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l l★K

Federal Reserve Bank of Dallas
2200 N. PEARL ST.
DALLAS, TX 75201-2272

November 24, 2003

Notice 03-66

TO: The Chief Executive Officer of each
financial institution and others concerned
in the Eleventh Federal Reserve District

SUBJECT
Modifications to the Method for Imputing Priced-Service Income
from Clearing-Balance Investments
DETAILS
The Board of Governors has approved modifications to the method for imputing pricedservice income from clearing-balance investments. The Federal Reserve Banks impute this income
when setting fees and measuring actual cost recovery each year.
The Reserve Banks will impute the income from clearing-balance investments on the
basis of a broader portfolio of investments than used previously, selected from those available to
banks. The Reserve Banks will impute an investment return expressed as a constant annual spread
over the rate used to determine the cost of clearing balances. The constant annual spread will be
determined based on an underlying imputed investment portfolio. Selection of the portfolio
investment mix will be subject to a risk-management framework that includes criteria consistent with
those used by banks, bank holding companies, and regulators in evaluating investment risk. The
revised method will be used to impute investment income on clearing balances beginning January
2004.
ATTACHMENTS
A copy of the Board’s notice as it appears on pages 61413–18, Vol. 68, No. 208 of the
Federal Register dated October 28, 2003, is attached. Also attached is a copy of a correction to the
Board’s notice. The correction appears on page 63194, Vol. 68, No. 216 of the Federal Register dated
November 7, 2003.

For additional copies, bankers and others are encouraged to use one of the following toll-free numbers in contacting the Federal
Reserve Bank of Dallas: Dallas Office (800) 333-4460; El Paso Branch Intrastate (800) 592-1631, Interstate (800) 351-1012;
Houston Branch Intrastate (800) 392-4162, Interstate (800) 221-0363; San Antonio Branch Intrastate (800) 292-5810.

-2MORE INFORMATION
For more information, please contact Gregory Evans, Manager, at (202) 452-3945, or
Brenda Richards, Senior Financial Analyst, at (202) 452-2753, Division of Reserve Bank Operations
and Payment Systems, at the Board of Governors.
Paper copies of this notice or previous Federal Reserve Bank notices can be printed from
our web site at www.dallasfed.org/banking/notices/index.html.

Federal Register / Vol. 68, No. 208 / Tuesday, October 28, 2003 / Notices

61413

FEDERAL RESERVE SYSTEM
[Docket No. R–1152]

Federal Reserve Bank Services
Imputed Investment Income on
Clearing Balances
AGENCY: Board of Governors of the
Federal Reserve System.
ACTION:

Notice.

SUMMARY: The Board has approved
modifications to the method for
imputing priced-service income from
clearing balance investments. The
Federal Reserve Banks impute this
income when setting fees and measuring
actual cost recovery each year. The
Reserve Banks will impute the income
from clearing balance investments on
the basis of a broader portfolio of
investments than used previously,
selected from those available to banks.
The Reserve Banks will impute an
investment return expressed as a
constant annual spread over the rate
used to determine the cost of clearing
balances. The constant annual spread
will be determined based on an
underlying imputed investment
portfolio. Selection of the portfolio
investment mix will be subject to a riskmanagement framework that includes
criteria consistent with those used by
banks, bank holding companies, and
regulators in evaluating investment risk.
The revised method will be used to
impute investment income on clearing
balances beginning in January 2004.
FOR FUTHER INFORMATION CONTACT:

Gregory L. Evans, Manager (202/452–
3945) or Brenda L. Richards, Sr.
Financial Analyst (202/452–2753);
Division of Reserve Bank Operations
and Payment Systems.
Telecommunications Device for the Deaf
(TDD) users may contact 202/263–4869.
SUPPLEMENTARY INFORMATION:

I. Background
The Monetary Control Act (MCA)
requires Federal Reserve Banks to
establish fees for ‘‘priced services’’
provided to depository institutions at a
level necessary to recover, over the long
run, all direct and indirect costs actually

