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Facing Change, Managing Risk Contents President’s Message..........................................2 Santomero’s Reflections on Greenspan and Bernanke.......................................................6 The Transition to a New Chairman.....................7 Evolution of Payments in the U.S......................12 Fed’s Role in a Changing Banking Industry.....16 Preventing Check Fraud...................................20 Managing Risk at the Bank and Across the System......................................22 Protecting Our Information Systems.................24 Helping Consumers Make Better Financial Decisions.....................................26 Board of Directors............................................28 Advisory Councils.............................................30 Executive Committee........................................33 Current Officers................................................34 Operating Statistics..........................................35 Statement of Auditor Independence.................36 Financial Reports.............................................37 Notes to Financial Statements.........................44 Remembering David Eastburn.........................59 www.philadelphiafed.org President’s Message Facing Change and Managing Risk Change and risk are words that are inextricably linked, and nowhere is this more evident than in the financial system. As markets grow more complex, as technology advances, as customers demand more services, the financial system must adapt to meet the needs of this ever-changing environment. Every step of the way, we must consider how to balance risk with the benefits and necessity of progress. The Philadelphia Fed’s 2005 annual report, “Facing Change, Managing Risk,” examines this concept in detail. After all, as stewards of the financial system, it is the responsibility of the Federal Reserve System to navigate these changes, helping to ensure a thriving and prosperous economy for our nation. This particular annual report is special to me because it covers my last year as president of the Federal Reserve Bank of Philadelphia. I have been part of this Bank for nearly six years, including two years as a voting member of the Federal Open Market Committee. I am honored to have had the opportunity to lead such a prestigious institution as the Philadelphia Fed and to have worked with so many talented and dedicated people. Leading Change Our Bank has adapted to the changing times and has emerged as an even stronger and more vital institution. When I took office, my viAnthony M. Santomero, President sion was for the Philadelphia Bank to be known as an important center of central bank knowledge and capability. I believe this vision has been achieved in ways that have touched on virtually every aspect of the Fed. In my final message as president, I would like to share with you some highlights of the Philadelphia Bank’s accomplishments here in our District as well as in the Federal Reserve System. The Philadelphia Fed has long been a System leader in providing financial services to depository institutions. This is perhaps most evident in check operations. In 2005, we further solidified our position of strength when the Philadelphia Fed was selected to Federal Reserve Bank of Philadelphia become a System consolidation site for check processing, absorbing New York’s East Rutherford Operations Center, known as EROC. The Federal Reserve System chose Philadelphia based on its overall productivity and efficiency, its ability to handle the total check volume of both Districts, and its proximity to New York financial institutions. This new responsibility will mean additional equipment and space renovations to accommodate the increased workload. Furthermore, in the second half of 2006, we expect to create a substantial number of new positions to help process the additional volume. The Philadelphia Fed has also played a key role in providing financial services to the U.S. Treasury. We are now one of only two sites in the System that clear government-issued checks, and we have been actively engaged in modernizing the way the federal government makes these payments. At the same time, we have been involved in the ongoing monitoring of the nation’s financial and payment systems. Studies produced here and throughout the Federal Reserve System have emphasized the remarkable evolution taking place in U.S. payments. Later in this book, First Vice President Bill Stone elaborates on just how pervasive payment changes have become. We have advanced the System’s knowledge of evolving payments mechanisms as the first Federal Reserve Bank to establish a dedicated Payment Cards Center. In 2005, the Center produced papers and conducted conferences and workshops on a number of important topics to provide meaningful insights into developments in consumer credit and payments. Indeed, we are a palpable presence in the research and policy arena, which is perhaps most visible to the general public in our annual Philadelphia Fed Policy Forum. In 2005, we looked at “Fiscal Imbalance: Problems, Solutions, and Implications.” As in past years, the event brought together leading academics, policymakers, and market economists for debate and discussion of relevant macroeconomic and monetary policy issues. “Tony Santomero is an accomplished leader and talented economist. We at the Federal Reserve have greatly benefited from his perspective and keen insights. He has been a valued voice of wisdom at our meeting table. We will miss him.” — Former Chairman Alan Greenspan Managing Risk In central bank administration, 2005 was an important year as well. Over the past several years we have carved out a role in the “knowledge and information” sector of the Fed’s infrastructure. We now lead the System in the challenging area of Enterprise Risk Management (ERM). Our Bank’s ERM group, as well as our well-regarded accounting professionals, has furthered our reputation as an extremely efficient, high-quality organization with a strong focus on controls and risk management. In 2005, we developed a relationship with the central bank of Spain, which wants to implement an ERM program. As a result of this contact, our chief financial officer has been asked to co-chair a consortium of central banks—from Europe and elsewhere—that will meet annually to discuss common risk-management concerns. In an environment of high loan growth in 2005, our Supervision, Regulation and Credit (SRC) Department continued working with banks to ensure that credit quality www.philadelphiafed.org was never compromised. As the banking industry becomes more complex and competitive, the tenets of capital adequacy and risk management are more important than ever before. At the Philadelphia Fed, we recognize this and have established a unit in SRC to analyze retail credit risk. Now the System has charged us with developing the strategy for implementing this part of the new Basel II capital requirements. We are also home to the System’s Subcommittee on Credit, Reserves, and Risk Management, known as SCRRM. Our Bank has led the way here by coordinating System policies to supply depository institutions with needed liquidity, implement new discount window policies, and direct the upgrade of supporting System technology. Sharing Knowledge The Philadelphia Fed is an organization with a powerful niche in public service and a stellar reputation for quality and credibility. As important as it is to have knowledge and expertise, it is just as important to share it. Therefore, we have made strong contributions to our community and our country in the area of economic outreach. In 2005, our Bank offered a number of programs to promote knowledge and share resources concerning personal finance and the U.S. economy. We produced the educational consumer video, “Buried by Debt: The Dangers of Borrowing,” which offers at-risk consumers real-life examples of lending abuses and offers tips to avoid falling victim to such abuses. Philadelphia is a System leader in economic education and has developed financial literacy curriculums used both locally and nationally. In addition, our programs to promote financial literacy, improve access to credit, end predatory lending, and foster urban development continue to make a real difference in our District’s communities. Indeed, not only has the Bank become an even more important part of the Philadelphia community but also of economic policy discussions in our District. Our participation in these discussions has affirmed the Philadelphia Fed’s expertise in monetary policy. Board of Directors Of course, all of this would not be possible without the leadership and support of our board of directors, who guide us in all our accomplishments. It is only fitting that we recognize our debt to them for their service. These nine individuals play an important role in keeping us in touch with our District and by performing the oversight role of directors everywhere. We offer our sincere thanks to two members of our board who have completed their terms of service with us: Robert E. Chappell, chairman and CEO of The Penn Mutual Life Insurance Company, and Kenneth R. Shoemaker, president and CEO of Orrstown Bank. Each was a