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annual r e p o r t 2007

federal reserve bank
of cleveland

The Federal Reserve System is responsible for formulating and implementing U.S.
monetary policy. It also supervises banks and bank holding companies and provides
financial services to depository institutions and the federal government.

The Federal Reserve Bank of Cleveland is one of 12 regional Reserve Banks in the
United States that, together with the Board of Governors in Washington DC,
comprise the Federal Reserve System.

The Federal Reserve Bank of Cleveland, including its branch offices in Cincinnati and
Pittsburgh, serves the Fourth Federal Reserve District (Ohio, western Pennsylvania,
the northern panhandle of West Virginia, and eastern Kentucky).

It is the policy of the Federal Reserve Bank of Cleveland to provide equal
employment opportunity for all employees and applicants without regard to race,
color, religion, sex, national origin, age, or disability.

www.clevelandfed.org

Contents
President’s Foreword
3
Central Banks and Crisis Management
7
2007 Operational Highlights
22
Statement of Auditor Independence
30
Management’s Report on Internal Control over Financial Reporting
31
Report of Independent Auditors
32
Comparative Financial Statements
35
Notes to Financial Statements
38
Officers and Consultants
50
Boards of Directors
52
Business Advisory Councils
56

The ﬁve posters in this report date from the mid-1920s and were
intended for display by member banks. The 12 regional Reserve Banks
supervise member banks as part of the Federal Reserve System’s mandate
to promote strength and stability in the nation’s domestic markets and
banking system.

President’s Foreword
The U.S. economy rolled on in the early months of 2007,
continuing its solid performance of the past several years. Still,
some observers detected imbalances in the U.S. economy that
posed risks to its continued expansion—imbalances that had
been building for several years.
By late summer, it became clear that upbeat economic projections for 2007 would be sorely tested by a housing downturn,
and that some financial companies closely tied to the housing
sector would suffer losses. Then, as fall turned to winter, signs
of a more serious credit crunch began to take shape. Ongoing
stresses in the housing and mortgage markets began to affect
liquidity not just in the domestic financial sector, but across
the globe, as winter progressed into 2008.
The Federal Reserve System has responded to this turmoil
with a series of timely actions. The Federal Open Market
Committee has sharply lowered its federal funds rate target
and has taken steps to make its large holdings of Treasury
securities available to financial market participants. In related
actions, the Board of Governors has initiated several changes in
the discount window operations of the Reserve Banks. Some
of these actions are unprecedented in Federal Reserve history.
A financial crisis provides perhaps the most tangible
opportunity for a central bank to fulfill its role in fostering
financial stability. The proper response, however, depends on
the reasons behind the crisis and on the costs and benefits of
resolving any related market failure. Central bankers must also
keep in mind the intended and unintended consequences of
their response to the crisis at hand.

This year’s Annual Report essay, advanced by three of our
Research economists, offers some lessons from the past that
may be useful in placing current events in perspective. More
important, these lessons may help guide policymakers in
planning ahead to manage future financial crises. The particular
mechanisms that the authors propose are less important than
the principle of preplanning, to the extent possible, for the
inevitable dislocations in financial markets. A good crisis
prevention environment also requires aligning policies and
practices among all agencies involved in the chartering,
regulating, supervising, and insuring of financial institutions.
The Operational Highlights section of this report, beginning
on page 22, complements the main essay with a more detailed
analysis of the discount window and the Federal Reserve Bank
of Cleveland’s role in supporting the central bank’s monetary
policy activities.
u
While critically important, monetary policy support is just
one of many functions that helped the Federal Reserve Bank
of Cleveland advance its strategic objectives and achieve solid
performance in 2007.
The Bank advanced its thought leadership objective in
the areas of policy analysis, research, banking supervision,
payments, and support to the U.S. Treasury. Beyond our
work in financial stability, highlights include initiating a
research study to improve survey-based measurement of
inflation expectations; managing significant growth in the
electronification of check services as a result of Check 21
legislation; and serving as a national business leader for
eGovernment and Treasury Retail Securities.

Federal Reserve Bank of Cleveland

◆
R. Chris Moore, ﬁrst vice president and chief operating ofﬁcer;
Sandra Pianalto, president and chief executive ofﬁcer;
Tanny B. Crane, chairwoman; and
Alfred M. Rankin Jr., deputy chairman.

In 2007, the Bank also strengthened its external focus
objective, designed to foster public understanding of
the Federal Reserve System’s mission and to inform our
contributions to monetary policy. The Bank provided
information and analysis on regional and national economic
issues through academic research, speeches, and a strong
community presence. The Community Affairs function
hosted its fifth annual Policy Summit, which focused on
foreclosures, vacant and abandoned properties, and new
sources of community development. Also, the Bank’s
learning Center and Money Museum welcomed more than
10,000 visitors, hosted two special exhibits, and provided
educational outreach.
The Bank also continued to advance its strategic objective
of operational excellence. Cleveland was named one of four
regional check-processing sites in the Federal Reserve System,
while the Retail Payments Office continues to manage the
ongoing consolidation of check operations across the nation.
In addition, the Bank was selected to develop and administer
four key operations for the U.S. Treasury and earned high marks
for customer service and support. The Cash function also
consistently met aggressive operational and financial targets.
u
The Bank’s boards of directors and advisory councils in
Cleveland, Pittsburgh, and Cincinnati were instrumental in
guiding our success in 2007.
I extend a deep measure of thanks to Henry l. Meyer III,
chairman and CeO of keyCorp, who is stepping down from
our Cleveland Board of directors after three years. Henry
has brought energy and commitment to his term of office,
including participation on two board committees. I am
delighted that he has agreed to serve as the Bank’s Federal
Advisory Council representative in 2008.

I also thank edwin J. Rigaud, president and CeO of enova
Partners in Cincinnati, who served on our Cleveland Board of
directors as well as two board committees. We greatly valued
his insights and counsel.
Thanks also go to two retiring members of our Pittsburgh
Board of directors: Robert O. Agbede, president and CeO of
Chester engineers in Pittsburgh, served for six years and was
chairman of the Pittsburgh board in 2007. Michael J. Hagan,
president and CeO of Iron and Glass Bank in Pittsburgh, also
served for two three-year terms. We thank Bob and Mike for
their dedicated service and leadership.
From our Cincinnati board, we say farewell to two directors
who have also provided six years of service each: Herbert R.
Brown, senior vice president for Western & Southern
Financial Group in Cincinnati, and James H. Booth,
president of Czar Coal Company in lovely, kentucky. Herb
and Jim have brought unique insights to our Bank, and we
greatly appreciate their contributions.
Finally, I thank George W. Schaefer Jr., chairman of Fifth
Third Bancorp in Cincinnati, who has served as our Bank’s
representative on the Federal Advisory Council for the past
two years. George’s leadership has been outstanding.
At the Federal Reserve Bank of Cleveland, we continue to
advance our strategic objectives of leadership in thought and
deed, external focus, and operational excellence. In this effort,
we are driven by the diversity, talent, and dedication of more
than 1,500 employees in our Cleveland, Cincinnati, and
Pittsburgh offices. I am indebted to the Bank’s officers and
staff for all of their contributions to our success.
I know that no matter what the challenges we face, the Federal
Reserve Bank of Cleveland has a wealth of human capital—
in terms of innovative and engaged directors and employees—
to sustain and strengthen us.

Sandra Pianalto
President and Chief executive Officer

FedeRAl ReSeRve BAnk OF ClevelAnd

The 1913 Federal Reserve Act requires all nationally chartered banks
to become members of the Federal Reserve System. State-chartered banks
have the option of becoming members. The Depository Institutions
Deregulation and Monetary Control Act of 1980 opened up
the beneﬁts of Federal Reserve membership to a broader range of
ﬁnancial institutions.

Central Banks &
Crisis Management
by Joseph Haubrich, James Thomson, and O. Emre Ergungor
As 2007 began, historians prepared to reflect on several anniversaries of financial turmoil.
It had been 10 years since the East Asian crisis, 20 years since the Black Monday stock market crash,
100 years since the Panic of 1907, and 150 years since the Hamburg financial crisis of 1857.
Not many, however, could have predicted that 2007 would write its own chapter
in history with the subprime mortgage meltdown.
The historical perspective may reveal the deeper issues behind recent events. The fundamental causes and full
consequences of previous crises did not become apparent until after they had passed. Reflecting on historical
analogies may serve us better than adopting too narrow a focus on day-to-day market changes and results.
Certainly, there are some critical differences in today’s events from those in previous episodes. For example, since
the savings and loan crisis and bank problems of the 1980s, regulation has emphasized solvency issues, such
as ensuring adequate capital and proper measures of bank risk. But it was liquidity problems that first garnered
widespread attention in the current crisis—a seizing up of markets for securitized credit and asset-backed
commercial paper, which placed considerable balance sheet and liquidity pressures on many large U.S. and
European banks and securities firms.
The financial market events of 2007 (which have continued into 2008) provide yet another opportunity to
consider financial crisis management, and in particular the problems confronting central banks. In this essay, we
identify two long-standing issues that central banks must confront during periods of financial market stress. The first
is moral hazard, a situation in which people do not take adequate care because they do not fully bear the costs of
their decisions. The second is dynamic inconsistency, an environment in which policymakers take actions that make
short-term sense, but that do not necessarily lead to the best long-term outcome.
We begin by asking why a central bank’s mission includes responsibility for financial stability. Next we consider
the central bank’s response to crisis and its intended and unintended consequences. Because many issues faced
by the central bank depend on the broader crisis-management environment, we conclude by addressing
how a central bank fits into the broader context of advance planning and the design of institutions that
should be in place before the turmoil begins.

Federal Reserve Bank of Cleveland

Why we care: the basics of a healthy financial system
The Federal Reserve System was created in 1913, after a long
series of banking panics from 1857 to 1907. The initial motivation was to stem financial crises originating from shortages
of money in the banking system. Thus, the preamble to the
Federal Reserve Act announced the intention “to furnish an
elastic currency, to afford means of rediscounting commercial
paper, [and] to establish a more effective supervision of banking in the United States.” Over time, it has become evident
that healthy economies require healthy financial systems, and
central banks such as the Federal Reserve can operate on a
number of fronts to foster financial stability.
The Federal Reserve Act has been amended at various times
to provide the System with the means for accomplishing this
objective. For example, the Banking Act of 1935 amended the
Federal Reserve Act “to provide for the sound, effective, and
uninterrupted operation of the banking system” and afforded
the System greater regulatory and supervisory authority over
banking organizations. Also, the Federal Reserve has long had
a strong operating presence in the nation’s wholesale and retail
payments systems, which it has used to promote reliability in
clearing and settling of financial obligations.
Although many people identify price stability as the most
important objective of a central bank, economists know that
price stability, financial stability, and sustainable economic
growth go hand in hand. Congress amended the Federal
Reserve Act in 1977, instructing the System to control the
long-run growth of money and credit “to promote effectively
the goals of maximum employment, stable prices, and
moderate long-term interest rates.”1
Why is financial stability so integral to the healthy functioning
of the economy? The role of the financial system is to allocate
capital—to move funds to their best possible uses. A company,
hoping to expand and build a new factory, raises the money by
selling stocks or bonds to investors or by securing a bank loan.
In either case, many individuals pool their savings to make
the investment possible. Of course, allocating funds is part of
the process. If people cannot see a profit in the firm’s expansion, they will not buy the company’s securities and the factory
will not get built. If the bank thinks the project is too risky, it
will not lend the money—it will decide to invest elsewhere.

The financial system, then, matches savings and investment,
fostering economic growth. Indeed, international studies have
shown that a major difference between developed and lessdeveloped countries is the ability to pool investment capital.
An impressive amount of money flows through the financial system. In 2007, net borrowing by U.S. household and
business sectors totaled $1.9 trillion, or 14 percent of GDP. 2
Outstanding debt for the same sectors totaled $23.9 trillion.
It makes sense, then, that problems in the financial markets
will cause problems in the labor, capital, and product markets.
A serious disruption in the flow of funds through financial
institutions can shrink investment, delaying the start-up and
expansion of businesses or pushing them into bankruptcy. It
can depress consumption if household access to credit markets
becomes curtailed. Weaknesses in economic activity can then
further impair the condition of financial institutions, once
again decreasing income and spending. The entire process can
be amplified by uncertainty and caution.
To fully understand the roles a central bank can play in
mitigating the worst effects of financial crises, we must take
a closer look at the various ways in which banking panics and
market crashes can disrupt the real economy, leading to higher
unemployment and loss of income. Let’s begin with the period
prior to the founding of the Federal Reserve System in 1913.
A major concern at the time was that the money supply was
inelastic—that is, it could not expand and contract along with
the needs of trade. When a crisis threatened, each bank would
hoard its funds, reduce loans, and refuse to convert deposits
into currency. The result was predictable: reduced lending, a
smaller money supply, and financial stringency.
Without a central bank to increase the quantity of money
that anyone would accept as payment for an obligation, each
individual’s attempt to protect himself made the problem
worse. Banks could be solvent but not liquid enough to meet
their current obligations without having to sell valuable assets
at a steep discount to raise cash. J.P. Morgan mobilized private
funds to end the banking panic of 1907, but the federal
government decided that going forward, the nation should
rely on a central bank.

1. Section 2a of the Federal Reserve Act:12 USC 225a as added by act of November 16, 1977 (91 Stat. 1387).
2. Data from the Flow of Funds, table F.1, for the nonfinancial, nongovernment sector.

8 | 2007

ANNUAL REPORT

Why place this responsibility with the central bank? Part
of the reason stemmed from dissatisfaction with how crises
had been resolved in the past, but perhaps a greater reason
was that financial innovations were already pointing to the
benefits of a centralized response. In the nineteenth century,
groups of banks formed clearing house associations, which in
the panics of 1873, 1893, and 1907 issued “clearing house
loan certificates” in exchange for deposits of legal currency.

This early form of elastic currency helped mitigate the
effects of the panic. The Federal Reserve Act essentially
cast the Federal Reserve System into the role of the nation’s
most powerful clearing house. The Act provided another
means for making the nation’s money supply more elastic:
“rediscounting,” the process by which banks pledge collateral
and borrow from the Federal Reserve (see box on page 10).

Clearing House Loan Certiﬁcates

The clearing house originated as a single location to provide clearing and settlement services for
its member banks. Thus, a single bank did not have to deal with all other banks, but only with
the clearing house. Clearing houses originally arose to settle and clear banknotes, but as checks
became more important in the U.S. economy, clearing house volumes increasingly shifted to
checks and the clearing house associations expanded.
In times of panic, however, the clearing house took on additional roles beyond clearing checks. Starting
in 1857, the clearing house, on approval of its policy committee, would issue clearing house loan
certiﬁcates, a currency substitute that was the liability of the clearing house association, not of any
speciﬁc bank. Banks could use the certiﬁcates in clearing checks with other banks, freeing up currency to
pay depositors. Later, after 1873, the certiﬁcates were issued directly to depositors. These certiﬁcates
were thus an early form of elastic currency and — because the certiﬁcates represented a claim on the
entire group of banks — an early form of the lender of last resort. Clearing houses also pioneered a
variety of other central bank activities, such as capital requirements, reserve requirements, interest rate
caps, and regular audits and reports.

Sources: Gorton (1985); Gorton and Huang (2006).

FEDERAL RESERVE BANK OF CLEVELAND

Central banks provide nations with some tools for
dealing with financial crises, but having a central bank
does not immunize nations from experiencing severe
financial disturbances and poor economic performance.
Consider the evidence from several historical episodes.
The most famous, of course, is the Great depression.
Although bank failures featured prominently in the
depression, at first they appeared to have little direct
impact on the economy. The failures seemed either to
reflect the deteriorating economy or to have resulted in
a drastic decrease in the money supply, which in fact did
the damage.3 More recent work, however, suggests that
the banking crisis did have real effects above and beyond
monetary policy. With nearly one-third of U.S. banks

failing, financial services dried up and credit became
much more difficult to obtain.4
In a well-functioning system, other means of financing
could have offset at least part of reduced lending and bank
services. However, pronounced deflation (prices fell by
25 percent from 1929 to 1937) substantially reduced
the wealth of debtors, as the real value of principal and
interest rose as prices fell. With less wealth and less
collateral to stand behind borrowings, funding became
difficult. In addition, consumers cut back on purchases
in the hope of retaining some liquidity.5 The commercial
paper market also dried up. With both businesses and
consumers hurting, and alternative funding unavailable,
the stage was set for a serious depression.

The Discount Window
Discount window lending is used when depository
institutions borrow directly from their local Federal
Reserve Bank. They may borrow under several programs (including primary credit, seasonal credit, and
most recently, the Term Auction Facility), provided
they have the appropriate collateral and meet several
other requirements. This lending expands the bank’s
reserves, increasing its liquidity. A discount window
loan also expands the reserves of the banking system,
increasing overall liquidity. When a loan is paid off,
reserves and liquidity decrease. Today, the overall
change is usually offset by open market operations,
leaving the stance of monetary policy unchanged.
This practice was known as rediscounting. The original discount was when the merchant sold the paper
to the bank. Interest was paid because the bank advanced less money than the merchant would eventually pay back, and the Federal Reserve advanced less than what the bank paid. Today the process for
extending credit to depository institutions is known as discount window lending. See the Operational
Highlights section of this report on page 22 for more information on this function.

