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The Region

Federal Reserve Bank
of Minneapolis

A pril 2001

Federal Reserve Bank of Minneapolis

2000

Annual
Report
C ontents
Presidents Message

3

Thoughts on the Fed’s Role in the Payments System

5

Financial Statements

28

Volume 15 Number 1
April 2001
ISSN 1045-3369

Minneapolis Board of Directors

48

Helena Branch Board of Directors

49

Executive Editor:
Arthur J. Rolnick
Editor:
David Fettig
Managing Editor:
Kathy Cobb
Designer:
Mark Shafer

Advisory Council on Small Business, Agriculture and Labor

50

Minneapolis Officers

51

The Region
Federal Reserve Bank
of Minneapolis
P.O. Box 291
Minneapolis, MN
55480-0291
E-mail: paeditor@mpls.frb.org
Web: minneapolisfed.org










President’s Message
I n YEARS PAST, the Minneapolis Fed’s Annual Report essay has often voiced ideas that cut
against the grain of conventional wisdom, including, on occasion, wisdom within the Federal
Reserve. It’s not that we’re given to iconoclasm for its own sake; rather, it is our intention to
inform debate on particular issues that we think significant, irrespective of their popularity.
This year’s essay is no exception.
Unlike monetary policy and banking supervision, the role of the Federal Reserve System as a pay­
ment services provider is likely less well-known among the general public, and yet this function
demands a great deal of our time and effort. The collection of checks, the processing of electronic
funds transfers and the provision of net settlement services to private clearing arrangements may
seem rather arcane, but they are also rather important for a smooth-running economy.
The question at hand regards the Federal Reserve’s role in the payments system, generally
speaking, but specifically its role in a system that is undergoing rapid change due to technologi­
cal and institutional innovations. As Ed Green and Dick Todd write: “[I]n every significant
transformation of the economic environment, all institutions must monitor, and if necessary
realign, their strategies.” While the views in this essay are Ed and Dick’s, we are clearly sympa­
thetic to their overall message, and their work provides a useful framework to think about the
Federal Reserve’s role in the evolving payments system. It is important to emphasize, though,
that we print the essay to stimulate thought and discussion at this stage. The essay does not rep­
resent any change in Federal Reserve policy, practice or commitment to serve particular pay­
ment services markets.
To sum up, the essay may not provide all the answers but it raises some pertinent questions.
Those of us within the Minneapolis Fed spend a fair amount of time considering such ques­
tions, as befits our role, but we also think there is value in discussing such issues within a public
context. I hope you agree, and that you find the following essay informative and engaging.

Gary H. Stern
President







Thoughts
on the

Feds Role
in the
Payments
System
Edward J. Green
Senior Policy Advisor
Federal Reserve Bank of Chicago
and
Richard M. Todd
Vice President
Federal Reserve Bank of Minneapolis

Thoughts
on the
Fed’s Role
in the
Payments
System




T e c h n o l o g i c a l a n d i n s t i t u t i o n a l i n n o v a t i o n s , including
the growth of the Internet and of interstate banking, have enhanced the prospect for rapid
evolution of the U.S. payments system. The Federal Reserve is collaborating with other pay­
ments system participants to facilitate this change. The Fed has undertaken to foster the effi­
ciency, integrity and accessibility of the payments system, and that commitment will remain
as timely when the change is complete as it is today. However, as in every significant transfor­
mation of the economic environment, all institutions must monitor, and if necessary realign,
their strategies, to ensure that they continue to support their respective goals under the
emerging conditions. Although forethought cannot frame an all-embracing plan that will be
sound regardless of what the future brings, it can identify a general strategic direction that
supports the institution’s enduring goal and provides the agility needed to take best advantage of emerging circumstances. Thus, while no one knows whether the U.S. payments sys­
•T

tem will evolve rapidly or slowly, responsible institutions will already be considering how
they can best serve the public if and when current policy achieves the transition to a new
generation of payment instruments.
In that spirit, we suggest an approach to keeping the Reserve Banks’ role as payment services
providers well aligned with the Fed’s mission. We draw on both general economic and business
principles and also the specific principles that Congress and the Federal Reserve have adopted
over time to ensure that the Reserve Banks’ service-provider role embodies good public policy.1
These considerations lead us to recommend a strategy for Reserve Bank payment services pro­
vision that gives top priority to services closely related to interbank settlement. For most other
payment services under our strategy, the transition to the next generation of payment instru­
ments would prompt the Reserve Banks to make a transition as well, toward promoting effi­
ciency, integrity and accessibility primarily by means other than direct service provision—such
as participation in the setting of standards, the drafting of model legislation and the regulation
of payment services markets.
Our reasoning about the Federal Reserve’s strategy toward the emerging payments system
starts from the idea that specialization is beneficial to most organizations and has specific
additional benefits for the Federal Reserve System. That specialization promotes efficiency is
one of the most basic and firmly established principles of economics and a widespread work­
ing assumption in management theory as well. It implies that agents in the economy—institu­
tions, as well as individuals—tend to serve the public best by focusing their resources and
efforts on their respective areas of special strength, rather than by each attempting to do the
broadest range of tasks that it can manage at a merely competent level.2 Since we regard eco­
nomic analysis corroborated by historical evidence as indicating that a central bank’s most
critical functions in the payments system revolve around settlement of interbank payments,
we view these functions as a central bank’s area of primary payment services strength.3
Applying the specialization principle to the Fed, we thus recommend that specific services
comprising, or closely related to, the Reserve Banks’ core interbank settlement functions
The

v ie w s e x p r e s s e d i n t h is p a p e r a r e s o l e l y t h o s e o f t h e a u t h o r s ,

AND NOT NECESSARILY THOSE OF THE FEDERAL RESERVE BANK OF MINNEAPOLIS,
the

Fe d e r a l R e s e r v e B a n k

of

C h ic a g o

or the

The Region

Fe d era l R eserve S y s t e m .

Our reasoning
about the Federal
Reserves strategy
toward the
emerging payments
system starts from
the idea that
specialization is
beneficial to most

organizations and
has specific
additional benefits
for the Federal
Reserve System.




should have highest strategic priority among the Reserve Banks’ payment services activities.
This recommendation is strengthened by some considerations specific to the Federal Reserve
System. The Fed is, preeminently, the U.S. central bank, responsible for monetary policy,
aspects of financial supervision and regulation, and oversight of the functioning of the pay­
ments system. Direct provision of payment services may support these functions in some
respects, but it also creates potential difficulties with them in others. Governance structure is an
example. A regionally oriented structure of 12 distinct, independent corporations has con­
tributed to central bank independence and public accountability by providing a coherent insti­
tutional basis for the Reserve Bank presidents’ role in making and implementing monetary pol­
icy. However, as the U.S. banking industry has become more integrated nationwide, an inte­
grated governance structure for the provision of Federal Reserve payment services has become
practically indispensable. Because the central bank functions and payment services within each
Reserve Bank share some common support and overhead, such as information technology staff
and facilities, the governance arrangements for the two types of functions cannot be kept com­
pletely distinct. As a matter of logic, even if moving de facto to joint governance of the 12
Reserve Banks in a broad sphere of decision making would prove to be key to enabling Federal
Reserve financial services to recover their costs in a competitive market, such a market test
would not conclusively show such consolidation to be desirable. A cost-recovery test for priced
financial services is not designed to reflect the burden (or, conceivably, the benefit) that consoli­
dation might entail for monetary policy and other such central bank functions.
A further consideration in favor of the Reserve Banks playing a specialized role in the pay­
ments system concerns maintaining an overall relationship of mutual deference between the
Fed and the private sector. The Fed’s reputation as a trustworthy and neutral organization
focused on broad public objectives is an indispensable asset in meeting its public responsibili­
ties. That asset can be put at some risk if banks, other commercial firms or the general public
perceive the Reserve Banks to be encroaching on activities that the private sector can perform
efficiently and equitably.4
These various considerations do not have the stark consequence that the Reserve Banks
should never participate in markets beyond what is required to discharge the Fed’s core centralbank responsibilities. They do suggest, however, that such participation be undertaken cau­
tiously, when careful consideration shows that the several alternative means of attaining the
Fed’s payments system objectives are clearly inferior.
Near the end of this article, we apply the ideas introduced here by developing a list of specif­
ic observations and recommendations concerning the Fed’s role in the payments system. If the
payments environment evolves as we anticipate, these recommendations would focus the
Reserve Banks’ payments provider role more tightly. The more focused role we envision is con­
sistent, we believe, with current Federal Reserve legislative authority and policy.5 Some current
activities would be phased out if their policy rationales became less salient.6
By recommending that the Federal Reserve should specialize in some activities in which we
think it has a comparative advantage, we are by no means advocating that those activities should be
reserved to the Fed alone. Nor do we advocate that other activities, otherwise appropriate for the
Reserve Banks, should be proscribed by law or regulation solely on this account. To the contrary,
institutions’ spheres of comparative advantage are best identified, and the institutions’ respective
activities accordingly shaped, through a continuous process of open and vigorous competition.

April 2001

Thoughts
on the
Fed’s Role
in the
Payments
System




The Fed’s Payments System Objectives
and Tools for Achieving Them
T

he

EFFICIENCY, INTEGRITY AND ACCESSIBILITY of payment services are the well-estab­

lished goals of the Federal Reserve with regard to the payments system. (See inset on adjacent
page that surveys the Fed’s authoritative statements and interpretations of these goals.) Direct
provision of payment services is one means to attain these goals, but it is not the only means
that the Fed can and does use. To facilitate a balanced view on the role of service provision in
the Fed’s pursuit of payments system objectives, we outline in this section a variety of methods
available to, and largely in use by, the Fed. This survey sets the stage to consider which options
the Fed should use in a particular situation and, in particular, when it should take on the role of
payment services provider.
The Federal Reserve has pursued its payments system goals in part through direct provision
of payment services. As a nationwide complex of institutions, the Reserve Banks can address
payments system access issues directly, by providing interbank payment services to all banks on
equivalent terms. They can also address integrity issues by making their services very reliable as
well as accessible, and by offering them to failing institutions as well as healthy ones. The hard
part is to meet the access and integrity objectives through direct service provision without
falling short on the efficiency objective. However, the Monetary Control Act of 1980 (MCA)
requires the Reserve Banks to be cost-effective enough to recover the costs of their directly pro­
vided services, including adjustments for taxes, the cost of capital and other private-sector
expenses, from the fees they charge their customers. According to a priced-services accounting
system that has been in place for almost 20 years and has survived significant internal and
external scrutiny, the Reserve Banks have met the MCA’s requirements. In that sense, the Fed
has successfully provided wide access to a set of reliable and efficient services for many years, in
furtherance of its general goals for the payments system.
Provision of payments system services by the Reserve Banks continues to be guided by the
White Paper. This guidance was reaffirmed and amplified during the 1990s, when Federal
Reserve Chairman Alan Greenspan asked then-Vice Chair Alice Rivlin to head a committee
reviewing the Reserve Banks’ role in providing payment services, especially automated clear­
inghouse (ACH) and check clearing. On the basis of internal analysis as well as extensive public
testimony, the Rivlin Committee reported in early 1998 that the Reserve Banks should continue
to provide ACH and check clearing services.7
Besides direct provision of services by the Reserve Banks, there are other ways to pursue the
Fed’s goal of maintaining a U.S. payments system that serves the public well. Perhaps the sim­
plest alternative is to rely on private market institutions to provide efficient, reliable and acces­
sible payment services. Economic theory implies that, in an ideal environment, private compe­
tition will lead to efficient arrangements for producing and distributing services that are of
optimal quality and available to all at prices appropriately reflecting marginal cost. Experience
suggests that this actually occurs, at least approximately and sufficiently, for many goods and
services in the U.S. economy. Competition is also generally accepted to be especially successful
in promoting long-term innovation and efficiency in many markets. In the payments system,
private competition is already the primary mechanism for ensuring access to low-cost, reliable
services for consumers and nonfinancial businesses. Deferring to private market provision of
The Region

Contestability

disciplines
market
participants
to pursue
efficiency,
integrity and
accessibility
of services.