valuable contributor to our board and helped immeasurably in our attempts to maintain close contacts with all sectors within the District. We offer special thanks to our outgoing chairman of the board, Ron Naples. His leadership, keen insights into the regional, national, and global economy, and his corporate governance skills will be missed—as will his good humor. I am pleased to report that Doris M. Damm, president and CEO of ACCU Staffing Services, has been appointed chairman of the board of directors, and William F. Hecht, Federal Federal Reserve Reserve Bank Bank of of Philadelphia Philadelphia chairman and CEO of PPL Corporation, has been appointed deputy chairman of the board of directors. I leave my position with the knowledge that the Bank’s board has strong leaders at the top. At the same time, we welcome our newest board members and look forward to their counsel and guidance. John G. Gerlach, president and CEO of Pocono Community Bank; Audrey S. Oswell, president and CEO of Resorts Atlantic City; and Charles P. Pizzi, president and CEO of Tasty Baking Company, joined the board on January 1, 2006. On behalf of all of us here at the Philadelphia Fed, I thank our board for its valuable contributions. Let me also acknowledge the contribution of Bruce L. Hammonds, president and CEO of MBNA Corporation, who has completed his term as a member of the Federal Advisory Council (FAC), and welcome Ted T. Cecala, chairman and CEO of Wilmington Trust Company, who has been appointed to represent the Third District on the FAC. “President Closing Thoughts Santomero has made significant contributions to the Bank, the Federal Reserve System, and our region. We will miss his outstanding leadership and knowledge. We have full confidence in the leadership team Tony helped build that will continue to manage the Bank .” The world has changed a great deal in just the first few years of this new millennium and so, too, has the Philadelphia Reserve Bank. We are strongly connected to the financial industry and engaged in our community. We have increased our visibility in our District on many fronts. We contribute to and lead many System initiatives. I am confident this tradition of excellence will carry on as the Philadelphia Fed continues to be a high-quality provider of financial services and a leader in the Federal Reserve System. As part of the nation’s central bank, the Philadelphia Fed is an organization with a powerful niche in public service and a stellar — Ronald J. Naples reputation for quality and credibility. Our Bank will continue to move 2005 Chairman, Board of Directors forward under its new leadership and will remain steadfastly committed to the strength and growth of the Third District’s economy. In closing, I would like to express my gratitude for having had the pleasure of national service in a truly outstanding institution and for the opportunity to work under Alan Greenspan, a Chairman who was universally regarded as America’s and the world’s finest central banker. At the same time, I applaud the President’s choice of Ben Bernanke as the 14th Chairman of the Board of Governors. The Federal Reserve is in good hands. Anthony M. Santomero President March 2006 www.philadelphiafed.org Santomero’s Reflections on Greenspan and Bernanke Alan Greenspan How did Alan Greenspan accomplish so much? Everyone wants to know the answer to this and there is no shortage of explanations. But from my vantage point the answer is rather clear. Alan Greenspan is first and foremost an extraordinary economist. As a professional economic forecaster, he has an uncanny ability to project our economy’s course. His almost total recall of even the most obscure statistics is unparalleled. As a result, he has shown the most remarkable ability to adapt to the pervasive, ongoing changes in the economy while still standing strong against inflation. But while Alan Greenspan is an extraordinary Former Chairman Alan Greenspan economist, he is also an extraordinary leader. He will be remembered as a consensus builder and a developer of talent. It shows in the strength of the organization and the strong consensus that has been achieved at our monetary policy meetings. Unanimity has been the rule, not the exception, in spite of strong voices and difficult circumstances. This is a testament to his leadership. Yet, historians will probably most remember Greenspan and the Greenspan era for the changes made to transparency in Fed policymaking over the past decade. This openness has been the defining aspect of monetary policy under Greenspan. Information about the Fed’s policy goals, its assessment of the current economic situation, and its strategic direction are increasingly part of the public record. Ben Bernanke Chairman Bernanke has close ties to the Philadelphia Bank. He served as a visiting scholar in our Research Department, a participant in our annual Policy Forum, and a neighbor during his time at Princeton. I came to know Ben quite well when he was on the Board of Governors in 2003 and 2004, and I always appreciated his collegiality and insight. He is scholarly and unassuming — a true intellectual. He is a man of impeccable credentials and sound policy judgment. His reputation is one of intellectual rigor and integrity. Ben is considered one of the finest monetary economists of our time, with a gift for understanding how economic concepts apply to real world markets. This allows him to neatly bridge the gap between sound ideas and good policies. He questions the status quo and offers fresh interpretations of the data. As chair of Princeton’s Economics Department, Bernanke described his managerial style as “primus inter pares” (first among equals). He has said, “We’re all the same rank. I’m just the one sitting in the chair.” This approach could also serve him well as Chairman of the FOMC, where all participants contribute to the outcome and policy action. Chairman Ben Bernanke Federal Reserve Bank of Philadelphia The Transition to a New Chairman Facing Change, Managing Risk By Anthony M. Santomero The prospect of a new Chairman at the helm of the Federal Reserve has always caused anxiety from Wall Street to Main Street. Here President Anthony Santomero shares his thoughts on the Fed’s transition to a new Chairman, bidding farewell to the venerable Alan Greenspan and welcoming a new era under Chairman Ben Bernanke. The Changing of the Guard When Alan Greenspan was nominated to replace Paul Volcker as head of the Federal Reserve in June 1987, the world’s financial markets collectively held their breath. Skepticism was rampant as to whether Greenspan would be able to do as good a job as Volcker. A New York Times article expressed these concerns, saying: “The markets had incredible confidence in Paul. Investors saw him as the one guy with the knowledge, guts and skill to stop inflation and hold the system together… Indeed, some economists are saying that one reason there is growing fear of an economic catastrophe is that the Reagan administration let Volcker go, replacing him with the less-experienced and less-wellknown Alan Greenspan.” Barron’s also opined on the Federal Reserve Chairman Ben Bernanke, former Chairman Paul Volcker, and former Chairman Alan Greenspan at a reception in January 2006. transition, calling Volcker “a legend in his own time,” and comparing him to Greenspan, who was “a relatively un- The Volcker Legacy Before Greenspan, Paul Volcker known quantity.” Little did they know at earned quite a reputation — for him- the time, they were referring to the man self and for the Federal Reserve as an who would come to be known as “the institution. When he assumed office in Maestro.” 1979, Volcker also assumed the burden www.philadelphiafed.org of double-digit inflation. It was the most up or down, he decided the Fed should sustained period of inflation post-WWII focus on controlling the money supply America had ever faced—rising at annu- and be committed to slowing monetary al rates of over 10 percent and up to 14 growth to beat inflation. To achieve its or 15 percent in some months. As Fed money growth targets, the Fed would Chairman, Volcker devised a strategy have to allow interest rates to rise, and that would crush inflation and change they rose dramatically. The fed funds the face of central banking. rate reached 19 percent in 1981 and Rather than follow the Fed’s traditional practice of nudging interest rates held fast despite the ensuing recession. But the policy proved effective, and within three years, inflation had been tamed. By 1983, Volcker’s policy succeeded in bringing the inflation rate down to around 4 percent, and the economy was on the path to a sustained expansion. Volcker was lauded as a genius, and his powerful policy changes earned the Fed an unprecedented level of credibility and prestige. Greenspan’s Tenure At his confirmation hearing before the Senate Banking Committee, Greenspan spoke of the same Fed goals Volcker had advocated. He too recognized and argued forcefully that to create an environment for solid, sustained economic growth, it was absolutely crucial that the Fed focus on containing inflation. As the expansion of the 1980s matured, the Chairman remained true to his words. However, only two months after he took office, Greenspan was faced