3. Temin (1976); Friedman and Schwartz (1963).
4. Bernanke (1983).
5. Mishkin (1978).

10 | 2007

AnnUAl RePORT

Financial disruptions affected the overall economy in later
episodes as well. Before 1981, Federal Reserve Regulation Q
put a cap on the interest rate that banks and thrifts could
pay on deposits. Rising interest rates would often lead to
disintermediation, where depositors withdrew money from
the regulated institutions and moved it into higher-yielding
financial instruments from unregulated institutions. In
response, the regulated institutions, particularly savings and
loans (S&Ls), cut back lending, in turn reducing house
construction, which depended heavily on mortgages from
S&Ls. Even moderately restrictive monetary policy could
have large effects. For example, in 1966, residential
construction fell by 23 percent in just one year.6
A further lesson on the lingering effects of financial problems
comes from Japan. In the 1970s and 1980s, Japan experienced
a real estate and stock market boom. The real estate bubble
reached a point at which the land beneath the emperor’s palace
in Tokyo had a market value equal to all of the real estate in
California.7 The stock market peaked in 1989 and real estate
prices peaked in 1990, after which both lost more than half
their value. Loans collateralized by land (or stock) did not seem
as safe as they once did. The severity of the collapse proved the
truth of the old adage, “If you owe the bank $100 and can’t
pay, that’s your problem. If you owe $100 million, that’s the
bank’s problem.”
Faced with numerous problem loans, Japanese banks
resorted to “evergreening,” extending new loans to troubled
borrowers so these firms could continue to make interest
payments, enabling the banks to avoid reporting losses.

But by propping up problem loans, the banks had less capital
to fund growing, profitable firms. This became a classic
illustration of opportunity cost. The problem was not that
lending decreased—in fact, bank loans increased until the
mid-1990s—but that capital was misallocated as loans
went to the wrong firms.8 Failure to resolve the financial
problems led to years of disappointing growth.

Crisis and Response
A financial crisis provides perhaps the most concrete
opportunity for a central bank to assert its role in achieving
financial stability. But what role should the central bank
play in a crisis? Much depends on the cause of the crisis,
the market failure behind it, and the costs and benefits of
resolving the market failure.
The historical record provides many examples of crises and
panics of different sorts in various countries (see figures 1
and 2). For example, the past century has seen classic banking
panics, when people run on banks, as well as broader crises
when funding markets collapse. We have also seen currency
crises, when people rush to get out of a nation’s money, and
twin crises, consisting of a simultaneous run on a country’s
banks and currency.
Sometimes a small shock will be responsible for the crisis, as a
seemingly insignificant incident—a fraud, scandal, or rumor—
sets off a panic. At other times, a large shock, such as a war or
an abrupt change in government policy, will set off a crisis.

Figure 2: Industrial Countries

Figure 1: Emerging Markets
Number of Crises
100

Number of Crises
50

Banking Crises
Currency Crises
Twin Crises
All Crises

Banking Crises
Currency Crises
Twin Crises

All Crises

0
1880 – 1913

1919 – 1939

Source: Bordo and Eichengreen (2002).

1945 – 1971

1973 – 1997

1880 – 1913

1919 – 1939

1945 – 1971

1973 – 1997

Source: Bordo and Eichengreen (2002).

6. Bernanke (2007).
7. Allen (2001).
8. Peek and Rosengren (2005).

Federal Reserve Bank of Cleveland

| 11

Still, most crises do share a resemblance. Uncertain about
economic conditions, people rush to convert their illiquid
assets to cash, sometimes in dramatic fashion. When
depositors rush to convert bank deposits into cash, we
have the classic bank run dramatized in the movie It’s a
Wonderful Life. When investors rush to exchange the Thai
baht for dollars, we have a currency run. When institutional investors refuse to roll over asset-backed commercial
paper, we have the financial turmoil of 2007–08 (see box
on page 13). In many cases, this desire to convert assets
takes the form of a demand for liquidity.
A liquidity crisis can cause otherwise solvent firms to fail,
disrupting the financial system, reducing investment, and
slowing economic growth. Banks must reduce lending
or even call in loans. Businesses that rely on short-term
funding, such as commercial paper, find it impossible to
keep issuing that paper and must restrict investment and
let profitable projects languish. Furthermore, most commercial paper is backed by bank lines of credit, meaning
that disruptions in the commercial paper market can place
increasing liquidity pressures on commercial banks.
Central banks are assigned different roles, responsibilities,
and policy tools in their home countries. Their ability to
promote and maintain a healthy financial system depends
on their specific policy tools and their capability to perform
during periods of stress. Nevertheless, by definition, central
banks control the supply of base money in their countries,
and thus can supply their financial systems with a highly
liquid financial asset during times when markets hunger
for it.
This, then, is where the central bank plays its most
powerful role. As the monetary authority, it can create fiat
money—the essence of liquidity.9 By creating liquidity,
the central bank can forestall liquidation or fire sales of
productive assets, preserving the “going concern value”
of firms.

A good example is the Penn Central Crisis of 1970. The
railroad went bankrupt, defaulting on its commercial
paper. With credit markets already tight, investors became
reluctant to invest in commercial paper, jeopardizing
the funding of many corporations. The Federal Reserve
stepped in, providing liquidity. As one observer put it:
What the Fed did was to provide assurance to the
financial markets that the liquidity essential to their
operation would be preserved. If panicky investors
refused to renew their holdings of commercial paper,
preferring Treasury bills … instead, their extreme
preference for safety would not be allowed to contribute
to widespread insolvency. Once everyone understood
that, there was little reason for panic.10
Liquidity problems, though, are not the only reason a
firm may have trouble borrowing, and this makes the
central bank’s decision more difficult. The classic distinction is between liquidity and solvency: A firm is insolvent
if the total value of its liabilities exceeds the total value
of its assets—in other words, if it owes more than it is
worth. A firm is illiquid if it cannot pay on its liabilities
due right now. The classic notion of a solvent but illiquid
firm is a company with valuable assets and good prospects
of future sales, but whose cash flows lie in the future, so it
must borrow money to keep going.
The distinction between liquidity and solvency problems
means that central bank actions—or inaction—appropriate in one situation may be exactly the wrong prescription
in another. Furthermore, actions taken during a crisis have
consequences long after the crisis is resolved.

9. Theoretically, at least, it is conceivable that private agents might create money (as was done in the U.S. Free Banking Era from 1838 to 1863),
but today it is generally the function, and indeed the defining feature, of the central bank.
10. Melton (1985, 158).

12 | 2007

ANNUAL REPORT

The Current Financial Distress in a Nutshell
Weak underwriting standards for subprime mortgages, combined with falling home prices, led to soaring
delinquencies in 2007. Most of these mortgages were bundled together and sold into mortgagebacked securities, then repackaged into collateralized debt obligations. When it became clear that these
securities could suffer heavy losses, despite their high ratings (AAA and AA), investors lost faith in
the ratings system for complex structured securities and pulled back in a wide range of markets. The
outstanding value of asset-backed commercial paper declined by one-third, or about $350 billion,
between August and December 2007. For banks, which provided back-up liquidity facilities for the
vast majority of asset-backed commercial paper outstanding, difficulties in rolling over commercial paper
resulted in significant balance sheet and liquidity pressures. As a result, banks became reluctant to lend
to others, particularly in the term funding markets.
Commercial Paper Spread
Percentage Points
3.0
2.5

2.0
1.5

Financial 3-month minus
3-month Treasury Constant Maturity

Monoline bond insurers were
hit particularly hard, leading to
questions about their ability to
stand behind municipal bonds.
Hedge funds, despite suffering
notable losses in August by funds
using quantitative trading strategies (quant funds), have mostly
survived.

These events were reflected
in the rates paid in the commer
0.5
cial paper market, particularly
Nonfinancial 3-month minus
3-month Treasury Constant Maturity
the spread between 90-day
0.0
commercial paper and threeJul 07
Aug 07
Sep 07
Oct 07
Nov 07
Dec 07
Jan 08
Feb 08
month Treasury bills. This spread
Source: Federal Reserve Board.
measures the difference between
interest rates on a risky security
(commercial paper) and a safe security (the Treasury bill) and therefore indicates the financial market’s
assessment of risk in the economy. The figure shows the course of this yield spread since the subprime
meltdown began in summer 2007.
1.0

The liquidity problems did not abate as quickly as many in the market had hoped, and the Federal
Reserve took a number of steps, beyond reductions in its federal funds rate target, to ease strains in
financial markets. The changes during this period of market disruption fall into four broad categories:
(1) longer terms of lending, (2) broader types of collateral, (3) a wider class of counterparties, and
(4) a tighter spread between the primary credit rate and the target federal funds rate. These initiatives
were designed to bolster market liquidity and promote orderly market functioning.

Federal Reserve Bank of Cleveland

| 13

Crisis Response: Intended and
Unintended Consequences
While central banking may properly be considered more art
than science, the central bank has some time-honored advice
for confronting a liquidity crisis. First suggested by Sir Francis
Baring in 1797 and Henry Thornton in 1802, the advice is
best known in the formulation of Walter Bagehot (founder
and first editor of The Economist magazine), in his book
Lombard Street:
The end is to stay the panic; and the advances should,
if possible, stay the panic. And for this purpose there
are two rules:—First. That these loans should only be
made at a very high rate of interest. This will operate as
a heavy fine on unreasonable timidity, and will prevent
the greatest number of applications by persons who do
not require it….
Secondly. That at this rate these advances should be
made on all good banking securities, and as largely as
the public asks for them. The reason is plain. The object
is to stay alarm, and nothing therefore should be done
to cause alarm.11
Bagehot’s rules can be summarized as “lend freely at a penalty
rate.” The central bank must provide enough liquidity to meet
the needs of the market, but it must also prevent banks from
profiting at the central bank’s expense. The penalty rate should
allow those firms that need liquidity to survive, but it should
discourage those looking only for cheap funding.
The rules distill some hard-won wisdom gleaned by the Bank
of England. It is not sufficient merely to resolve the financial
crisis. The central bank must ensure that its actions do not set
the stage for future crises. Bagehot saw how the wrong lending policy could make financial problems worse. In modern
jargon, this problem is known as moral hazard. The term is
borrowed from insurance, when people tend to take on more
risk simply because they are insured. For example, people build
houses near the beach, knowing that insurance will reimburse
them for some of their losses after a hurricane hits. The term
has taken on a broader meaning of how behavior changes
when people do not bear the full costs of their actions.

14 | 2007

Indeed, moral hazard lay behind one of the more severe
recent financial crises: the S&L crisis of the 1980s. When the
inflation of the late 1970s rendered many S&Ls economically
insolvent by pushing deposit rates above the rates on fixed-rate
mortgages, S&Ls responded by taking on increasingly risky
investments. If the investments paid off, the S&L returned to
health; if they did not, the Federal Savings and Loan Insurance
Corporation, which insured their deposits, paid the depositors.
Moral hazard meant that insolvent S&Ls gambled for
resurrection because federal deposit insurance insulated new
depositors from the risky investments. Many of the gambles
famously did not pay off, impoverishing the insurance fund
and the taxpayers who stood behind it.12 The $152 billion
direct cost to taxpayers, large as it was, did not measure the
full impact on the economy. Those loans went to buildings
that remained empty and shopping malls that never saw
customers. The total indirect economic costs of the crisis are
estimated at $500 billion.13
Guarantees can take other forms besides explicit deposit
insurance, and they sometimes do. For example, Continental
Illinois was labeled “too big to fail” and was rescued in 1984.
Expectations of rescue have the same effect as insurance. As
economic historian Charles Kindleberger puts it: “…if the
market knows it is to be supported by a lender of last resort,
it will feel less (little? no?) responsibility for the effective
functioning of money and capital markets during the next
boom. The public good of the lender of last resort weakens
the private responsibility of ‘sound’ banking.”14
Of course, crises do not always sort themselves into the
“liquidity” type of the classic bank run and the “solvency”
type of the S&L crisis. Solvency issues often lay behind
the demand for liquidity in the 1800s, and many modern
financial crises display attributes of both, particularly the
international “twin crises” that combine a banking panic
with a run on a nation’s currency. The classic example is
the East Asian crisis of the past decade.

11. Bagehot (1874, 197).

13. Stern and Feldman (2004).

12. Kane (1989).

14. Kindleberger (2000, 161).

ANNUAL REPORT

Anatomy of the East Asian Crisis
In the early 1990s, the East
Asian “tigers” (Indonesia,
Malaysia, Philippines, Thailand)
and “dragons” (Hong Kong,
Singapore, South Korea,
Taiwan) experienced strong
economic growth with extensive
foreign investment, much of it
short-term and denominated in
dollars. Thus, these economies
were vulnerable if foreigners
wanted to withdraw their funds.
At the same time, the banking and ﬁnancial systems in these nations expanded, fueled by both
foreign money and deregulation.
In early 1997, exports slowed and bankruptcies increased sharply. Foreign lenders began withdrawing their capital, increasing pressure on exchange rates. The region’s central banks started to
defend their currencies, but the drain proved too much. In July, Thailand stopped supporting
the baht, and the Philippines and Malaysia soon ceased their defense of the peso and ringitt,
with Indonesia supporting the rupee until August.
The International Monetary Fund added $100 billion of emergency funds but failed to stem
the crisis. The plunging exchange rates and capital withdrawal worsened the domestic ﬁnancial
problems as more ﬁrms went bankrupt, further weakening the banking system. Moody’s downgraded the debt of Indonesia, Korea, and Thailand to junk-bond status. In early 1998, the
Thai government explicitly guaranteed all bank liabilities, including those to foreign creditors.

Sources: Radalet, Sachs, Cooper, and Bosworth (1998); Tirole (2002); Allen and Gale (2007).

FEDERAL RESERVE BANK OF CLEVELAND

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The exact causes of the East Asian crisis may never be
untangled, but its progression illustrates the extreme pressure
for active government intervention beyond liquidity assistance.
Even a government that is aware of moral hazard problems
can have trouble following through on its promises. This
constitutes the second key dilemma in resolving financial
crises—dynamic inconsistency.
Recall the beach example. Residents build houses near
the beach but cannot get insurance because the chance of
hurricanes is too great. The government promises no flood
relief, but once a hurricane comes and the damage is done,
the government relents and picks up the tab for damages.
Homeowners, expecting the government to provide relief,
feel confident building near the beach in the first place.
In the analogous case of a financial crisis, even though
no explicit insurance exists, a central bank could step in to
alleviate liquidity strains on some financial firms or their
creditors. The firms and creditors, recognizing this possibility,
could take less-than-adequate care of their risk and their
liquidity once they believe they will have access to government support. Two episodes illustrate this situation:
• I n 1925, more than 500 banks had been borrowing
from the Federal Reserve for more than a year, including
80 percent of the more than 200 failing banks.
• I n 1974, Franklin National Bank borrowed extensively from
the discount window for five months before the bank was
closed, with the loans at one point totaling half of its assets.
This allowed the uninsured depositors time to exit the bank
before it was finally declared insolvent.15
In the beach example, if the government kept its promise,
then over time fewer people would likely build homes on
the beach. In the financial crisis example, if the central bank
did not alleviate the liquidity strains on some financial firms
or their creditors, financial institutions would likely engage
in less risky investment practices. Yet we should not forget
that Bagehot suggested that lending in a crisis be done on
all good banking collateral, as freely as the public wants.
How do we reconcile Bagehot’s advice with our concern
about dynamic inconsistency?

15. Schwartz (1992).

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The solution is to recognize that central-bank lending entails
both costs and benefits. The benefits come in the form of
stemming the panic, which means preventing negative
externalities that private decision-makers have no incentive
to take into account. The costs come in the form of introducing moral hazards—incentives for people to anticipate
that the central bank will act in the same ways in the future
and, accordingly, to take on excessive risk. The existence of
these costs does not necessarily mean that a central bank
should avoid intervening in private credit markets, but
rather that it is important for the central bank to look for
the lowest-cost (least-distorting) interventions.

Planning Ahead to
Confront Crises
Financial crisis management ultimately has two goals:
minimizing the depth and duration of the current episode
and minimizing the probability of future crises. These goals
can sometimes conflict because of the time-inconsistency
problem facing policymakers. That is, actions taken to
manage a crisis in the short run can lead to market incentives
that are inconsistent with financial stability in the long run.
Preparation can reduce the conflict between the goals, enhance
the credibility of the central bank, and lead to shorter, fewer,
and less-severe crises.
The essential problem is how to enhance the central bank’s
credibility. The central bank should provide market participants with incentives to internalize their cost of risk, even
if the central bank faces strong pressures to do otherwise.
Credibility involves more than just the central bank, however;
it depends on the broader environment needed to prevent
moral hazard and dynamic inconsistency. This is particularly
true in the United States, where the Federal Reserve is only
one of several financial-institution regulators.
This is where planning ahead really matters. When a crisis
breaks out, events move quickly. Facing up to financial losses
and resolving institutions expeditiously can lower uncertainty
and reduce the pressure for more drastic action. Although
it seems paradoxical, closing financial institutions quickly

limits creditor losses. Preventing small losses from growing
into large losses makes it less likely that the credit problems
will spill over into other financial firms or to the broader
economy, and it reduces the pressure for using public funds
to redress creditors’ losses.