The Federal Reserves Objectives Regarding the Payments System
and Payment Services Provision
T he Federal R eserve Board of G overnors articulated the Fed’s payments system
objectives in “The Federal Reserve in the Payments System,” published in the Federal
Reserve Bulletin in May 1990. Also known as the White Paper, this article states that “The
Federal Reserve will continue to bring to payment markets an overall concern for safety
and soundness, promotion of operational efficiency, and equitable access. Indeed, those
considerations relating to integrity, efficiency, and access to the payments system will
remain at the core of the Federal Reserve’s role and responsibilities regarding the operation
of the payments system.” The three key words that signify the Fed’s broad payments system
objectives—integrity, efficiency and accessibility—have been repeatedly reaffirmed.
The White Paper and other Federal Reserve documents interpret more specifically what
those three objectives mean. With regard to integrity, the White Paper not only offers “safety
and soundness” as a synonym but also goes on to explain that “A reliable payments system is
crucial to the economic growth and stability of the nation. The smooth functioning of mar­
kets for virtually every good and service is dependent on the smooth functioning of bank­
ing and financial markets, which, in turn, is dependent on the integrity of the nation’s pay­
ments system.” It cites payment breakdowns during the Panic of 1907 and in the wake of
the 1974 failure of Bankhaus Herstatt in Germany as examples of financial disruptions that
the Fed seeks to minimize. It suggests that the Fed’s roles in providing a reliable interbank
settlement mechanism and payments system access to failing institutions help prevent such
breakdowns.
The White Paper does not explicitly define efficiency, but by implication and context it
seems clear that a standard notion of economic efficiency is intended. Loosely speaking, this
implies that the social cost of the resources used to provide the prevailing level of payment
services cannot be reduced and that it is not possible to make everyone better off by leastcost provision of more or less of some payment services. In a dynamic economy, this also
encompasses efficiency over time, including appropriate investment in new technologies and
development of new services.
The Fed’s goal of promoting access to payment services primarily refers to access by banks
(defined to include thrifts, mutual savings banks and credit unions). As indicated in the
White Paper and elsewhere, the Fed does not necessarily aim directly at promoting payments
system access by consumers and nonfinancial businesses.* Instead it seeks to ensure that
banks have equitable access to interbank payment services, in order that the banks in turn
can make a broad range of payment services available on competitive market terms to U.S.
consumers and nonfinancial businesses.
The White Paper explicitly ties the Reserve Banks’ role as payments provider to the Fed’s
general payments system objectives. It states that “the role of the Federal Reserve in provid­
ing payment services is to promote the integrity and efficiency of the payments mechanism
and to ensure the provision of payment services to all depository institutions on an equi­
table basis, and to do so in an atmosphere of competitive fairness.” That is, the Reserve
continued on page 10

April 2001

Thoughts
on the
F ed’s Role

in the
Payments
System




The Federal Reserve’s Objectives Regarding the Payments System
and Payment Services Provision— continued
Banks engage in payments provision as a means of pursuing the Fed’s overall payments sys­
tem objectives.
3f

The Federal Reserve is responsible for administering certain laws and regulations that deal directly with
consumer and small business payment matters. However, the Fed does not have general responsibility or
authority for ensuring consumer and nonfinancial business access to the payments system.

interbank clearing and settling services is also an option the Fed can consider in pursuing its
payments system objectives. For some services, such as the clearing of interbank credit card,
ATM and debit card payments, the Fed has largely done so.8
Economic theory also acknowledges conditions under which private markets alone will not
ensure efficient, reliable and equitably accessible service provision, and there are concerns that
these conditions may prevail in some payment markets. For example, if a provider’s average
cost of providing a service declines continuously as its level of production increases, efficient
production requires that there be only one provider, in order to capture these economies of
scale. This is not necessarily a problem per se, because potential entrants can provide competi­
tive discipline to the incumbent provider without actually having to enter the market them­
selves. Markets subject to such potential competition are called contestable. However there can
be a problem for contestability if irretrievable “sunk” costs associated with entering or exiting
the industry constitute a barrier to entry by a potential competitor. Under these uncontestablemarket conditions, the single private seller could restrict output below the efficiently produced
level, in order to raise prices and increase profits. Alternatively, the monopoly producer might
be free to increase profits by reducing the integrity of the product below the efficient level of
product quality. Because of higher prices and lower quality, some potential consumers who
would have been willing to purchase the service at the efficient price and quality will, in effect,
have lost access to service.
This general description of a monopolized market is thought by some to capture the situ­
ation that would prevail if the provision of check clearing services to small, remote markets
were left to the private market. It is assumed, that is, that these markets have only enough
volume to support a single physical shipment of checks per day, and that there are irretriev­
able sunk costs to enter or exit the clearing business. Such conditions could result in a single
for-profit shipper with monopoly power over check clearing services in that area. At best the
banks in that area would pay high prices for poor service. Fears of just this outcome were
frequently cited in the testimony of rural bankers before the Rivlin Committee, and it is a
traditional rationale for the nonprofit Reserve Banks to provide check clearing services at
cost in rural areas.
Private competitors may also fail to achieve socially optimal outcomes if efficient service
provision requires using a single shared resource, and the individual providers are unable to
agree on how to organize and manage the shared resource. On the one hand, critical shared
resources do not necessarily pose an insurmountable problem to industry participants, as
The Region

The central
question of this
article is: W hich
options should
the Fed use to
advance its public
policy goals for
the payments
system, and, in
particular, when
should it take
on the role of
paym ent services
provider?




illustrated by the generally successful operation of mutually owned and operated clearing
institutions in credit card, debit card and ATM networks. On the other hand, neither can the
viability of such institutions be taken for granted, as suggested by the history of litigation and
member “politics” experienced by mutually owned clearing organizations such as Visa and
MasterCard. When unable to agree among themselves on how to provide critical shared
resources, industry participants may invite a neutral (generally nonprofit) third party, includ­
ing perhaps a government or government-sponsored entity, to assist in arranging for the
needed services. Alternatively, public policymakers may step in themselves, if the industry
appears unable to arrange the provision of shared services in a way that promotes efficiency,
integrity and accessibility. For example, historically the Reserve Banks’ entry into payment
services provision partly reflected the private market’s inability to arrange for a single set of
accounts to effect interbank settlement. (For further details, see the inset on page 13.)
Private market “failures” of these and other kinds can be addressed in several ways. At least
three broad alternatives to direct Reserve Bank service provision can be identified: changing the
environment that gave rise to market failure so that private competition can again be relied on;
regulating the private providers; and arranging for public or nonprofit service provision by an
entity other than the Federal Reserve.
The factors that give rise to a market failure may be inherent in the industry’s technology (as
in the example above, with declining cost and barriers to entry) or may reflect financial and
institutional circumstances (such as a price-fixing conspiracy supported by a successful strategy
of eliminating competitors by predatory pricing). The former requires a fundamental techno­
logical solution, if competitive forces alone are to be trusted. Through the passage of time, and
perhaps in response to initiatives promoted by the Fed and other nonprivate entities, new tech­
nologies less likely to lead to market failure may be devised. The same forces—time and some­
times promotion by the Fed and others—may also be required to develop new institutional
arrangements that support the introduction and usage of the new technologies. When success­
ful, the new technologies transform the competitive environment, eliminating the market fail­
ures and permitting private competition to lead to the desired outcomes. For example, several
new technologies designed to use electronic images instead of paper originals to clear checks
could eliminate the natural monopoly problem said to plague rural check clearing markets
today. The Fed is among the institutions promoting and piloting these technologies. To the
extent that the Fed and others successfully convert the check clearing business to electronics,
the markets for both rural and urban check clearing may be perfectly well served by private
competition in the future.
Market failure deriving from persistent financial or institutional power is amenable to cor­
rection by legal intervention under antitrust laws. If the market failure arose solely from histori­
cal or strategic circumstances unrelated to the underlying technology, interventions such as
repealing legal obstacles to emerging competitors can permanently correct the problem and
again allow reliance on private service provision. Sometimes the market failure involves a com­
bination of technological factors and historical circumstances. In these cases, new technology
and legal intervention may both be required for private service provision to again lead to
desired outcomes. The Fed does not have direct authority or responsibility for antitrust
enforcement (except for limited authority related to bank mergers), so it cannot directly pursue
its payments system objectives through this means. However, when warranted it can contribute

April 2001

Thoughts
on the
Fed’s Role
in the
Payments
System




significant relevant information on the basis of its knowledge of payments industry conditions
and its economic research capabilities.
When the technology in an industry appears to be enduringly inconsistent with good public
policy outcomes under unfettered competition, ongoing intervention by government or gov­
ernment-sponsored regulators may be an effective alternative. In the context of the payments
system, specifically, the Federal Reserve System currently acts as a consumer-protection regula­
tor in consumer payment and credit markets, under legislative authority. If it wished, Congress
could expand the Federal Reserve System’s regulatory powers over interbank payment markets,
as an alternative to direct provision of services by the Reserve Banks.9
Although effective in principle, regulation can be difficult to implement well over the long
haul. In practice, it may sometimes be more effective to charter a government body or non­
profit agency to provide or subsidize certain services, rather than attempting to regulate pri­
vate providers. The historical origins of the Federal Reserve System, discussed below, partly
reflect these concerns, as do the origins of other government-sponsored service providers,
such as public postal services. A somewhat different example is the provision of scheduled air
service to small cities under the Essential Air Service program initiated in the Airline
Deregulation Act of 1978. In this case, the federal government has not established a nonprofit
provider but instead subsidizes private airlines to provide the desired service (GAO 2000).
And in Switzerland, the Swiss Interbank Clearing (SIC) system, which settles interbank pay­
ments via irrevocable transfers of funds held at the Swiss central bank, was developed by a
private joint venture, Telekurs AG, in collaboration with the central bank. Check clearing also
takes place at Telekurs, under central bank supervision (Bank for International Settlements
1993, pp. 361-363). The Fed could use similar arrangements for services such as check clear­
ing, including in remote rural areas.

Specialization and the Core Functions of the Reserve Banks
in the Payments System
Which options should the Fed use to
advance its public policy goals for the payments system, and, in particular, when should it
take on the role of payment services provider? Our answer, developed more fully in subse­
quent sections of this paper, is tied to our view that the unique strength of the Federal
Reserve in the payments system derives from its status as the U.S. central bank. We will infer
from this premise, and from the premise that specialization is generally beneficial, that the

T

he

CENTRAL QUESTION

of

THIS ARTICLE

is :

way in which the Fed pursues its payments system goals should be determined in large mea­
sure by its core central-bank function. Before pursuing that line of reasoning further, in this
section we defend the general specialization principle and characterize the core function of a
central bank in the payments system.
The benefits of specialization among nations were elucidated early in the history of eco­
nomics, most clearly by David Ricardo. His key idea was that all countries benefit when
goods are freely traded and each country focuses its finite resources on producing those
goods in which it has a comparative advantage. As long as countries have finite but different
endowments of resources (natural resources, human resources and capital), then specializa-

The Region

One implication ...
is that as service
providers the
Federal Reserve
Banks should place
high strategic
priority on
services that the
central bank has
special advantages
in providing.




Interbank Settlement and the Emergence of Central Banks
HERE WE EXAMINE

in

MORE DETAIL the development of corresponding banking arrange­

ments that paved the way for the emergence of central banks as hubs in national payment
networks. (See Goodhart 1988 for a detailed analysis.) We cast our discussion in terms of
check transactions, which were the principal form of transactions (both for large- and smallvalue payments) from the mid-19th century until the Federal Reserve introduced the precur­
sor to Fedwire, its wire transfer service for large-value payments, in 1918. The points that we
make here are as valid for electronic payments as for checks, however.
To begin, consider how transfers of bank balances are used to make payments in an econ­
omy with only one bank. A person (household or firm) holds wealth in a demand account,
with zero or very low return, primarily in order to make payments. Payment by transfer of a
bank balance is acceptable to a payee because it is secure against both theft and loss of mar­
ket value and is verifiable. Payment by transfer of bank balances is mutually advantageous to
the payor and payee because it is fairly inexpensive, so that the cost of making a payment
does not eat up the gain to trade.
Now consider what happens when there are several banks. It would probably be infeasi­
ble, and would certainly be inefficient, for each person to have an account at every bank.
Unless two traders happen to have accounts at the same bank, no individual banker can
make payments for them in the way that has just been envisioned. Payment requires a way
to get funds from one bank to another. Now, if there are relatively few banks (as in Canada,
until recently), a solution to this problem is for every bank to have an account with every
other bank. Suppose that, with this arrangement in effect, A writes a check for $1,000 to B,
who has a different bank from A. B takes the check to his or her bank, which in turn pre­
sents it to As bank. As bank debits $1,000 from As account and credits $1,000 to the
account of B’s bank at As bank. B’s bank then credits $1,000 to B’s account. Over time,
there will be payment flows from account holders at As bank to account holders at B’s
bank and vice versa. Then—say, when the balance in each bank’s account at the other is
above $1 million—the banks can agree to reduce those balances by offsetting amounts of
up to $1 million without any funds actually having to be transferred. Banks’ ability to
make such reductions of offsetting payments, known as bilateral netting, can keep the cost
of making payments by interbank transfer almost as low as by transfer of balances within a
single bank. Only where there is persistent asymmetry in the payment flows between the
two banks does it become necessary to make an actual money transfer, which typically
does involve significant cost.
During the period 1837-1913, the United States did not have a central bank. The regime
of interbank payments just described was, in principle, how the U.S. payments system
operated. However, since there were too many banks for it to be advantageous for every
bank to have an account at every other one, a system of correspondent banking arose.
Actually, there was a hierarchy of correspondent banks. Each small city had one or more
correspondents that served the local banks; each major city had several correspondents
that served the correspondent banks of the smaller cities of that region; and New York City
continued on page 14

April 2001

Thoughts
on the
F ed ’s Role

in the
Payments
System




Interbank Settlement and the Emergence of Central Banks— continued
had a number of banks that were correspondents for the regional correspondent banks
across the country. If B’s bank did not have an account at As bank, then it presented As
check to a third bank—the correspondent bank—at which both it and As bank had
accounts, and the correspondent bank transferred the amount of the check from the
account of As bank to the account of B’s bank. Moreover, if there is a cycle of offsetting
payments— $1,000 from A to B, $1,000 from B to C and $1,000 from C to A—then the
payments that are induced between these payors’ banks cancel. Correspondent banking
thus provides the possibility of economizing in the payments process by multilateral net­
ting, which reduces the need to make actual money transfers even below the level that
would be required under bilateral netting.
Offsetting interbank payments such as we have just discussed typically are not simulta­
neous. If a correspondent bank waits until receipt of an offsetting payment in order to do
netting, rather than debiting the bank on which the first check is drawn, then either the
bank that presents the first check, or the correspondent bank, is extending credit to the
paying bank of that first check. For example, if A’s bank deposits a check to A from B in
the morning and the correspondent bank promptly credits the amount of the check to the
account of A’s bank, while B’s bank does not deposit a check for an equal amount to B
from A (or payable to and from any two customers of the respective banks of B and A)
until the afternoon, then the correspondent bank is making a loan to B’s bank over the
midday period. On the other hand, if the correspondent bank waits until an offsetting
check is deposited with it to credit the account of A’s bank, while not debiting the account
of B’s bank (which would constitute gross payment rather than net payment), then A’s
bank is extending credit to B’s bank over midday, in effect. Because the correspondent
bank has an ongoing relationship with each of its respondents, its credit is typically more
acceptable to the presenting bank than the credit of a payor bank that the presenting bank
may not know well. When the correspondent bank provides credit in this way, it has the
___
option, in effect, to insure the value of the payment to the presenting bank. That is, the
correspondent irrevocably credits the account of the paying bank at the time of present­
ment. Such an arrangement is said to provide immediate finality. Particularly in the case of
large-value payments, interbank payments are made more efficient by the provision of
legal and practical immediate finality in this way.
The roles that large correspondent banks played in netting interbank obligations and
extending credit to facilitate interbank settlement were, in our view, the core payments sys­
tem roles assumed by the Reserve Banks and other central banks.
* Before the Reserve Banks provided a streamlined interbank settlement service, there was a large, direct cost
in the form of expensive shipment of currency or gold. Today there remains a cost, albeit a much smaller
one, associated with the opportunity cost of holding wealth as balances to effect settlement rather than
investing it in productive projects.
** That is, the correspondent bank has the option to offer its respondents a contract to this effect. In some
cases, the correspondent may be required by law to do so.