with the biggest stock market crash since the Great Depression. On October 19, 1987—Black Monday—the Dow Jones Industrial Average plummeted nearly 23 Chairman Bernanke and former Chairman Greenspan at the public swearing-in ceremony on February 6, 2006. percent, its greatest loss ever in percentage terms. Amid widespread fears of a recession, Greenspan acted quickly to provide liquidity to financial markets and calm investors. His quick response Federal Reserve Bank of Philadelphia and competent leadership shaped his Supported by strong monetary reputation and earned him high marks stimulus, the economy proved surpris- from his peers and the public. The Fed’s ingly resilient—indeed, more so than actions under Greenspan helped secure most had believed possible. Despite an public confidence in future price stability, unprecedented series of disturbances though not without a period of recession —the declining stock market, a terrorist as the new decade began. attack on American soil, two wars, nu- It was during the expansion of the merous financial scandals, skyrocketing 1990s that Chairman Greenspan put oil prices, and even natural disasters his own unique stamp on the conduct —the economy recovered and again of monetary policy. In the first half of embarked on a path of sustainable the decade, the economy moved from expansion. Indeed, under Chairman recession to recovery, and the Fed re- Greenspan’s leadership, the 21st cen- moved the monetary accommodation tury began with the Fed providing the it had provided. Then, mid-decade, the economy with unprecedented monetary economy began to boom. Growth accel- support during a difficult downturn and, erated, and unemployment began falling at the same time, preserving public con- to levels not seen in 30 years. The ortho- fidence in its commitment to long-term dox monetary policy prescription was to price stability. tighten. But Greenspan veered from the Alan Greenspan served as Fed orthodox view. He believed that the rules Chairman for more than 18 years. The of the game had changed. In a new era second longest-serving Chairman in the of accelerating productivity growth and history of the Fed, he was appointed or increased competition, he believed it reappointed by four different Presidents. was possible to run the economy on all During his tenure, the U.S. economy cylinders and close to full employment, achieved both strong growth and stable without undue inflationary pressures. prices. Inside the Fed, Greenspan, like With the Fed ever-vigilant, the expansion Volcker, exerted a powerful influence went on to become the longest in U.S. and fundamentally altered the way we history. think about policymaking. “The Fed’s job is to take away the punch bowl just when the party really gets going.” Still, Greenspan knew that all was not perfect. In 1996, he gave his famous “irrational exuberance” speech, allud- Bernanke at the Helm In February 2006, Ben Bernanke ing to concerns about a stock market succeeded Alan Greenspan as Fed bubble. When the bubble finally burst Chairman. Again, there is some appre- and the economy fell into recession, the hension because a relative unknown is Federal Reserve responded aggressive- following a celebrated success. Again, ly. Short-term rates were slashed nearly the incoming Chairman has stated pub- 5 percent in one year and brought down licly his commitment to pursuing the to a mere 1 percent by 2003. The U.S. Fed’s fundamental goals, in particular, financial markets had not seen rates so preserving a stable price environment. low in nearly 50 years. If history is a guide, circumstances will www.philadelphiafed.org — Former Chairman William McChesney Martin challenge the new Chairman to meet that commitment and offer him opportu- policy only enhances its effectiveness. nities to put his own stamp on the con- Indeed, the financial markets begin duct of monetary policy. building anticipated policy actions into On a personal level, Chairman Ben Bernanke is an accomplished scholar in the field of monetary ally implemented. Thus, the response to serve well as the head of the nation’s to Fed policy in the financial sector, and central bank. He is an accomplished in the economy as a whole, is swifter, scholar in the field of monetary econom- smoother, and stronger than it would ics, a former Fed Governor and econom- otherwise be. ic advisor to the President, and widely porter of transparency, and, as a Gover- communicator. nor, he had often spoken in support of a Beyond that, Ben Bernanke has instance, he has already indicated that FOMC in monetary policy matters. All he would like to see more consideration seven Fed Governors and 12 Reserve of an explicit inflation target. So, indica- Bank presidents participate in FOMC tions are that the Fed may well consider meetings, collectively assessing the additional steps toward transparency economy, discussing policy alternatives, under Chairman Bernanke. Chairman Bernanke has in making communicator. Among the most powerful allies The Chairman’s Leadership Looking back, Paul Volcker and effective monetary policy is one his Alan Greenspan came to the Fed predecessor helped to create: greater Chairmanship with a strong sense of transparency. Greater openness about the Fed’s mission, keen insight into monetary policy decisions was a defin- the workings of the economy, and the ing aspect of the Greenspan Fed, and it confidence to act decisively in the face was an important means through which of challenging circumstances. During Greenspan built the Fed’s reputation their tenures, they advanced the Fed’s and influence. capabilities and instilled strong public Prior to 1994, there was no direct communication between the FOMC and confidence. Sharing their strengths and build- the markets. Today, the FOMC issues ing on their legacy, Ben Bernanke now press releases after each meeting, stat- leads the way as Fed Chairman. We ing its near-term fed funds target, with will all be watching to see how the new an explanation of the action and an leader of the Fed changes the System’s indication of the likely future course of approach to monetary policy and builds policy. The release also summarizes the on its strong legacy. FOMC’s outlook for growth and inflation. 10 more open Federal Reserve System. For the support of his colleagues on the and widely and clear Our new Chairman is a strong sup- recognized as a deep thinker and clear and ultimately selecting a policy action. a deep thinker asset prices even before they are actu- Bernanke has the talent and expertise economics recognized as This transparency in monetary Federal Reserve Bank of Philadelphia Facing Change, Managing Risk “Facing Change, Managing Risk” aptly describes the work of the Federal Reserve Bank of Philadelphia in 2005. We have even recently seen change at the highest level as the Federal Reserve System welcomed new Chairman Ben Bernanke. The Philadelphia Bank is expecting to soon have a new president as well. Without question change has been an integral part of the financial services landscape over the last several years. For the nation’s central bank, managing the risks inherent in this evolution is always a top priority. In this report, we have highlighted the Philadelphia Reserve Bank’s role in both meeting the needs of the ever-changing banking environment and addressing the associated risks. www.philadelphiafed.org 11 Facing Change, Managing Risk Evolution of Payments in the U.S. By William H. Stone, Jr. The 2004 Federal Reserve Payments Study asserted that electronic payments, for the first time ever, had trumped paper checks in number of total transactions. First Vice President William Stone discusses the major changes faced by our nation’s payments system and shares how the Federal Reserve is managing the risks inherent in this evolution. The Federal Reserve is highly vested in the evolution of payments. Our role encompasses both the responsibility to maintain the integrity of the payments system and participation in new innovation as a financial services provider. According to the Fed’s most recent study, only about 45 percent of all U.S. noncash retail payments are made by paper check, with payment cards and ACH accounting for much of the remainder. At current growth rates, credit cards and debit cards will both individually surpass the paper check in terms of total annual transactions by 2007. From the early days of banking until quite recently, checks had maintained dominance as our nation’s noncash payment of choice. Then, in the early 1970s, the Fed introduced its automated clearinghouse (ACH) and began an evolution William H. Stone, Jr., First Vice President of electronic payments that would replace transactions traditionally made via rolls, quickly followed, as did other forms checks. ACH grew quickly by distributing of debit and credit payments. various U.S. Treasury credit payments, 12 Financial institutions continue to such as armed services payrolls and find innovative uses for ACH, spanning Social Security payments, to name just a a broad range of retail transactions and few. Commercial bank credit payments, shifting substantial volumes to this sys- such as direct deposit of employers’ pay- tem, primarily at the expense of check Federal Reserve Bank of Philadelphia