the program. Over a ten-year 
horizon, the estimated net present value of these depository 
institution costs is approximately $100 million.
Conclusion
    Reserve Banks estimate that the final recirculation policy could 
result in a net societal benefit of approximately $140 million over the 
next ten years on a net present value basis. Both Reserve Banks and 
depository institutions would incur some costs under the policy; 
however, Reserve Banks estimate that any costs incurred by depository 
institutions will be significantly less than the costs that Reserve 
Banks will avoid if the institutions reduce or cease cross-shipping 
currency.

III. 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 Board's policy, ``The 
Federal Reserve in the Payments System.'' \27\ Under this policy, the 
Board assesses whether the proposed 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 proposed change has such an effect, the Board 
must evaluate it further to assess whether its benefits--such as 
contributions to payments system efficiency, payment system integrity, 
or other Board objectives--can be retained while reducing hindrances to 
competition. As noted above, only Reserve Banks can issue and 
ultimately redeem currency; these are governmental functions that 
private-sector entities cannot perform. Private-sector entities do, 
however, provide currency deposit, withdrawal, and related services to 
depository institutions that might otherwise deal directly with a 
Reserve Bank. Therefore, the Board has considered the potential 
competitive effects of the policy on private-sector currency service 
providers.
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    \27\ Federal Reserve Regulatory Service 9-1558.
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    Under the recirculation policy, some correspondent banks will incur 
increased operational costs, or pay recirculation fees. The fees that 
correspondent banks charge to respondent banks could increase to 
reflect those costs. While it might be less costly for the respondent 
banks to obtain currency services directly from Reserve Banks because 
they would likely benefit from the de minimis exemption, the Board 
understands that respondent banks generally choose a correspondent to 
provide a package of services, not exclusively for currency services. 
In that event, depository institutions might retain their correspondent 
relationships despite an

[[Page 14700]]

increase in costs caused by this recirculation policy.
    Overall, the Board believes that while private-sector currency 
service providers cannot duplicate the entire range of Reserve Bank 
cash functions, they can count, sort, and process currency. In 
addition, private-sector service providers offer an array of value-
added cash services that Reserve Banks do not provide. For example, 
some private-sector service providers maintain automated teller 
machines for depository institutions and offer specific retail services 
for the depository institutions' customers. This policy is unlikely to 
result in any significant shift of business from private-sector 
providers to Reserve Banks. Indeed, the policy may shift some currency 
processing business to private-sector providers. In order to minimize 
the potential effect of recirculation fees, some depository 
institutions may choose to fitness-sort their customers' deposits 
themselves or through a service provider rather than continuing to rely 
on the Reserve Bank to fitness-sort their currency. Armored carriers or 
local consortia of depository institutions might offer less costly 
alternatives because the fitness sorting can be performed as an adjunct 
to deposit processing services they already perform for their 
customers. The currency recirculation policy, therefore, is not likely 
to adversely affect the ability of depository institutions or other 
service providers to compete with Reserve Banks to provide cash 
services.

IV. Federal Reserve Currency Recirculation Policy

    The Board has adopted the following policy to promote depository 
institutions' recirculation of fit $10 and $20 Federal Reserve 
notes.\28\
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    \28\ By May 2006, Reserve Banks expect to revise Reserve Bank 
Operating Circular 2 to provide additional guidance on the 
recirculation policy. For additional information, see http://
www.frbservices.org/Cash/index.html.
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Custodial Inventory Program

    The custodial inventory program promotes recirculation of fit $10 
and $20 notes by reducing depository institutions' opportunity costs 
for holding currency. Participants in the custodial inventory program 
may hold, in their vaults, currency on the books of Reserve Banks that 
they otherwise might have shipped to, and then ordered from, Reserve 
Banks during the same business week.
Requirements \29\
    (1) Only depository institutions are eligible to participate in the 
custodial inventory program. Depository institutions that outsource 
operation of their currency vault(s) would be eligible if the other 
requirements are met.
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    \29\ Failure to comply with any of these requirements could 
result in the loss of eligibility to participate in the program.
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    (2) A depository institution must be able to recirculate among its 
customers a substantial volume of $10 and $20 notes in the zone or sub-
zone of a custodial inventory site. At the outset of the program, each 
vault in which a depository institution seeks to operate a custodial 
inventory must be able to recirculate 200 bundles of $10 and $20 notes 
on a regular weekly basis to qualify for the program. Reserve Banks 
will review annually the minimum bundles required for depository 
institution participation in the custodial inventory program.
    (3) A depository institution must hold on its own books no less 
than one day of average payments, defined as the total dollar amount of 
$10 and $20 notes that the depository institution paid to its customers 
during an appropriate, previous five-business-day period in the zone or 
sub-zone of a custodial inventory site, divided by five.\30\
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    \30\ For requirements 3 and 4, the five-business-day period 
consists of Monday through Friday. Reserve Banks will perform this 
calculation on a weekly basis, based on data from the most recent, 
appropriate period. If a Federal holiday falls within the period, 
the other four business days will constitute the period and the 
total dollar amount of $10 and $20 notes that a depository 
institution paid to its customers in a zone or sub-zone of a 
custodial inventory site during that period will be divided by four.
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    (4) A depository institution may transfer into the custodial 
inventory no more than four days of average payments, defined as the 
total dollar amount of $10 and $20 notes that the depository 
institution paid to its customers during an appropriate, previous five-
business-day period in the zone or sub-zone of a custodial inventory 
site, divided by five and multiplied by four.
    (5) Depository institutions may deposit currency into or withdraw 
currency from custodial inventories at any time during the local 
Reserve Bank's business day.
    (6) A depository institution may operate a custodial inventory only 
under the following conditions:
    (a) The depository institution will indemnify the Reserve Bank 
against theft or loss of Reserve Bank currency.
    (b) It will comply with Reserve Bank physical security guidelines 
for vaults, access control, and camera coverage.
    (c) It will operate its facility in accordance with Reserve Bank 
guidelines for access and control.
    (d) It will segregate Reserve Bank currency from other currency.
    (e) It will allow full access by Reserve Banks, the Board, the 
Government Accountability Office, and their agents for unannounced 
audits of any aspect of the custodial inventory operation.
    (f) It is operating in a safe and sound manner, as determined by 
its Administrative Reserve Bank.
    (7) Any depository institution that uses a custodial inventory, in 
the judgment of Reserve Banks, to circumvent the intent of the 
recirculation policy will lose its eligibility to participate in the 
program.