The Region

Reserve Banks
should ensure
that when they
provide paym ent
services, they do
so in a way that
does not impede
entry or exit in
those markets.




tion in production combined with international trade tends to make available the greatest
amount of goods for consumers in each country. This is one of the most widely accepted prin­
ciples of economics.
The idea that specialization is beneficial is also widely assumed to apply to firms and other
organizations. At first glance, this assumption may seem suspect. If Firm A has efficiently spe­
cialized in producing good X, and firm B has efficiently specialized in producing good Y, why
couldn’t a merged firm A+B remain equally efficient at producing X and Y? After all, individual
firms appear to be free to expand not only their efforts but also the resources they employ,
whereas nations can only slowly expand their total resource base. So why can’t firms (and other
organizations) avoid the need to specialize by simply adding enough resources to perform mul­
tiple diverse activities efficiently?
There is no hard and fast reason why organizations cannot expand to perform a range of
tasks well, but experience suggests that the results are often disappointing. Perhaps the most
familiar evidence for the benefits of organizational specialization stems from the demise of
many of the conglomerates formed in the 1960s. These were firms that combined, through
mergers and acquisitions, numerous diverse activities under a single management and own­
ership structure. Over time, many of these entities underperformed their less-diversified,
more-focused competitors (Ravenscraft and Scherer 1987), and by the 1980s many were bro­
ken up in what Bhagat, Shleifer and Vishny (1990, p. 2) refer to as the “deconglomeratization
of American business and a return to corporate specialization.”10
Although the frequently disappointing performance of large, diversified organizations is not
fully understood, experience and theory suggest that there may be limits on how many different
activities can be managed effectively in a single organization. No one manager can be truly
expert on a wide range of products and activities, so multiple management lines are required to
maintain an adequate knowledge base. It seems, however, that the effectiveness of multiple
management lines is often less than would be expected by summing the results of their inde­
pendent operation, perhaps because of internal rivalries, or because of disputes and ambiguities
related to ex-ante incentives and ex-post rewards.
Although we recognize that the intellectual foundations of the specialization principle for
organizations are less complete than those underlying Ricardo’s comparative advantage con­
cept for nations, we believe that the principle is fairly strongly supported by the weight of
practical experience and by elements of financial economics and of organizational studies.11
How would the general principle of specialization be applied to the Reserve Banks’ role in
the payments system? One implication, we will argue, is that as a service provider the
Reserve Banks should place high strategic priority on services that the central bank has spe­
cial advantages in providing. Specifically, this strategic core of payment services consists of
maintaining deposit accounts for private banks and providing short-term credit to, and
effecting transfers of balances among, those accounts as a means of settling interbank oblig­
ations efficiently.12 Our characterization of this core function relies on consideration of
both economic history and economic theory.
We define a central bank to be an institution that:
• has both the government and the commercial banks as account holders;
• can influence overall interbank credit market conditions, through its credit policies toward
account-holding banks and its intermediation on behalf of the government;

April 2001

Thoughts
on the
Fed’s Role
in the
Payments
System




• has been given lead public policy responsibility for achieving credit market conditions
that foster prosperity and economic stability—price stability in particular.
This definition reflects the fact that, historically, central banks have been chartered to per­
form two functions. One is to be an intermediary between the government and its lenders,
enabling the government to obtain credit by ensuring that implicit default through inflation
will occur only in genuine national emergencies.13 The other is to serve broad public interests
as the trustworthy and neutral apex of a hierarchy of banks that, in turn, provide the nonbank
public with accounts used to settle financial, business and personal payments by transfer of bal­
ances.14 Indeed, there is an economy of scope between these two functions that gives the cen­
tral bank a comparative advantage in serving the latter. That is, since almost all banks need to
transfer funds from their customers to the government to pay taxes, the government’s bank is
in a natural position to serve as apex.15
The role as apex of the banking hierarchy puts the central bank in a unique and distin­
guished position in the payments business. As explained in more detail on page 13, this role
evolved out of market interactions, as correspondent banking grew from provision of a passive
service—simply maintaining an account for respondents—to a role with respect to banks that
is closely analogous to the role that banks play with respect to their nonbank customers—
including netting, extension of credit and concomitant monitoring of creditworthiness.
Moreover, just as private banks are often structured to avoid conflicts of interest with their own
nonbank customers, central banks evolved in part to avoid conflicts of interest with banks. A
foundry, for example, would be loath to have its bank also be in the foundry business. As lender
to the foundry, the bank would have a legitimate need for information regarding the foundry’s
customers. If the bank also owned a foundry itself, the bank could abuse the information
obtained from the borrowing foundry to compete unfairly in their shared business by stealing
the foundry’s most profitable customers. For similar reasons, banks were reluctant to have a
correspondent bank that also did general banking business in the same market.
Market demand thus arose for a special-purpose intermediary (that is, one that does not do
business with nonbank traders) that is able to play this role without the incentive conflicts that a
bank would have. Both private-sector and public-sector intermediaries of this type exist, typical­
ly as nonprofit organizations in order to further mitigate incentive conflicts. And both the pri­
vate- and public-sector special intermediaries are subject to government oversight as well.16
Examples within the private sector include mutually owned clearinghouses for checks, credit
card receivables (such as Visa), and electronic funds and securities transfers as well as the bankowned, government-regulated, special correspondent institutions known as bankers’ banks.17
Examples within the government or government-sponsored sector include specialized
intermediaries such as central banks and certain industry lenders (such as the Federal Home
Loan Banks in the United States, especially vis-a-vis thrift institutions before 1980). The
Reserve Banks—nonprofit entities created by an act of Congress and supervised by a govern­
ment agency, the Board of Governors of the Federal Reserve System—are a case in point. The
potential for activities of a Reserve Bank to create conflict of interest with commercial banks
is controlled in three ways: by its nonprofit status, by restrictions in its corporate charter
(specified in the Federal Reserve Act) and by the oversight of a federal government agency,
the Board of Governors of the Federal Reserve System. The most blatant source of potential
conflict of interest with the banks that the Fed serves—lending by Reserve Banks to nonbank

The Region

The role as apex
of the banking
hierarchy puts
the central bank
in a unique and
distinguished
position in the
payments
business.




borrowers— is ruled out (except in emergency conditions) explicitly by charter restriction.
And a combination of Reserve Banks’ nonprofit status and Board oversight is designed to
control conflicts of interest that might arise through the Reserve Banks’ discharge of their
payments system functions.
This historically oriented description of the function of a central bank in the payments sys­
tem is consonant with a fast-developing—albeit not yet mature—body of economic theory
regarding the function of central banks.18 Together, history and theory suggest that there are
two payments system functions that a central bank is better able than other institutions (except,
perhaps, a clearinghouse) to perform for banks. These core central-bank payment functions,
which we explain in the story on page 13, are analogous to the core functions that banks pro­
vide to their customers.
• A central bank can manage in the broad public interest a system of accounts that all banks
are eligible to own, and that they can use to settle interbank transactions.
• By extending credit to banks, a central bank can provide the benefits of interbank
payments netting immediate finality of payments.
Its ability to perform these functions and, in particular, its position of neutrality and trust
among the public and the institutions that it serves is the unique strength of a central bank as a
provider of payment services. From this finding, together with the general principle that the
public is best served when each institution in the economy focuses its resources in its area of
unique strength, we conclude that these two functions form the core of the services that should
continue to be provided directly by the Reserve Banks, and that they should receive the highest
strategic priority among the Reserve Banks’ activities as providers of payment services.

The Reserve Banks’ Role in Providing Other Services
T

he

RESERVE B a n k s ’ PROVISION of accounts to banks and of final interaccount settlement

supported by central-bank credit only partially fulfills the Fed’s payments system goal. The
Fed has also accepted the role of promoting the efficiency, integrity and accessibility of a
broad range of payment services, notably numerous interbank clearing functions, whose
good performance depends on more than just access to the Reserve Banks’ core payment ser­
vices. What tools should the Fed use to help assure good outcomes across this full spectrum
of payment services?
For some—probably very limited— range of services, efficiency considerations alone may
imply that direct service provision by Reserve Banks is the right solution. The provision of
these services may be so technologically or institutionally related to the Reserve Banks’ core ser­
vices that it would clearly be much cheaper for the Reserve Banks to provide them in conjunc­
tion with their core services than for them to be provided in any other way. In economic terms,
provision of these services is said to be complementary to the provision of core services, result­
ing in positive economies of scope. (See story on page 19 for a more detailed explanation of
these concepts and of how they might suggest that the Reserve Banks should provide certain
services outside the core.) The range of payment services with high core complementarity is
unclear and can be determined only with detailed analysis that is beyond the scope of this essay,
but our a priori expectation is that it is narrow.

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Thoughts
on the
Fed’s Role
in the
Payments
System




Beyond the Reserve Banks’ core services, plus possibly some clearly complementary activi­
ties, provision of payment services by the Reserve Banks should be considered as merely one
option among many for pursuing the Fed’s goal. We see no reason to presume that payments
service provision is the best option. At a minimum, the full range of options discussed above
should be analyzed and considered.
In analyzing these options, we would apply both the general and Fed-specific versions of our
specialization principle. The general version was elaborated in the previous section. The Fedspecific version involves a general sense of caution about complicating Reserve Bank gover­
nance structures or putting the Federal Reserve in the position of encroaching significantly on
private-market institutions, as discussed in the introduction. We now apply each specialization
principle to the question at hand.
As noted above, the general specialization principle provides a rationale for the Reserve
Banks to provide core interbank settlement, accounting and credit functions. However, because
we take as given the Fed’s goal of promoting the efficiency, integrity and accessibility of the pay­
ments system more broadly, the general specialization principle does not imply that the Reserve
Banks should always strictly limit their role as a payments provider to only those core func­
tions. Nevertheless, the general specialization principle does suggest that core functions have
the highest claim to be performed directly by the Reserve Banks. The more remotely related to
the core a payments system objective is, the stronger are the considerations in favor of using
other policy tools to accomplish it.
The Fed-specific benefit of specialization has to do with the Fed’s relationship with the gen­
eral public and the banking industry. We would argue the Fed was deliberately designed to
decentralize central bank policymaking and to minimize the extent of its head-on competition
with other financial intermediaries, in order to promote its effectiveness in its core monetary
policy and payments system roles. Our argument—that activities that tend to burden Reserve
Bank independence or significantly aggravate the problem of direct competition or conflict
between the central bank and other financial intermediaries have indirect costs that the Fed
should not ignore— applies to core as well as noncore functions to some degree. However, in
the case of core functions, there are few competitors and few good alternatives. So the real force
of this consideration applies to noncore functions. There we see this consideration tending to
rank options such as Reserve Bank service provision or extensive Federal Reserve System regu­
lation lower than less-intrusive options.
Perhaps the most attractive means of meeting the Fed’s goal, when it is available, is to help
ensure that private payment markets are contestable. Recall that a contestable market is one in
which existing participants always face numerous actual or potential rivals. When a large num­
ber of rivals are present in the market, it can be termed competitive, in the usual sense.
However, even markets with one or just a few actual participants can still be contestable, pro­
vided potential rivals can enter and exit the market without incurring large irretrievable costs in
the process. In the absence of sunk costs of entry or exit, existing participants are always com­
peting not only against each other but also against any number of nonparticipants who can
enter the market if profits appear abnormally high.
This potential competition promotes socially desirable results in line with the Fed’s pay­
ments system goal. Even when only a single firm is actively providing a service, potential
competition prevents that provider from setting prices significantly above competitive

The Region

By facilitating
the adoption of

new electronic
clearing methods,
the Fed could
help ensure
contestability
and consider an
orderly withdrawal
from its current
role as a provider
of check clearing
services.




Functions Complementary to the Core
A n ECONOMY OF SCOPE EXISTS when there is a technological reason to produce several

goods or services jointly rather than separately. For example, since jet fuel, gasoline, heating
oil, lubricating oil and so forth are all constituents of petroleum that are gotten by “cracking”
the petroleum into the separate constituents of its mixture, there is an economy of scope in
operating a refinery. It is obviously better to produce all of these products jointly than to try
to produce them separately.
In central banking, there could be an economy of scope between a core function and a
payments function outside the core. In such a case, if the central bank performs the core
function, the public is well served (other things being equal) by having it perform the addi­
tional function as well.
As an example, we are inclined to think that the Fed’s Multilateral Settlement Service
enables depository institutions to take advantage of an economy of scope between settlement
services and risk management services utilizing the Fed’s Account Balance Monitoring
System (ABMS). The ABMS is a computer system that provides the option to monitor, in
real time, the reserve account of a depository institution. This system is used for risk man­
agement of Fedwire, the Reserve Banks’ real-time gross settlement system for large-value
payments. Recently, the Federal Reserve established the Multilateral Settlement Service,
which enables check clearinghouses, credit card networks and other entities to use ABMS for
risk management of their private (usually net settlement) payment arrangements. Given that
the Fed has already built ABMS and is operating it for internal use, and that the incremental
cost of granting access to these other entities is small, there is an economy of scope here.
The economy of scope in this central-banking example is much subtler than the one in
petroleum refining. In fact, it is typically true that careful statistical analysis is required to
document an economy of scope convincingly. When and if such an economy of scope does
exist, it provides a prima facie reason for a central bank to expand its payments system activi­
ties in a particular, targeted way beyond its core functions.
Even where an economy of scope may demonstrably exist, one must weigh several ques­
tions before deciding that central-bank participation in a payments market is the best form
of policy. For example, if the economy of scope were an artifact of regulation, then would
revising or removing the regulation be preferable to expanding the role of the central bank?
Does adoption of new technology (such as movement from paper-based check collection to
electronic payments) remove an old economy of scope or create a new one, and, if so, should
the range of central-bank activities be adjusted? We emphasize that an economy of scope is a
threshold condition for the central bank to examine judiciously whether it ought to under­
take an activity outside its core function, and does not alone constitute an open-and-shut
case for such activity.