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61414

Federal Register / Vol. 68, No. 208 / Tuesday, October 28, 2003 / Notices

incurred and imputed costs.1 2 In
addition, the Reserve Banks impute a
priced services return on capital
(profit).3 The imputed costs and
imputed profit are collectively referred
to as the private-sector adjustment factor
(PSAF). Just as the PSAF is used to
impute costs that would have been
incurred and profits that would have
been earned had the services been
provided by a private business firm
rather than the central bank, the Reserve
Banks impute income that would have
been earned on the investment of
clearing balances that customers hold
with the Reserve Banks as if those
balances had been held with a
correspondent bank. This imputed
income, less the costs associated with
the clearing balances, is referred to as
the net income on clearing balances
(NICB).
Calculating the PSAF includes
projecting the level of priced-services
assets, determining the financing mix
used to finance the assets, and the rates
used to impute financing costs.4 Much
of the data for the PSAF are developed
from the ‘‘bank holding company (BHC)
model,’’ a model that contains
consolidated financial data for the
nation’s fifty largest (based on deposit
balances) BHCs. As part of this process,
a core amount of clearing balances is
considered stable and available to
finance long-term assets.
The method for deriving the NICB is
reviewed periodically to ensure that it is
still appropriate in light of changes that
may have occurred in Reserve Bank
priced services activities, accounting
standards, finance theory, regulatory
practices, and banking activity.5 The
1 Priced services include primarily check,
automated clearinghouse, Fedwire funds transfer,
and Fedwire securities services.
2 Imputed costs include financing costs, taxes,
and certain other expenses.
3 The return on capital is imputed using the
average of the results of three economic models: the
comparable accounting earnings model, the
discounted cash-flow model, and the capital asset
pricing model.
4 Equity is imputed based on the Federal Deposit
Insurance Corporation’s (FDIC) definition of a
‘‘well-capitalized’’ institution for insurance
premium purposes.
5 In 1994, the Board requested comment on a
proposal to modify the method for imputing
clearing balance income. The Board proposed
replacing the three-month Treasury bill imputed
investment with a longer-term Treasury investment
based on the earning asset maturity structure of the
largest BHCs. As a result of issues related to interest
rate risk raised in the comments, the Board did not
adopt the proposal. The proposal would have
created an asset and liability mismatch that created
interest rate risk exposure inappropriate for Federal
Reserve priced services. In addition, Federal
Reserve priced services would not have assumed
the interest rate risk associated with longer-maturity
investments because the imputed return would
have been adjusted monthly to reflect current rates
(59 FR 42832, August 19, 1994).

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current method for imputing investment
income assumes that the Reserve Banks
invest all clearing balances, net of
imputed reserve requirements and the
amount used to fund priced-services
assets, in three-month Treasury bills.
The imputed income on the Treasury
bill investments net of the actual
earnings credits granted to clearing
balance holders based on the federal
funds rate is considered income for
priced-services activities. The net
income associated with clearing
balances is one component in pricing
decisions and in evaluating cost
recovery.
A. Clearing Balances
Depository institutions may hold both
reserve and clearing balances with the
Federal Reserve Banks.6 7 Reserve
balances are held pursuant to a
regulatory requirement and are not a
result of an institution’s use of priced
services.8 Clearing balances are held to
settle transactions arising from use of
Federal Reserve priced services for
institutions that either do not hold
reserve balances or find their reserve
balances inadequate to settle their
transactions.9 At year-end 2002,
depository institutions held more than
$10 billion in clearing balances at
Reserve Banks.
Clearing balances held at Reserve
Banks are similar to compensating
balances held by respondent banks at
correspondent banks. Respondent banks
hold compensating balances to support
the settlement of payments, and to pay
fees assessed by the correspondent
bank. Reserve Banks and some
correspondent banks establish a
contracted balance level that the
account holder must maintain on
average over a specified period. Both
Reserve Banks and correspondent banks
provide compensation in the form of
earnings credits to the holders of
clearing or compensating balances.
Historically, earnings credits provided
by the Reserve Banks have been based
on the federal funds rate. In May 2003,
the Board requested comment on
whether it should consider
modifications to the Reserve Banks’
earnings credit rate in the future, and,
if so, what factors should be considered
6 Clearing balances were introduced when
Reserve Banks implemented the MCA.
7 Clearing balances, unless otherwise indicated,
refer to total clearing balances, including contracted
balances and balances in excess of the contracted
amount, held by depository institutions with the
Federal Reserve Banks.
8 Regulation D, 12 CFR part 204.
9 Many depository institutions also set their
contracted clearing balance level to generate
earnings credits needed to pay fees assessed for
Reserve Bank priced services.