“Planning ahead can allow the crisis
managers to assemble such vital information
as the distressed institution’s loans, deposits,
and derivatives exposure. A clear view of the
size of the problem can reduce the chance
of regulatory panic in the face of uncertainty,
and real-time knowledge of the situation
can enable more nimble responses.”

Evidence shows that waiting increases losses. Researchers
note that during the S&L crisis, the average time from
insolvency to closure was a lengthy 38 months: 345 thrifts
recovered, making profits of $1.5 billion, but 1,600 failed,
losing $60 billion.16 Consequently, being prepared to resolve
troubled financial institutions expeditiously saves money in
the long run.
The planning process might be long and tedious, and its
benefits could seem doubtful when markets are calm; nevertheless, the effort could have great benefits in times of distress.
For example, advance planning can reduce pressures for
inappropriate guarantees. Uncertainty about the extent of
a crisis, and the chance that it will devolve into a major
economic catastrophe as in the 1930s, may induce regulators
to err on the side of safety. Planning ahead can allow the crisis
managers to assemble such vital information as the distressed
institution’s loans, deposits, and derivatives exposure. A clear
view of the size of the problem can reduce the chance of
regulatory panic in the face of uncertainty, and real-time
knowledge of the situation can enable more nimble responses.

Even knowing who to call or where to find information—
a nontrivial exercise in itself—is not enough. In the United
States, a crisis involving several large financial institutions
could easily involve the Office of the Comptroller of the
Currency, the Federal Deposit Insurance Corporation, the
Federal Reserve, the Securities and Exchange Commission,
the Commodity Futures Trading Commission, and state bank
and insurance regulators. With multiple actors, planning
ahead to define roles and responsibilities adds clarity to the
process and makes coordination between the actors (and the
public) more likely. International regulators took a step in this
direction in 1974 with the formation of the Basel Committee
on Banking Supervision, created to encourage cooperation in
the supervision of banks operating across national borders.
Planning is also important because actions taken today
constrain the range of choices later on. Crisis resolution has
three distinct stages: containment, restructuring, and recovery.
These stages are interdependent, as early decisions made in
the containment phase restrict the possible options in future
stages, and the options available at future stages help determine the most appropriate response early on.
Early in the containment phase of a crisis, the heightened
uncertainty and the pressure to do something as conditions
rapidly deteriorate combine to increase the likelihood of
clumsy (time-inconsistent) actions to bring the situation
under control. The immediacy of the situation can produce
pressures to stop the crisis at any cost. However, wellconceived contingency plans increase the likelihood that crisis
managers can respond quickly and forcefully to emerging
problems without setting the stage for future crises.
A case can be made that such advance planning is particularly important now. Through its Primary Dealer Credit
Facility, the Federal Reserve is providing emergency liquidity
assistance to some of the primary securities dealers that serve as
its counterparties in open market operations. In addition, the
Federal Reserve facilitated the resolution of a large securities
firm that served as a primary dealer. For bank failures, experience and institutional memory may substitute for the lack
of a publicly articulated plan (although we have argued that
this has its downside as well), but for nonbank failures, more
basic requirements such as fact-finding mechanisms and
resolution procedures need to be developed.

16. Santomero and Hoffman (1999); DeGennaro and Thomson (1996).

Federal Reserve Bank of Cleveland

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Planning also includes practice. A crisis management team
cannot just exist on paper. Preparedness for a financial
crisis involves conducting crisis simulations where different
scenarios are rehearsed and responses are mapped out. Under
standing what decisions must be made, what information
is required, and who needs to be informed—whether it be
talking to the Secretary of the Treasury or writing a press
release for the public—takes practice.
This approach to planning has been adopted in several areas.
The Federal Deposit Insurance Corporation Improvement Act
of 1991 (FDICIA) took a broad-based approach to changing
the regulatory environment, reforming the bank regulatory
system with the aim of minimizing taxpayer losses. It issued
new guidelines for bank examinations, capital requirements,
and deposit insurance. Of key importance, it mandated a set
of prompt corrective action guidelines intended to assist bank
supervisors in handling troubled depository institutions as they
slide toward insolvency. Prompt corrective action provides for
a wide degree of discretion to ensure that short-term regulatory
actions are consistent with long-run incentives for regulated
banks and thrifts.
FDICIA’s systemic risk exemption allows for public funds to be
paid to unsecured creditors of large or systemically important
insured depository institutions, but it does so in a politically
accountable manner. Invoking the exemption requires votes
by the Board of Governors of the Federal Reserve System, the
Board of the Federal Deposit Insurance Corporation, and the
Secretary of the Treasury. The idea is that these public rescues
should be viewed as an extraordinary response and not the
default response to the economic failure of a large institution.
Hence, the spirit of this legislative remedy for too-big-to-fail
policies is that such policies should be used as a last resort.

What Sort of Plan?
A formal plan can keep a broader range of options on the
table—be they emergency loans, private restructurings, or
haircuts—lowering the odds of simply relying on a familiar
but perhaps flawed response used in the last crisis. Addressing
some questions beforehand, such as when to impose creditor
timeouts, can lead to a more careful assessment of the costs
and benefits. For other cases, such as expediting depositor
payoffs, a plan can assess—and perhaps remedy—feasibility

18 | 2007

ANNUAL REPORT

concerns. Making the plan public in advance should also
enhance its credibility, increasing the likelihood that principles
such as prompt loss recognition or central bank support for
illiquid, but not insolvent, firms will be followed. Privatemarket participants would know what principles will drive
the decisions of government entities during a time of crisis.
Agreeing to a public plan builds consensus among all parties
to follow through on their obligations when it is time to
put the plan to use. Publishing a plan in advance could help
government entities resist undue influence from various
interest groups in a time of crisis. Potential vehicles for
developing such a plan might be the President’s Working
Group on Financial Markets, the Financial Stability Forum,
the Basel Committee on Banking Supervision, or another
similar group.
Beyond the general suggestions of contingency planning,
publicizing plans, and designating a crisis team, what more
specific features could a financial crisis plan include, when a
primary consideration is to avoid moral hazard and dynamic
inconsistency? Another key step is to determine what additional
authority and powers might be needed in an emergency—in
other words, a crisis management infrastructure.
As discussed above, experience from Japan, the S&L crisis,
and other banking episodes illustrates that delaying failure
usually increases costs both to the government and to the
overall economy. Because a critical element of the restructuring
stage of a crisis is to recognize the losses as quickly as possible
so that private investment can return and credit flows can
be restored, a potentially useful component of the crisis
management infrastructure might be a publicly chartered
asset disposition company modeled after the Reconstruction
Finance Corporation (chartered in 1932) or the Resolution
Trust Corporation (chartered in 1989). For the purposes
of this essay, let’s call the proposed entity the Resolution
Management Corporation (RMC). The RMC would be an
independent federal corporation chartered by Congress and
charged with asset recovery and disposition. It would remain
dormant until activated as part of the response to a financial
crisis and stay active only as long as needed. It is critically
important that the RMC be separate from the Federal Reserve
to ensure that the central bank’s role as liquidity provider of
last resort is insulated from the solvency and asset disposition
activities of the RMC.

The RMC would be most useful in what we have termed the
restructuring and recovery phases of the crisis. First, by helping
to segregate bad assets from good ones, it would speed the
return of productive assets to their best use in the private
sector. Second, with asset salvage and disposal fully audited,
the RMC would increase the transparency of embedded
losses. This, in turn, would improve price discovery—that is,
the revelation of the true value of the assets—increasing the
speed at which distressed assets are returned to the private
sector and the ability of financial firms to recapitalize. Finally,
by explicitly committing public funds to resolve the crisis,
the RMC would improve the accountability of crisis managers
and subject the resolution process to congressional oversight.

“With multiple entities potentially involved
in resolving financial institution problems,
a good crisis prevention environment
requires a consistent alignment of policies
and practices among all parties, both to
minimize moral hazard among the privatesector participants and to achieve dynamic
consistency among the policymakers.”

The creation of a standby RMC is not without its drawbacks,
however, so institutional design issues would need to be
carefully studied. For instance, routine activation of the RMC
charter during even mild periods of financial distress could
socialize losses, increase moral hazard, and reduce market
discipline. Moreover, some might be tempted to use an RMClike entity to delay loss recognition and thereby reduce transparency. In other words, the RMC could have unintended
consequences if it is poorly designed, including increasing the
likelihood or severity of a financial crisis. This brief example
illustrates how difficult it can be to both plan ahead and avoid
distorting the incentives of private-market participants and
policymakers. Nevertheless, the potential difficulties should
not deter an examination of the pros and cons.

Another element to consider in building a better crisis
management infrastructure is publishing timely and objective
information about financial rescues that involve public funds
or guarantees. In the United States, a number of federal (and
sometimes state) agencies may be involved in the chartering,
regulating, supervising, and insuring of financial institutions.
With multiple entities potentially involved in resolving
financial institution problems, a good crisis prevention
environment requires a consistent alignment of policies
and practices among all parties, both to minimize moral
hazard among the private-sector participants and to achieve
dynamic consistency among the policymakers. Discussions of
regulatory reform in the financial services industry could be
expanded to include provisions for a government agency that
would conduct forensic analysis of financial market failures,
increasing the information available to the public about the
underlying causes of these failures. More information about
the causes of failures, and more ex post analysis of policy
choices, could lead to more effective market discipline on the
private-sector participants and to improved policy choices
by public-sector officials.17 These benefits should be relevant
regardless of the design of the broader regulatory structure.

The Silberzug and Beyond
The Panic of 1857 began with the New York office of an
Ohio bank and, after sweeping through Europe, ended when
a loan of silver came to Hamburg via a special train—the
Silberzug—from Vienna. Of course, we are unlikely to see
those exact circumstances occur again. But financial crises
and the need to manage them are likely to be with us for
some time. How we deal with these crises depends on our
choices. The ubiquity of crises and their impact on the
economy demand some action, but too great a concern over
losses only encourages greater risk-taking. Once the risks are
taken and the losses occur, the political pressures for action
increase exponentially.
Planning ahead can provide credibility to the promise of
limited intervention. With a broad menu of options, current
information, and a public plan in place, the central bank
is positioned to contain the current financial crisis without
contributing to a new one in the future.

17. See Getmansky, Lo, and Mei (2004) and Kane (2001) for some suggestions along these lines.

Federal Reserve Bank of Cleveland

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Referen ces
Allen, Franklin. 2001. “Do Financial Institutions Matter?”
Journal of Finance 56(4): 1165–75.
Allen, Franklin, and Douglas Gale. 2007. Understanding
Financial Crises. Oxford: Oxford University Press.
Bagehot, Walter. 1874. Lombard Street: A Description of the
Money Market. Reprint, London: Scribner, Armstrong &
Company, 2006.
Bernanke, Ben S. 1983. “Nonmonetary Effects of the
Financial Crisis in the Propagation of the Great Depression.”
American Economic Review 73(3): 257–76.
Bernanke, Ben S. 2007. “Housing, Housing Finance, and
Monetary Policy.” Speech, Federal Reserve Bank of Kansas
City’s Economic Symposium, Jackson Hole, WY (August 31).
Bordo, Michael, and Barry Eichengreen. 2002. “Crises
Now and Then: What Lessons from the Last Era of Financial
Globalization?” Working Paper No. 8716. National Bureau of
Economic Research (January).
DeGennaro, Ramon P., and James B. Thomson. 1996.
“Capital Forbearance and Thrifts: Examining the Costs of
Regulatory Gambling.” Journal of Financial Services Research
10(3): 199–211.
Ergungor, O. Emre, and James B. Thomson. 2007.
“Systemic Banking Crises.” Research in Finance 23: 279–310.
Friedman, Milton, and Anna J. Schwartz. 1963. A Monetary
History of the United States: 1867–1960. National Bureau of
Economic Research, Princeton, NJ: Princeton University Press.
Getmansky, Mila, Andrew W. Lo, and Shauna X. Mei.
2004. “Sifting through the Wreckage: Lessons from Recent
Hedge-Fund Liquidations.” Journal of Investment Management
2(4): 6–38.
Gorton, Gary B. 1985. “Clearinghouses and the Origin of
Central Banking in the United States.” Journal of Economic
History 45(2): 277–83.
Gorton, Gary B., and Lixin Huang. 2006. “Bank Panics and
the Endogeneity of Central Banking.” Journal of Monetary
Economics 53(7): 1613–29.
Kane, Edward J. 1989. The S&L Insurance Mess: How Did It
Happen? Washington DC: The Urban Institute Press.

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Kane, Edward J. 2001. “Using Disaster Planning to Optimize
Expenditures on Financial Safety Nets.” Atlantic Economic
Journal 29(3): 243–53.
Kindleberger, Charles P. 2000. Manias, Panics and Crashes:
A History of Financial Crises. 4th ed. New York: John Wiley
& Sons.
Melton, William C. 1985. Inside the Fed: Making Monetary
Policy. Homewood, IL: Dow Jones Irwin.
Mishkin, Frederic S. 1978. “The Household Balance Sheet
in the Great Depression.” Journal of Economic History 38(4):
918–37.
Peek, Joe, and Eric S. Rosengren. 2005. “Unnatural
Selection: Perverse Incentives and the Misallocation of Credit
in Japan.” American Economic Review 95(4): 1144–66.
Radelet, Steven, Jeffrey D. Sachs, Richard N. Cooper, and
Barry P. Bosworth. 1998. “The East Asian Financial Crisis:
Diagnosis, Remedies, Prospects.” Brookings Papers on Economic
Activity 1: 1–90.
Santomero, Anthony M., and Paul Hoffman. 1999.
“Problem Bank Resolution: Evaluating the Options.” In
International Banking Crises: Large-Scale Failures, Massive
Governmental Interventions, Benton E. Gup, ed. Westport, CT:
Quorum Books: 239–63.
Schwartz, Anna J. 1992. “The Misuse of the Fed’s Discount
Window.” Federal Reserve Bank of St. Louis, Review
(September): 58–69.
Stern, Gary H., and Ron J. Feldman. 2004. Too Big to Fail:
The Hazard of Bank Bailouts. Washington DC: Brookings
Institution Press.
Temin, Peter. 1976. Did Monetary Forces Cause the Great
Depression? New York: W.W. Norton & Company.
Tirole, Jean. 2002. Financial Crises, Liquidity, and the
International Monetary System. Princeton, NJ: Princeton
University Press.

Federal Reserve System member banks have the right to elect six of the
nine directors of their local Reserve Bank. Member bank constituents
are also eligible for service as a director. If elected to serve as a
Reserve Bank director, a member bank representative has the opportunity
to participate in monetary policy formulation.

2007 Operational Highlights
THE DISCOUNT WINDOW: A FLEXIBLE AND STRONG FINANCIAL RESOURCE
Analyst: This is Jack Hodgkiss, Credit Risk Management.
How can I help you?
Bidder: This is Jane Smith, XyZ Bank and Trust. May I
put in a bid today for your TAF product?

Bidder: Right.
Analyst: Ok, and now the amount.
Bidder: Seven-hundred fifty million...even.

Analyst: Sure, anytime before one o’clock. The first thing
I need is your bank’s ABA number.

Analyst: Seven-hundred fifty, even. Ok, and your
phone number?

Bidder: 1234-5678-9.

Bidder: 555-555-1234.

Analyst: All right, Jane, got it. let’s start with your bid,
in terms of the bid rate.

Analyst: Got it. Again, that’s five point two five zero for
seven-hundred fifty million dollars.

Bidder: Um, bid rate...five-twenty-five.

Bidder: yep, that’s it.

Analyst: That’s five point two five percent, correct?

Analyst: Thanks. I’ll transfer you to another member of our staff
who will verify your request and then we’ll be all set.

This transcript details one of the many phone calls received in 2007 from Fourth Federal Reserve district depository institutions
seeking funds from the discount window.1 It was one of the first bids received from such an institution seeking credit under the
Federal Reserve Board’s new Term Auction Facility, or TAF.

discount window: n. the Federal Reserve instrument of monetary
policy that allows eligible financial institutions to borrow money from
the central bank
dId YOU KNOW? The discount window, now a figurative expression,
once referred to a real physical location. In the early years of the Federal
Reserve System, bankers came to a Federal Reserve Bank teller window to
obtain credit. The Federal Reserve Bank of Cleveland’s Discount Window
department was located in the Bank’s first-floor lobby. You can see these
windows on a Bank tour or by visiting the Bank’s learning Center and
Money Museum.