volume. A relatively recent variation to-person payments supported by credit even allows merchants to convert paper cards. In addition, some banks and checks to electronic payments through other card issuers even offer online con- the ACH at the point of purchase. Anoth- solidated bill payment on their websites. er variation, known as ARC, for accounts The second most popular elec- receivable conversion, allows billers such tronic instrument for making retail pay- as utilities and credit card issuers to con- ments today is the debit card. It arrived vert checks that are sent to pay monthly on the scene relatively recently—during bills. These new uses have increased the 1980s—but its growth in usage has substantially as of late. already been dramatic. But despite innovations in ACH, the greatest driver of change in our nation’s payments system has been Payment Card Growth At first, the debit card emerged payment cards. The credit card was the as a result of automated teller machine first ubiquitous consumer-based elec- (ATM) systems, but it then moved be- tronic payments instrument to emerge, yond being solely a mechanism to ac- and it was the credit card that proved cess currency. Now, bank customers most instrumental in moving payments have the option to simply present the from paper to electronics at the point card to the merchants and have their of sale. Credit cards began as offline bank account directly debited. travel and dining cards in the 1960s, The greatest driver of change in our nation’s payments system has been payment cards. The Fed’s payment study found grew to become more general-purpose that debit payments had the largest purchasing cards in the 1970s, and then compound annual growth rate, at 24 increased vastly in usage in the 1980s. percent. Indeed, the growing popularity of debit cards seems to be part of a Technology Boom In the 1990s, when the technology broader phenomenon. Last year, Visa announced that for the first time ever, boom made information processing and its global debit transaction volume sur- telecommunications more powerful and passed its credit transaction volume. less expensive, credit card companies The last decade has marked a were poised to gain. Low-cost telecom clear turning point in our payments has made real-time, point-of-service system. From that time on, Federal Re- verification of cardholders and their serve research has indicated a steady credit availability widespread, speeding decline in check usage. While the num- transactions and curtailing fraud. Of sig- ber of checks written remains large, the nificance for the future, this technology majority of noncash payments in the has made the credit card a viable means U.S. are now initiated electronically. In of payment for e-commerce as well. We fact, since their peak a decade ago, have also seen a rise in Internet person- checks are not only losing market share, www.philadelphiafed.org 13 they are actually declining in absolute for the 21st Century Act, or Check 21, it volume. became even easier to move toward a The last few years, in particular, have marked dramatic change for the in- banks have additional options for hand- dustry. While the 37 billion checks writ- ling image-based payments. ten in the U.S. in 2003 were down more The Philadelphia Fed has earned the distinction of being the largest producer more electronic check process because As a provider of financial services, than 12 percent from their 2001 levels, the Fed has been actively engaged in electronic transactions over that period bringing a whole array of new products totaled over 44 billion, representing an to market to enable banks to more fully increase of roughly 45 percent. take advantage of Check 21 benefits. Looking forward, the share of re- Our business has been enhanced in a tail transactions handled by cards, both number of ways to encourage the new debit and credit, will continue to grow, image technology the act allows. To particularly at the point of sale. In ad- cite just a few: We have established an dition, organizations other than banks, image archive for electronic items; we especially retailers, will expand their role have modified deposit deadlines and en- in the payments system. hanced clearing times; and we have en- But the question remains: How hanced our ability to produce substitute quickly will the move from paper to elec- checks, the intermediate step toward a tronics occur? The transition depends full image-exchange environment. In on both the evolution of our payments fact, the Philadelphia Fed has earned system’s capabilities and consumer the distinction of being the largest pro- Federal Reserve acceptance. Consumer habits tend to ducer of substitute checks in the Federal change gradually. People will only ac- Reserve System. System. cept a payment structure in which they of substitute checks in the have the utmost confidence. As a result, the paper check is likely to be with us for some time. Evolution in Efficiency With the evolution of the payments system accelerating, the Federal Reserve System has made major adjust- Future of Check Clearing In the meantime, the Fed has been 14 ments to both its physical infrastructure and its payments services. Our program trying to maximize the efficiencies af- of aggressive electronification of retail forded by electronic processing of pay- payments will facilitate Check 21 and ments, whether that transaction is initiat- allow us to identify new processing effi- ed electronically or by paper check. For ciencies. The ongoing shift to electronic the latter, the Fed is doing what it can to payments has also profoundly affected foster check truncation and electronifica- our check processing operations. The tion as early as possible in the payment Fed currently clears about one-third of process. Under the Check Clearing all checks written in the U.S. Still, the Federal Reserve Bank of Philadelphia number of checks collected annually Bank in the future, as this Systemwide through the Reserve Banks has fallen leadership role solidifies our position of nearly 20 percent since 1999, and the strength in check processing efficiency. decline continues to accelerate. Consequently, the Fed has had to consolidate its operations, closing down Future of Electronic Payments As the check continues to be re- processing sites where appropriate. Yet, placed by more efficient payment types, we still maintain national service levels new technologies continue to help curtail by re-routing checks to nearby sites. To check fraud. The Federal Reserve and, illustrate the scale of this effort, consider in particular, the Philadelphia Fed have that two years ago the Fed had 45 check been industry leaders in identifying tech- processing sites. By mid-2006 we will be nology to help reduce fraud in the check down to 22. This downsizing helps us fill payment system. These efforts have our traditional role of payments proces- constrained the $5 billion annual fraud sor while at the same time maintaining losses that burden financial services in- efficiency in this new environment. stitutions and their customers. The Philadelphia Fed has been To address the evolution taking selected to become a System consolida- place in the payments system, in 2000, tion site for check processing, absorbing the Philadelphia Fed established its Pay- New York’s East Rutherford Operations ment Cards Center. The Center’s work Center — known as EROC. The Federal has been instrumental in enhancing our Reserve System chose us based on understanding of electronic payment ve- our overall productivity and efficiency, hicles, their use by consumers, and their ability to handle total check volume for broader impact on the financial system. both Districts, and our proximity to New The Federal Reserve System en- York financial institutions. The Phila- courages the market to drive checks to- delphia Fed has long been a leader in ward electronics. The Philadelphia Fed the System with a premier check opera- will play a key leadership role in manag- tion, but new responsibility will mean ing check payments as they morph into additional employees, equipment, and new payment forms. We will also con- space renovations to accommodate the tinue to develop our unique expertise in increased workload. In the second half understanding and tracking the payment of 2006, we expect to create approxi- card industry as new payment vehicles mately 60 new positions to help process evolve in both market share and com- the additional volume. These changes plexity. The Federal Reserve and, in particular, the Philadelphia Fed have been industry leaders in identifying technology to help reduce fraud in the check payment system. should have positive implications for our www.philadelphiafed.org 15 Fed’s Role in a Changing Banking Industry Facing Change, Managing Risk For Supervision, Regulation and Credit, facing change and managing risk are all in a day’s work. Senior Vice President and Chief Lending Officer Michael E. Collins talks about the dynamic nature of the banking industry and how the Fed is adapting to changing times. Q: How is the banking industry faring in today’s economy? Collins: In 2005, the industry delivered strong performance, smoothly adapting from a benign economic environment to one of