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in the evaluation.10 One commenter
stated that the Federal Reserve should
evaluate the appropriateness of its
earnings credit rate as part of its overall
pricing of services, including a review
of private sector practice. The Board
recently changed the earnings credit rate
to be based on a discounted three-month
Treasury bill rate, which is now more
consistent with market practice.11
B. Imputed Investment of Clearing
Balances
The Reserve Banks impute income on
the clearing balance investments rather
than using the actual results from
monetary policy investment activities.12
The imputation of clearing balance
income is analogous to assuming that
the priced-services enterprise, which is
essentially a ‘‘monoline’’ bank offering
only payment services, also includes a
treasury function. Income is currently
imputed based on the assumption that
all available clearing balances are
invested in three-month Treasury
bills.13 14
Historically, most of the net income
on clearing balances was the result of
imputed earnings on excess balances
held, which have no associated cost.
The practice of imputing clearing
balance investments in three-month
Treasury bills while paying earnings
credits at the federal funds rate resulted
in an average interest rate spread of
negative 18 basis points over the past
twenty years with a standard deviation
over the same period of 23 basis points
and ranged from 23 to ¥58 basis
points.15
10 68

FR 32513, May 30, 2003.
specifically, the earnings credit rate will
be 90 percent of a rolling 13-week average of the
annualized coupon equivalent yield of three-month
Treasury bills in the secondary market. See
companion notice, Federal Reserve Bank Services,
elsewhere in today’s Federal Register.
12 Decisions about monetary policy investment
transactions are not motivated by profit objectives;
therefore, the actual investment results are not
applicable to priced-service activities.
13 Clearing balances needed to meet an imputed
reserve requirement (10 percent of clearing
balances) and to fund assets used in the production
of priced services ($407 million in 2004) are not
available for investment.
14 The Board chose three-month Treasury bills as
the imputed investment vehicle in 1982 because, at
that time, the yield was considered to approximate
the return that would be realized had clearing
balance funds been held and invested by a
correspondent bank. In addition to providing a
short-term earnings rate consistent with creating a
matched asset and liability structure with the shortterm liabilities, the three-month Treasury bill yield
data are easily verified by outside observers with
publicly available data.
15 The standard deviation measures the variance
around the average and indicates the level of
volatility of the rates. Two-thirds of the time the
actual yield will fall in the range of the average plus
or minus one standard deviation. Ninety-five
percent of the time the actual yield is expected to
11 More

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Federal Register / Vol. 68, No. 208 / Tuesday, October 28, 2003 / Notices
Given that a simple change to federal
funds investments would have
simultaneously eliminated the interest
rate spread and reduced the volatility,
as expressed by the standard deviation,
to zero, the Board believed that the
Reserve Banks’ imputed investment
income method may have imputed an
inappropriately low NICB to priced
services.16 Correspondent banks and
BHCs invest in a much wider array of
investments than those imputed by the
Federal Reserve, including loans,
Treasury securities with longer
maturities, government agency
securities, government-sponsored
enterprise securities, federal funds,
commercial bonds, commercial paper,
money market mutual funds, assetbacked securities, foreign currencies,
repurchase agreements, and derivatives.
As a result, the Board requested
comment on a proposal to expand
imputed investment options within a
risk management framework similar to
that used by banks, BHCs, and
regulators in evaluating investment risk.
To implement the proposal, the Board
requested comment on two methods.
II. Summary and Analysis of Comments
The Board received two responses,
both from Reserve Banks, to its request
for comment. Although the Federal
Reserve worked with private-sector
representatives in developing the
methods on which the Board requested
comment, the Board received no
comments from the banking industry.
Both commenters favor changing the
method used for imputing investment
income and believe that a new method
more consistent with the practices of
BHCs will provide a better basis on
which to impute income used in setting
Federal Reserve fees.
A. Investments
Because the BHCs are a proxy for
providers of priced-services activities,
options for Reserve Bank clearing
balance investments should be
comparable to those available to BHCs.
In principle, all of the investments
available to BHCs could be appropriate
clearing balance investments. In its
request for comment, the Board
proposed limiting imputed investments
to federal funds; investments suitable
for a buy-and-hold strategy, such as
Treasury securities, government agency
securities, commercial paper, and
fall in the range of the average plus or minus two
standard deviations.
16 While reducing interest rate risk, a change in
investment from Treasury bills to Federal funds
would, in theory, increase credit risk. As a practical
matter, however, banks have not incurred losses
due to default in federal funds transactions.