April 2001

Thoughts
on the
Fed’s Role
in the
Payments
System




norms. More generally, it spurs existing participants to innovate and adopt efficient new
technologies, so as not to be overtaken by a more progressive entrant to the market. For the
same reasons, existing participants cannot skimp on the quality and reliability of their ser­
vices or discriminate among customers to a greater extent than is required for economic effi­
ciency. In other words, contestability disciplines market participants to pursue efficiency,
integrity and accessibility of services.
The Fed can, and already does, promote contestability in payment markets. First of all, the
Reserve Banks should ensure that when they provide payment services, they do so in a way that
does not impede entry or exit in those markets or related payment markets. As was mentioned
earlier, the Reserve Banks make their core payment services available to both incumbent
providers and potential entrants in various payment services, including some in which the
Reserve Banks do not participate directly. As a regulator, the Fed can try to ensure that its regu­
lations do not inadvertently create unnecessary barriers to entry into or exit from payment ser­
vices markets. Through its oversight of the payments system and its research capabilities, the
Fed can also seek to highlight regulatory or institutional entry and exit barriers that are the
responsibility of other agencies, institutions or lawmakers. Finally, the Fed can work with the
payments industry to facilitate the adoption of new technologies and institutions that ease
entry and exit barriers. Possibly the clearest current example would be to facilitate the adoption
of technologies and institutional arrangements for electronic check clearing, in order to trivial­
ize the effects that small volumes and long distances can have on check clearing markets for
small and remotely located banks. By facilitating the adoption of new electronic clearing meth­
ods, the Fed could help ensure contestability and consider an orderly withdrawal from its cur­
rent role as a provider of check clearing services.
Another potentially effective option for achieving the Fed’s payments system goals is to shift
some regulatory or service provision activities to other governmental, nonprofit or cooperative
entities whose core functions better suit them for these tasks. For example, the Reserve Banks
already utilize the U.S. Postal Service to perform some routine transportation and delivery
functions in remote areas, and the Reserve Banks do not directly compete with the mutually
owned organizations (such as Visa and MasterCard) that serve as trusted third parties in the
credit card payments clearing market. A related option would be for the Reserve Banks to con­
tract with other organizations to provide certain payment functions, using an open bid process
and imposing restrictions if necessary to ensure integrity and accessibility. Either way, the Fed
would retain its oversight role, as well as the option to enter into direct service provision or
impose more extensive regulation if needed (up to the limits of its statutory authority).
However, as long as these other entities meet the Fed’s objectives in these markets, the Fed
would be free to better focus its resources on its core activities.
The examples above illustrate that the Fed has at least some alternatives to direct service pro­
vision for assuring the efficiency, integrity and accessibility of the payments system. Based on
the advantages to the Fed of specializing its payments system role, we conclude that the Reserve
Banks should provide core interbank settlement services, plus any closely complementary ser­
vices. Beyond that, the Fed should consider its full range of tools but exercise caution regarding
intrusive options such as direct service provision or extensive regulation.

aThe Region

20

However, as
long as these
other entities
meet the Fed s
objectives in these
markets, the Fed
would be free to
better focus its
resources on its
core activities.




Some Specific Implications
Here we apply the general conclusions derived in the previous sections to specific choices con­
fronting the Fed at the beginning of the 21st century.

The Fed should continue to provide an interbank funds transfer system o f unquestion­
able strength, quality and efficiency.
There is fairly strong international consensus that central-bank operation of an interbank
settlement system directly based on transfers of balances among banks’ reserve accounts is an
effective way to ensure the security and integrity of that system of interbank settlement.19 That
is, given the limitations of current technology and that which is likely to be available in the near
future, there is thought to be an economy of scope between maintaining reserve accounts and
providing funds transfers among those accounts. An interbank settlement system should pro­
vide ease of use and fast throughput with impeccable data security, reliability and risk controls.
The very high standards for these attributes that are appropriate in the large-value context
imply a stronger economy of scope than exists in the retail-payments case.
The Reserve Banks currently meet those standards with their internal network of computers
and their specialized hardware and software that allow depository institutions to directly initi­
ate funds transfers, subject to Fed risk controls. Continuing to meet these standards in today’s
rapidly evolving technological environment will require an ongoing and well-targeted effort to
upgrade hardware and software and retain critical staff. The Fed will need to stay abreast of
numerous developments in communications, security and encryption, software and hardware
to ensure that its core systems retain their strength and integrity as they evolve to support the
emerging products, standards and access channels that the financial sector will demand to
achieve efficiency and boost productivity. An uncompromising commitment to ensure both
efficiency and strength (security, reliability, etc.) in core interbank settlement services should be
the Reserve Banks’ highest payment services priority.

Payment services whose value added stems prim arily from paym ents clearing
rather than interbank settlement will generally not be core paym ent functions o f the
Reserve Banks.
The Reserve Banks’ involvement in payment services is sometimes held to contribute to the
Federal Reserve System’s core central-banking functions, such as monetary policy, banking
supervision and financial stabilization. To the extent these arguments are limited to what we
have termed core payment services, chiefly interbank settlement services (including provision
of short-term credit to facilitate net settlement), they are consistent with our own suggestion
here. However, some commentators appear to argue that the Reserve Banks’ provision of a
broader array of services, including check clearing and ACH, significantly enhances the Fed’s
ability to carry out its central-banking functions.20
We are not convinced. Other central banks, such as the Bank of England, appear to have per­
formed their central-banking responsibilities well with no such broad involvement in payment
services. While this may in part reflect historical differences in the payment and banking indus­
April 2001

Thoughts
on the
Fed’s Role

in the
Payments
System




tries in these other countries, even in the United States the relevance to central banking of the
Reserve Banks’ role in activities such as check clearing has diminished sharply over time. When
the Fed was founded, checks constituted the principal means of interbank payment, so check
clearing then constituted essentially a core service according to our characterization. Even
later, when wire transfers had supplanted checks as the primary tool for direct interbank set­
tlement, checks remained almost the sole form of consumer and small business noncash pay­
ment. Through its involvement in check clearing along with wire transfers, the Fed could
provide services to almost the entire payments system during periods of banking instability
and may also have derived a broad understanding of commercial bank payments activity and
an ability to manage failing institutions. These advantages are now diminishing considerably,
as payment services organized without direct Reserve Bank participation, such as credit and
debit cards, take an increasing share of the payments market and commercial banks’ payments
activity. No one suggests that the Reserve Banks need to provide these emerging and maturing
payment services in order to conduct monetary policy, stabilize markets or supervise banks,
and we believe the same is true for the comparable payment markets the Reserve Banks are in
already. In light of the great diversity and rapid evolution of modern means of making retail
payments, we do not see provision of a handful of those means as an effective way for a cen­
tral bank to monitor and understand the payments industry. The Fed has, and must have,
other ways to do that.

The advantages o f having commercial paym ent intermediaries serve the public in the
Reserve Banks’ traditional noncore market niches are likely to increase as electronic
paym ent options expand.
The Reserve Banks historically had a prima facie advantage over commercial banks as a
nationwide payment services provider, because banks faced legal and regulatory obstacles to
providing a full spectrum of customer services nationwide. Those obstacles no longer exist. The
Federal Reseve Banks also specialized historically in providing interbank payment services to
banks that were only marginally profitable to serve on a commercial basis because of factors
such as location in a sparsely populated area.21 We anticipate that such factors will be of little
or no relevance in the electronic payments environment of the future, and that this is a signifi­
cant reason why the Fed should promote migration to electronic payments.
If these two traditional Reserve Bank market niches diminish as we expect, so will the need
for the Reserve Banks to provide nonsettlement payment services that commercial firms are
unable or unwilling to replicate. Then the costs that a central bank incurs by competing broadly
with commercial banks (including correspondent banks) in various other service lines are likely
to become salient.

The Federal Reserve’s policy on its role in the payments system should explicitly recog­
nize promotion o f contestable paym ent markets as a key tactic in the Fed’s pursuit o f its
payments system goal. A t the same time, pursuit o f electronic paym ent technologies
should be considered primarily as a means for promoting contestability, rather than as
an end in itself or as a direct means o f pursuing the Fed’s goals.

The Region

O ur suggested
principles thus
countenance a
configuration of
Federal Reserve
Bank payment
services that
would differ
from what exists
today. We
emphasize that
this is a long­
term vision.




As stressed by Board of Governors Vice Chairman Roger Ferguson (1998), promotion of
contestable payment markets has become a key Fed tactic. Its status should be formally recog­
nized. Then the Fed would promote a transition to an electronic payments environment that
enhances the contestability of payment markets. This would allow the Fed to achieve its pay­
ments system goal through greater reliance on private competition, with a reduced role by the
Reserve Banks as direct providers of noncore payment services.

The Fed should give high priority to supporting the Multilateral Settlement System.
As we reflect on emerging payment trends and the Fed’s payments system priorities, we have
come to view the Reserve Banks’ Multilateral Settlement Service as a good example of how a
Reserve Bank service can promote contestable markets and improve the payments system over­
all. The Multilateral Settlement Service, introduced in 1999, makes it simple for a group of any
two or more banks to submit a settlement file listing debits and credits to be applied to their
accounts at the Fed.22 The Reserve Banks first process the debits, applying Fedwire-equivalent
risk controls to ensure that each paying bank has the funds or authorization to cover the
amount debited. Assuming this is the case, the Reserve Banks then process the credits as irrevo­
cable final payments to the receiving institutions, all on the same day that the settlement file
was submitted. This service provides low-cost, direct access to same-day interbank settlement
for groups (of banks) of any size, without regard to the underlying transactions that generate
their mutual debits/credits or any requirement that the underlying transactions be processed or
handled by the Reserve Banks.23 It has the potential to provide a safe, convenient, reliable and
efficient means of settling the interbank obligations generated by all forms of emerging com­
mercial payment vehicles. Barriers to entry in the payments clearing market are thereby
reduced, because groups of banks can enter a wide range of payments clearing activities in the
knowledge that they will not have to also establish their own safe and reliable settlement mech­
anism. We would make the continued enhancement of the Multilateral Settlement Service a
priority for the Fed.

Federal Reserve market share is not a public policy goal per se.
Effective competition from private firms may result in a declining payments market share
for the Reserve Banks. As long as the Reserve Banks are conducting their business capably, such
loss of market share should not be a cause for concern about the efficiency, integrity or accessi­
bility of the payments system. It is often simply a sign that a private firm is currently the more
effective form of organization to achieve those results. In the absence of evidence that the
Reserve Banks are being supplanted by monopoly or oligopoly providers in a noncontestable
market, a decrease in market share should normally be viewed as neutral or positive.

April 2001

Thoughts
on the
Fed’s Role
in the
Payments
System




Conclusion
We have noted that the Fed can pursue its payments system goals by several means, and not just
by providing payment services directly. We have argued that the Fed should prioritize its activi­
ties in the payments system in a way that makes best use of its character as a specialized institu­
tion—a central bank—and that most effectively supports its overall mission by de-emphasizing
noncore activities that intrude significantly on the private sector. We have drawn several more
specific implications from this approach.
Our suggested principles thus countenance a configuration of Reserve Bank payment ser­
vices that would differ from what exists today. We emphasize that this is a long-term vision. If it
were to be adopted, then the transition to it would have to be managed with care and foresight.
This essay has focused on the Reserve Banks’ involvement in the payments system as
providers of payment services. In closing, we would draw attention to the numerous other
forms of involvement in the payments system that the Fed maintains, apart from its role as a
service provider. In fact, when the public thinks about the Fed’s leadership in the payments sys­
tem, it is largely—and justly—those other forms of leadership that come to mind.
We therefore think the Fed should continue to pursue payments system monitoring and
leadership by other means as well. The Fed has traditionally participated with industry, govern­
ment and academic representatives on initiatives such as the setting of technical standards and
the drafting of model payments legislation. It can play a critical role in those efforts by promot­
ing new institutions and technologies that support a safe, reliable and efficient payments sys­
tem. The Fed’s banking supervision and market stabilization missions require it to understand
the functioning of the payments system. To this end, maintaining an ongoing dialogue with
payment providers will continue to be essential. Finally, the Fed has contributed to its own
understanding and to the making of good public policy toward the payments system through
its contributions to basic research in monetary theory, the industrial organization of payment
mechanisms and related areas. Maintaining or strengthening this tradition is also likely to
become increasingly important.