Recirculation Fee

    (1) Reserve Banks will monitor currency orders and deposits for all 
endpoints of each depository institution in each Reserve Bank office 
service area (``zone'') for cross-shipping. Reserve Bank zones with 
large metropolitan areas located at a significant distance from a 
Reserve Bank office may be divided into smaller service areas (``sub-
zones''). The criteria for establishing sub-zones will balance the 
population of a metropolitan area against its distance from the Reserve 
Bank office. Reserve Banks will review sub-zone criteria annually. 
Customers may choose the zone or sub-zone in which to include border 
endpoints. Reserve Banks will monitor the deposits and orders of 
endpoints located in and near a sub-zone. Reserve Banks will monitor 
endpoints in other parts of a zone as a group separate from the 
endpoints in the sub-zone.\31\
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    \31\ Reserve Bank sub-zones will be published on the Web at 
http://www.frbservices.org.
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    (2) Reserve Banks will assess recirculation fees when a depository 
institution deposits fit $10 or $20 notes and orders the same 
denomination during the same business week, within a Reserve Bank zone 
or sub-zone.\32\
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    \32\ Reserve Banks will not assess fees for deposits or orders 
of $1, $2, $5, $50, and $100 notes.
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    (3) Reserve Banks will set a standard national recirculation fee 
based on those Reserve Bank costs that vary with the quantity of 
currency received, processed, and paid to depository institutions. 
Reserve Banks will review the changes to those costs annually and will 
adjust the fee accordingly. Such costs include personnel, materials, 
and equipment. The fee will not include overhead costs such as 
facilities, legal, business development, audit, and protection services 
that Reserve Banks incur to meet their central bank currency services 
responsibilities.

[[Page 14701]]

    (4) Reserve Banks will allocate recirculation de minimis exemptions 
to depository institutions for each zone or sub-zone where they do 
business. Reserve Banks will apply the exemptions to depository 
institutions' total cross-shipped volume.\33\ De minimis exemptions may 
not be transferred from one zone or sub-zone to another. Unused de 
minimis exemptions will expire at the end of each quarter. Initially, 
the de minimis exemption will be 875 bundles per quarter. Reserve Banks 
will review the level of the de minimis exemption annually.
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    \33\ Exemptions will not be denomination-specific.
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    (5) Reserve Banks will monitor depository institutions' order and 
deposit activity weekly for cross-shipping. For the purposes of 
monitoring cross-shipping activity, a week includes consecutive days 
from Monday through Friday. If, in the judgment of Reserve Banks, a 
depository institution circumvents the recirculation policy by reducing 
its cross-shipping volume without increasing recirculation, such as 
would be the case if it alternated the weeks in which it orders and 
deposits currency, Reserve Banks will apply the recirculation fee to 
fit notes in such deposits.
    (6) Reserve Banks will determine the number of fit notes processed 
from each institution's deposits as a percentage of total notes 
deposited by that institution during each month. Reserve Banks will 
then apply this monthly average fitness rate by zone or sub-zone to an 
institution's weekly deposits during that month to determine how much 
currency it cross-shipped.\34\
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    \34\ For example, if the notes processed from an institution's 
deposits in a zone or sub-zone included 80 percent fit currency in 
January, the Reserve Bank would multiply that institution's weekly 
deposits during January by 80 percent to determine how much fit 
currency the institution deposited each week of the month. The 
Reserve Bank will then compare that institution's weekly deposits of 
fit currency with their weekly orders in the zone or sub-zone to 
determine the amount of currency the institution cross-shipped. At 
the end of the quarter, the Reserve Bank will assess fees for each 
bundle of currency cross-shipped above the de minimis exemption.
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    (7) Reserve Banks publish currency fitness and equipment guidelines 
at http://www.frbservices.org/Cash/pdf/FRB_Fitness_Standards.pdf.

Phased Implementation

    The Reserve Banks will implement the recirculation policy in two 
phases. The first phase will expand the custodial inventory program to 
all eligible participants. One year later, in the second phase, the 
Reserve Banks will begin assessing the recirculation fee, provided 
however, that they have implemented a currency quality policy.

    By order of the Board of Governors of the Federal Reserve 
System, March 17, 2006.
Robert deV. Frierson,
Deputy Secretary of the Board.
[FR Doc. 06-2790 Filed 3-22-06; 8:45 am]
BILLING CODE 6210-02-P