rising interest rates and stronger growth. Throughout this transition, the nation’s financial institutions have been able to successfully deal with changing circumstances while still generating healthy profits. Going forward, we believe the U.S. banking industry is well positioned to support a thriving and prosperous U.S. economy. Our banking system is truly the nexus of our economy. It supports a dynamic and competitive financial services market while still encouraging innovation and responsiveness. The industry’s central role in allocating Michael E. Collins, Senior Vice President and Lending Officer resources, pooling capital, and funding economic growth has continued to grow Q: So, adapting to change is an im- and change as its complexity evolves. portant aspect of the banking busi- Technological advances, combined ness. How does this affect SRC? with new products and markets, 16 have changed the financial services Collins: Our supervisory practices have landscape, creating opportunities and become geared more toward evaluation challenges for both financial institutions of risk management and less toward and industry supervisors. point-in-time financial assessments. Federal Reserve Bank of Philadelphia Supervision itself is a preventative out shocks and risks, ideally with mini- and collaborative practice, intended to be mal regulatory involvement. Effective flexible and designed to identify and as- market discipline gives banks strong sess risk. Our approach to supervision incentives to conduct their business in a focuses on a bank’s systems, policies, safe, sound, and efficient manner. and internal controls. This helps us en- However, since we can never ex- sure that appropriate procedures are in actly duplicate the market’s discipline, place to contain risk and, importantly, that we must depend on supervisory guid- bank management adheres to them. Our ance, rules, and procedures to ensure goal is to ensure public confidence and a safety and soundness in our institutions. sound banking and financial system. Also, financial institutions may not al- Regulation, on the other hand, is ways objectively consider the broader Supervision largely responsive. Regulation typically implications of their decisions on other grows from fraud and abuse, disrup- stakeholders in the marketplace. So, it is tive technologies, and rapidly evolving incumbent upon the Fed and other regu- social trends. It establishes rules and latory agencies to work with financial in- directives, with due consideration to past stitutions and help them achieve optimal events, and should be an ongoing pro- outcomes without stifling their innovation. collaborative Q: Credit risk has historically been practice, cess aligned with strategy. In both supervision and regulation, we always strive to avoid unintended the leading cause of bank failures. consequences and excessive burden. What is the industry doing to protect Supervisory processes and regulations assets and ensure against undue and guidelines undergo periodic evalua- credit risk? itself is a preventative and intended to be flexible and designed to tion to ensure their continued effectiveness. We believe governance is a fluid Collins: Imbalances and undue risk can process, which should encompass best build on a bank’s balance sheet as a re- practices and guidance. sult of the growth in nontraditional mortgage products, the rise in commercial Q: How do you balance your supervi- real estate concentrations, and the in- sory and regulatory duties while still creased use of leverage. We expect in- encouraging banks to sort out their stitutions with higher risk profiles to have own best practices? more robust risk management systems. identify and assess risk. As such, institutions increasingly manCollins: Given the increasing scale and age risk on a portfolio basis, conduct- diversity of financial institutions and the ing stress testing and using secondary rapid pace of change, it is important for markets to mitigate risk. They also price supervision and regulation to try to mir- for risk to ensure a balanced risk-reward ror the discipline the market itself would equation. Such risk-based pricing is con- impose. sistent with expanding access to credit. Markets are remarkably resilient and have an inherent capacity to sort Banks are willing to take on riskier loans because they can hedge away www.philadelphiafed.org 17 some risk by issuing asset-backed secu- prudent lending and adherence to good rities. These markets are sophisticated credit fundamentals. and complex, allowing many individual Our supervisory practices have adapted to a changing banking industry, becoming geared investors to purchase a portion of the ing these loans to ensure that borrowers loans, which have been “bundled” for have the capacity to repay them, thereby diversification purposes. The situation is sustaining the expansion of homeown- win-win. The bank is rendered less vul- ership these products make possible. nerable to the risk of the original loans, This is an area of increasing sensitivity and the investors are willing to bear that in regulatory circles, largely because of risk for the chance to earn higher poten- the newness of these types of products. tial returns. Risk management procedures must While we recognize that credit con- of risk management. loan types. Borrowers must be able to excessive levels may expose an insti- sustain their investment and repay these tution to high credit loss volatility and, new loans. And underwriters must have when unchecked, can be an unsafe and systems in place to ensure that they will. unsound strategy. Banks have implemented in-house limits and strength- Q: What is the Fed doing to protect ened their oversight of concentrations by consumers? improving portfolio stratification. Nevertheless, regulators have released draft Collins: As an agency charged with guidance related to commercial real banking supervision and regulation, the estate concentrations given the historic Fed has a responsibility to ensure that adverse impact on the industry. banks follow safe and sound management practices and serve all segments Q: What is the Fed’s position on the of their community. People must have use of more exotic instruments, such access to a sound banking system as interest-only loans? where their money can be invested productively with minimal risk. Collins: The Fed understands the need The Federal Reserve writes for innovation in the financial services regulations to implement many of the industry to ensure we have a vibrant major consumer protection laws. These banking system. Innovation is good, include the Truth in Lending Act, which but, as with anything new, we must be ensures consumers receive adequate careful about how these instruments information about credit, and the Truth are used. We must also ensure that the in Savings Act, which requires banks public is sufficiently financially literate to disclose certain information about to choose and use these instruments deposit accounts. The Federal Reserve properly. also has responsibility for reviewing Of course, despite these solutions, 18 consider the unique nature of these new centrations can be effectively managed, more toward evaluation It is incumbent upon bankers mak- banks’ compliance with its regulations. In the competitive drive to win customers addition, the Federal Reserve responds should not supersede the discipline of to inquiries and investigates complaints Federal Reserve Bank of Philadelphia from the public regarding the institutions Consolidation can improve ef- it supervises and refers other inquiries/ ficiency and scale while still allowing complaints to the appropriate regulatory the benefits of local banking. Through agency. branch networks, institutions build not only their reputation and brand but also Q: What is the purpose of the new the ability to expand distribution chan- Bank Secrecy Act manual? nels and delivery networks. However, despite ongoing consolidation among Collins: The new interagency Bank Se- larger institutions, there continues to be crecy Act examination manual, released a steady level of requests for new bank in June, was a collaborative effort of the charters, which indicates that strong federal banking agencies and the U.S. consumer and investor demand for com- Department of the Treasury’s Financial munity banks still exists. Crimes Enforcement Network. It intro- The vast array of opportunities and duces no new rules or guidance, but risks likely means there will be no pre- rather it is a compilation of existing regu- eminent model for the successful bank- latory requirements, supervisory expec- ing organization of the future. Rather, tations, and sound practices designed several models will likely thrive and sur- to ensure that the banking system is not vive. The proper execution of the model used to finance illicit activities. and unparalleled attention to customers Now, more than ever before, capital adequacy, risk management, will determine its success. and effective Q: What is the status of Basel II? supervision its operations from money laundering or Collins: Capital adequacy is an ongoing are of critical terrorist financing. concern for bank supervisors. The U.S. Sound Bank Secrecy Act/antimoney laundering risk