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municipal and corporate bonds; and
money market and mutual funds.17 For
investments with a fixed term, this
strategy eliminates capital gains and
losses from the investment returns and
simplifies the recognition and reporting
of imputed investment income. Realized
and unrealized gains and losses on
imputed mutual fund investments
would be incorporated in the total
return and recorded as net earnings. The
Board requested comment on whether
this investment strategy was
appropriate.
Both commenters considered it
reasonable to expand the imputed
investment options. To limit discretion
allowed in ‘‘managing’’ the portfolio
and on the array of allowable
investments, one commenter suggested
that the investments be selected from a
relatively narrow set of assets with
readily observable market values. The
second commenter suggested choosing
investments with average or lower than
average risk characteristics and
recommended that the set of fixedincome investments be limited to those
that are investment grade.
The Board has concluded that in
constructing an imputed portfolio,
investments will be selected from those
allowable to banks and BHCs and will
employ a buy-and-hold strategy for
those investments with a stated
maturity. Mutual fund gains and losses
will be incorporated in the total return
and recorded as net earnings. When
investing in fixed-income instruments,
only those of investment grade will be
imputed.
B. Risk-Management Framework
The Board considered the
comparability of the imputed
investments with investments of a
similar private-sector entity, and
requested comment on establishing a
risk-management framework to limit the
imputed investments to prudent levels
in accordance with sound business
practice and regulatory constraints. To
address these risks, the exposure to any
one type of risk would be limited and
measured in terms of earnings or equity
at risk. The Reserve Banks currently use
three risk measures in calculating the
PSAF that address liquidity, interest
rate, and credit risk. In its request for
comment, the Board proposed
incorporating these measures, while
17 Mutual fund investments would be selected
from those that are publicly available and widely
held. The specific funds used for imputing income
would be disclosed during the price-setting process
so that performance could be tracked and
replicated. See companion notice, Federal Reserve
Bank Services, elsewhere in today’s Federal
Register.

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61415

adopting a specific constraint on credit
risk, and adding a measure to address
the longer-term effects of interest rate
risk. In addition, the Board requested
comment on any other risk-management
criteria that should be considered.
1. Liquidity Risk
Although clearing balances are short
term in nature, the Board previously
determined that a portion of clearing
balances remained stable and initially
established $4 billion as available to
fund long-term assets used in the
delivery of priced services, rather than
invested only in short-term assets.18
Neither commenter objected to making
the portion of core clearing balances not
used to fund priced services assets
available for investment in longer-term
instruments. The Board believes that
limiting the use of clearing balances to
fund longer-term assets to only that
portion that is deemed core clearing
balances effectively manages liquidity
risk.
2. Interest Rate Risk
In considering interest rate risk, one
must evaluate the effect on earnings
should the rate used to determine the
cost of funds and the investment yield
on those funds change at different
intervals. To evaluate the risk of funding
longer-term assets with short-term
liabilities at rates that do not change
concurrently and the resulting earnings
volatility, the Board adopted the interest
rate sensitivity analysis measure as part
of its PSAF method. As adopted, this
measure requires that longer-term
investment of clearing balances be
managed so that a 200-basis-point
change in the rates for both the yield on
all relevant priced services assets and
the cost of all relevant priced service
liabilities would not affect earnings,
measured by the overall priced services
recovery rate, by more than 200 basis
points.
In requesting comment, the Board
proposed adopting a second measure of
interest rate risk, known as economic
value of equity (EVE), for use in
conjunction with the earnings at risk
measure. The EVE measure, which is
used by BHCs and regulators, compares
the present value of interest-bearing
assets and liabilities in the current rate
environment resulting from a change in
interest rates. The comparison shows
the change in present values as a
proportion of equity.19 The Board
18 66