1. The bidder’s identification has been changed to preserve anonymity.

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AnnUAl RePORT

The 2007 discount window bears little resemblance to its
1914 ancestor, which was one of the Federal Reserve’s key
activities when it opened for business that year. It may seem
that the story of the “window” lacks vibrancy and interest. But
when examined in light of its recent revitalization—including
the introduction of the TAF—the window’s history reveals
a timeline of events that parallels the exciting ebb and flow
of financial markets and the U.S. economy. These events
have tested the relevancy of Federal Reserve lending activity
and confirmed the important role the discount window has
played—and continues to play—in supporting the Federal
Reserve’s monetary policy activities.2

Key Dates in Discount Window History

•

1914 – 1933
The Early Years

1951 – 1955
A Recalibration

2001 – 2007
Re-engaged,
Reinvented

The Early Years - The discount window was intended to be
the Federal Reserve’s primary means for influencing credit
and monetary developments. In the early years, Reserve Banks
influenced the availability of credit to financial institutions
by altering the discount rate (the interest rate at which the
central bank agrees to make funds available to borrowing
institutions). Collateral requirements were stringent and
limited to high-quality, highly liquid, short-term agricultural,
industrial, and commercial obligations.
Initially, lending activity for the Federal Reserve System and
the Federal Reserve Bank of Cleveland was vigorous. The
central philosophy was to grant credit liberally, particularly
when emergencies caused by unusual conditions required
prompt relief. The Federal Reserve’s approach was influenced
by the prevailing theory of monetary policy, known as
the Real Bills doctrine, which held that the central bank
should provide liquidity only in exchange for securities that
directly finance commerce.3 The self-liquidating nature
of the discounted paper allowed the quantity of money in
circulation to rise and fall with the needs of trade.
As a result, most reserves supplied to the national and local
economies were through member bank discounting and
direct lending (or advances, using the term of the day).

Discounts and advances in relation to Federal Reserve
credit reached a peak of about 82 percent in 1921 and did
not fall below 37 percent until 1930 (see figure below).
During this period, roughly 60 percent of member banks
maintained an active borrowing relationship with their
local Reserve Bank. It was not uncommon for hundreds
of banks to borrow continuously in excess of their capital
and surplus.4 Similar experiences were reported for Fourth
District institutions. Economic times were often quite
volatile, characterized by growth and prosperity followed
by reversals and recessions.
At the end of the 1920s and into the 1930s, open market
operations—purchases and sales of U.S. Treasury and government agency obligations—gradually began to replace the
discount window. Part of the reason was the low attractiveness
of private obligations for discounting, given the volatile
economic period (especially during the Great Depression) and,
later, in view of the extensive holdings of government debt
as a result of the Roosevelt administration’s national recovery
efforts.5 Despite its secondary role, the discount window
continued to support member banks as needed, particularly
as a source of funds when financial pressures heightened.

Sources of Reserve Bank Credit
Percent of Credit
100
90
80
70
60
50
40
30
20
10
0

1920 - 27 1928 - 33 1934 - 44 1945 - 53 1954 - 66
Period

■ Open Market Operations

■ Discount Window

■ Float

In the early years of the Federal Reserve, the discount window played an
important role in the implementation of monetary policy. In time, open
market operations became the primary mechanism.
Source: Shull (1971).

2. The focus of this essay is the Federal Reserve discount window’s primary credit program and its predecessor,
the adjustment credit program. The Federal Reserve also offers two other lending programs: the seasonal credit
program, designed to assist small depository institutions in managing significant seasonal swings in their loans
and deposits, and the emergency credit program, which is authorized by the Board of Governors in unusual
and exigent circumstances for individuals, partnerships, and corporations that are not depository institutions.

3. Marshall (2002).
4. Shull (1971).
5. Marshall (2002).

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A Recalibration – From the Depression until the early years
after World War II, Reserve Bank discount window lending
declined and remained low. This outcome was not unexpected,
as banks maintained large holdings of government securities
and held excess reserves, thus reducing their need to borrow.6
Following the Treasury–Federal Reserve Accord in 1951,
which released the Federal Reserve from the obligation to support the market for U.S. government debt at pegged prices and
allowed the independent conduct of monetary policy, normal
monetary policy operations resumed and banks returned to
the discount window. Despite a relatively nominal increase in
lending activity, discount officers’ perceptions reflected a shift
in opinion. In contrast to the earlier days, which had generally
encouraged lending (perhaps for all but speculative purposes),
the new sentiment considered lending an exceptional activity
(for appropriate reasons and typically permitted only under the
close watch of the responsible discount officer).7
In 1953, the Federal Reserve organized a committee to evaluate discount window lending guidance. The committee’s
findings led to a 1955 revision of Regulation A, the authority
governing discount window lending administration. This
revision “reflected a choice to restrict activity at the discount
window well below even the lowest levels reached in the 1920s
and to provide almost all reserves through open market operations.”8 The new rules required discount officers to scrutinize
borrowing requests and closely monitor borrowing duration
and frequency. In other words, questions were asked about

why banks were borrowing money, and appropriate answers
were expected. Not surprisingly, lending activity was minimal
in the years that followed. Over time, the discount window
was regarded as a generally unattractive source, even under
what would otherwise be considered reasonable circumstances.
“Reluctance to borrow” became a well-established discount
window concept for many institutions.
Legislative Changes - Following Regulation A’s revision, not
much was done publicly to address the window, although the
topic was well-studied behind the scenes. Twenty-five years
later, in 1980, Congress passed the first of two laws affecting
discount window availability. The Depository Institutions
Deregulation and Monetary Control Act dramatically
expanded the universe of depository institutions eligible to
borrow at the discount window. As a result, the Federal
Reserve assumed responsibility for meeting the liquidity needs
of not only member banks, but any institution subject to
reserve requirements. The Federal Deposit Insurance
Corporation Improvement Act of 1991 (FDICIA) restricted
Federal Reserve lending capabilities to potentially insolvent
institutions. This act was designed to address perceived issues
in discount window lending in the turbulent 1980s, when the
Federal Reserve lent for extended periods to banks that
eventually failed. In some cases, this lending helped provide
uninsured depositors and other creditors sufficient time to
remove their funds from a troubled bank, which increased the
losses to the federal deposit insurance fund.9

The discount window’s ability to support Federal Reserve policy objectives,
particularly as the lender of last resort, came into sharp focus in 2001.

PRESS RELEASE: SEPTEMBER 11, 2001

“The Federal Reserve System is open and operating. The discount window is available to meet liquidity needs.”
In addition to the more horrible loss of life, the attacks on New York City and Washington DC on September 11, 2001,
disrupted domestic and global financial markets. The Federal Reserve moved quickly, cutting interest rates, infusing emergency
cash into the financial system, encouraging lenders to loosen repayment terms for distressed borrowers, and coordinating monetary
policy easing and payments-system support internationally. System lending activity reached historic proportions, with $46 billion
lent on September 12 (more than 200 times the daily average for the previous month). The Federal Reserve Bank of Cleveland
experienced similar historic lending activity, reporting the largest single day ($5.3 billion) and week of lending in its history.
Among the lessons learned in the event response was the critical importance of the Federal Reserve’s “lender of last resort” role
in helping to maintain stability within the financial markets.
Sources: Board of Governors of the Federal Reserve System (2001); Schlesinger (2001).

24 | 2007

6. Shull (1971).

8. Shull (1971).

7. Hakkio and Sellon (2000).

9. Broaddus (2000).

ANNUAL REPORT

For the rest of the century, discount window lending activity
began to depart from its historical pattern of rising in periods
when the spread between the federal funds rate and the discount rate increased, and falling when the spread narrowed.10
At times, lending activity bore little relationship between
the direction of interest rates and the funds/discount rate
spread.11 The federal funds rate displayed increased volatility,
particularly on settlement day (when depository institutions
must meet their reserve requirements).
Perceptions of stigma were more pronounced, with bankers
reporting that the discount window was not an attractive
source of funding—despite its favorable rate (generally 50
basis points below the federal funds rate target)—given the
high scrutiny and other restrictions assigned to loan requests.
For example, interested institutions were required to exhaust
all other funding sources before making a loan request.
Formal limitations were also placed on borrowing frequency
and the use of loan proceeds.
This combination of factors signaled a noticeable decline in
the attractiveness of the discount window as a contingency
funding source. Simply put, healthy institutions were often
unwilling to turn to it—even under appropriate circumstances
—for fear of provoking market or regulatory concerns.12 Over
time, these issues raised real concerns regarding the discount
window’s ability to carry out its role of relieving dislocations
in local financial markets.
Re-engaged, Reinvented – The events of September 11,
2001, presented a rare opportunity to reveal the discount
window’s primary strength—its ability to provide liquidity to
institutions in need. Barring this extraordinary event, however,
borrower reluctance remained.
The New Primary Credit Lending Program –To address
the shortcomings of the window, the Board of Governors
introduced the primary credit program in January 2003 as
the principal safety valve for ensuring adequate liquidity
in the banking system. For institutions not qualifying for
primary credit, the newly established secondary credit
program would apply.13

10. The federal funds rate is the interest rate at which depository
institutions lend balances at the Federal Reserve to one another.
11. Hakkio and Sellon (2000).
12. Clouse (1994).

Federal Reserve’s Primary
Credit Program
Purpose
To help sound depository institutions meet short-term,
backup funding needs
Key Terms
•Term: Typically overnight; term borrowing permitted
up to 90 days
•Eligibility: Institutions in generally sound overall condition
•Collateral: Pledge of a wide range of eligible assets
•Rate: Federal funds rate + 25 basis points (variable)
Administration
Minimal; generally “no questions asked”

The new program was different from its predecessor, the
adjustment credit program, in two important ways. First, the
discount rate was priced at an above-market rate (initially,
the funds rate plus 100 basis points, although the spread was
permitted to vary—and has since mid-2007—to facilitate
discount window availability in response to financial market
developments) in contrast to the below-market rate for
the former program. Second, the new program would be
administered with substantially reduced oversight.
An important goal of the new program was to reduce
borrower reluctance. By rationing credit based on price
and the condition of the borrowing institution (including
financial condition and capitalization eligibility standards)
rather than on discount officer administration and oversight, the new program would more efficiently serve as a
safety valve, relieving financial market pressures.

13. Secondary credit is extended under the same collateral requirements as primary credit.
Extended at a rate 50 basis points higher than the applicable primary credit rate,
secondary credit is available to institutions that are unable to meet the financial
condition and capitalization standards for primary credit. Given the adverse financial
condition of these parties, secondary credit requests are subject to discount officer
scrutiny. Borrowers are generally able to obtain funds only on a short-term basis.
Federal Reserve Bank of Cleveland

| 25

Federal Reserve Bank of Cleveland’s Credit Risk Management Department in front of the discount
window in the Bank’s main lobby
Todd Berardinelli, Mark Meder, Jack Hodgkiss, Doug Banks, Jeff Hirsch, Ann Makohon,Toby Trocchio,
Eric Polansky, and Stacey Steadman; (not pictured) Jane Chodzin, Kathy Lucic, and Sue Prior

FOURTH DISTRICT CONTRIBUTIONS
The Credit Risk Management Department at the Federal Reserve Bank of Cleveland made significant contributions to the
New Primary Credit Lending Program. In 2002, Cleveland staff chaired a national project that developed a standard
depository institution risk assessment framework. The framework enabled greater consistency across the Federal Reserve
System and helped establish eligibility standards for the primary credit and TAF programs.
In 2003, Cleveland discount window leadership assumed responsibility for regulatory and other outreach, promoting
awareness of the new primary credit program. Notable contributions included the creation of an innovative, selfdirected web-based training tool, including content for the banking community, regulators, and general public (see
www.frbdiscountwindow.org); more than 20 presentations on the new lending program to various local and national
groups; and several articles promoting awareness of the new program.

26 | 2007

ANNUAL REPORT

One study concluded that while the primary credit
program did not significantly affect overnight borrowing
activity (the higher direct costs of borrowing under the
new program effectively countered the attractive, reduced
credit administration), its utility in relieving funding market
pressures was evident. The study noted a significant
reduction in the spread between the target and effective
federal funds rates, suggesting that the new primary credit
program was acting appropriately to relieve overnight borrowing rate volatility. In essence, depository institutions
were turning to the discount window when rates spiked
rather than paying higher rates in the overnight markets.14
The Term Auction Facility - The most recent chapter in
the rebirth of the discount window occurred in December
2007 with implementation of the new temporary Term
Auction Facility (TAF). Beginning in late summer 2007,
the financial markets were rocked by adverse developments
in the subprime mortgage and other markets. On August
17, 2007, the Federal Reserve responded by reducing the
primary credit rate by 50 basis points (in turn, narrowing
the spread between the primary credit rate and the federal
funds rate from 100 basis points to 50 basis points) and
by providing term financing for up to 30 days, renewable

by the borrower. These changes were designed to reassure
depository institutions about the cost and availability of
funding. Subsequently, on December 12, 2007, the Federal
Reserve introduced the TAF as an additional measure to
address the elevated short-term pressures in funding markets.
To further bolster market liquidity and promote orderly
market functioning, on March 16, 2008, the authorized
term for primary credit was extended from 30 days to
90 days, and the spread on primary credit to the federal funds
rate was narrowed to 25 basis points.
The TAF allows banks to borrow from the Federal Reserve
at relatively attractive rates against a wide range of their
assets. TAF credit is a fixed-rate term advance (generally
one-month maturity) determined through an auction
process. Under this program, the Board sets the auction
parameters, including the offering amount, the minimum
and maximum bid amounts, the minimum bid rate, bid
submission date, and opening and closing times. Participants must be eligible for primary credit.
At the time of this writing, the Board has successfully
completed 12 auctions, yielding $510 billion in funds
advanced.

THE TERM AUCTION FACILITY
HOW DOES IT WORK?
•

Eligible bidding depository institutions contact their local Reserve Bank discount window to submit their TAF bid.

•

Once the bid submission period is closed, the Reserve Bank forwards all eligible bids to the TAF auction agent.

•

The TAF auction agent orders the bids from the highest to lowest rate.

• Bids are accepted starting with the highest rate submitted, working down to successively lower rates, until the
offering amount for the auction is fully allocated or the minimum bid rate is reached (whichever is first).
• The lowest accepted interest rate is the “stop-out rate.” Bids at interest rates above the stop-out rate will be
allocated the full bid amount. Bids at the stop-out rate may be prorated.
• All

participants awarded a TAF advance will pay the stop-out rate, regardless of the interest rate at which they bid.

14. Artuç and Demiralp (2007).

Federal Reserve Bank of Cleveland

| 27

Conclusion – Jack Hodgkiss, the analyst in the TAF
phone transcript at the beginning of this essay, is a member of the Federal Reserve Bank of Cleveland’s Credit Risk
Management (CRM) Department. Jack and his colleagues
have played key roles in helping to shape U.S. central
bank discount window lending and collateral policies
and procedures. CRM staff administer Fourth District
discount window lending (specifically, the primary,
secondary, seasonal, and emergency credit programs) and
collateral activities; oversee depository institution access
to daylight and overnight credit; and administer reserve
requirements. With the assistance of the Banking Supervision and Regulation Department, CRM monitors the
financial condition of the 1,152 institutions in the Fourth
District to determine their eligibility for participation in
the discount window primary credit and TAF programs
and to administer daylight credit.
The Fourth District discount window and its related
programs are in good hands. But what does the future
hold? Will the TAF continue to complement the window
as a permanent fixture of monetary policy? Early reports
suggest that the TAF has been successful, but time will
provide the true test. For now, we in the Fourth District
financial community look to the discount window to
be our financial bridge, to remain flexible and strong, to
offer support during times of transition, and to present an
alternative route when disruptions block our way.

References
Artuç, Erhan, and Selva Demiralp. 2007. “Discount Window
Borrowing after 2003: The Explicit Reduction in Implicit Costs.”
TÜSIAD-Koç University, Economic Research Forum Working Papers
(October): 4.
Board of Governors of the Federal Reserve System. 2001.
Press release, September 11. www.federalreserve.gov/boarddocs/press
/general/2001/20010911/default.htm
Broaddus Jr., J. Alfred. 2000. “Market Discipline and
Fed Lending.” Remarks, 36th Annual Conference on Bank
Structure and Competition, Chicago, IL (May 5).
Clouse, James A. 1994. “Recent Developments in Discount
Window Policy.” Federal Reserve Bulletin (November): 965.
Ferguson, Roger A. 2003. “September 11, the Federal
Reserve, and the Financial System.” Remarks, Vanderbilt
University, Nashville, TN (February 5).
Hakkio, Craig S., and Gordon H. Sellon Jr. 2000. “The
Discount Window: Time for Reform?” Federal Reserve Bank of
Kansas City, Economic Review (Second Quarter): 10–11.
Marshall, David. 2002. “Origins of the Use of Treasury Debt in
Open Market Operations: Lessons for the Present.” Federal Reserve
Bank of Chicago, Economic Perspectives (First Quarter): 45–52.
Schlesinger, Tom. 2001. “Discount Window Liquidity for the
Airlines.” Financial Markets Center (September 18): 1.
Shull, Bernard. 1971. “Report on Research Undertaken in
Connection with a System Study.” In Reappraisal of the Federal
Reserve Discount Mechanism, Board of Governors of the Federal
Reserve System (August): 39–40.