Endnotes
1 In compliance with the provisions of the Monetary Control Act of 1980, the Reserve Banks price their ser­
vices to cover costs, including estimates of the taxes and capital costs that their private sector competitors pay.
In addition to this fundamental cost recovery discipline, the Federal Reserve System has promulgated policy
principles to guide its participation in payment services markets, published as “The Federal Reserve in the
Payments System” (the so-called White Paper) in the May 1990 Federal Reserve Bulletin.
^ This rough characterization will suffice for the purposes of this essay. To the reader who wishes to recast our
argument in the most explicit and careful form, we recommend the discussion of comparative advantage in any
standard text on the economics of international trade.
3 The term “bank” refers broadly in this essay to depository institutions and other financial institutions that, for
reasons of public policy, are permitted to hold accounts at the central bank.
4 Evidence is provided by the role of friction with the state banks, and their consequent opposition, in defeat­
ing renewal of the charter of the Second Bank of the United States. The actions of the Second Bank of the
The Region




United States were lawful, in conformity with sound banking practices, and inspired by defensible considera­
tions of public policy. Nevertheless those actions were bitterly resented because they forestalled some privatesector banks from doing legitimate business. Cf. Catterall (1902), pp. 166, 451.
^ In particular, we regard it as being consistent with the White Paper on the role of the Federal Reserve in the
payments system.
6 One such rationale would be fostering the transition to an electronic-based retail payments system, which
would already be well under way in the environment that we contemplate. Another rationale would be coping
with market failures. We suggest that an electronic system would correct such a market failure or make it
addressable by general competition policy, such as antitrust law.
7 In addition, the Committee recommended that the Federal Reserve System play an active role, in conjunc­
tion with other payment service providers and users, in enhancing the efficiency of ACH and check clearing
services and in framing strategies for moving to the next generation of payment instruments. In 1999, the
Payments System Development Committee was established by the Board to help follow up on recommenda­
tions of the Rivlin Committee and actively to foster innovation in the payments system, where this is in the
public interest.
** It is true that a number of such commercial networks ultimately rely on Reserve Bank payment services (for
example, the Fed ACH) to transfer funds between their members’ reserve accounts for final settlement. When
the Reserve Banks play such a limited, specialized role in support of payment services in which they do not
directly compete, they contribute to the integrity of those services and provide a means to transfer funds
among a more inclusive group of participants than might otherwise be cost-effective. By playing this role, the
Reserve Banks also enhance competition, because both incumbent service providers and potential entrants
have the option to settle on the Reserve Banks’ books. In other words, this is an example of the Reserve Banks
promoting the Fed’s payments system goal by offering an interbank settlement service that supports private
payments initiation and clearing.
^ It might be suggested that, in contrast to the way that we treat them here, regulation and direct provision of
services are not completely distinct, unrelated alternatives. Indeed some would emphasize that the Reserve
Banks’ fairly broad participation in markets for payment services makes the Federal Reserve a better informed,
and thus more skillful, regulator than it might otherwise be. We agree that there is such a complementarity in
principle, but are not convinced that it is important in practice. It has not been recognized as important in
other industries such as broadcasting, transportation, and power generation and distribution, where issues of
regulation have been studied more intensively than in the payments industry. A strong and complete case for
complementarity in the payments industry would therefore have to identify a special feature of the industry
that makes it exceptional in this respect. Furthermore, the Fed already serves as an effective regulator of banks
that issue credit and debit cards without participating in those markets, and no one regards regulation in this
area as deficient on this account.
I® See Montgomery 1994 for a review of much of the relevant literature.
11 Financial economics implies that, absent specific technological complementarities among the activities of
several firms, the firms’ investors cannot benefit from a merger on the basis of diversification per se. From the
investors’ perspective, the merger has no advantage over holding a portfolio of the separate firms’ securities.
(See Myers 1968, 1976.) The organizational studies of which we are aware suggest that specialization is typically
advantageous, but also document some instances that are presumed to be exceptions to the general rule— situa­
tions in which diversification has seemed to produce efficiencies.
12 The Federal Reserve, like almost all central banks, has the exclusive authority to issue and destroy currency.
However, this authority is exercised in coordination with the Treasury and primarily to accommodate the pref­
erences of banks and the public regarding the proportion of total central-bank liabilities that should be out­
standing in the form of currency as opposed to banks’ balances at the Reserve Banks. For these reasons, we do
not consider currency provision in this essay. However, the strategic core might alternatively be defined to
include currency provision.

April 2001




15 The leading example was the founding of the Bank of England. North and Weingast (1989) study this histo­
ry and show that the establishment of a central bank greatly benefited England. Sargent and Velde (1995) show
the subsequent value of the Bank of England to British public finance during the 18th century. Sargent (1986)
provides a set of historical studies of the role of an independent central bank in controlling inflations and
hyperinflations in various countries during the 20th century, as well as a theoretical study (“Some unpleasant
monetarist arithmetic,” co-authored with Neil Wallace) that provides an analytic framework for understanding
the historical episodes.
The central bank’s function as intermediary between the government and its creditors does imply that the
central bank will be a major user of the payments system, but we think that this function should not be a prin­
cipal ground for it to play a role of strategic leadership in the payments system. Part of the government-finance
intermediary role can be for the central bank to manage the making and receiving of payments for the govern­
ment. This is the fiscal agency responsibility that the Federal Reserve Act assigns to the Reserve Banks. Given
the volume of Treasury payments today, this responsibility implies that the Federal Reserve will be among the
most intensive users of the payments system. However, the fiscal agency mandate properly involves conserva­
tive, cost-effective satisfaction of the government’s direct payment needs. It should not be regarded as authoriz­
ing the central bank to provide what would be, in effect, off-budget financing for a broad program of govern­
ment-sponsored investment in the payments system per se without appropriate budgetary oversight by
Congress. (Broaddus and Goodfriend (1996) explains, in the context of the issue of foreign-exchange-market
intervention, why central-bank funding of broad Treasury initiatives risks disturbing the institutional balance
between the central bank and the government on which control of inflation depends in the long run.) Recent
legislation requiring the Treasury to report the value of services it receives from the Federal Reserve helps to
address the potential problem of circumventing congressional oversight, but this development does not release
the Federal Reserve from responsibility to be circumspect in its role as the government’s fiscal agent.
14 Goodhart (1988) emphasizes this function.
On this understanding, the central bank occupies a position of comparative advantage regardless of whether
account balances there are intrinsically less subject to default than balances held at other banks— a question
regarding which there has been long-running debate in monetary history and economics.
15 Goodhart (1988) examines in detail the concurrent evolution of clearinghouses and central banks.
Regarding government oversight, while this may be less prominent in the case of clearinghouses than of central
banks, clearinghouses are typically subject to antitrust law and also to prudential supervision (often by the cen­
tral bank) in cases where issues of systemic risk are judged to exist.
17 Analogously, many credit unions are members of special jointly owned, government-regulated intermedi­
aries called corporate credit unions.
1® Cf. Freeman (1996), Green (1997).
19 However, central-bank operation of interbank settlement is not universal. We note above that Switzerland’s
SIC system is operated by a private joint venture under central-bank oversight. In addition, the Bank of Canada
is a regulator and guarantor of the Large Value Transfer System, and the Bank of England is a co-owner of
CHAPS, but neither system is operated directly by the central bank.
70 Corrigan (1983), pp. 352, 357.
71 Incidentally, to the credit of the Fed’s financial services staff, the Reserve Banks have consistently recovered
costs and generally earned the acclaim of their customers in these difficult-to-serve markets.
77 A bank that does not have an account of its own at a Reserve Bank can also participate in the Multilateral
Settlement Service, provided a bank with a Reserve Bank account agrees to act as its settler by accepting the
nonaccount-holding bank’s debits and credits in its Reserve Bank account.
75 It also significantly facilitates the provision of same-day settlement finality for net settlement arrangements,
a longstanding goal of the Fed’s interbank settlement function.

The Region




References
Bank for International Settlements. 1993. Payment systems in the Group of Ten countries. Basle, December.
Bhagat, Sanjai; Shleifer, Andrei; and Vishny, Robert W. 1990. Hostile takeovers in the 1980s: The return to cor­
porate specialization. Brookings Papers on Economic Activity, Microeconomics, special issue: 1-84.
Board of Governors of the Federal Reserve System. 1990. The Federal Reserve in the payments system. Federal
Reserve Bulletin (May): 293-8.
Broaddus, J. Alfred, and Goodfriend, Marvin. 1996. Foreign exchange operations and the Federal Reserve. 1995
Annual Report. Federal Reserve Bank of Richmond.
Catterall, Ralph C. H. 1902. The Second Bank of the United States. Chicago: University of Chicago Press.
Committee on the Federal Reserve in the Payments Mechanism. 1998. The Federal Reserve in the payments
mechanism. Washington, D.C.: Federal Reserve System.
Corrigan, E. Gerald. 1983. Background materials to the statement of E. Gerald Corrigan, president, Federal
Reserve Bank of Minneapolis, Minneapolis, Minn., in Banking Committee Serial No. 98-36, Role of the Federal
Reserve in check clearing and the nation’s payments system. Joint Hearings before the Subcommittee on
Domestic Monetary Policy of the Committee on Banking, Finance and Urban Affairs and the Subcommittee on
Commerce, Consumer and Monetary Affairs of the Committee on Government Operations. U.S. House of
Representatives (Ninety-Eighth Congress, First Session). June 16.
Ferguson, Roger W. Jr. 1998. The Federal Reserve’s role in the payments system and its effects on competition.
Remarks before the Bankers Roundtable, Phoenix, Ariz., April 4. (On the Internet at
http://federalreserve.gov/boarddocs/speeches/1998/19980404.htm)
Freeman, Scott. 1996. The payments system, liquidity, and rediscounting, American Economic Review 86 (5): 1126-38.
Goodhart, Charles. 1988. The evolution of central banks. Cambridge, Mass.: MIT Press.
Government Accounting Office. 2000. Essential air service: Changes in subsidy levels, air carrier costs, and passen­
ger traffic. Washington, D.C.: GAO/RCED-OO-34, April.
Green, Edward J. 1997. Money and debt in the structure of payments. Bank of Japan Monetary and Economic
Studies 15:63-86. (Reprinted in Federal Reserve Bank of Minneapolis Quarterly Review 23 (Spring 1999): 13-29.)
Montgomery, Cynthia A. 1994. Corporate diversification. Journal of Economic Perspectives, 8 (Summer): 163-178.
Myers, Stewart C. 1968. Procedures for capital budgeting under uncertainty. Industrial Management Review 9:1 20. (Reprinted in Modern Developments in Financial Management, ed. Stewart C. Myers. 1976. New York: Praeger.)
_______________ 1976. Introduction: a framework for evaluating mergers. In Modern Developments in
Financial Management, ed. Stewart C. Myers. New York: Praeger.
North, Douglass, and Weingast, Barry. 1989. Constitutions and commitment: The evolution of institutions gov­
erning public choice in seventeenth century England. Journal of Economic History 49 (4): 803-32.
Ravenscraft, David J., and Scherer, F.M. 1987. Mergers, sell-offs, and economic efficiency. Washington, D.C.:
The Brookings Institution.
Ricardo, David. Principles of political economy and taxation. [1817] Pelican Books, 1971.
Sargent, Thomas J. 1986. Rational expectations and inflation. New York: Harper Collins.
Sargent, Thomas J., and Velde, Francois. 1995. Macroeconomic features of the French Revolution. Journal of
Political Economy 103 (3): 474-518.
Sargent, Thomas J., and Wallace, Neil. 1981 Some unpleasant monetarist arithmetic. Federal Reserve Bank of
Minneapolis Quarterly Review 5 (Fall): 1-17.
April 2001

27

Federal Reserve Bank of Minneapolis




90 Hennepin Avenue, P.O. Box 291
Minneapolis, Minnesota 55480-0291
Phone 612 204-5000

January 29, 2001
To the Board of Directors:
The management of the Federal Reserve Bank of Minneapolis is responsible for the preparation
and fair presentation of the Statement of Financial Condition, Statement of Income, and
Statement of Changes in Capital as of December 31, 2000 (the “Financial Statements”). The
Financial Statements have been prepared in conformity with the accounting principles, policies,
and practices established by the Board of Governors of the Federal Reserve System and as set
forth in the Financial Accounting Manual for the Federal Reserve Banks, and as such, include
amounts, some of which are based on judgments and estimates of management.
The management of the Federal Reserve Bank of Minneapolis is responsible for maintaining an
effective process of internal controls over financial reporting including the safeguarding of
assets as they relate to the Financial Statements. Such internal controls are designed to provide
reasonable assurance to management and to the Board of Directors regarding the preparation
of reliable Financial Statements. This process of internal controls contain self-monitoring
mechanisms, including, but not limited to, divisions of responsibility and a code of conduct.
Once identified, any material deficiencies in the process of internal controls are reported to
management, and appropriate corrective measures are implemented.
Even an effective process of internal controls, no matter how well designed, has inherent limita­
tions, including the possibility of human error, and therefore can provide only reasonable
assurance with respect to the preparation of reliable financial statements.
The management of the Federal Reserve Bank of Minneapolis assessed its process of internal
controls over financial reporting including the safeguarding of assets reflected in the Financial
Statements, based upon the criteria established in the “Internal Control - Integrated
Framework” issued by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO). Based on this assessment, the management of the Federal Reserve Bank
of Minneapolis believes that the Federal Reserve Bank of Minneapolis maintained an effective
process of internal controls over financial reporting including the safeguarding of assets as they
relate to the Financial Statements.

Gary H. Stern, President

James M. Lyon, First Vice President

P^CBWATeRHOUs^CDPERS




PricewaterhouseCoopers LLP
650 Third Avenue South
Suite 1300
Minneapolis MN 55402-4333
Telephone (612) 596 6000
Facsimile (612) 373 7160

Report of Independent Accountants
To the Board of Directors of the
Federal Reserve Bank of Minneapolis:
We have examined management’s assertion that the Federal Reserve Bank of Minneapolis
(“FRB of Minneapolis”) maintained effective internal control over financial reporting and the
safeguarding of assets as they relate to the Financial Statements as of December 31,2000,
included in the accompanying Management’s Assertion.
Our examination was made in accordance with standards established by the American Institute
of Certified Public Accountants, and accordingly, included obtaining an understanding of the
internal control over financial reporting, testing, and evaluating the design and operating effec­
tiveness of the internal control, and such other procedures as we considered necessary in the
circumstances. We believe that our examination provides a reasonable basis for our opinion.
Because of inherent limitations in any internal control, misstatements due to error or fraud
may occur and not be detected. Also, projections of any evaluation of the internal control over
financial reporting to future periods are subject to the risk that the internal control may
become inadequate because of changes in conditions, or that the degree of compliance with the
policies or procedures may deteriorate.
In our opinion, management’s assertion that the FRB of Minneapolis maintained effective
internal control over financial reporting and over the safeguarding of assets as they relate to the
Financial Statements as of December 31, 2000, is fairly stated, in all material respects, based
upon criteria described in “Internal Control - Integrated Framework” issued by the Committee
of Sponsoring Organizations of the Treadway Commission.