management enables an organization to identify risks and better direct resources to safeguard is striving to implement the proposed Q: Why do you think the industry has international regulatory framework of continued toward consolidation? Basel II by 2009. This framework will better align regulatory capital with risks Collins: The trend toward nationwide and represent a vast change in how banking and the desire to leverage in- banks determine capital adequacy. Un- vestments in technology have contrib- der its advanced approaches, banks will uted to banks’ desire to consolidate. In be required to adopt more formal, quan- addition, some consolidation activity has titative risk measures and risk manage- been the result of competitive changes ment procedures. Essentially, Basel II that allowed financial institutions to cross strengthens the link between regulatory lines of business and break into new capital and risk management. importance to maintaining a safe and sound financial system. markets. In turn, such activity has imposed significant change on the industry. www.philadelphiafed.org 19 Preventing Check Fraud Facing Change, Managing Risk Paper checks are still a major player in the payment system, and managing risk includes finding ways to prevent check fraud. Here’s what the Philadelphia Fed is doing in this area. Estimates of check fraud’s cost to consumers, merchants, and the financial services industry range from $5 billion to $10 billion a year. Whatever the actual number, check fraud is a costly and growing problem in the United States and around the world. In 2005, the Philadelphia Fed undertook several efforts to prevent check fraud, such as promoting the exchange of technologies and data throughout the payments system. The Bank also encouraged collaboration in the financial services industry to address certain challenges. But before we talk about that, some history is in order. For many years, the Federal Reserve Bank of Philadelphia, along with the Treasury, tested technologies that would help the financial services industry deter check fraud. The Treasury made a logical partner because it issues approximately 250 million checks a year for payments such as Social Security benefits and tax refunds. In 2003, after testing several technologies, the Philadelphia Fed and the Treasury adopted one for use with Treasury checks. This application allows the Treasury to encrypt a code on each check at the time of issue. The code describes the dollar amount, the date of 20 Federal Reserve Bank of Philadelphia Blake Prichard, Executive Vice President issue, the account number, and so forth, and it is invisible to the human eye. But when the check is digitally imaged, this technology survives the imaging and allows the hidden data to be compared against the information written on the check, then confirms whether the check is genuine. The Philadelphia Fed found it to be effective in identifying altered checks and payment and processing errors. Today, all Treasury checks include this technology. Blake Prichard, executive vice president, Retail Payments, points out that an important aspect of this partnership between the Philadelphia Fed and the Treasury is that “none of this would have happened without the perceptive leadership here at the Bank and the industry focus that has long been emphasized by top management at Treasury.” Role of Check 21 Another motivation for implementing such new technology was Check 21. This law allows a substitute check, created from an electronic image, to serve as the legal equivalent of the check itself. A collecting bank can create an electronic image of a check, transmit the image to the paying bank’s location, and then present the paying bank with a paper reproduction or with the electronic image. Philadelphia Fed management anticipated that this law would bring special concerns: Once banks started electronic imaging of checks and truncating the original paper checks, how could the industry adapt to the loss of the anti-check fraud features on the originals? The concern was that Check 21 might unwittingly invite greater check fraud unless the industry could find new technologies that would render fraud prevention measures “image survivable.” That’s why the Philadelphia Fed addressed this issue well in advance of Check 21’s implementation. The technology chosen by the Philadelphia Fed and the Treasury has solved this “survival” problem. Now, Prichard states, “Using this technology, we detect fraudulent checks almost every day in this Bank.” Recent Events In 2005, the Bank took the next steps in fighting check fraud: promoting standards for the exchange of check fraud technologies and encouraging the broad adoption of these standards throughout the payments system. Prichard notes, however, that “the Fed doesn’t plan to impose standards. Rather, we support efforts to create new technologies, and we want the marketplace to evaluate them.” To further support the development of new technologies, the Bank joined forces with the Financial Services Technology Consortium (FSTC), a research organization based in New York. FSTC encourages collaboration among various players in the financial services industry to find solutions to challenges facing the industry. The Bank and FSTC launched a project to create interoperability standards for fraud detection applications. Right now, if one bank uses, say, bar codes to verify a check’s authenticity, it may not be able to verify a check issued by a bank that relies on other types of check fraud technologies. An interoperable system would allow any financial institution—and eventually merchants and others—to verify a check regardless of who issued it and what type of security measures were used. One of the biggest benefits is that fraudulent checks will be intercepted much earlier in the payments stream. In 2006 and beyond, the Philadelphia Fed will continue to support efforts to develop new and better ways to detect fraudulent checks. www.philadelphiafed.org In 2006 and beyond, the Philadelphia Fed will continue to support efforts to develop new and better ways to detect fraudulent checks. 21 Facing Change, Managing Risk Managing Risk at the Bank and Across the System When you’re the nation’s central bank, effectively managing risk throughout the organization is a top priority. Indeed, managing risk from a broader perspective has become a hot topic both inside and outside the Fed. Managing risk is not a new concept for companies and corporations. However, lately, risk management has taken on a new aspect: incorporating risk management principles across the entire organization. Donna Franco, chief financial officer at the Philadelphia Fed, puts it this way: “Corporations have been managing risk for many years. What ERM adds is an organization-wide view.” A large institution like the Federal Reserve System is no exception. Like other organizations, the Fed is subject to operational, credit, market, strategic, and reputational risks. To deal with risk issues, the System developed an ERM framework several years ago, and two years ago, the Federal Re- Donna Franco, Chief Financial Officer, and Spyro Karetsos, Assistant Vice President, Enterprise Risk Management serve Bank of Philadelphia established the Enterprise Philadelphia Reserve Bank led a System Risk Management (ERM) Department. work group that produced a white paper The Philadelphia Fed’s and the System’s involvement with ERM dates back to 2002, when the general auditor of the 22 Federal Reserve Bank of Philadelphia that became the basis for implementing ERM in the Federal Reserve System. Why is managing risk at a broader level so important? The interconnected best practices across the System. One nature of the Fed is one reason. If a venue for doing so is the System’s an- risk-related issue arises at one Reserve nual ERM meeting, which Philadelphia Bank, it may well have implications for has hosted for the past three years. the other Reserve Banks. Importantly, at the 2005 meeting, it was Spyro Karetsos, assistant vice clear that a “community of interest” has president, Enterprise Risk Manage- emerged within the Federal Reserve. ment, notes that sometimes company One piece of evidence is that these managers and officers have made deci- meetings no longer rely on outside sions about risk-taking informally. By speakers to fill the agenda; presenters formalizing the decision-making pro- now come from within the System in ad- cess, Karetsos says, ERM “increases dition to external presenters. the awareness of risk and the potential For the Philadelphia Bank, sharing impact certain decisions may have.” Fur- ERM ideas sometimes means moving thermore, he says, it allows managers beyond the Fed’s walls and even beyond and others to understand a decision’s U.S. borders. In August 2005, Karetsos effect not just on one business area but published an article on the topic in the on other stakeholders as well. RMA Journal, a publication of the Risk Management Association. ERM has also Other Aspects of ERM Another valuable aspect of ERM, taken on an international scope. In 2005, the central bank of Spain toured various Karetsos observes, is that “it compels central banks because it wants to imple- entities to develop a common language. ment an ERM program. As