28 | 2007

ANNUAL REPORT

Each member bank is required to hold stock in its regional Federal Reserve
Bank. The stock cannot be sold, traded, or pledged as collateral for loans.
As speciﬁed by law, member banks receive a 6 percent annual dividend
on their Federal Reserve Bank stock.

Auditor Independence
The firm engaged by the Board of Governors for the audits of the individual and combined financial statements of the
Reserve Banks for 2007 was Deloitte & Touche LLP (D&T). Fees for these services totaled $4.7 million. To ensure
auditor independence, the Board of Governors requires that D&T be independent in all matters relating to the audit.
Specifically, D&T may not perform services for the Reserve Banks or others that would place it in a position of auditing
its own work, making management decisions on behalf of the Reserve Banks, or in any other way impairing its audit
independence. In 2007, the Bank did not engage D&T for any material advisory services.

Management’s Report on Internal Control
over Financial Reporting
To the Board of Directors of the Federal Reserve Bank of Cleveland:

The management of the Federal Reserve Bank of Cleveland (“FRB Cleveland”) is responsible for the preparation and fair
presentation of the Statement of Financial Condition, Statement of Income and Comprehensive Income, and Statement of
Changes in Capital as of December 31, 2007 (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 (“Manual”), and as such,
include amounts, some of which are based on management judgments and estimates. To our knowledge, the Financial
Statements are, in all material respects, fairly presented in conformity with the accounting principles, policies, and practices
documented in the Manual and include all disclosures necessary for such fair presentation.
The management of the FRB Cleveland is responsible for establishing and maintaining effective internal control over
financial reporting as it relates to the Financial Statements. Such internal control is designed to provide reasonable assurance
to management and to the Board of Directors regarding the preparation of the Financial Statements in accordance with the
Manual. Internal control contains self-monitoring mechanisms, including, but not limited to, divisions of responsibility and
a code of conduct. Once identified, any material deficiencies in internal control are reported to management and appropriate
corrective measures are implemented.
Even effective internal control, no matter how well designed, has inherent limitations, including the possibility of human error,
and therefore can provide only reasonable assurance with respect to the preparation of reliable financial statements. Also,
projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate
because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
The management of the FRB Cleveland assessed its internal control over financial reporting 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. Based on this assessment, we believe that the FRB Cleveland maintained effective
internal control over financial reporting as it relates to the Financial Statements.

Federal Reserve Bank of Cleveland
March 20, 2008

Sandra Pianalto
President & Chief Executive Officer

R. Chris Moore
First Vice President &
Chief Operating Officer

Gregory L. Stefani
Senior Vice President &
Chief Financial Officer

Federal Reserve Bank of Cleveland

| 31

report of Independent auditors

To the Board of Governors of the Federal reserve system
and the Board of directors of the Federal reserve Bank of Cleveland:
We have audited the accompanying statement of condition of the Federal reserve Bank of Cleveland (“FrB Cleveland”)
as of december 31, 2007 and the related statements of income and comprehensive income and changes in capital for
the year then ended, which have been prepared in conformity with accounting principles established by the Board of
Governors of the Federal reserve system. We also have audited the internal control over financial reporting of the FrB
Cleveland as of december 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the
Committee of sponsoring organizations of the Treadway Commission. The FrB Cleveland’s management is responsible
for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment
of the effectiveness of internal control over financial reporting, included in the accompanying Management’s report on
Internal Control over Financial reporting. our responsibility is to express an opinion on these financial statements and
an opinion on the FrB Cleveland’s internal control over financial reporting based on our audit. The financial statements
of the FrB Cleveland for the year ended december 31, 2006 were audited by other auditors whose report, dated March
12, 2007, expressed an unqualified opinion on those statements.
We conducted our audit in accordance with the standards of the Public Company accounting oversight Board (United
states). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement and whether effective internal control over financial reporting was
maintained in all material respects. our audit of the financial statements included examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant
estimates made by management, and evaluating the overall financial statement presentation. our audit of internal control
over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk
that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based
on the assessed risk. our audit also included performing such other procedures as we considered necessary in the circumstances.
We believe that our audit provides a reasonable basis for our opinions.

Member of
Deloitte Touche Tohmatsu

32 | 2007

annUal rePorT

The FrB Cleveland’s internal control over financial reporting is a process designed by, or under the supervision of, the
FrB Cleveland’s principal executive and principal financial officers, or persons performing similar functions, and effected
by the FrB Cleveland’s board of directors, management, and other personnel to provide reasonable assurance regarding
the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with the
accounting principles established by the Board of Governors of the Federal reserve system. The FrB Cleveland’s internal
control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in
reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the FrB Cleveland; (2) provide
reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance
with the accounting principles established by the Board of Governors of the Federal reserve system, and that receipts and
expenditures of the FrB Cleveland are being made only in accordance with authorizations of management and directors
of the FrB Cleveland; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use, or disposition of the FrB Cleveland’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion
or improper management override of controls, material misstatements due to error or fraud may not be prevented or
detected on a timely basis. also, projections of any evaluation of the effectiveness of the internal control over financial
reporting to future periods are subject to the risk that the controls may become inadequate because of changes in
conditions, or that the degree of compliance with the policies or procedures may deteriorate.
as described in note 3 to the financial statements, the FrB Cleveland has prepared these financial statements in conformity
with accounting principles established by the Board of Governors of the Federal reserve system, as set forth in the Financial
Accounting Manual for Federal Reserve Banks, which is a comprehensive basis of accounting other than accounting principles
generally accepted in the United states of america. The effects on such financial statements of the differences between the
accounting principles established by the Board of Governors of the Federal reserve system and accounting principles generally
accepted in the United states of america are also described in note 3.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of
the FrB Cleveland as of december 31, 2007, and the results of its operations for the year then ended, on the basis of
accounting described in note 3. also, in our opinion, the FrB Cleveland maintained, in all material respects, effective
internal control over financial reporting as of december 31, 2007, based on the criteria established in Internal Control Integrated Framework issued by the Committee of sponsoring organizations of the Treadway Commission.

March 20, 2008

Federal reserve Bank oF Cleveland

| 33

PricewaterhouseCoopers LLP
PricewaterhouseCoopers Center
300 Madison Avenue
New York NY 10017
Telephone (646) 471 3000
Facsimile (813) 286 6000

Report of Independent Auditors

To the Board of Governors of the Federal Reserve System
and the Board of Directors of the Federal Reserve Bank of Cleveland:
We have audited the accompanying statement of condition of the Federal Reserve Bank of Cleveland (the “Bank”) as of
December 31, 2006, and the related statement of income and comprehensive income and statement of changes in capital
for the year then ended, which have been prepared in conformity with the accounting principles, policies, and practices
established by the Board of Governors of the Federal Reserve System. These financial statements are the responsibility of
the Bank’s management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards as established by the Auditing Standards Board
(United States) and in accordance with the auditing standards of the Public Company Accounting Oversight Board (United
States). 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, assessing the accounting principles used and significant estimates made by management,
and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
As described in Note 3, these financial statements were prepared in conformity with the accounting 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 specialized accounting and reporting needs of the Federal Reserve System, are set forth in the
Financial Accounting Manual for Federal Reserve Banks which is a comprehensive basis of accounting other than accounting
principles generally accepted in the United States of America.
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, 2006, and the results of its operations for the year then ended, on the basis of accounting
described in Note 3.

March 12, 2007

34 | 2007

ANNUAL REPORT

Comparative Financial Statements
Statements of Condition
(in millions)
December 31, 2007 December 31, 2006

ASSETS
Gold certificates
$
Special drawing rights certificates
Coin
Items in process of collection
Loans to depository institutions
Securities purchased under agreements to resell
U.S. government securities, net
Investments denominated in foreign currencies
Accrued interest receivable
Bank premises and equipment, net
Interest on Federal Reserve notes due from U.S. Treasury
Other assets

428
$
446
104
104
113
73
268
451
853
—
1,903
—
30,514 33,836
3,354 1,570
260
290
176
186
69
—
59
62

38,101

Total assets

37,018

LIABILITIES AND CAPITAL
Liabilities:
Federal Reserve notes outstanding, net
$
32,223
$ 29,807
Securities sold under agreements to repurchase
1,800 1,279
Deposits:
Depository institutions
446
954
Other deposits
3
4
Deferred credit items
200
405
Interest on Federal Reserve notes due to U.S. Treasury
—
29
Interdistrict settlement account
741 2,264
Accrued benefit costs
90
88
Other liabilities
16
14

Total liabilities

35,519 34,844

Capital:
Capital paid-in
1,291
Surplus (including accumulated other comprehensive loss
of $17 million and $22 million at December 31, 2007 and 2006,
respectively)
1,291

Total capital

Total liabilities and capital

2,582
38,101

1,087

1,087
2,174
37,018

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

Federal Reserve Bank of Cleveland

| 35

Statements of Income and Comprehensive Income
(in millions)

For the year ended
For the year ended
December 31, 2007 December 31, 2006

Interest income:
Interest on U.S. government securities
$
1,609
$
Interest on securities purchased under agreements to resell
59
Interest on investments denominated in foreign currencies
41
Interest on loans to depository institutions
1

Total interest income

1,710

Interest expense:
Interest expense on securities sold under agreements to repurchase
70

1,541
58

Net interest income

1,640

1,483

Other operating income:
Compensation received for services provided
Reimbursable services to government agencies
Foreign currency gains, net
Other income

80
62
132
6

Total other operating income

280

68
60
91
4
223

Operating expenses:
Salaries and other benefits
128
Occupancy expense
17
Equipment expense
13
Assessments by the Board of Governors
47
Other expenses
79

112
16
14
46
80

Total operating expenses

284

268

Net income prior to distribution

1,636

1,438

Change in funded status of benefit plans

—

1,438

Distribution of comprehensive income:
Dividends paid to member banks
$
66
$
Transferred to surplus and change in accumulated other comprehensive loss
204
Payments to U.S. Treasury as interest on Federal Reserve notes
1,371

63
95
1,280

Comprehensive income prior to distribution

Total distribution

1,641

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

36 | 2007

1,512
—
29
—

ANNUAL REPORT

1,438

Statements of Changes in Capital
(in millions)
For the years ended December 31, 2007 and December 31, 2006

Surplus

Accumulated
Other
Net Income
Comprehensive

Capital Paid-In Retained Loss

Total Surplus

Total Capital

Balance at January 1, 2006
(20.3 million shares)

2,028

1,014

—

1,014

Net change in capital stock issued
(1.4 million shares)

—

Transferred to surplus

—

Adjustment to initially apply SFAS
No. 158

—

(22)

Balance at December 31, 2006
(21.7 million shares)

1,087

1,109

(22)

1,087

2,174

Net change in capital stock issued
(4.1 million shares)

204

—

204

Transferred to surplus and change in
accumulated other comprehensive loss

—

199

204

Balance at December 31, 2007
(25.8 million shares)

1,291

1,308

(17)

1,291

2,582

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

Federal Reserve Bank of Cleveland

| 37

Notes to Financial Statements

1. STRUCTURE
The Federal Reserve Bank of Cleveland (“Bank”) is part of the Federal Reserve System (“System”) and one of the twelve Reserve Banks (“Reserve Banks”) created
by Congress under the Federal Reserve Act of 1913 (“Federal Reserve Act”), which established the central bank of the United States. The Reserve Banks are
chartered by the federal government and possess a unique set of governmental, corporate, and central bank characteristics. The Bank and its branches in
Cincinnati and Pittsburgh serve the Fourth Federal Reserve District, which includes Ohio and portions of Kentucky, Pennsylvania, and West Virginia.
In accordance with the Federal Reserve Act, supervision and control of the Bank is exercised by a 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 directors,
including those designated as chairman and deputy chairman, are appointed by the Board of Governors of the Federal Reserve System (“Board of Governors”)
to represent the public, and six directors are elected by member banks. Banks that are members of the System include all national banks and any state-chartered
banks that apply and are approved for membership in the System. 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.
The System also consists, in part, of the Board of Governors and the Federal Open Market Committee (“FOMC”). The Board of Governors, an independent
federal agency, is charged by the Federal Reserve Act with a number of specific duties, including general supervision over the Reserve Banks. The FOMC is
composed of members of the Board of Governors, the president of the Federal Reserve Bank of New York (“FRBNY”), and on a rotating basis four other
Reserve Bank presidents.

2. OPERATIONS AND SERVICES
The Reserve Banks perform a variety of services and operations. Functions include participation in formulating and conducting monetary policy; participation
in the payments system, including large-dollar transfers of funds, automated clearinghouse (“ACH”) operations, and check collection; distribution of coin and
currency; performance of fiscal agency functions for the U.S. Treasury, certain federal agencies, and other entities; serving as the federal government’s bank;
provision of short-term loans to depository institutions; service to the consumer and the community by providing educational materials and information
regarding consumer laws; and supervision of bank holding companies, state member banks, and U.S. offices of foreign banking organizations. Certain services
are provided to foreign and international monetary authorities, primarily by the FRBNY.
The FOMC, in the conduct of monetary policy, establishes policy regarding domestic open market operations, oversees these operations, and annually
issues authorizations and directives to the FRBNY for its execution of transactions. The FRBNY is authorized and directed by the FOMC to conduct
operations in domestic markets, including the direct purchase and sale of U.S. government securities, the purchase of securities under agreements to resell,
the sale of securities under agreements to repurchase, and the lending of U.S. government securities. The FRBNY executes these open market transactions
at the direction of the FOMC and holds the resulting securities and agreements in the portfolio known as the System Open Market Account (“SOMA”).
In addition to authorizing and directing operations in the domestic securities market, 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 to meet other needs specified by the FOMC
in carrying out the System’s central bank responsibilities. The FRBNY is authorized by the FOMC to hold balances of, and to execute spot and forward
foreign exchange (“FX”) and securities contracts for, nine foreign currencies and to invest such foreign currency holdings ensuring adequate liquidity is
maintained. The FRBNY is authorized and directed by the FOMC to maintain reciprocal currency arrangements (“FX swaps”) with four central banks and
“warehouse” foreign currencies for the U.S. Treasury and Exchange Stabilization Fund (“ESF”) through the Reserve Banks. In connection with its foreign
currency activities, the FRBNY may enter into transactions that contain varying degrees of off-balance-sheet market risk that results from their future
settlement and counter-party credit risk. The FRBNY controls credit risk by obtaining credit approvals, establishing transaction limits, and performing
daily monitoring procedures.
Although the Reserve Banks are separate legal entities, in the interests of greater efficiency and effectiveness they collaborate in the delivery of certain operations and
services. The collaboration takes the form of centralized operations and product or function offices that have responsibility for the delivery of certain services on
behalf of the Reserve Banks. Various operational and management models are used and are supported by service agreements between the Reserve Bank providing
the service and the other eleven Reserve Banks. In some cases, costs incurred by a Reserve Bank for services provided to other Reserve Banks are not shared; in
other cases, the Reserve Banks are billed for services provided to them by another Reserve Bank.
Major services provided on behalf of the System by the Bank, for which the costs were not redistributed to the other Reserve Banks, include National Check
Adjustments, Check Restructuring Projects, Retail Payments Office, National Check Automation Services, Treasury Retail Services Technology, Check 21
Technology, Cash Technology, National Billing Operations, and Audit Application Competency Center Services.