FR 52617, October 16, 2001.
is used as a complement to the interest
rate sensitivity analysis already adopted to evaluate
the effects of long-term mismatches between assets
and liabilities on the value of an entity; the interest
19 EVE

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61416

Federal Register / Vol. 68, No. 208 / Tuesday, October 28, 2003 / Notices

requested comment on whether a risk
tolerance of a change of 8 percent of
equity resulting from a 200-basis-pointrate change is appropriate.20 One
commenter agreed that the introduction
of EVE is appropriate given the current
supervisory guidelines for the BHC peer
group and stated that the proposed
constraint is appropriate.
The Board received no comment on
whether these two measures of interest
rate risk, earnings at risk and equity at
risk, are together sufficient measures for
monitoring and controlling interest rate
risk. The Board will adopt the EVE
measure and set the risk tolerance at a
change of 8 percent of equity resulting
from a 200-basis-point-rate change. In
addition, the earnings at risk tolerance
will be maintained as a prudent
constraint on the imputed investments.
3. Credit Risk
The overall level of credit risk
compared with the level of equity is
measured by the ratio of risk-adjusted
assets to capital.21 The FDIC uses two
risk-based capital measures as criteria in
defining a ‘‘well-capitalized’’ institution
for insurance premium purposes. One
requires a risk-based capital ratio of 10
percent or more for total capital and the
other requires a risk-based ratio of 6
percent or more for tier one capital.22
Only tangible equity capital (tier one
capital) is imputed to Reserve Bank
priced services; therefore, the two
measures are the same. The current
investment in three-month Treasury
bills carries a risk weight of zero. As a
result, the balance sheet underlying the
2003 PSAF showed that the priced
services risk-based capital ratio is nearly
33 percent for both measures.23 A
change in investment strategy that
includes investments with greater risk
requires establishing a minimum riskbased total capital ratio within which to
make investment decisions. To manage
credit risk, the Board requested
comment on whether either of two
options for establishing a minimum
risk-adjusted total capital ratio
adequately limits imputed investment
risk. The first option would maintain
the ratio of total capital to risk-adjusted
rate sensitivity analysis captures the risk to nearterm earnings.
20 Large BHCs typically manage the EVE measure
within a risk-tolerance range of 5 to 10 percent.
More information on measurement of interest rate
risk can be found at http://www.federalreserve.gov/
boarddocs/supmanual/trading/trading.pdf.
21 Credit risk results from the possibility that the
issuer of a bond or other borrower cannot repay its
obligations as promised. Criteria for managing
credit risk are necessary when investing in
instruments other than Treasury securities.
22 http://www.fdic.gov.
23 66 FR 67834, November 7, 2002.

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assets at a level equal to or greater than
that maintained by the fifty largest
BHCs, which has remained near 12
percent between 1997 and 2002. Under
the second option, the risk-based capital
ratio would be maintained equal to or
greater than the minimum required by
the FDIC for a well-capitalized
institution, which is currently 10
percent.
One commenter noted that the current
priced services risk-based capital ratio is
not representative of that of its peers
and supported a change to a ratio within
the range of 10 to 12 percent and
provided empirical data suggesting that
the FDIC minimum is within the range
of risk-based capital ratios for the top 50
BHCs. The Board has concluded that
imputed investments will be limited to
those that result in priced-services
activities maintaining a risk-based
capital ratio equal to or greater than the
minimum required by the FDIC for a
well-capitalized institution, which is
currently 10 percent.
In responding to whether other risk
management criteria should be
considered, one commenter suggested
that, because of rapidly changing risk
management practices, the Board
regularly review BHC peer group risk
management practices. Because the
priced services risk-based capital ratio
will be based on FDIC requirements, it
will be reviewed each year to determine
the ratio necessary to meet the
regulatory capital requirements. The
Board has concluded that all four risk
constraints will be included in the
framework used to select investments
on which to impute priced-services
income.
C. Implementation Methods
The Board requested comment on two
alternative methods to impute clearing
balance investment income based on the
proposed conceptual framework. Both
methods emerge from an underlying
imputed portfolio of investments. The
first method proposed constructing a
specific portfolio of hypothetical
investments, tracking its yield, and
ascribing the income to priced-services
activities (the actual return method).
The second method proposed using
average hypothetical portfolio returns,
expressed as a constant spread over the
three-month Treasury bill rate, as the
basis for future investment performance
and ascribing the income to priced
services activities (the constant annual
spread method).
1. Constructing a Portfolio
To construct a hypothetical portfolio,
the Reserve Banks would select from the
investment options described earlier