a result of its Having everyone use the same terminol- contact with the Philadelphia Fed, the ogy to talk about risk reduces the need Banco de España has developed a rela- to ‘translate’ risk concepts.” Karetsos tionship with the ERM staff here. In early adds that a formal ERM program also 2006, Franco flew to Madrid to share gives organizations a tool for monitoring ideas with her peers from other central risk: “Initially, a company may determine banks. She has also been asked to co- the amount of risk associated with a cer- chair a consortium of central banks that tain action. But ERM gives you ways to will meet annually to discuss common monitor your actual risk level after you’ve risk-management concerns. carried out the decision. It’s really a system of checks and balances.” One good feature about the Sys- are and align resources appropriately, we can reduce inherent risks to a level within our tolerance range.” — Spyro Karetsos covers an organization’s activities and business lines. ERM also acts as a lens that allows a company to view existing Karetsos says. It provides standards information from a risk perspective. No that allow a Systemwide perspective, organization can entirely eliminate risk, but each Bank’s ERM processes can be Karetsos notes, but “if we know what the customized to fit that Bank’s culture. risks are and align resources appropri- ERM programs, and one goal is to share what the risks Ultimately, ERM is an umbrella that tem’s ERM framework is its flexibility, Other Reserve Banks also have “If we know ately, we can reduce inherent risks to a level within our tolerance range.” www.philadelphiafed.org 23 Facing Change, Managing Risk Protecting Our Information Systems Many of the biggest risks facing the Federal Reserve Bank of Philadelphia come from cyberspace. Threats to the security of the Bank’s information networks—for example, from the Internet or e-mail—are almost constant. The Information Technology Services Department has primary responsibility for managing the risk posed by these threats. Fending off attacks from cyberspace may have a “Star Wars” sound to it, but it’s a task that the Bank’s Information Technology Services (ITS) Department deals with every day. According to Pat Regan, vice president, ITS, “The Federal Reserve System takes very seriously the establishment of information security standards for all of the Fed’s technology.” To protect computer systems from intruders, the Federal Reserve uses intrusion detection technology. According to Regan, the technology “senses” certain types of unauthorized activity and reports it to a group that analyzes the information and, if necessary, takes action. The Philadelphia Fed also uses technology to look for vulnerabilities in its computing systems. Keith Morales, information security manager, notes that assessing vulnerability is one of Pat Regan, Vice President, ITS, and Keith Morales, Information Security Manager the first steps in learning how to protect ourselves. it before the bad guys can exploit it. But industry has noted a dramatic increase it doesn’t take long before the bad guys in the number of exposures and the have another virus or worm to spread.” number of computer hacking attempts. 24 vulnerability,” he says, “our goal is to fix Regan points out that the security The Philadelphia Fed is also the He describes the Bank’s information site for the Federal Reserve System’s security situation as a “punch/counter- Groupware Leadership Center (GLC). punch” problem. “When we learn of a The GLC provides e-mail, desktop con- Federal Reserve Bank of Philadelphia ferencing, instant messaging, document As Regan notes, “We have a high level management, and self-service team of security awareness at the Bank. But website capabilities for almost 20,000 an important element in protecting the customers across all 12 Reserve Banks. Bank’s—and the System’s—computer To protect the System’s computers, the network is training our employees and GLC employs rigorous security safe- relying on them to follow security pro- guards that act as a layer of defense cedures.” Internal audits help to ensure against numerous threats from a variety that employees develop and use good of sources. Such safeguards include fil- security habits. tering spam, which actually exceeds the total volume of delivered e-mail. In addition to the endeavors listed above, Philadelphia’s ITS Department is involved with many other ongoing proj- System Architecture Morales says many of the Bank’s ects related to information security. For example, the Bank is leading an initiative information security measures are de- to look at how the Fed handles compli- signed to fit the System’s security archi- ance with legislation such as the Federal tecture, which focuses on finding solu- Information Security Management Act tions to information security risks. This (FISMA). FISMA defines what actions architecture sets security standards from federal agencies need to take to be the standpoint of risk management rath- deemed appropriately secure. Morales er than risk avoidance. “Because we’re says, “It’s the government’s version of such a large organization,” Morales the Federal Reserve’s security architec- observes, “we have multiple layers of ture and risk management.” So although defenses in place. However, no layer is the Reserve Banks are not federal perfect. So the System’s security archi- agencies, the Board of Governors and tecture helps us look at the solutions we the U.S. Treasury are; so any systems have in place and figure out if they’re the developed for use by the Board or the right ones. The Fed’s computer network Treasury need to comply with FISMA. is so interconnected that a weakness in Mike Ram, senior information security one area may create weaknesses else- consultant, is playing a leadership role where.” supporting some of the Fed’s initiatives Another ITS effort involves the con- with FISMA. tainment of malicious software, or “mal- Ultimately, Morales summarizes ware”—for example, spyware or adware the Bank’s security position this way: that websites download onto computers “The Fed wants security at an appropri- that connect to them. This effort also en- ate level. We’re not trying to build 80-foot compasses potentially harmful elements walls around all of our computer sys- distributed through e-mail attachments tems. But it may be appropriate to have and embedded links to “bad” websites. 300-foot walls around Fedwire, which is A final factor that helps ITS staff keep computer systems safe is the To protect the Fed’s computers, the GLC employs rigorous security safeguards that act as a layer of defense against numerous threats from a variety of sources. a significant part of our nation’s payment system.” Bank’s own internal audit procedures. www.philadelphiafed.org 25 Facing Change, Managing Risk Helping Consumers Make Better Financial Decisions Since the early 1980s, the Community Affairs Department has helped financial institutions understand the credit needs of low- and moderateincome people and communities. As a result, these people and communities have experienced a significant increase in their ability to build wealth and access credit, particularly for homeownership or home repair. In 2005, the Community Affairs Department offered a variety of programs to help students and adult consumers become more knowledgeable about personal finance and the U.S. economy. One major project was creating a video about lending abuses. In “Buried by Debt: The Dangers of Borrowing,” people tell true stories about how they were taken in by unscrupulous lenders and contractors. Why a Video? The idea for the video first surfaced in November 2003 when 11 ministers from large congregations throughout Philadelphia were meeting at the Bank to launch a financial education program for their congregants. “We asked the ministers what we could do to help them reach their communities,” says Dede Myers, vice president and community affairs officer. “They told us that many of their congregants were victims of unscrupulous lenders and asked if we Dede Myers, Vice President and Community Affairs Officer could produce a video that would help educate people about lending practices.” Myers and Marvin M. Smith, com- 26 Smith, “The challenge was to make a video that would still be useful five years munity development research advisor, from now. We started by doing back- set the process in motion. According to ground research to discover the most Federal Reserve Bank of Philadelphia common problems people encountered. it or housing counselor attended all the We focused on balloon loans, unreason- showings and encouraged employees to ably high interest rates, loan flipping, ask questions. The sessions were very prepayment penalties, and contractor popular and lasted nearly 90 minutes. schemes.” To make the video, Community Affairs enlisted the help of Irv Ackelsberg Other Efforts To further help employees, Com- and Brian Mildenberg, two attorneys munity Affairs also offered a five-week who have had a lot of experience hand- homeownership program, and several ling consumer credit cases. In fact, they of the participants have since bought asked several of their clients to be in the houses. Other consumer education proj- video. Smith