38 | 2007

ANNUAL REPORT

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 accounting
standard-setting bodies. The Board of Governors has developed specialized accounting principles and practices that it considers to be appropriate for the
nature and function of a central bank, which differ significantly from those of 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 of the Reserve Banks are required to adopt and apply accounting policies and practices that are consistent with the Financial Accounting Manual and the financial
statements have been prepared in accordance with the Financial Accounting Manual.
Differences exist between the accounting principles and practices in the Financial Accounting Manual and generally accepted accounting principles in the
United States (“GAAP”), primarily due to the unique nature of the Bank’s powers and responsibilities as part of the nation’s central bank. The primary difference
is the presentation of all securities holdings at amortized cost, rather than using the fair value presentation required by GAAP. U.S. government securities and
investments denominated in foreign currencies 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. Amortized cost more appropriately reflects the Bank’s securities holdings given the System’s unique responsibility
to conduct monetary policy. While the application of current market prices to the securities holdings 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 Bank earnings or capital. Both the domestic and foreign components of the SOMA portfolio may involve transactions that result in gains or losses when
holdings are sold prior to maturity. Decisions regarding securities and foreign currency transactions, including their purchase and sale, are motivated by monetary
policy objectives rather than profit. Accordingly, market values, earnings, and any gains or losses resulting from the sale of such securities and currencies are
incidental to the open market operations and do not motivate decisions related to policy or open market activities.
In addition, the Bank has elected not to present a Statement of Cash Flows because the liquidity and cash position of the Bank are not a primary concern given
the Reserve Banks’ unique powers and responsibilities. A Statement of Cash Flows, therefore, would not provide additional meaningful information. Other
information regarding the Bank’s activities is provided in, or may be derived from, the Statements of Condition, Income and Comprehensive Income, and
Changes in Capital. 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 reported amounts of assets and liabilities, the 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 significant
accounting policies are explained below.

a. Gold and Special Drawing Rights Certificates
The Secretary of the U.S. Treasury is authorized to issue gold and special drawing rights (“SDR”) certificates to the Reserve Banks.
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. The 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 reduced. The value of gold for purposes of backing the gold certificates is set by law at $42 2/9 a fine troy
ounce. The Board of Governors allocates the gold certificates among Reserve Banks once a year based on the average Federal Reserve notes outstanding
in each Reserve Bank.
SDR certificates 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. SDR certificates 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 participation in the SDR system, the Secretary of the U.S. Treasury is authorized to issue SDR
certificates somewhat like gold certificates to the Reserve Banks. When SDR certificates are issued to the Reserve Banks, 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 SDR certificates, at the direction of the U.S. Treasury, for the purpose of financing SDR acquisitions or for financing exchange
stabilization operations. At the time SDR transactions occur, the Board of Governors allocates SDR certificate transactions among Reserve Banks based
upon each Reserve Bank’s Federal Reserve notes outstanding at the end of the preceding year. There were no SDR transactions in 2007 or 2006.

b. Loans to Depository Institutions
Depository institutions that maintain reservable transaction accounts or nonpersonal time deposits, as defined in regulations issued by the Board
of Governors, have borrowing privileges at the discretion of the Reserve Bank. Borrowers execute certain lending agreements and deposit sufficient
collateral before credit is extended. The Bank offers three discount window programs to depository institutions: primary credit, secondary credit, and
seasonal credit, each with its own interest rate. Interest is accrued using the applicable discount rate established at least every fourteen days by the board
of directors of the Reserve Bank, subject to review and determination by the Board of Governors.
In addition, depository institutions that are eligible to borrow under the Reserve Bank’s primary credit program are also eligible to participate in the
temporary Term Auction Facility (“TAF”) program. Under the TAF program, the Reserve Banks conduct auctions for a fixed amount of funds, with the
interest rate determined by the auction process, subject to a minimum bid rate. All advances under the TAF must be fully collateralized.
Outstanding loans are evaluated for collectibility, and currently all are considered collectible and fully collateralized. If loans were ever deemed to be
uncollectible, an appropriate reserve would be established.

Federal Reserve Bank of Cleveland

| 39

c. U.S. Government Securities and Investments Denominated in Foreign Currencies
Interest income on U.S. government securities and investments denominated in foreign currencies comprising the SOMA is accrued on a straight-line basis.
Gains and losses resulting from sales of securities are determined by specific issues based on average cost. Foreign-currency-denominated assets are revalued
daily at current foreign currency 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 gains, net” in the Statements of Income and Comprehensive Income.
Activity related to U.S. government securities, including the premiums, discounts, and realized and unrealized gains and losses, is allocated to each Reserve Bank on
a percentage basis derived from an annual settlement of the interdistrict settlement account that occurs in April of each year. The settlement also equalizes Reserve
Bank gold certificate holdings to Federal Reserve notes outstanding in each District. Activity related to investments denominated in foreign currencies is allocated to
each Reserve Bank based on the ratio of each Reserve Bank’s capital and surplus to aggregate capital and surplus at the preceding December 31.

d. Securities Purchased Under Agreements to Resell, Securities Sold Under Agreements to Repurchase, and Securities Lending
The FRBNY may engage in tri-party purchases of securities under agreements to resell (“tri-party agreements”). Tri-party agreements are conducted with two
commercial custodial banks that manage the clearing and settlement of collateral. Collateral is held in excess of the contract amount. Acceptable collateral under triparty agreements primarily includes U.S. government securities, pass-through mortgage securities of the Government National Mortgage Association, Federal Home
Loan Mortgage Corporation, and Federal National Mortgage Association, STRIP securities of the U.S. Government, and “stripped” securities of other government
agencies. The tri-party agreements are accounted for as financing transactions, with the associated interest income accrued over the life of the agreement.
Securities sold under agreements to repurchase are accounted for as financing transactions and the associated interest expense is recognized over the life
of the transaction. These transactions are reported in the Statements of Condition at their contractual amounts and the related accrued interest payable is
reported as a component of “Other liabilities.”
U.S. government securities held in the SOMA are lent to U.S. government securities dealers in order to facilitate the effective functioning of the domestic securities
market. Securities-lending transactions are fully collateralized by other U.S. government securities and the collateral taken is in excess of the market value of the securities
loaned. The FRBNY charges the dealer a fee for borrowing securities and the fees are reported as a component of “Other income.”
Activity related to securities sold under agreements to repurchase and securities lending is allocated to each of the Reserve Banks on a percentage basis derived from
an annual settlement of the interdistrict settlement account. On February 15, 2007, the FRBNY began allocating to the other Reserve Banks the activity related to
securities purchased under agreements to resell.

e. FX Swap Arrangements and Warehousing Agreements
FX swap arrangements are contractual agreements between two parties, the FRBNY and an authorized foreign central bank, whereby the parties agree to
exchange their currencies up to a prearranged 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 temporary access to the foreign currencies it may need to support its international operations and give the authorized foreign
central bank temporary access to dollars. Drawings under the FX swap arrangements can be initiated by either party and must be agreed to by the other party. The
FX swap arrangements are structured so that the party initiating the transaction bears the exchange rate risk upon maturity. Foreign currencies received pursuant
to these agreements are reported as a component of “Investments denominated in foreign currencies” in the Statements of Condition.
Warehousing is an arrangement under which the FOMC agrees to exchange, at the request of the U.S. Treasury, U.S. dollars for foreign currencies held by the U.S.
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 U.S. Treasury and ESF for
financing purchases of foreign currencies and related international operations.
FX swap arrangements and warehousing agreements are revalued daily at current market exchange rates. Activity related to these agreements, with the exception of
the unrealized gains and losses resulting from the daily revaluation, is allocated to each Reserve Bank based on the ratio of each Reserve Bank’s capital and surplus
to aggregate capital and surplus at the preceding December 31. Unrealized gains and losses resulting from the daily revaluation are recorded by FRBNY and not
allocated to the other Reserve Banks.

f. Bank Premises, Equipment, and Software
Bank premises and equipment are stated at cost less accumulated depreciation. Depreciation is calculated on a straight-line basis over the estimated useful lives of
the assets, which range from two to fifty years. Major alterations, renovations, and improvements are capitalized at cost as additions to the asset accounts and are
depreciated over the remaining useful life of the asset or, if appropriate, over the unique useful life of the alteration, renovation, or improvement. Maintenance,
repairs, and minor replacements are charged to operating expense in the year incurred.
Costs incurred for software during the application development stage, either developed internally or acquired for internal use, are capitalized based on the cost
of direct services and materials associated with designing, coding, installing, or testing software. Capitalized software costs are amortized on a straight-line basis
over the estimated useful lives of the software applications, which range from two to five years. Maintenance costs related to software are charged to expense
in the year incurred.
Capitalized assets including software, buildings, leasehold improvements, furniture, and equipment are impaired when events or changes in circumstances indicate
that the carrying amount of assets or asset groups is not recoverable and significantly exceeds their fair value.

40 | 2007

ANNUAL REPORT

g. Interdistrict Settlement Account
At the close of business each day, each Reserve Bank assembles the payments due to or from other Reserve Banks. These payments result from transactions
between Reserve Banks and transactions that involve depository institution accounts held by other Reserve Banks, such as Fedwire funds and securities
transfers, and check and ACH transactions. The cumulative net amount due to or from the other Reserve Banks is reflected in the “Interdistrict settlement
account” in the Statements of Condition.

h. Federal Reserve Notes
Federal Reserve notes are the circulating currency of the United States. These notes are issued through the various Federal Reserve agents (the chairman of the board
of directors of each Reserve Bank and their designees) to the Reserve Banks upon deposit with such agents of specified 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 at least equal to the sum of the notes applied for by such Reserve Bank.
Assets eligible to be pledged as collateral security include all of the Bank’s assets. The collateral value is equal to the book value of the collateral tendered, with the
exception of securities, for which the collateral value is equal to the par value of the securities tendered. The par value of securities pledged for securities sold under
agreements to repurchase is deducted.
The Board of Governors may, at any time, call upon a Reserve Bank for additional security to adequately collateralize the Federal Reserve notes. To satisfy the
obligation to provide sufficient collateral for outstanding Federal Reserve notes, the Reserve Banks have entered into an agreement that provides for certain assets
of the Reserve Banks to be jointly pledged as collateral for the Federal Reserve notes issued to all Reserve Banks. 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, Federal Reserve notes are
obligations of the United States government. At December 31, 2007, all Federal Reserve notes issued to the Reserve Banks were fully collateralized.
“Federal Reserve notes outstanding, net” in the Statements of Condition represents the Bank’s Federal Reserve notes outstanding, reduced by the Bank’s currency
holdings of $7,130 million and $6,709 million at December 31, 2007 and 2006, respectively.

i. Items in Process of Collection and Deferred Credit Items
Items in process of collection in the Statements of Condition primarily represents amounts attributable to checks that have been deposited for collection
and that, as of the balance sheet date, have not yet been presented to the paying bank. Deferred credit items are the counterpart liability to items in process
of collection, and the amounts in this account arise from deferring credit for deposited items until the amounts are collected. The balances in both accounts
can vary significantly.

j. 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. These shares are nonvoting with a par value of $100 and may not be transferred or hypothecated. As a member bank’s
capital and surplus changes, its holdings of Reserve Bank stock must be adjusted. Currently, only one-half of the subscription is paid-in and the remainder
is subject to call. A member bank is liable for Reserve Bank liabilities up to twice the par value of stock subscribed by it.
By law, each Reserve Bank is required to pay each member bank an annual dividend of 6 percent on the paid-in capital stock. This cumulative dividend
is paid semiannually. To reflect the Federal Reserve Act requirement that annual dividends are deducted from net earnings, dividends are presented as a
distribution of comprehensive income in the Statements of Income and Comprehensive Income.

k. Surplus
The Board of Governors requires the Reserve Banks to maintain a surplus equal to the amount of capital paid-in as of December 31 of each year. 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.
Accumulated other comprehensive income is reported as a component of surplus in the Statements of Condition and the Statements of Changes in Capital. The
balance of accumulated other comprehensive income is comprised of expenses, gains, and losses related to defined benefit pension plans and other postretirement
benefit plans that, under accounting standards, are included in other comprehensive income but excluded from net income. Additional information regarding the
classifications of accumulated other comprehensive income is provided in Notes 9 and 10.
The Bank initially applied the provisions of SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, at December
31, 2006. This accounting standard requires recognition of the overfunded or underfunded status of a defined benefit postretirement plan in the Statements of
Condition, and recognition of changes in the funded status in the years in which the changes occur through comprehensive income. The transition rules for
implementing the standard required applying the provisions as of the end of the year of initial implementation, and the effect as of December 31, 2006, is recorded
as “Adjustment to initially apply SFAS No. 158” in the Statements of Changes in Capital.

Federal Reserve Bank of Cleveland

| 41

l. Interest on Federal Reserve Notes
The Board of Governors requires the Reserve Banks to transfer excess earnings to the U.S. Treasury as interest on Federal Reserve notes, after providing for
the costs of operations, payment of dividends, and reservation of an amount necessary to equate surplus with capital paid-in. This amount is reported as
“Payments to U.S. Treasury as interest on Federal Reserve notes” in the Statements of Income and Comprehensive Income and is reported as a liability, or as
an asset if overpaid during the year, in the Statements of Condition. Weekly payments to the U.S. Treasury may vary significantly.
In the event of losses or an increase in capital paid-in at a Reserve Bank, payments to the U.S. Treasury are suspended and earnings are retained until the
surplus is equal to the capital paid-in.
In the event of a decrease in capital paid-in, the excess surplus, after equating capital paid-in and surplus at December 31, is distributed to the U.S. Treasury
in the following year.

m. Income and Costs Related to U.S. 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. During the years ended December 31, 2006 and 2007, the Bank was reimbursed for all services
provided to the Department of the Treasury.

n. Compensation Received for Services Provided
The Federal Reserve Bank of Atlanta (“FRBA”) has overall responsibility for managing the Reserve Banks’ provision of check and ACH services to depository
institutions, and, as a result, recognizes total System revenue for these services on its Statements of Income and Comprehensive Income. Similarly, the FRBNY
manages the Reserve Banks’ provision of Fedwire funds and securities transfer services, and recognizes total System revenue for these services on its Statements
of Income and Comprehensive Income. The FRBA and FRBNY compensate the other Reserve Banks for the costs incurred to provide these services. The Bank
reports this compensation as “Compensation received for services provided” in the Statements of Income and Comprehensive Income.

o. Assessments by the Board of Governors
The Board of Governors assesses the Reserve Banks to fund its operations based on each Reserve Bank’s capital and surplus balances as of December 31 of the prior
year. The Board of Governors also assesses each Reserve Bank for the expenses incurred for the U.S. Treasury to prepare and retire Federal Reserve notes based on
each Reserve Bank’s share of the number of notes comprising the System’s net liability for Federal Reserve notes on December 31 of the prior year.

p. Taxes
The Reserve Banks are exempt from federal, state, and local taxes, except for taxes on real property. The Bank’s real property taxes were $2 million for each
of the years ended December 31, 2007 and 2006, and are reported as a component of “Occupancy expense.”

q. Restructuring Charges
The Reserve Banks recognize restructuring charges for exit or disposal costs incurred as part of the closure of business activities in a particular location, the relocation
of business activities from one location to another, or a fundamental reorganization that affects the nature of operations. Restructuring charges may include costs
associated with employee separations, contract terminations, and asset impairments. Expenses are recognized in the period in which the Bank commits to a
formalized restructuring plan or executes the specific actions contemplated in the plan and all criteria for financial statement recognition have been met.
Note 11 describes the Bank’s restructuring initiatives and provides information about the costs and liabilities associated with employee separations and contract
terminations. The costs associated with the impairment of certain of the Bank’s assets are discussed in Note 6. Costs and liabilities associated with enhanced pension
benefits in connection with the restructuring activities for all of the Reserve Banks are recorded on the books of the FRBNY.

r. Recently Issued Accounting Standards
In September, 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS No. 157”). SFAS No. 157 establishes a single authoritative
definition of fair value, sets out a framework for measuring fair value, and expands on required disclosures about fair value measurement. SFAS No. 157
is generally effective for the Bank on January 1, 2008, though the effective date of some provisions is January 1, 2009. The provisions of SFAS No. 157
will be applied prospectively and are not expected to have a material effect on the Bank’s financial statements.

42 | 2007

ANNUAL REPORT

4. U.S. GOVERNMENT SECURITIES, SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL, SECURITIES

SOLD UNDER AGREEMENTS TO REPURCHASE, AND SECURITIES LENDING
The FRBNY, on behalf of the Reserve Banks, holds securities bought outright in the SOMA. The Bank’s allocated share of SOMA balances was approximately
4.092 percent and 4.318 percent at December 31, 2007 and 2006, respectively.
The Bank’s allocated share of U.S. government securities, net, held in the SOMA at December 31, was as follows (in millions):

Par value:

U.S. government:
Bills
$
Notes
Bonds
Total par value

Unamortized premiums

Unaccreted discounts
Total allocated to the Bank
$

2007

9,324
$
16,442
4,542
30,308
327
(121)
30,514
$

2006

11,961
17,374
4,298
33,633
376
(173)
33,836

At December 31, 2007 and 2006, the fair value of the U.S. government securities allocated to the Bank, excluding accrued interest, was $31,803 million
and $34,367 million, respectively, as determined by reference to quoted prices for identical securities.
The total of the U.S. government securities, net, held in the SOMA was $745,629 million and $783,619 million at December 31, 2007 and 2006, respectively.
At December 31, 2007 and 2006, the fair value of the U.S. government securities held in the SOMA, excluding accrued interest, was $777,141 million
and $795,900 million, respectively, as determined by reference to quoted prices for identical securities.
Although the fair value of security holdings can be substantially greater or less than the recorded value at any point in time, these unrealized gains or losses
have no effect on the ability of the Reserve Banks, as central bank, to meet their financial obligations and responsibilities, and should not be misunderstood
as representing a risk to the Reserve Banks, their shareholders, or the public. The fair value is presented solely for informational purposes.
Financial information related to securities purchased under agreements to resell and securities sold under agreements to repurchase for the year ended
December 31, 2007, was as follows (in millions):
Securities Purchased Under Securities Sold Under
Agreements to Resell Agreements to Repurchase

Allocated to the Bank:
Contract amount outstanding, end of year
$
Weighted average amount outstanding, during the year
Maximum month-end balance outstanding, during the year
Securities pledged, end of year

1,903
$
1,435
2,108
—

1,800
1,426
1,800
1,803

System total:
Contract amount outstanding, end of year
$
Weighted average amount outstanding, during the year
Maximum month-end balance outstanding, during the year
Securities pledged, end of year

46,500
$
35,073
51,500
—

43,985
34,846
43,985
44,048

At December 31, 2006, the total contract amount of securities sold under agreements to repurchase was $29,615 million, of which $1,279 million was
allocated to the Bank. The total par value of SOMA securities that were pledged for securities sold under agreements to repurchase at December 31, 2006,
was $29,676 million, of which $1,281 million was allocated to the Bank.
The contract amounts for securities purchased under agreements to resell and securities sold under agreements to repurchase approximate fair value.
The maturity distribution of U.S. government securities bought outright, securities purchased under agreements to resell, and securities sold under agreements
to repurchase that were allocated to the Bank at December 31, 2007, was as follows (in millions):
Securities Purchased Under Securities Sold Under
U.S. Government Securities Agreements to Resell Agreements to Repurchase
(Par value)
(Contract amount)
(Contract amount)

Within 15 days
$
16 days to 90 days
91 days to 1 year
Over 1 year to 5 years
Over 5 years to 10 years
Over 10 years
Total allocated to the Bank
$

1,117
$
6,127
6,231
9,845
3,353
3,635
30,308
$

1,903
$
—
—
—
—
—
1,903
$

1,800
—
—
—
—
—
1,800

At December 31, 2007 and 2006, U.S. government securities with par values of $16,649 million and $6,855 million, respectively, were loaned from the
SOMA, of which $681 million and $296 million, respectively, were allocated to the Bank.