March 2, 2001
Minneapolis, Minnesota




Federal Reserve Bank of M inneapolis

Financial
Statements
for years ended
December 31, 2000
and 1999

P n CBWATeMOUsEQoPERS i




PricewaterhouseCoopers LLP
650 Third Avenue South
Suite 1300
Minneapolis MN 55402-4333
Telephone (612) 596 6000
Facsimile (612) 373 7160

Report of Independent Accountants
To the Board of Governors of The Federal Reserve System
and the Board of Directors of The Federal Reserve
Bank of Minneapolis
We have audited the accompanying statements of condition of The Federal Reserve Bank of
Minneapolis (the “Bank”) as of December 31, 2000 and 1999, and the related statements of
income and changes in capital for the years then ended. These financial statements are the
responsibility of the Bank’s management. Our responsibility is to express an opinion on the
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards in the
United States of America. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material misstatement.
An audit includes examining, on a test basis, evidence supporting the amounts and disclosures
in the financial statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 3, the financial statements were prepared in conformity with the account­
ing principles, policies, and practices established by the Board of Governors of The Federal
Reserve System. These principles, policies, and practices, which were designed to meet the spe­
cialized accounting and reporting needs of The Federal Reserve System, are set forth in the
“Financial Accounting Manual for Federal Reserve Banks” and constitute a comprehensive basis
of accounting other than generally accepted accounting principles.
In our opinion, the financial statements referred to above present fairly, in all material respects,
the financial position of the Bank as of December 31, 2000 and 1999, and results of its opera­
tions for the years then ended, on the basis of accounting described in Note 3.

March 2, 2001
Minneapolis, Minnesota




Federal Reserve Bank of Minneapolis

STATEMENTS OF CONDITION
(in millions)

As of December 31,
2000
1999
Assets
Gold certificates
Special drawing rights certificates
Coin
Items in process of collection
Loans to depository institutions

$

U.S. government and federal agency securities, net
Investments denominated in foreign currencies
Accrued interest receivable
Prepaid expense-interest on Federal Reserve notes
to the U.S. Treasury
Bank premises and equipment, net
Other assets
Total assets
Liabilities and Capital
Liabilities:
Federal Reserve notes outstanding, net

158
30
33
516
5
2,183
572

$

25

140
78
13
599
10
5,787
549
58

31
150
19

—
155
16

$

3,722

$

7,405

$

1,587

$

2,766

Deposits:
Depository institutions
Other deposits
Deferred credit items
Interest on Federal Reserve notes due U.S. Treasury
Interdistrict settlement account
Accrued benefit costs
Other liabilities

456
2
451
—
642
41
10

482
2
584
4
3,050
38
9

3,189

6,935

Capital paid-in

368

235

Surplus

165

235

533

470

Total liabilities
Capital:

Total capital
Total liabilities and capital

$

3,722

The accompanying notes are an integral part of these financial statements.

The Region

32

$

7,405




Federal Reserve Bank of Minneapolis
STATEMENTS OF INCOME
(in millions)

For the years ended December 31,
2000
1999
Interest income:
Interest on U.S. government and
federal agency securities
Interest on investments denominated in
foreign currencies
Interest on loans to depository institutions

197

$

Total interest income
Other operating income:
Income from services
Reimbursable services to government agencies
Foreign currency (losses), net
U.S. Government securities (losses), net
Other income
Total other operating income
Operating expenses:
Salaries and other benefits

320

10
4

8
1

211

329

46

45

25
(51)

20
(17)

(1)
1

—
1

20

49

70

65
12

Occupancy expense
Equipment expense
Assessments by Board of Governors
Other expenses

13
9
10
43

Total operating expenses

145

Net income prior to distribution

$

8
13
31
129

$

86

$

249

$

19
67

$

13
33

Distribution of net income:
Dividends paid to member banks
Transferred to surplus
Payments to U.S. Treasury as interest on
Federal Reserve notes

203

—

Total distribution

$

86

The accompanying notes are an integral part of these financial statements.

April 2001

33

$

249




Federal Reserve Bank of Minneapolis

STATEMENTS OF CHANGES IN CAPITAL
for the years ended December 31, 2000, and December 31, 1999
(in millions)

Balance at January 1, 1999
(4.1 million shares)
Net income transferred to surplus

Capital
Paid-in

Surplus

Total
Capital

$ 202
—

$ 202
33

$ 404
33

Net change in capital stock issued
33

(0.6 million shares)
Balance at December 31, 1999
(4.7 million shares)
Net income transferred to surplus

$ 235
—

Surplus transfer to the U.S. Treasury
Net change in capital stock issued
(2.7 million shares)
Balance at December 31, 2000
(7.4 million shares)

—

$ 235
67

34

$ 470
67

—

(137)

(137)

133

—

133

$ 368

$ 165

$ 533

The accompanying notes are an integral part of these financial statements.

The Region

33

Federal Reserve Bank of Minneapolis

Notes to Financial Statements




1. ORGANIZATION

The Federal Reserve Bank of Minneapolis (“Bank”) is part of the Federal Reserve System
(“System”) created by Congress under the Federal Reserve Act of 1913 (“Federal Reserve Act”)
which established the central bank of the United States. The System consists of the Board of
Governors of the Federal Reserve System (“Board of Governors”) and twelve Federal Reserve
Banks (“Reserve Banks”). The Reserve Banks are chartered by the federal government and pos­
sess a unique set of governmental, corporate, and central bank characteristics. Other major ele­
ments of the System are the Federal Open Market Committee (“FOMC”) and the Federal
Advisory Council. The FOMC is composed of members of the Board of Governors, the presi­
dent of the Federal Reserve Bank of New York (“FRBNY”) and, on a rotating basis, four other
Reserve Bank presidents.
Structure

The Bank and its branch in Helena, Montana, serve the Ninth Federal Reserve District, which
includes Minnesota, Montana, North Dakota, South Dakota, and portions of Michigan and
Wisconsin. In accordance with the Federal Reserve Act, supervision and control of the Bank is
exercised by a Board of Directors. Banks that are members of the System include all national
banks and any state chartered bank that applies and is approved for membership in the System.
Board of Directors

The Federal Reserve Act specifies the composition of the Board of Directors for each of the
Reserve Banks. Each board is composed of nine members serving three-year terms: three direc­
tors, including those designated as Chairman and Deputy Chairman, are appointed by the Board
of Governors, and six directors are elected by member banks. Of the six elected by member
banks, three represent the public and three represent member banks. Member banks are divided
into three classes according to size. Member banks in each class elect one director representing
member banks and one representing the public. In any election of directors, each member bank
receives one vote, regardless of the number of shares of Reserve Bank stock it holds.
2. OPERATIONS AND SERVICES

The System performs a variety of services and operations. Functions include: formulating and
conducting monetary policy; participating actively in the payments mechanism, including
large-dollar transfers of funds, automated clearinghouse operations and check processing; dis­
tribution of coin and currency; fiscal agency functions for the U.S. Treasury and certain federal
agencies; serving as the federal governments bank; providing short-term loans to depository
institutions; serving the consumer and the community by providing educational materials and
information regarding consumer laws; supervising bank holding companies and state member
banks; and administering other regulations of the Board of Governors. The Board of
Governors’ operating costs are funded through assessments on the Reserve Banks.
The FOMC establishes policy regarding open market operations, oversees these operations, and
issues authorizations and directives to the FRBNY for its execution of transactions. Authorized
transaction types include direct purchase and sale of securities, matched sale-purchase transac­
tions, the purchase of securities under agreements to resell, and the lending of U.S. government
securities. The FRBNY is also authorized by the FOMC to hold balances of and to execute spot
April 2001

35

Federal Reserve Bank
of Minneapolis

Notes to
Financial Statements
(Continued)




and forward foreign exchange and securities contracts in nine foreign currencies, maintain
reciprocal currency arrangements (“F/X swaps”) with various central banks, and “warehouse”
foreign currencies for the U.S. Treasury and Exchange Stabilization Fund (“ESF”) through the
Reserve Banks.
3. SIGNIFICANT ACCOUNTING POLICIES

Accounting principles for entities with the unique powers and responsibilities of the nation’s
central bank have not been formulated by the Financial Accounting Standards Board. The
Board of Governors has developed specialized accounting principles and practices that it
believes are appropriate for the significantly different nature and function of a central bank
as compared to the private sector. These accounting principles and practices are documented
in the “Financial Accounting Manual for Federal Reserve Banks” (“Financial Accounting
Manual”), which is issued by the Board of Governors. All Reserve Banks are required to
adopt and apply accounting policies and practices that are consistent with the Financial
Accounting Manual.
The financial statements have been prepared in accordance with the Financial Accounting
Manual. Differences exist between the accounting principles and practices of the System and
generally accepted accounting principles (“GAAP”). The primary differences are the presenta­
tion of all security holdings at amortized cost, rather than at the fair value presentation require­
ments of GAAP, and the accounting for matched sale-purchase transactions as separate sales
and purchases, rather than secured borrowings with pledged collateral, as is generally required
by GAAP. In addition, the Bank has elected not to present a Statement of Cash Flows. The
Statement of Cash Flows has not been included as the liquidity and cash position of the Bank
are not of primary concern to the users of these financial statements. Other information
regarding the Bank’s activities is provided in, or may be derived from, the Statements of
Condition, Income, and Changes in Capital. Therefore, a Statement of Cash Flows would not
provide any additional useful information. There are no other significant differences between
the policies outlined in the Financial Accounting Manual and GAAP.
The preparation of the financial statements in conformity with the Financial Accounting
Manual requires management to make certain estimates and assumptions that affect the report­
ed amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date
of the financial statements and the reported amounts of income and expenses during the
reporting period. Actual results could differ from those estimates. Unique accounts and signifi­
cant accounting policies are explained below.
a. Gold Certificates

The Secretary of the Treasury is authorized to issue gold certificates to the Reserve Banks to
monetize gold held by the U.S. Treasury. Payment for the gold certificates by the Reserve
Banks is made by crediting equivalent amounts in dollars into the account established for the
U.S. Treasury. These gold certificates held by the Reserve Banks are required to be backed by
the gold of the U.S. Treasury. The U.S. Treasury may reacquire the gold certificates at any
time and the Reserve Banks must deliver them to the U.S. Treasury. At such time, the U.S.
Treasury’s account is charged and the Reserve Banks’ gold certificate accounts are lowered.
The value of gold for purposes of backing the gold certificates is set by law at $42 2/9 a fine

The Region

36

Federal Reserve Bank
of Minneapolis

Notes to
Financial Statements
(Continued)




troy ounce. The Board of Governors allocates the gold certificates among Reserve Banks
once a year based upon Federal Reserve notes outstanding in each District at the end of the
preceding year.
b. Special Drawing Rights Certificates

Special drawing rights (“SDRs”) are issued by the International Monetary Fund (“Fund”) to its
members in proportion to each member’s quota in the Fund at the time of issuance. SDRs
serve as a supplement to international monetary reserves and may be transferred from one
national monetary authority to another. Under the law providing for United States participa­
tion in the SDR system, the Secretary of the U.S. Treasury is authorized to issue SDR certifi­
cates, somewhat like gold certificates, to the Reserve Banks. At such time, equivalent amounts
in dollars are credited to the account established for the U.S. Treasury, and the Reserve Banks’
SDR certificate accounts are increased. The Reserve Banks are required to purchase SDRs, at
the direction of the U.S. Treasury, for the purpose of financing SDR certificate acquisitions or
for financing exchange stabilization operations. The Board of Governors allocates each SDR
transaction among Reserve Banks based upon Federal Reserve notes outstanding in each
District at the end of the preceding year.
c. Loans to Depository Institutions

The Depository Institutions Deregulation and Monetary Control Act of 1980 provides that all
depository institutions that maintain reservable transaction accounts or nonpersonal time
deposits, as defined in Regulation D issued by the Board of Governors, have borrowing privi­
leges at the discretion of the Reserve Banks. Borrowers execute certain lending agreements and
deposit sufficient collateral before credit is extended. Loans are evaluated for collectibility, and
currently all are considered collectible and fully collateralized. If any loans were deemed to be
uncollectible, an appropriate reserve would be established. Interest is recorded on the accrual
basis and is charged at the applicable discount rate established at least every fourteen days by
the Board of Directors of the Reserve Banks, subject to review by the Board of Governors.
However, Reserve Banks retain the option to impose a surcharge above the basic rate in certain
circumstances.
d. U.S. Government and Federal Agency Securities and Investments Denominated in
Foreign Currencies

The FOMC has designated the FRBNY to execute open market transactions on its behalf and
to hold the resulting securities in the portfolio known as the System Open Market Account
(“SOMA”). In addition to authorizing and directing operations in the domestic securities mar­
ket, the FOMC authorizes and directs the FRBNY to execute operations in foreign markets for
major currencies in order to counter disorderly conditions in exchange markets or other needs
specified by the FOMC in carrying out the System’s central bank responsibilities.
Purchases of securities under agreements to resell and matched sale-purchase transactions are
accounted for as separate sale and purchase transactions. Purchases under agreements to resell
are transactions in which the FRBNY purchases a security and sells it back at the rate specified
at the commencement of the transaction. Matched sale-purchase transactions are transactions
in which the FRBNY sells a security and buys it back at the rate specified at the commencement
of the transaction.