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that are available to banks and BHCs,
based on an allocation method that uses
historical data to create an optimized
portfolio. Historical data are used to
create the optimized portfolio to avoid
any perception that the Federal Reserve
is signaling future monetary policy
actions or is otherwise projecting future
economic conditions or interest rate
environments. This optimized portfolio
is the basis for the investment allocation
within the risk-management framework
that maximizes the spread of the rate of
return on the portfolio over the Treasury
bill rate.24 To avoid the administrative
complexities of incorporating realized
capital gains and losses in the imputed
investment results for fixed-term
investments, such as corporate bonds,
the Board proposed to impute these
investments as held to maturity.25
To impute the pricing-year’s
investment income, the Board proposed
using this portfolio method to create a
pricing-year imputed portfolio of
investments for the actual return
method or to create a ten-year average
portfolio performance for the constant
annual spread method.
To create a pricing-year imputed
portfolio of investments to implement
the actual return method, the Board
proposed assuming that the pricing-year
portfolio is the most current optimized
portfolio for the most current ten-year
period. For example, the 2004 pricingyear’s imputed portfolio yield would be
the yield obtainable in 2004 from the
optimum portfolio allocated based on
the optimized portfolio’s investment
return performance from 1994 through
2003.
To create ten years of optimized
portfolio actual returns to average for
implementing the constant annual
spread method, the Board proposed
creating the optimized portfolio for each
year in the most recent ten-year period.
For example, the 2004 pricing-year’s
constant annual spread would be based
on the actual investment return
performance from 1993 through 2002.
The optimized portfolio for 1993 would
be based on historical investment return
performance from 1983 through 1992,
the portfolio for 1994 would be based on
performance from 1984 through 1993,
and so on.
The key difference in the
implementation methods is how the
24 A ten-year period was selected because the data
are available and the period includes a variety of
interest rate environments.
25 This results in a ladder approach to
determining the average yield. For an investment in
five-year corporate bonds, for example, the average
yield would incorporate the yield from bonds
purchased in increments over the preceding five
years.

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Federal Register / Vol. 68, No. 208 / Tuesday, October 28, 2003 / Notices
investment return is imputed for costrecovery measurement purposes for the
pricing year. Imputing the return under
the actual return method requires
applying the investment yields during
the pricing year to the imputed
investments. The constant annual
spread method, however, simplifies the
process during the year by applying the
historical ten-year average portfolio
spread over the current three-month
Treasury bill rate.26
2. Imputing the Actual Return
The data in the table show the results
of selecting an optimized portfolio for

each year as described above and
imputing the return as if the portfolio
were held during that year.27 The
investments were chosen to optimize
the return while placing a 35 basis point
constraint on the standard deviation of
the spread. Over the ten-year period, the
asset mix is composed primarily of
commercial paper or one-year Treasury
notes and money market mutual funds.
When holding clearing balance levels
constant as in this example, fluctuations
experienced using the actual return
method reflect both variance in the
Treasury bill rate and variance in the

61417

spread between the portfolio yield and
the Treasury bill rate. The actual
standard deviation associated with the
actual return method over the ten-year
period is greater than the 23 basis point
standard deviation associated with the
current imputed investment method.
The actual standard deviation of the
portfolio spreads is also greater than the
35 basis point standard deviation
applied to select each year’s optimum
portfolio. The ten-year average NICB
generated in this example would have
been $106.4 million with a standard
deviation of $42.2 million.

Actual return method
Spread over
3-month T-bill

Year

NICB
(millions)

1993 .........................................................................................................................................................
1994 .........................................................................................................................................................
1995 .........................................................................................................................................................
1996 .........................................................................................................................................................
1997 .........................................................................................................................................................
1998 .........................................................................................................................................................
1999 .........................................................................................................................................................
2000 .........................................................................................................................................................
2001 .........................................................................................................................................................
2002 .........................................................................................................................................................
Average 10-year ...............................................................................................................................