Federal Reserve Bank of Cleveland

| 43

5. INVESTMENTS DENOMINATED IN FOREIGN CURRENCIES
The FRBNY, on behalf of the Reserve Banks, holds foreign currency deposits with foreign central banks and with the Bank for International Settlements
and invests in foreign government debt instruments. Foreign government debt instruments held include both securities bought outright and securities
purchased under agreements to resell. These investments are guaranteed as to principal and interest by the issuing foreign governments.
The Bank’s allocated share of investments denominated in foreign currencies was approximately 7.091 percent and 7.663 percent at December 31, 2007
and 2006, respectively.
The Bank’s allocated share of investments denominated in foreign currencies, including accrued interest, valued at foreign currency market exchange rates
at December 31, was as follows (in millions):

2007

2006

European Euro:
Foreign currency deposits
$
Securities purchased under agreements to resell
Government debt instruments

1,949
$
181
331

478
170
312

Japanese Yen:
Foreign currency deposits
Government debt instruments

199
405

200
410

Swiss Franc:
Foreign currency deposits

Total allocated to the Bank

289
3,354

—
1,570

At December 31, 2007, the total amount of foreign currency deposits held under FX contracts was $24,381 million, of which $1,729 million was allocated
to the Bank. At December 31, 2006, there were no open foreign exchange contracts.
At December 31, 2007 and 2006, the fair value of investments denominated in foreign currencies, including accrued interest, allocated to the Bank was
$3,352 million and $1,566 million, respectively. The fair value of government debt instruments was determined by reference to quoted prices for identical
securities. The cost basis of foreign currency deposits and securities purchased under agreements to resell, adjusted for accrued interest, approximates fair
value. Similar to the U.S. government securities discussed in Note 4, unrealized gains or losses have no effect on the ability of a Reserve Bank, as central
bank, to meet its financial obligations and responsibilities.
Total System investments denominated in foreign currencies were $47,295 million and $20,482 million at December 31, 2007 and 2006, respectively.
At December 31, 2007 and 2006, the fair value of the total System investments denominated in foreign currencies, including accrued interest, was
$47,274 million and $20,434 million, respectively.
The maturity distribution of investments denominated in foreign currencies that were allocated to the Bank at December 31, 2007, was as follows (in millions):
European Euro

Within 15 days
$
16 days to 90 days
91 days to 1 year
Over 1 year to 5 years
Total allocated to the Bank

Japanese Yen Swiss Franc

Total

355
$
1,638
195
273

212
$
29
142
221

—
$
289
—
—

567
1,956
337
494

2,461

604

289

3,354

At December 31, 2007 and 2006, the authorized warehousing facility was $5,000 million, with no balance outstanding.

6. BANK PREMISES, EQUIPMENT, AND SOFTWARE
Bank premises and equipment at December 31 was as follows (in millions):

2007

Bank premises and equipment:
Land
$
Buildings
Building machinery and equipment
Construction in progress
Furniture and equipment

44 | 2007

2006

9
$
172
57
—
71

9
172
51
5
71

Subtotal

309

308

Accumulated depreciation

(133)

(122)

Bank premises and equipment, net

176

Depreciation expense, for the years ended December 31

ANNUAL REPORT

186
13

The Bank leases space to outside tenants with remaining lease terms ranging from one to seven years. Rental income from such leases was $1 million for
each of the years ended December 31, 2007 and 2006, and is reported as a component of “Other income.” Future minimum lease payments that the Bank
will receive under noncancelable lease agreements in existence at December 31, 2007, are as follows (in millions):

2008
$
2009
2010
2011
2012
Thereafter
Total
$

1
1
1
1
1
1
6

The Bank has capitalized software assets, net of amortization, of $26 million and $34 million at December 31, 2007 and 2006, respectively. Amortization
expense was $15 million and $18 million for the years ended December 31, 2007 and 2006, respectively. Capitalized software assets are reported as a
component of “Other assets” and the related amortization is reported as a component of “Other expenses.”
Assets impaired as a result of the Bank’s restructuring plan, as discussed in Note 11, include assets associated with legacy check processing. Asset impairment
losses of $3 million for the period ending December 31, 2007, were determined using fair values based on quoted market values or other valuation techniques
and are reported as a component of “Other expenses.” Impairment losses for the period ending December 31, 2006, were immaterial.

7. COMMITMENTS AND CONTINGENCIES
At December 31, 2007, the Bank was obligated under noncancelable leases for premises and equipment with remaining terms of approximately two years.
These leases provide for increased rental payments based upon increases in real estate taxes, operating costs, or selected price indices.
Rental expense under operating leases for certain operating facilities, warehouses, and data processing and office equipment (including taxes, insurance and
maintenance when included in rent), net of sublease rentals, was $349 thousand and $1 million for the years ended December 31, 2007 and 2006, respectively.
Future minimum rental payments under noncancelable operating leases, net of sublease rentals, with terms of one year or more, at December 31, 2007,
were not material.
At December 31, 2007, the Bank, acting on its own behalf, had unrecorded unconditional purchase commitments and long-term obligations extending
through the year 2008 with a remaining fixed commitment of $1 million. Purchases of $8 million and $11 million were made against these commitments
during 2007 and 2006, respectively. These commitments represent Electronic Treasury Financial Services and facilities-related expenditures, and have only
fixed components. The fixed payments for the next five years under these commitments are as follows (in millions):
Fixed
Commitment

2008
$
2009
2010
2011
2012

1
—
—
—
—

At December 31, 2007, the Bank, acting on behalf of the Reserve Banks, had unrecorded unconditional purchase commitments extending through the
year 2012 with a remaining fixed commitment of $41 million. Purchases of $27 million were made against these commitments during 2007 and 2006,
respectively. These commitments represent Check software and hardware, including license and maintenance fees, and have only fixed components. The
fixed payments for the next five years under these commitments are as follows (in millions):
Fixed
Commitment

2008
$
2009
2010
2011
2012

19
16
2
2
2

Under the Insurance Agreement of the Federal Reserve Banks, each of the Reserve Banks has agreed to bear, on a per incident basis, a pro rata share of losses
in excess of one 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 of a Reserve Bank’s capital paid-in to the total capital paid-in of all Reserve Banks at the beginning of the calendar year in which the loss is shared.
No claims were outstanding under the agreement at December 31, 2007 or 2006.
The Bank is involved in certain legal actions and claims arising in the ordinary course of business. Although it is difficult to predict the ultimate outcome
of these actions, in management’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 operations of the Bank.

Federal Reserve Bank of Cleveland

| 45

8. RETIREMENT AND THRIFT PLANS
Retirement Plans
The Bank currently offers three defined benefit retirement plans to its employees, based on length of service and level of compensation. Substantially all of
the Bank’s employees participate in the Retirement Plan for Employees of the Federal Reserve System (“System Plan”). Employees at certain compensation
levels participate in the Benefit Equalization Retirement Plan (“BEP”) and certain Reserve Bank officers participate in the Supplemental Employee
Retirement Plan (“SERP”).
The System Plan provides retirement benefits to employees of the Federal Reserve Banks, the Board of Governors, and the Office of Employee Benefits of
the Federal Reserve Employee Benefits System. The FRBNY, on behalf of the System, recognizes the net asset and costs associated with the System Plan in
its financial statements. Costs associated with the System Plan are not redistributed to other participating employers.
The Bank’s projected benefit obligation, funded status, and net pension expenses for the BEP and the SERP at December 31, 2007 and 2006, and for the
years then ended, were 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 $4 million for each of the years ended December 31, 2007 and 2006, and are reported as a component of “Salaries and
other benefits” in the Statements of Income and Comprehensive Income. The Bank matches employee contributions based on a specified formula. For the
years ended December 31, 2007 and 2006, the Bank matched 80 percent on the first 6 percent of employee contributions for employees with less than five
years of service and 100 percent on the first 6 percent of employee contributions for employees with five or more years of service.

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, accordingly, has no plan assets.
Following is a reconciliation of the beginning and ending balances of the benefit obligation (in millions):

Accumulated postretirement benefit obligation at January 1
$
Service cost-benefits earned during the period
Interest cost on accumulated benefit obligation
Net actuarial (gain) loss
Contributions by plan participants
Benefits paid
Medicare Part D subsidies
Accumulated postretirement benefit obligation at December 31
$

2007

2006

79.2
$
3.9
5.0
(4.0)
0.5
(3.6)
0.2
81.2
$

59.2
2.2
3.5
17.5
0.4
(3.8)
0.2
79.2

At December 31, 2007 and 2006, the weighted-average discount rate assumptions used in developing the postretirement benefit obligation were 6.25 percent
and 5.75 percent, respectively.
Discount rates reflect yields available on high-quality corporate bonds that would generate the cash flows necessary to pay the plan’s benefits when due.
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):

Fair value of plan assets at January 1
$
Contributions by the employer
Contributions by plan participants
Benefits paid, net of Medicare Part D subsidies

46 | 2007

2007

2006

—
$
2.9
0.5
(3.4)

—
3.2
0.4
(3.6)

Fair value of plan assets at December 31

—

Unfunded obligation and accrued postretirement benefit cost

81.2

79.2

Amounts included in accumulated other comprehensive
loss are shown below:
Prior service cost

5.7

8.0

Net actuarial loss

(22.6)

(30.2)

Total accumulated other comprehensive loss

(16.9)

(22.2)

ANNUAL REPORT

Accrued postretirement benefit costs are reported as a component of “Accrued benefit costs” in the Statements of Condition.
For measurement purposes, the assumed health care cost trend rates at December 31 are as follows:

Health care cost trend rate assumed for next year
Rate to which the cost trend rate is assumed to decline
(the ultimate trend rate)
Year that the rate reaches the ultimate trend rate

2007

2006

8.00%

9.00%

5.00%
2013

5.00%
2012

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, 2007 (in millions):
One Percentage One Percentage

Point Increase
Point Decrease

Effect on aggregate of service and interest cost components
of net periodic postretirement benefit costs
$
Effect on accumulated postretirement benefit obligation

1.6
$
11.4

(1.3)
(9.3)

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

Service cost-benefits earned during the period
$
Interest cost on accumulated benefit obligation
Amortization of prior service cost
Amortization of net actuarial loss
Net periodic postretirement benefit expense
$

2007

2006

3.9
$
5.0
(2.3)
3.6
10.2
$

2.2
3.5
(2.3)
1.0
4.4

Estimated amounts that will be amortized from accumulated
other comprehensive loss into net periodic postretirement
benefit expense in 2008 are shown below:
Prior service cost
$
Net actuarial loss

(2.3)
2.0

Total

(0.3)

Net postretirement benefit costs are actuarially determined using a January 1 measurement date. At January 1, 2007 and 2006, the weighted-average discount
rate assumptions used to determine net periodic postretirement benefit costs were 5.75 percent and 5.50 percent, respectively.
Net periodic postretirement benefit expense is reported as a component of “Salaries and other benefits” in the Statements of Income and Comprehensive Income.
The Medicare Prescription Drug, Improvement and Modernization Act of 2003 established a prescription drug benefit under Medicare (“Medicare Part D”)
and a federal subsidy to sponsors of retiree health care benefit plans that provide benefits that are at least actuarially equivalent to Medicare Part D. The benefits
provided under the Bank’s plan to certain participants are at least actuarially equivalent to the Medicare Part D prescription drug benefit. The estimated effects
of the subsidy, retroactive to January 1, 2004, are reflected in actuarial loss in the accumulated postretirement benefit obligation and net periodic postretirement
benefit expense.
There were no receipts of federal Medicare Part D subsidies in the year ended December 31, 2006. Receipts in the year ended December 31, 2007, related
to benefits paid in the years ended December 31, 2006 and 2007, were $0.3 million and $0.2 million, respectively. Expected receipts in 2008, related to
benefits paid in the year ended December 31, 2007, are immaterial.
Following is a summary of expected postretirement benefit payments (in millions):
Without Subsidy

With Subsidy

2008
$
2009
2010
2011
2012
2013–2017

3.9
$
4.3
4.8
5.2
5.6
34.5

3.6
4.0
4.4
4.8
5.1
31.4

Total

58.3

53.3

Postemployment Benefits
The Bank offers benefits to former or inactive employees. Postemployment benefit costs are actuarially determined using a December 31 measurement date
and include the cost of medical and dental insurance, survivor income, disability benefits, and self-insured workers’ compensation expenses. The accrued
postemployment benefit costs recognized by the Bank were $7.7 million for each of the years ended December 31, 2007 and 2006. This cost is included as a
component of “Accrued benefit costs” in the Statements of Condition. Net periodic postemployment benefit expense included in 2007 and 2006 operating
expenses were $1 million and $200 thousand, respectively, and are recorded as a component of “Salaries and other benefits” in the Statements of Income
and Comprehensive Income.

Federal Reserve Bank of Cleveland

| 47

10. ACCUMULATED OTHER COMPREHENSIVE INCOME AND OTHER COMPREHENSIVE INCOME
Following is a reconciliation of beginning and ending balances of accumulated other comprehensive loss (in millions):
Amount Related to Postretirement
Benefits Other Than Pensions

Balance at January 1, 2006
$
Adjustment to initially apply SFAS No. 158

—
(22)

Balance at December 31, 2006
$
Change in funded status of benefit plans:
Net actuarial gain arising during the year
Amortization of prior service cost
Amortization of net actuarial loss
Change in funded status of benefit plans other comprehensive income

(22)

Balance at December 31, 2007

(17)

4
(2)
3
5

Additional detail regarding the classification of accumulated other comprehensive loss is included in Note 9.

11. BUSINESS RESTRUCTURING CHARGES
2007 Restructuring Plans
In 2007, the Reserve Banks announced a restructuring initiative to align the check processing infrastructure and operations with declining check
processing volumes. The new infrastructure will involve consolidation of operations into four regional Reserve Bank processing sites in Philadelphia,
Cleveland, Atlanta, and Dallas. Additional announcements in 2007 included restructuring plans associated with Electronic Treasury Financial Services.
This restructure was a result of the U.S. Treasury initiating a Collection and Cash Management Modernization (CCMM) program.

2005 and Prior Restructuring Costs
The Bank incurred various restructuring charges prior to 2006 related to the restructuring of Check Operations.
Following is a summary of financial information related to the restructuring plans (in millions):
2005 and Prior Restructuring Plans

Information related to restructuring
plans as of December 31, 2007:
Total expected costs related to
restructuring activity
Estimated future costs related to
restructuring activity
Expected completion date
Reconciliation of liability balances:
Balance at January 1, 2006
Employee separation costs
Other costs
Payments
Balance at December 31, 2006
Employee separation costs
Payments
Balance at December 31, 2007

1.2

2007 Restructuring Plans

—
2006

2.9

Total

4.1

0.1
2009

0.1

0.9
$
(0.1)
0.4
(1.0)

—
$
—
—
—

0.9
(0.1)
0.4
(1.0)

0.2
$
—
(0.2)
—
$

—
$
2.9
—
2.9
$

0.2
2.9
(0.2)
2.9

Employee separation costs are primarily severance costs for identified staff reductions associated with the announced restructuring plans. Separation costs
that are provided under terms of ongoing benefit arrangements are recorded based on the accumulated benefit earned by the employee. Separation costs
that are provided under the terms of one-time benefit arrangements are generally measured based on the expected benefit as of the termination date and
recorded ratably over the period to termination. Restructuring costs related to employee separations are reported as a component of “Salaries and other
benefits” in the Statements of Income and Comprehensive Income.
Restructuring costs associated with the impairment of certain Bank assets, including software, buildings, leasehold improvements, furniture, and equipment, are
discussed in Note 6. Costs associated with enhanced pension benefits for all Reserve Banks are recorded on the books of the FRBNY as discussed in Note 8.