April 2001

37

Federal Reserve Bank
of Minneapolis

Notes to
Financial Statements
(Continued)




Effective April 26, 1999, FRBNY was given the sole authorization by the FOMC to lend U.S.
government securities held in the SOMA to U.S. government securities dealers and to banks
participating in U.S. government securities clearing arrangements, in order to facilitate the
effective functioning of the domestic securities market. These securities-lending transactions
are fully collateralized by other U.S. government securities. FOMC policy requires FRBNY to
take possession of collateral in excess of the market values of the securities loaned. The market
values of the collateral and the securities loaned are monitored by FRBNY on a daily basis, with
additional collateral obtained as necessary. The securities loaned continue to be accounted for
in the SOMA. Prior to April 26, 1999, all Reserve Banks were authorized to engage in such
lending activity.
Foreign exchange contracts are contractual agreements between two parties to exchange speci­
fied currencies, at a specified price, on a specified date. Spot foreign contracts normally settle
two days after the trade date, whereas the settlement date on forward contracts is negotiated
between the contracting parties, but will extend beyond two days from the trade date. The
FRBNY generally enters into spot contracts, with any forward contracts generally limited to the
second leg of a swap/warehousing transaction.
The FRBNY, on behalf of the Reserve Banks, maintains renewable, short-term F/X swap
arrangements with two authorized foreign central banks. The parties agree to exchange their
currencies up to a pre-arranged maximum amount and for an agreed upon period of time (up
to twelve months), at an agreed upon interest rate. These arrangements give the FOMC tem­
porary access to foreign currencies that it may need for intervention operations to support the
dollar and give the partner foreign central bank temporary access to dollars it may need to sup­
port its own currency. Drawings under the F/X swap arrangements can be initiated by either
the FRBNY or the partner foreign central bank, and must be agreed to by the drawee. The F/X
swaps are structured so that the party initiating the transaction (the drawer) bears the exchange
rate risk upon maturity. The FRBNY will generally invest the foreign currency received under
an F/X swap in interest-bearing instruments.
Warehousing is an arrangement under which the FOMC agrees to exchange, at the request of
the Treasury, U.S. dollars for foreign currencies held by the Treasury or ESF over a limited
period of time. The purpose of the warehousing facility is to supplement the U.S. dollar
resources of the Treasury and ESF for financing purchases of foreign currencies and related
international operations.
In connection with its foreign currency activities, the FRBNY, on behalf of the Reserve Banks,
may enter into contracts which contain varying degrees of off-balance sheet market risk
because they represent contractual commitments involving future settlement, and counter­
party credit risk. The FRBNY controls credit risk by obtaining credit approvals, establishing
transaction limits, and performing daily monitoring procedures.
While the application of current market prices to the securities currently held in the SOMA
portfolio and investments denominated in foreign currencies may result in values substantially
above or below their carrying values, these unrealized changes in value would have no direct
effect on the quantity of reserves available to the banking system or on the prospects for future
Reserve Bank earnings or capital. Both the domestic and foreign components of the SOMA

The Region

38

Federal Reserve Bank
of Minneapolis

Notes to
Financial Statements
(Continued)




portfolio from time to time involve transactions that can result in gains or losses when holdings
are sold prior to maturity. However, decisions regarding the securities and foreign currencies
transactions, including their purchase and sale, are motivated by monetary policy objectives
rather than profit. Accordingly, earnings and any gains or losses resulting from the sale of such
currencies and securities are incidental to the open market operations and do not motivate its
activities or policy decisions.
U.S. government and federal agency securities and investments denominated in foreign curren­
cies comprising the SOMA are recorded at cost, on a settlement-date basis, and adjusted for
amortization of premiums or accretion of discounts on a straight-line basis. Interest income is
accrued on a straight-line basis and is reported as “Interest on U.S. government and federal
agency securities” or “Interest on investments denominated in foreign currencies,” as appropri­
ate. Income earned on securities lending transactions is reported as a component of “Other
income.” Gains and losses resulting from sales of securities are determined by specific issues
based on average cost. Gains and losses on the sales of U.S. government and federal agency
securities are reported as “U.S. government securities (losses), net.” Foreign currency denomi­
nated assets are revalued monthly at current market exchange rates in order to report these
assets in U.S. dollars. Realized and unrealized gains and losses on investments denominated in
foreign currencies are reported as “Foreign currency (losses), net.” Foreign currencies held
through F/X swaps, when initiated by the counter-party, and warehousing arrangements are
revalued monthly, with the unrealized gain or loss reported by the FRBNY as a component of
“Other assets” or “Other liabilities,” as appropriate.
Balances of U.S. government and federal agency securities bought outright, investments
denominated in foreign currency, interest income, amortization of premiums and discounts on
securities bought outright, gains and losses on sales of securities, and realized and unrealized
gains and losses on investments denominated in foreign currencies, excluding those held under
an F/X swap arrangement, are allocated to each Reserve Bank. Effective April 26, 1999, income
from securities lending transactions undertaken by FRBNY was also allocated to each Reserve
Bank. Securities purchased under agreements to resell and unrealized gains and losses on the
revaluation of foreign currency holdings under F/X swaps and warehousing arrangements are
allocated to the FRBNY and not to other Reserve Banks.
e. Bank Premises and Equipment

Bank premises and equipment are stated at cost less accumulated depreciation. Depreciation is
calculated on a straight-line basis over estimated useful lives of assets ranging from 2 to 50
years. New assets, major alterations, renovations and improvements are capitalized at cost as
additions to the asset accounts. Maintenance, repairs and minor replacements are charged to
operations in the year incurred. Internally developed software is capitalized based on the cost
of direct materials and services and those indirect costs associated with developing, implement­
ing, or testing software.
f. Interdistrict Settlement Account

At the close of business each day, all Reserve Banks and branches assemble the payments due to
or from other Reserve Banks and branches as a result of transactions involving accounts resid­
ing in other Districts that occurred during the day’s operations. Such transactions may include
funds settlement, check clearing and automated clearinghouse operations, and allocations of
April 2001

39

Federal Reserve Bank
of Minneapolis

Notes to
Financial Statements
(Continued)




shared expenses. The cumulative net amount due to or from other Reserve Banks is reported
as the “Interdistrict settlement account.”
g. Federal Reserve Notes
Federal Reserve notes are the circulating currency of the United States. These notes are issued
through the various Federal Reserve agents to the Reserve Banks upon deposit with such
Agents of certain classes of collateral security, typically U.S. government securities. These notes
are identified as issued to a specific Reserve Bank. The Federal Reserve Act provides that the
collateral security tendered by the Reserve Bank to the Federal Reserve Agent must be equal to
the sum of the notes applied for by such Reserve Bank. In accordance with the Federal Reserve
Act, gold certificates, special drawing rights certificates, U.S. government and federal agency
securities, triparty agreements, loans to depository institutions, and investments denominated
in foreign currencies are pledged as collateral for net Federal Reserve notes outstanding. The
collateral value is equal to the book value of the collateral tendered, with the exception of secu­
rities, whose collateral value is equal to the par value of the securities tendered. The Board of
Governors may, at any time, call upon a Reserve Bank for additional security to adequately col­
lateralize the Federal Reserve notes. The Reserve Banks have entered into an agreement which
provides for certain assets of the Reserve Banks to be jointly pledged as collateral for the Federal
Reserve notes of all Reserve Banks in order to satisfy their obligation of providing sufficient
collateral for outstanding Federal Reserve notes. In the event that this collateral is insufficient,
the Federal Reserve Act provides that Federal Reserve notes become a first and paramount lien
on all the assets of the Reserve Banks. Finally, as obligations of the United States, Federal
Reserve notes are backed by the full faith and credit of the United States government.
The “Federal Reserve notes outstanding, net” account represents Federal Reserve notes reduced
by cash held in the vaults of the Bank of $7,994 million and $8,581 million at December 31,
2000 and 1999, respectively.
h. Capital Paid-in
The Federal Reserve Act requires that each member bank subscribe to the capital stock of the
Reserve Bank in an amount equal to 6 percent of the capital and surplus of the member bank.
As a member bank’s capital and surplus changes, its holdings of the Reserve Bank’s stock must
be adjusted. Member banks are those state-chartered banks that apply and are approved for
membership in the System and all national banks. Currently, only one-half of the subscription
is paid-in and the remainder is subject to call. These shares are nonvoting with a par value of
$100. They may not be transferred or hypothecated. By law, each member bank is entitled to
receive an annual dividend of 6 percent on the paid-in capital stock. This cumulative dividend
is paid semiannually. A member bank is liable for Reserve Bank liabilities up to twice the par
value of stock subscribed by it.
i. Surplus
The Board of Governors requires Reserve Banks to maintain a surplus equal to the amount of
capital paid-in as of December 31. This amount is intended to provide additional capital and
reduce the possibility that the Reserve Banks would be required to call on member banks for
additional capital. Reserve Banks are required by the Board of Governors to transfer to the
U.S. Treasury excess earnings, after providing for the costs of operations, payment of dividends,
and reservation of an amount necessary to equate surplus with capital paid-in.
The Region

40

Federal Reserve Bank
of Minneapolis

Notes to
Financial Statements
(Continued)




The Consolidated Appropriations Act of 2000 (Public Law 106-113, Section 302) directed the
Reserve Banks to transfer to the U.S. Treasury additional surplus funds of $3,752 million dur­
ing the Federal Government’s 2000 fiscal year. Federal Reserve Bank of Minneapolis transferred
$137 million to the U.S. Treasury during the year ended December 31, 2000. Reserve Banks
were not permitted to replenish the surplus for these amounts during fiscal year 2000 which
ended September 30, 2000.
Due to the substantial increase in capital paid-in and the transfer of surplus required by the
Consolidated Appropriations Act of 2000, surplus was not equated to capital at December 31,
2000. The amount of additional surplus required due to these events exceeded the Bank’s net
income in 2000. Net income is affected by SOMA participation as discussed in footnote 4.
In the event of losses or a substantial increase in capital, payments to the U.S. Treasury are sus­
pended until such losses or increases in capital are recovered through subsequent earnings. At
year end, the Bank’s payments had not resumed. Payments made to the U.S. Treasury earlier in
the year are classified as “Prepaid expense-interest on Federal Reserve notes to the U.S.
Treasury.” Weekly payments to the U.S. Treasury may vary significantly.
j. Income and Costs related to Treasury Services

The Bank is required by the Federal Reserve Act to serve as fiscal agent and depository of the
United States. By statute, the Department of the Treasury is permitted, but not required, to
pay for these services. The costs of providing fiscal agency and depository services to the
Treasury Department that have been billed but will not paid are immaterial and included in
“Other Expenses.”
k. Taxes

The Reserve Banks are exempt from federal, state, and local taxes, except for taxes on real prop­
erty, which are reported as a component of “Occupancy expense.”
4. U.S. GOVERNMENT AND FEDERAL AGENCY SECURITIES

Securities bought outright are held in the SOMA at the FRBNY. An undivided interest in
SOMA activity, with the exception of securities held under agreements to resell and the related
premiums, discounts and income, is allocated to each Reserve Bank on a percentage basis
derived from an annual settlement of interdistrict clearings. The settlement, performed in
April of each year, equalizes Reserve Bank gold certificate holdings to Federal Reserve notes
outstanding. The Bank’s allocated share of SOMA balances was 0.421 percent and 1.196 per­
cent at December 31, 2000 and 1999, respectively.

April 2001

4l

Federal Reserve Bank
of Minneapolis

Notes to
Financial Statements
(Continued)




The Bank’s allocated share of securities held in the SOMA at December 31, that were bought
outright, were as follows (in millions):
2000
Par value:
Federal agency

$

U.S. government:
Bills
Notes
Bonds
Total par value
Unamortized premiums
Unaccreted discounts
Total allocated to Bank

$

1

1999
$

2

752

2,111

1,011
391

2,613
992

2,155
41

5,718
109

(13)
2,183

(40)
5,787

$

Total SOMA securities bought outright were $518,501 million and $483,902 million at
December 31, 2000 and 1999, respectively.
The maturity distribution of U.S. government and federal agency securities bought outright,
which were allocated to the Bank at December 31, 2000, were as follows (in millions):

Maturities of Securities Held
Within 15 days
16 days to 90 days

U.S. Government
Securities
$

91 days to 1 year
Over 1 year to 5 years
Over 5 years to 10 years
Over 10 years
Total

$

76
459
528
559
233
299
2,154

Par value
Federal Agency
Obligations
$

1

76
459
528
560

1

233
299
2,155

$

$

Total

$

At December 31, 2000 and 1999, matched sale-purchase transactions involving U.S. government
securities with par values of $21,112 million and $39,182 million, respectively, were outstanding,
of which $89 million and $469 million were allocated to the Bank. Matched sale-purchase
transactions are generally overnight arrangements.

The Region

42

Federal Reserve Bank
of Minneapolis

Notes to
Financial Statements
(Continued)




5. INVESTMENTS DENOMINATED IN FOREIGN CURRENCIES

The FRBNY, on behalf of the Reserve Banks, holds foreign currency deposits with foreign cen­
tral banks and the Bank for International Settlements and invests in foreign government debt
instruments. Foreign government debt instruments held include both securities bought out­
right and securities held under agreements to resell. These investments are guaranteed as to
principal and interest by the foreign governments.
Each Reserve Bank is allocated a share of foreign-currency-denominated assets, the related
interest income, and realized and unrealized foreign currency gains and losses, with the excep­
tion of unrealized gains and losses on F/X swaps and warehousing transactions. This allocation
is based on the ratio of each Reserve Bank’s capital and surplus to aggregate capital and surplus
at the preceding December 31. The Bank’s allocated share of investments denominated in for­
eign currencies was approximately 3.653 percent and 3.400 percent at December 31,2000 and
1999, respectively.
The Bank’s allocated share of investments denominated in foreign currencies, valued at current
exchange rates at December 31, were as follows (in millions):
2000
European Union Euro:
Foreign currency deposits
Government debt instruments
including agreements to resell

$

Japanese Yen:
Foreign currency deposits
Government debt instruments
including agreements to resell
Accrued interest
Total

$

169

1999
$

147

100

86

100

11

201
2

303
2

572

$

549

Total investments denominated in foreign currencies were $15,670 million and $16,140 million
at December 31, 2000 and 1999, respectively.