0.29
¥0.19
0.60
0.18
0.67
0.37
¥0.37
0.35
0.44
1.12
0.35

$78.4
43.1
152.3
101.2
151.4
118.4
35.4
129.2
111.7
142.6
106.4

Standard deviation 10-year ..............................................................................................................

0.42

$42.2

3. Imputing the Constant Annual Spread
During the development of this
proposal, the Federal Reserve met with
a group of representatives from banks,
corporate credit unions, and their trade
associations to obtain information about
institution investment practices. 28
These representatives observed that
construction of a risk-management
framework and hypothetical portfolio
appeared unduly complex for imputing
income from hypothetical investments
and suggested that a constant basis
point calculation could be simpler and
provide similar results. They suggested
that the NICB calculation impute
investment income based on a clearing
balance investment yield expressed as a
constant spread over the rate used to
determine the clearing balance cost of
funds. The representatives observed that
this approach might be easier to
understand, administer, and monitor.
26 A calculation of the optimized portfolio return
will still be necessary, however, to factor into future
pricing-years’ constant annual spread.
27 To eliminate fluctuations in implementation
method results related to changes in clearing
balances in the table, all clearing balance amounts
are held constant throughout the analysis period.
To construct the optimized portfolio, balances are
held at the levels estimated for 2002 price-setting;

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Using a constant spread over the
three-month Treasury bill rate to impute
the income from investing clearing
balances would, by definition, not
reflect the actual variability within the
year between the investment rate of
return and the Treasury bill rate that
would occur with the actual return
method. Although investment income
imputed using a constant annual spread
would vary with fluctuations in the
three-month Treasury bill rate, finance
theory suggests that a discount to the
constant annual rate might be required
to earn the consistency during the year
that is produced by a constant spread
method.
Unfortunately, historical mutual fund
data needed to calculate NICB under the
constant annual spread method are not
available.29 Conceptually, however, the
averaging of the basis-point spreads in
the constant annual spread method will
reduce the basis-point fluctuations that
otherwise would have occurred.

Removing the fluctuations in the return
related to the actual variability between
the investment yield rate of return and
the Treasury bill rate that would occur
with the actual return method generates
a higher return in some years than
would have been experienced with the
actual return method and a lower return
in others.
Both commenters preferred the actual
return method over the constant annual
spread method. The commenters noted
that the actual return method is more
transparent and more representative of
BHC practices. One commenter stated
that the need to demonstrate that the
constant annual spread would be
achievable with the actual portfolio
would result in the same level of effort
as the actual return method.
The Board agrees with the industry
representatives that the constant annual
spread method reduces some
complexity associated with the
imputation process during the pricing

investable balances are $5.473 million and balances
on which earnings credits are paid are $5.892
million. To impute the results for each year, the
balances are held at the 2004 level; investable
balances are $10.302 million and balances on which
earnings credits are paid are $9,711.
28 The advisory group included participants from
the American Bankers Association, the Independent

Community Bankers of America, and the
Association of Corporate Credit Unions.
29 In order to model the results that the constant
annual spread method would have produced for
years prior to 2004, returns for years prior to 1993
would need to be simulated. Those simulated
portfolios would, in turn, be based on optimum
portfolios that include years prior to 1983, the
earliest year for which required data are available.