12. SUBSEQUENT EVENTS
In March 2008, the Board of Governors announced several initiatives to address liquidity pressures in funding markets and promote financial stability,
including increasing the Term Auction Facility (see Note 3b) to $100 billion and initiating a series of term repurchase transactions (see Notes 3d and 4) that
may cumulate to $100 billion. In addition, the Reserve Banks’ securities lending program (see Notes 3d and 4) was expanded to lend up to $200 billion
of Treasury securities to primary dealers for a term of 28 days, secured by federal agency debt, federal agency residential mortgage-backed securities, agency
collateralized mortgage obligations, non-agency AAA/Aaa-rated private-label residential mortgage-backed securities, and AAA/Aaa-rated commercial
mortgage-backed securities. The FOMC also authorized increases in its existing temporary reciprocal currency arrangements (see Notes 3e and 5) with
specific foreign central banks. These initiatives will affect 2008 activity related to loans to depository institutions, securities purchased under agreements to
resell, U.S. government securities, net, and investments denominated in foreign currencies, as well as income and expenses. The effects of the initiatives do
not require adjustment to the amounts recorded as of December 31, 2007.

48 | 2007

ANNUAL REPORT

There are currently 2,479 member banks nationwide (includes both
state- and nationally chartered members), with 136 in the Fourth District.
Consolidation within the banking industry over the years has led to larger
banks and fewer banks altogether. Consolidation and technical innovation
in the industry have also transformed Federal Reserve services,
in terms of both availability and delivery approaches.

Special thanks to the Federal Reserve Bank of San Francisco,
which graciously provided copies of these posters from its archives.

Officers and Consultants
As of December 31, 2007

Sandra Pianalto
President and Chief Executive Officer
R. Chris Moore
First Vice President and Chief Operating Officer
Mark S. Sniderman
Executive Vice President and Chief Policy Officer
Economic Research, Policy Analysis,
Public Affairs, Community Affairs
Lawrence Cuy
Senior Vice President
Treasury Retail Securities, eGovernment,
Information Technology
Stephen H. Jenkins
Senior Vice President
Supervision and Regulation, Credit Risk
Management, Statistics and Analysis
Robert W. Price
Senior Vice President
Retail Payments Office, National Check
Automation and Operations, National Product
Development

Ruth M. Clevenger
Vice President and Community Affairs Officer
Community Affairs
Cheryl L. Davis
Vice President and Corporate Secretary
Office of the President, Advisory Councils,
Executive Information
William D. Fosnight
Vice President and Associate General Counsel
Legal
Amy J. Heinl
Vice President
Treasury Retail Securities

Susan G. Schueller
Senior Vice President and General Auditor
Audit
Gregory L. Stefani
Senior Vice President
Financial Management, Risk Management,
Strategy and Performance, National Billing

Suzanne M. Howe
Vice President
eGovernment Operations, Treasury Electronic
Check Processing

Anthony Turcinov
Senior Vice President
Facilities, District Check Operations and
Adjustments, Information Security, Business
Continuity

David P. Jager
Vice President
eGovernment

Lisa M. Vidacs
Senior Vice President
Cash, Protection
Andrew W. Watts
Senior Vice President and General Counsel
Legal, Ethics Officer

ANNUAL REPORT

Michael F. Bryan
Vice President and Economist
Macroeconomic Policy

Barbara B. Henshaw
Vice President
Cincinnati Location Officer, Branch Board
of Directors and Community Outreach,
Protection, Business Continuity

Peggy A. Velimesis
Senior Vice President
District Human Resources, Internal
Communications, Payroll, EEO Officer,
Harassment/Ombuds Programs

50 | 2007

Douglas A. Banks
Vice President and Consumer Affairs Officer
Supervision and Regulation

Jon C. Jeswald
Vice President
National Check Automation and Operations,
Retail Payments Office
Mark S. Meder
Vice President
Credit Risk Management, Statistics and Analysis

Stephen J. Ong
Vice President
Regional Banking Organizations, Supervision
and Policy Development
Terrence J. Roth
Vice President
National Product Development, Retail Payments
Office, Check Products
Robert B. Schaub
Vice President
Pittsburgh Location Officer, Branch Board of
Directors and Community Outreach, Protection,
Business Continuity
James B. Thomson
Vice President and Economist
Office of Policy Analysis, Policy Development,
Project Management
Michelle C. Vanderlip
Vice President
District Human Resources, Human Resources
Development
Jeffrey R. Van Treese
Vice President
Cincinnati Check Operations

Kelly A. Banks
Assistant Vice President
and Public Information Officer
Public Information, Web Services, Learning
Center, Bankwide Public Programs
Tracy L. Conn
Assistant Vice President
Supervision and Regulation, Support Services
Jeffrey G. Gacka
Assistant Vice President
Financial Management Services, National Billing,
Accounting
Stephen J. Geers
Assistant Vice President
Depository Institution Relationship Management
Patrick J. Geyer
Assistant Vice President
eGovernment Operations
Kenneth J. Good
Assistant Vice President
Check Operations
Felix Harshman
Assistant Vice President
Financial Management Services, Expense
Accounting/Budget
Joseph G. Haubrich
Consultant and Economist
Banking and Finance
Bryan S. Huddleston
Assistant Vice President
Supervision and Regulation
Paul E. Kaboth
Assistant Vice President
Supervision and Regulation, Community
Supervision
Kenneth E. Kennard
Assistant Vice President
Protection
Susan M. Kenney
Assistant Vice President
eGovernment Technical Support, Pay.gov
Jill A. Krauza
Assistant Vice President
Treasury Retail Securities
Dean A. Longo
Consultant
Information Technology, Infrastructure Support

Anthony V. Notaro
Assistant Vice President
Facilities
Timothy M. Rachek
Assistant Vice President
Check Adjustments
James W. Rakowsky
Assistant Vice President
Cleveland Facilities
Robin R. Ratliff
Assistant Vice President
and Assistant Corporate Secretary
Communications and Design, Office of the
Corporate Secretary
John P. Robins
Consultant and Examining Officer
Supervision and Regulation
Elizabeth J. Robinson
Assistant Vice President
Human Resources
Thomas E. Schaadt
Assistant Vice President
Check Automation Services
Jerome J. Schwing
Assistant Vice President
Cincinnati Check Operations
James P. Slivka
Assistant Vice President and Assistant General Auditor
Audit
Diana C. Starks
Assistant Vice President
Executive/Corporate Information Management,
Diversity
Henry P. Trolio
Assistant Vice President
Information Technology
Janine M. Valvoda
Assistant Vice President
and Chief Culture Officer
Michael Vangelos
Assistant Vice President
Information Security, Business Continuity
Nadine M. Wallman
Assistant Vice President
Supervision and Regulation, Market Liquidity
and Quantitative Risk

Martha Maher
Assistant Vice President
Retail Payments Office

Federal Reserve Bank of Cleveland

| 51

Federal Reserve Banks each have a board of nine directors.
Directors supervise the Bank’s budget and operations, make recommendations
on the primary credit rate and, with the Board of Governors’ approval,
appoint the Bank’s president, first vice president, and officers.
u
Class A directors are elected by and represent the interests
of Fourth District member banks. Class B directors also are elected by
member banks but represent the public interests of agriculture, commerce,
industry, services, labor, and consumers. Class C directors are selected by the
Board of Governors and also represent these public interests.
u
Directors serve for three years. Two Class C directors are designated
by the Board of Governors as chairman and deputy chairman of the board.
Directorships generally are limited to two successive terms to ensure that
the individuals who serve the Federal Reserve System represent a diversity
of backgrounds and experience.
u
The Cincinnati and Pittsburgh Branch offices each have a board of seven
directors who serve three-year terms. Board members are appointed by the
Federal Reserve Bank of Cleveland or the Board of Governors.

52 | 2007

ANNUAL REPORT

Cleveland Board of Directors
As of December 31, 2007

Tanny B. Crane
Chairwoman
President and Chief Executive Officer
Crane Group Company
Columbus, Ohio
Alfred M. Rankin Jr.
Deputy Chairman
Chairman, President, and Chief Executive Officer
NACCO Industries, Inc.
Cleveland, Ohio
C. Daniel DeLawder
Chairman and Chief Executive Officer
Park National Bank
Newark, Ohio
V. Ann Hailey
Retired Executive Vice President,
Corporate Development
Limited Brands
Columbus, Ohio

Henry L. Meyer III
Chairman and Chief Executive Officer
KeyCorp
Cleveland, Ohio
Les C. Vinney
Senior Advisor and Immediate Past President
and Chief Executive Officer
STERIS Corporation
Mentor, Ohio
Bick Weissenrieder
Chairman and Chief Executive Officer
Hocking Valley Bank
Athens, Ohio
George A. Schaefer Jr.
Federal Advisory Council Representative
Chairman
Fifth Third Bancorp
Cincinnati, Ohio

Roy W. Haley
Chairman and Chief Executive Officer
WESCO International, Inc.
Pittsburgh, Pennsylvania

Edwin J. Rigaud*, Les C. Vinney, C. Daniel DeLawder, V. Ann Hailey, Bick Weissenrieder, Tanny B. Crane, Roy W. Haley, Alfred M. Rankin Jr., and Henry L. Meyer III.
*Edwin J. Rigaud, president and chief executive officer, Enova Partners, LLC, Cincinnati, Ohio, retired from the Board of Directors in September 2007.

Federal Reserve Bank of Cleveland

| 53

Cincinnati Board of Directors
As of December 31, 2007

James M. Anderson
Chairman
President and Chief Executive Officer
Cincinnati Children’s Hospital Medical Center
Cincinnati, Ohio
James H. Booth
President
Czar Coal Corporation
Lovely, Kentucky
Herbert R. Brown
Senior Vice President
Western & Southern Financial Group
Cincinnati, Ohio

Glenn D. Leveridge
President, Lexington Market
JPMorgan Chase Bank, NA
Lexington, Kentucky
Charlotte W. Martin
President and Chief Executive Officer
Great Lakes Bankers Bank
Gahanna, Ohio
Janet B. Reid
Principal Partner
Global Lead Management Consulting
Cincinnati, Ohio

Daniel B. Cunningham
President and Chief Executive Officer
Long – Stanton Manufacturing Companies
Cincinnati, Ohio

Herbert R. Brown, Glenn D. Leveridge, Charlotte W. Martin, Daniel B. Cunningham, James M. Anderson, James H. Booth, and Janet B. Reid.

54 | 2007

ANNUAL REPORT

Pittsburgh Board of Directors
As of December 31, 2007

Robert O. Agbede
Chairman
President and Chief Executive Officer
Chester Engineers, Inc.
Pittsburgh, Pennsylvania
Michael J. Hagan
President and Chief Executive Officer
Iron and Glass Bank
Pittsburgh, Pennsylvania
Howard W. Hanna III
Chairman and Chief Executive Officer
Howard Hanna Real Estate Services
Pittsburgh, Pennsylvania

Robert A. Paul
Chairman and Chief Executive Officer
Ampco – Pittsburgh Corporation
Pittsburgh, Pennsylvania
Georgiana N. Riley
President and Chief Executive Officer
TIGG Corporation
Bridgeville, Pennsylvania
Sunil T. Wadhwani
Chief Executive Officer and Co-founder
iGATE Corporation
Pittsburgh, Pennsylvania

Margaret Irvine Weir
President
NexTier Bank
Butler, Pennsylvania

Sunil T. Wadhwani, Margaret Irvine Weir, Howard W. Hanna III, Georgiana N. Riley, Robert A. Paul, Robert O. Agbede, and Michael J. Hagan.

FEDERAL RESERVE BANK OF CLEVELAND

| 55

Business Advisory Councils
As of December 31, 2007

Business Advisory Council members are a diverse group of Fourth District businesspeople who
advise the president and senior officers on current business conditions.
Each council — in Cleveland, Cincinnati, and Pittsburgh — meets with senior Bank leaders at
least twice yearly. These meetings provide anecdotal information that is useful in the consideration
of monetary policy direction and economic research activities.

Cleveland

Cincinnati

Pittsburgh

Gerald E. Henn
President and Founder
Henn Corporation
Warren, Ohio

Ross A. Anderson
Senior Vice President – Finance
and Chief Financial Officer
Milacron Inc.
Cincinnati, Ohio

Eric Bruce
Chief Executive Officer
TriLogic Corporation
Canonsburg, Pennsylvania

Christopher J. Hyland
Chief Financial Officer
Hyland Software, Inc.
Westlake, Ohio
Gary A. Lesjak
Chief Financial Officer
The Shamrock Companies Inc.
Westlake, Ohio
Rodger W. McKain
Vice President, Government Programs
Rolls-Royce Fuel Cell Systems (U.S.) Inc.
North Canton, Ohio
Kevin M. McMullen
Chairman and Chief Executive Officer
OMNOVA Solutions Inc.
Fairlawn, Ohio
Michael J. Merle
President and Chief Executive Officer
Ray Fogg Building Methods, Inc.
Brooklyn Heights, Ohio
Frederick D. Pond
President
Ridge Tool Company
Elyria, Ohio
Scott E. Rickert
President and Co-founder
Nanofilm, Corporate Headquarters
Valley View, Ohio
Jack H. Schron Jr.
President and Chief Executive Officer
Jergens Inc.
Cleveland, Ohio
Steven J. Williams
President and Chief Executive Officer
Elsons International, Inc.
Cleveland, Ohio

Cynthia O. Booth
President and Chief Executive Officer
COBCO Enterprises
Cincinnati, Ohio
Charles H. Brown
Vice President of Accounting and Finance
Toyota Motor Manufacturing
North America, Inc.
Erlanger, Kentucky
Calvin D. Buford
Partner, Corporate Development
Dinsmore & Shohl LLP
Cincinnati, Ohio
James E. Bushman
President and Chief Executive Officer
Cast-Fab Technologies, Inc.
Cincinnati, Ohio
Richard O. Coleman
President and Chief Executive Officer
GenStone Acquisition Company
Cincinnati, Ohio
Jerry A. Foster
President
Diversified Tool & Development
Richmond, Kentucky
Carol J. Frankenstein
President
BIO/START
Cincinnati, Ohio
Rebecca S. Mobley
Partner
TurfTown Properties, Inc.
Lexington, Kentucky
Jon R. Moeller
Vice President and Treasurer
The Procter & Gamble Company
Cincinnati, Ohio
Joseph L. Rippe
Principal
Rippe & Kingston Co. psc
Cincinnati, Ohio

56 | 2007

ANNUAL REPORT

R. Yvonne Campos
President
Campos Inc.
Pittsburgh, Pennsylvania
Reneé S. Frazier
Senior Vice President and Executive Officer
VHA Pennsylvania
Pittsburgh, Pennsylvania
Dawn Fuchs
President
Weavertown Environmental Group
Carnegie, Pennsylvania
D. Michael Hartley
Chairman and Chief Executive Officer
Standard Bent Glass Corporation
Renfrew, Pennsylvania
John L. Kalkreuth
President
Kalkreuth Roofing and Sheet Metal
Wheeling, West Virginia
Scott D. Leib
President
Applied Systems Associates, Inc.
Murrysville, Pennsylvania
Marion P. Lewis
Chief Executive Officer
Tachyon Solutions
Sewickley, Pennsylvania
Steven C. Price
Chief Executive Officer
Solenture, Inc.
Pittsburgh, Pennsylvania
Stephen V. Snavely
Chief Executive Officer
Snavely Forest Products, Inc.
Pittsburgh, Pennsylvania
Robert G. Visalli
President and Chief Executive Officer
Kerotest Manufacturing Corporation
Pittsburgh, Pennsylvania

Acknowledgments
This Annual Report was prepared by the Public
Information and Research departments of the Federal
Reserve Bank of Cleveland.
For additional copies, contact the Research Library,
Federal Reserve Bank of Cleveland, PO Box 6387,
Cleveland, OH 44101, or call 216.579.2052.
he Annual Report is also available electronically
T
through the Federal Reserve Bank of Cleveland’s
website, www.clevelandfed.org.
We invite your comments and questions. Please email
us at editor@clev.frb.org.

Managing Editor
Robin Ratliff, Assistant Vice President
and Assistant Corporate Secretary
Editor
Amy Koehnen,
Communications and Design
Managing Designer
Michael Galka, Manager,
Communications and Design
Designer
Natalie Bashkin,
Communications and Design
Essay Authors
Joseph Haubrich, Consultant and Economist
James Thomson, Vice President and Economist
O. Emre Ergungor, Economist
Operational Highlights Author
Jeffery Hirsch, Banking Supervisor
Research Support
Katie Corcoran
Portrait Photography
Chris Pappas Photography, Inc.

Cleveland: 1455 East Sixth Street, Cleveland, OH 44114 | 216.579.2000
Cincinnati: 150 East Fourth Street, Cincinnati, OH 45202 | 513.721.4787
Pittsburgh: 717 Grant Street, Pittsburgh, PA 15129 | 412.261.7800

Full text of Annual Report of the Federal Reserve Bank of Cleveland : 2007 Annual Report

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