April 2001

43

Federal Reserve Bank
of Minneapolis

Notes to
Financial Statements
(Continued)




The maturity distribution of investments denominated in foreign currencies which were
allocated to the Bank at December 31, 2000, were as follows (in millions):
Maturities of Investments Denominated in Foreign Currencies
Within 1 year

$

537

Over 1 year to 5 years

15

Over 5 years to 10 years
Over 10 years

16
4

Total

$

572

At December 31, 2000 and 1999, there were no open foreign exchange contracts or outstanding
F/X swaps.
At December 31, 2000 and 1999, the warehousing facility was $5,000 million, with no balance
outstanding.
6.

BANK PREMISES AND EQUIPMENT

A summary of bank premises and equipment at December 31 is as follows (in millions):
2000

1999

Bank premises and equipment:
Land
Buildings
Building machinery and equipment
Furniture and equipment

$

$

110
14
48
185
(35)

Accumulated depreciation
Bank premises and equipment, net

13

$

150

13
109
14
48
184
(29)

$

155

Depreciation expense was $9 million and $8 million for the years ended December 31, 2000
and 1999, respectively.
This Bank has not entered into any capitalized leases for bank premises and equipment.
Future minimum payments under agreements in existence at December 31, 2000, were not
material.

The Region

44

Federal Reserve Bank
of Minneapolis

Notes to
Financial Statements
(Continued)




7. COMMITMENTS AND CONTINGENCIES

Future minimum rental payments under noncancelable operating leases and capital leases, net
of sublease rentals, with terms of one year or more, at December 31, 2000, were not material.
Rental expense under operating leases for certain operating facilities, warehouses, and data pro­
cessing and office equipment (including taxes, insurance and maintenance when included in
rent), net of sublease rentals, was $255 thousand and $271 thousand for the years ended
December 31, 2000 and 1999, respectively. Certain of the Bank’s leases have options to renew.
Under the Insurance Agreement of the Federal Reserve Banks dated as of March 2, 1999, each
of the Reserve Banks has agreed to bear, on a per incident basis, a pro rata share of losses in
excess of 1 percent of the capital paid-in of the claiming Reserve Bank, up to 50 percent of the
total capital paid-in of all Reserve Banks. Losses are borne in the ratio that a Reserve Bank’s
capital paid-in bears to the total capital paid-in of all Reserve Banks at the beginning of the cal­
endar year in which the loss is shared. No claims were outstanding under such agreement at
December 31, 2000 or 1999.
The Bank is involved in certain legal actions and claims arising in the ordinary course of busi­
ness. Although it is difficult to predict the ultimate outcome of these actions, in manage­
ment’s opinion, based on discussions with counsel, the aforementioned litigation and claims
will be resolved without material adverse effect on the financial position or results of opera­
tions of the Bank.
There were no other commitments and long-term obligations in excess of one year at
December 31, 2000.

8. RETIREMENT AND THRIFT PLANS
Retirement Plans

The Bank currently offers two defined benefit retirement plans to its employees, based on
length of service and level of compensation. Substantially all of the Bank’s employees partici­
pate in the Retirement Plan for Employees of the Federal Reserve System (“System Plan”) and
the Benefit Equalization Retirement Plan (“BEP”). The System Plan is a multi-employer plan
with contributions fully funded by participating employers. No separate accounting is main­
tained of assets contributed by the participating employers. The Bank’s projected benefit obli­
gation and net pension costs for the BEP at December 31, 2000 and 1999, and for the years
then ended, are not material.
Thrift Plan

Employees of the Bank may also participate in the defined contribution Thrift Plan for
Employees of the Federal Reserve System (“Thrift Plan”). The Bank’s Thrift Plan contributions
totaled $2 million for each of the years ended December 31, 2000 and 1999, and are reported as
a component of “Salaries and other benefits.”

April 2001

45

Federal Reserve Bank
of Minneapolis

Notes to
Financial Statements
(Continued)




9. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS
AND POSTEMPLOYMENT BENEFITS
Postretirement benefits other than pensions

In addition to the Bank’s retirement plans, employees who have met certain age and length of
service requirements are eligible for both medical benefits and life insurance coverage during
retirement.
The Bank funds benefits payable under the medical and life insurance plans as due and, accord­
ingly, has no plan assets. Net postretirement benefit costs are actuarially determined using a
January 1 measurement date.
Following is a reconciliation of beginning and ending balances of the benefit obligation (in
millions):
2000
Accumulated postretirement benefit obligation at January 1
Service cost-benefits earned during the period
Interest cost of accumulated benefit obligation
Actuarial loss (gain)

$

$

$

33.2

30.2
1.0
1.9
(1.6)

1.1
0.1
(1.4)

Contributions by plan participants
Benefits paid
Accumulated postretirement benefit obligation at December 31

30.3
0.9
2.2

1999

0.1
(1.3)
$

30.3

Following is a reconciliation of the beginning and ending balance of the plan assets, the
unfunded postretirement benefit obligation, and the accrued postretirement benefit costs (in
millions):
2000
Fair value of plan assets at January 1
Actual return on plan assets
Contributions by the employer
Contributions by plan participants
Benefits paid
Fair value of plan assets at December 31
Unfunded postretirement benefit obligation
Unrecognized initial net transition asset (obligation)

$

$
$

—
—
1.2
0.1
(1.3)
—
33.2

1999
$

—
—
1.2
0.1
(1.3)

$
$

30.3

—

—

Unrecognized prior service cost

—

—

Unrecognized net actuarial gain

1.8

2.9

Accrued postretirement benefit cost

$

The Region

46

35.0

$

33.2

Federal Reserve Bank
of Minneapolis

Accrued postretirement benefit costs are reported as a component of “Accrued benefit costs.”

Notes to
Financial Statements

At December 31, 2000 and 1999, the weighted-average assumption used in developing the
postretirement benefit obligation was 7.5 percent.

(Continued)




For measurement purposes, an 8.75 percent annual rate of increase in the cost of covered
health care benefits was assumed for 2001. Ultimately, the health care cost trend rate is expect­
ed to decrease gradually to 5.50 percent by 2008, and remain at that level thereafter.
Assumed health care cost trend rates have a significant effect on the amounts reported for
health care plans. A one percentage point change in assumed health care cost trend rates would
have the following effects for the year ended December 31,2000 (in millions):

1 Percentage
Point Increase
Effect on aggregate of service and interest cost
components of net periodic postretirement benefit costs
Effect on accumulated postretirement benefit obligation

$

0.8
6.1

1 Percentage
Point Decrease
( 0 .6 )

$

(5.0)

The following is a summary of the components of net periodic postretirement benefit costs for
the years ended December 31 (in millions):

Service cost-benefits earned during the period
Interest cost of accumulated benefit obligation
Amortization of prior service cost

$

2000
0.9
2.2

$

1999
1.0
1.9

—

Recognized net actuarial loss

—

—

Net periodic postretirement benefit costs

$

3.1

—
$

2.9

Net periodic postretirement benefit costs are reported as a component of “Salaries and other
benefits.”
Postemployment benefits

The Bank offers benefits to former or inactive employees. Postemployment benefit costs are
actuarially determined and include the cost of medical and dental insurance, survivor income,
and disability benefits. Costs were projected using the same discount rate and health care trend
rates as were used for projecting postretirement costs. The accrued postemployment benefit
costs recognized by the Bank at December 31, 2000 and 1999, were $6 million and $5 million,
respectively. This cost is included as a component of “Accrued benefit costs.” Net periodic
postemployment benefit costs included in 2000 and 1999 operating expenses were $1 million
for each year.

April 2001

47

2000 Minneapolis Board of Directors
James J. Howard
Chairman

Ronald N. Zwieg
Deputy Chairman

CLASS A ELECTED BY
MEMBER BANKS

CLASS B ELECTED BY
MEMBER BANKS

CLASS C APPOINTED BY THE
BOARD OF GOVERNORS

Roger N. Berglund

Jay F. Hoeschler

James J. Howard

President and Chief Executive Officer
Dakota Western Bank
Bowman, N.D.

President
Hoeschler Realty Corp.
La Crosse, Wis.

Chairman
Xcel Energy Inc.
Minneapolis, Minn.

W. W. Lajoie
Chairman and Chief Executive Officer
Central Savings Bank
Sault Ste. Marie, Mich.

Linda Hall Whitman

Kathryn L. Ogren

President
Ceridian Performance Partners
Minneapolis, Minn.

Owner
Bitterroot Motors Inc.
Missoula, Mont.

Bruce Parker
President
Wells Fargo Bank Montana, NA
Billings, Mont.

Ronald N. Zwieg

Rob L. Wheeler
Vice President and Sales Manager
Wheeler Manufacturing Co. Inc.
Lemmon, S.D.

Seated (from left):
Roger Berglund,
Linda Hall Whitman,
Rob Wheeler,
James Howard;
standing (from left):
Jay Hoeschler,
W.W. Lajoie,
Ronald Zwieg,
Bruce Parker,
Kathryn Ogren




The Region

President
United Food and
Commercial Workers Local 653
Plymouth, Minn.

2000 Helena Branch Board of Directors
William P. Underriner

Thomas O. Markle

Chairman

Vice Chairman

APPOINTED BY THE BOARD
OF GOVERNORS

APPOINTED BY THE
MINNEAPOLIS BOARD
OF DIRECTORS

Thomas O. Markle
President
Markle’s Inc.
Glasgow, Mont

Emil W. Erhardt
President
Citizens State Bank
Hamilton, Mont.

William P. Underriner
General Manager
Selover Buick Inc.
Billings, Mont.




Richard E. Hart
President
Mountain West Bank
Great Falls, Mont.

Sandra M. Stash
General Manager,
Chemicals, OBC
& Upstream Operations
ARCO Environmental
Remediation L.L.C.
Anaconda, Mont.

Seated (from left):
William Underriner,
Thomas Markle;
standing (from left):
Emil Erhardt,
Richard Hart,
Sandra Stash

FEDERAL ADVISORY
COUNCIL MEMBER
R. Scott Jones
President and Chief Executive Officer
Signal Financial Corp.
Mendota Heights, Minn.

April 2001

Advisory Council on Small Business,
Agriculture and Labor
Rob L. Wheeler, Chairman
Vice President and Sales Manager
Wheeler Manufacturing Co. Inc.
Lemmon, S.D.

Terry Anderson

Karl Murch

Kathryn J. Polansky

President
Anderson Chemical Co.
Litchfield, Minn.

Chief Financial Officer
Encor Technologies Inc.
Eau Claire, Wis.

President
Shorebank BIDCO
Marquette, Mich.

Howard A. Dahl

Donald C. Peterson

Jeanne M. Voigt

President
Amity Technology LLC
Fargo, N.D.

Owner
Yaggie’s Inc.
Yankton, S.D.

President
MindWare
Roseville, Minn.

John T. Forkan Jr.
Business Manager
Plumbers and Pipefitters Local 141
Butte, Mont.

Carrie Holmen
Rancher
Billings, Mont.

Seated (from left):
Howard Dahl,
Karl Murch,
Carrie Holmen,
Rob Wheeler;
standing (from left):
Jeanne Voigt,
Donald Peterson,
Kathryn Polansky




The Region

50

Federal Reserve Bank of Minneapolis

Officers
Gary H. Stern

David Levy

James T. Deusterhoff

President

Vice President

Assistant Vice President

James M. Lyon

Susan J. Manchester

Ron J. Feldman

First Vice President

Vice President

Assistant Vice President

Helena Branch
Samuel H. Gane
Vice President and Branch
Manager

Sheldon L. Azine

Preston J. Miller

David G. Fettig

Senior Vice President and
General Counsel

Vice President and
Monetary Advisor

Assistant Vice President and
Director of Public Affairs

Assistant Vice President

Scott H. Dake

Kinney G. Misterek

Jean C. Garrick

Senior Vice President

Vice President

Assistant Vice President

Assistant Vice President

Creighton R. Fricek

H. Fay Peters

Peter J. Gavin

Senior Vice President and
Corporate Secretary

Vice President

Assistant Vice President

Susan K. Rossbach

JoAnne F. Lewellen

Arthur J. Rolnick

Vice President and Deputy
General Counsel

Assistant Vice President

Julie L. Stackhouse

Assistant Vice President

Senior Vice President and
Director of Research

Theodore E. Umhoefer Jr.

Vice President

Richard W. Puttin

Senior Vice President

Thomas M. Supel
Niel D. Willardson
Senior Vice President

Marie R. Munson

Assistant Vice President

Vice President

Claudia S. Swendseid

Paul D. Rimmereid
Assistant Vice President

Vice President

Michael Garrett
Vice President

Linda M. Gilligan
General Auditor

Caryl W. Hayward
Vice President

Richard M. Todd

David E. Runkle
Research Officer

Vice President

Thomas H. Turner

Randy St. Aubin
Assistant General Auditor

Vice President

Warren E. Weber

James A. Schmitz
Research Officer

Senior Research Officer

Kenneth C. Theisen
Assistant Vice President

Ronald O. Hostad
Vice President

John D. Johnson
Vice President

Thomas E. Kleinschmit
Vice President

Richard L. Kuxhausen

Kelly A. Bernard

Cheryl Venable

Assistant Vice President

Assistant Vice President

Jacquelyn K. Brunmeier

John E. Yanish
Assistant Vice President and
Assistant General Counsel

Assistant Vice President

Duane Carter
Assistant Vice President

Vice President



April 2001

R. Paul Drake

Susan M. Woodrow





Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102