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61418

Federal Register / Vol. 68, No. 208 / Tuesday, October 28, 2003 / Notices

year. The Board believes that while
neither method can exactly simulate
banking industry practices, the constant
annual spread method provides a
reasonable proxy for the return a BHC
would receive with similar investments.
As a result, the pricing-year
administrative burden is somewhat
reduced with the constant annual
spread method.
The Board has adopted the constant
annual return method for imputing
income on investments for the NICB
calculation. Each pricing year, the
constant annual spread will be
determined based on an optimized
investment portfolio, subject to the riskmanagement framework. The constant
annual spread will be determined based
on the actual return from the optimized
investment portfolio in each of the most
recent ten years. The constant spread
will be calculated as the difference
between the portfolio rate of return and
the three-month Treasury bill rate. NICB
for 2004, using the constant annual
spread method with a 35 basis point
spread shown in the table, is estimated
to be $52.7 million.30
III. Competitive Impact Analysis
All operational and legal changes
considered by the Board that have a
substantial effect on payments system
participants are subject to the
competitive impact analysis described
in the March 1990 policy statement
‘‘The Federal Reserve in the Payments
System.’’31 Under this policy, the Board
assesses whether the change would have
a direct and material adverse effect on
the ability of other service providers to
compete effectively with the Federal
Reserve in providing similar services
because of differing legal power or
constraints or because of a dominant
market position of the Federal Reserve
deriving from such legal differences. If
the fees or fee structures create such an
effect, the Board must further evaluate
the changes to assess whether their
benefits—such as contributions to
payment system efficiency, payment
system integrity, or other Board
objectives—can be retained while
reducing the hindrances to competition.
These changes are intended to expand
the investments assumed in the NICB
calculation to resemble more closely
investments pursued by bank holding
companies, the services of which are
considered to resemble most closely the
services provided by Reserve Banks.
30 The two-year lag in data is consistent with the
PSAF method, which uses audited financial
statements for the top 50 BHCs from this period,
and is necessary because complete 2003 actual
return data are not yet available.
31 FRRS 9–1558.

Imputed investment decisions would be
made within a framework that
incorporates risk-management measures
used in industry and regulatory
practice. Accordingly, the Board
believes these changes will not have a
direct and material adverse effect on the
ability of other service providers to
compete effectively, due to legal
differences, with the Federal Reserve in
providing similar services.
IV. Method for Imputing Investment
Income on Clearing Balances
The Board has adopted the following
modifications to the method for
imputing investment income on clearing
balances:
• Investment income for each pricing
year will be imputed based on the
average annual spreads between the
investment yields and three-month
Treasury bill rates that would have been
realized on investments made in the
most recently available 10-year period
based on portfolios optimized as
described below. The selected spread
will be held for the pricing year.
• Imputed investments will be
selected from those available to banks
and BHCs. The imputed portfolio for
each year will be optimized and subject
to a risk management framework. The
portfolio will be optimized based on the
most recent ten-year historical data to
maximize the return that could have
been realized over that entire ten-year
period within the risk management
framework.
The risk management framework
consists of the following:
• A core amount of clearing balances,
currently $4 billion less core balances
use to fund long-term assets in the PSAF
calculation, is available to invest in
longer-term instruments.
• The earnings at risk measure will be
used as a constraint to manage shorterterm interest rate risk. Assuming a 200
basis point change in both the yield on
relevant assets and the cost of all
relevant liabilities, the effect to priced
services recovery will be limited to a
change of 200 basis points.
• The EVE measure is adopted as a
constraint to manage longer-term
interest rate risk, subject to a limit on
the effect to equity of 8 percent resulting
from a 200 basis point change in the
asset yield and clearing balance rates.
• Investments will be limited to
maintain the FDIC’s minimum riskbased capital ratio for a well-capitalized
institution, which is currently 10
percent.

By order of the Board of Governors of the
Federal Reserve System, October 23, 2003.
Jennifer J. Johnson,
Secretary of the Board.
[FR Doc. 03–27124 Filed 10–27–03; 8:45 am]
BILLING CODE 6210–01–P

63194

Corrections

Federal Register
Vol. 68, No. 216
Friday, November 7, 2003

1. On page 61417, in the second
column, in footnote 27, in the first line,
‘‘$5.473’’ should read ‘‘$5,473’’.
2. On the same page, in the same
column, in the same footnote, in the
second line, ‘‘$5.892’’ should read
‘‘$5,892’’.
3. On the same page, in the same
column, in the same footnote, in the
fifth line, ‘‘$10.302’’ should read
‘‘$10,302’’.
FEDERAL RESERVE SYSTEM

[FR Doc. C3–27124 Filed 11–6–03; 8:45 am]

[Docket No. R–1152]

BILLING CODE 1505–01–D

Federal Reserve Bank Services
Imputed Investment Income on
Clearing Balances
Correction
In notice document 03–27124
beginning on page 61413 in the issue of
Tuesday, October 28, 2003, make the
following corrections:

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