recalls that it took a lot of ects included offering a training session convincing to get the local residents to for faith-based organizations and provid- appear. But, finally, they understood that ing space and staff support for quarterly by participating in the video, they could meetings of the Financial Education help others avoid some of the problems Support Network of Southeastern Penn- they had experienced. sylvania. was to make a video that would still Additional endeavors by the How the Video Was Used “The challenge department’s economic education unit The resulting 14-minute tape has involved enhancing the curriculum of an been in great demand by various audi- existing financial literacy program, which ences. More than 3,000 copies were had met with great success in Delaware, distributed in 2005, including a Spanish and promoting it to teachers in Penn- version. The department posted informa- sylvania and New Jersey. The unit also tion about the video and an order form held a number of financial education on its website, which resulted in many seminars for teachers around the Third requests. Furthermore, other Federal District. be useful five years from now. We started by discovering the most common problems people Reserve Banks have asked for encounter.” copies to dis- — Marvin M. Smith tribute to their constituencies, as well. To help the Bank’s staff, Community Affairs also offered employees on all shifts a chance to see the video. Smith and a cred- www.philadelphiafed.org 27 Standing left to right: Kenneth Shoemaker, Wayne Weidner, Garry Maddox, and Coleman Townsend. Seated left to right: William Hecht, Robert Chappell, Ronald Naples, Eugene Rogers, and Doris Damm. 28 Federal Reserve Bank of Philadelphia Board of Directors Federal Reserve Bank of Philadelphia Robert E. Chappell Board member since January 2000. Chair, Budget and Operations Committee and Member, Personnel Committee. Chairman and CEO of Penn Mutual Life Insurance Company. Board member Insurance Federation of Pennsylvania. Member of Taxation and Financial Services Steering Committee for American Council of Life Insurers. Serves on boards of Quaker Chemical Corporation, South Chester Tube Company, and Wharton Financial Institutions Center at University of Pennsylvania. Doris M. Damm Deputy Chairman, Federal Reserve Bank of Philadelphia Board of Directors. Board member since January 2001. Chair, Personnel Committee and Member, Budget and Operations Committee. President and Chief Executive Officer of ACCU Staffing Services. Other affiliations include Cerebral Palsy of New Jersey, Our Lady of Lourdes Medical Center, Our Lady of Lourdes Foundation, and Cherry Hill Regional Chamber of Commerce. William F. Hecht Board member since January 2004. Member, Research and External Affairs and Budget and Operations committees. Chairman and CEO of PPL Corporation. Member of Executive Committee of Edison Electric Institute. Director of Nuclear Energy Institute, Edison Electric Institute, Lehigh Valley Hospital and Health Network, Dentsply International and RenaissanceRe Holdings, Ltd. President of Lehigh Valley Partnership. Garry L. Maddox Board member since January 2003. Member, Audit and Personnel committees. President and CEO of A. Pomerantz & Company. Founding President of World Wide Concessions, Inc. Founder and Executive Director of LPGA Urban Youth Golf Program of Greater Atlantic City. Founder and President of Youth Golf and Academics Program. Serves on boards of Boys and Girls Club of Camden County, Corporate Alliance for Drug Education, Greater Philadelphia Chamber of Commerce, Fairmount Park Commission, Neumann College, Philadelphia Sports Congress, Operation Good Neighbor, St. Christopher’s Hospital for Children, and Shippensburg University. Director Emeritus of Philadelphia Child Guidance Center. Member of Board of Governors of National Adoption Center. Ronald J. Naples Chairman, Federal Reserve Bank of Philadelphia Board of Directors. Board member since January 2001. Chairman and Chief Executive Officer of Quaker Chemical Corporation. Chairman of Board of University of the Arts. Serves on boards of Glatfelter, NCO Group, Philadelphia Museum of Art, Franklin Institute, Foreign Policy Research Institute, Rock School of the Pennsylvania Ballet, and American Red Cross - Southeastern Pennsylvania Chapter. Eugene W. Rogers Board member since January 2004. Member, Audit and Personnel committees. CEO of Newfield Bancorp, Inc., CEO of Newfield National Bank, and Director of FNBN Investment Corp. Director of Atlantic Central Bankers Bank. Member of Kennedy Hospital Advisory Board and New Jersey Bankers Association. Serves as Chairman of the South Jersey Community Bankers Association. Kenneth R. Shoemaker Board member since January 2003. Chair, Audit Committee and Member, Research and External Affairs Committee. President and CEO of Orrstown Bank, President and CEO of Orrstown Financial Services. Chairman of Council of Trustees of Shippensburg University. Serves on boards of Cumberland Valley School of Music, Carlisle Regional Medical Center and Pennsylvania Bankers Association. Founding President of Mainstreet Non-Profit Redevelopment Corporation. P. Coleman Townsend, Jr. Board member since January 2002. Chair, Research and External Affairs Committee and Member, Audit Committee. Chairman and CEO of Townsends, Inc. Member of Board of Trustees of University of Delaware and Winterthur Museum. Member Winterthur Museum Garden, Collections and Library committees. Serves on the Council of Advisors for Delaware Center of Horticulture. Advisory Board Member for Liberty Mutual and Lehman Art Center Brooks School. Active participant on Delaware Art Museum Collections Committee. Wayne R. Weidner Board member since January 2005. Member, Budget and Operations and Research and External Affairs committees. Chairman National Penn Bank. Chairman & CEO of National Penn Bancshares. Serves as a director of National Penn Investors Trust Company, Link Financial Services, Penn 1st Financial Services, National Penn Life Insurance Company, NPB Delaware, and Hawk Mountain Council Boy Scouts of America. www.philadelphiafed.org 29 2005 Business Advisory Council Federal Reserve Bank of Philadelphia Reneé Amoore Robert L. Gronlund Melinda K. Holman President & CEO Chairman & CEO President The Amoore Group Wood Mode Inc. Holman Enterprises King of Prussia, PA Kreamer, PA Pennsauken, NJ Daniel Blaschak Chair Eric May Treasurer Douglass C. Henry, Jr. President & Owner Blaschak Coal Corp. CEO Pen Fern Oil Co., Inc. Mahanoy City, PA Henry Molded Products, Inc. Dallas, PA Lebanon, PA Keith Campbell* Albert Morrison, III* Chairman Chairman, President, & CEO Mannington Mills, Inc. Burnham Holdings Salem, NJ Lancaster, PA Mark S. Stellini President & CEO InfoSystems Wilmington, DE Kenneth L. Tuckey Chairman, President, & CEO Tuckey Mechanical Services, Inc. Carlisle, PA Rodman Ward President Speakman Company Wilmington, DE David C. Wenger President & CEO RoadLink USA East Philadelphia, PA Standing left to right: Melinda Holman, David Wenger, Robert Gronlund, Daniel Blaschak, and Kenneth Tuckey. Seated left to right: Rodman Ward, Reneé Amoore, Mark Stellini, Douglass Henry, and Eric May. * Not pictured 30 Federal Reserve Bank of Philadelphia 2005 Community Bank Advisory Council Federal Reserve Bank of Philadelphia John W. Adonizio Mark E. Huntley William F. Snell* Chairman CEO President & CEO Landmark Community Bank Delaware National Bank Farmers and Merchants Pittston, PA Georgetown, DE Trust Co. Thomas A. Bracken* John T. Parry* President & CEO President & CEO Peter C. Zimmerman Sun National Bank First National Bank & Trust President & CEO Vineland, NJ Co. of Newtown First National Bank of Newtown, PA Newport Chambersburg, PA Donna M. Coughey* Newport, PA President & CEO Michael M. Quick* First Financial Bank Chairman Downingtown, PA Susquehanna Patriot Bank Marlton, NJ Allan R. Dennison President & CEO AmeriServ Financial Johnstown, PA Robert E. Forse Chairman, President, & CEO Woodlands Bank Williamsport, PA Mark D. Gainer* President & CEO Union National Community Bank Mt. Joy, PA Chair Aaron L. Groff Chairman, President, & CEO Ephrata National Bank Ephrata, PA Clockwise left to right: Allan Dennison, Peter Zimmerman, Robert Forse, Aaron Groff, John Adonizio, and Mark Huntley. * Not pictured www.philadelphiafed.org 31 2005 Credit Union Advisory Council Federal Reserve Bank of Philadelphia David W. Clendaniel* Alfreda A. Earnest Chair President & CEO President & CEO Louise P. Lingenfelser Dover FCU Deepwater Industries FCU President & CEO Dover, DE Deepwater, NJ UGI Employees FCU Wyomissing, PA Eileen Crean James E. Everhart, Jr. President & CEO President & CEO Jeff March* CUMCO FCU Louviers FCU President & CEO Vineland, NJ Newark, DE Citadel FCU Maurice Dawkins Dorothy A. Fox President & CEO President & CEO Robert L. Marquette American Spirit FCU NE PA Community FCU President & CEO Newark, DE Stroudsburg, PA Members 1st FCU Thorndale, PA Mechanicsburg, PA Larry D. Miller President & CEO Mennonite Financial FCU Lancaster, PA Larry L. Stoner President & CEO Susquehanna Valley FCU Camp Hill, PA Edwin L. Williams President & CEO Discovery FCU Wyomissing, PA Clockwise standing from left: Maurice Dawkins, Edwin Williams, Larry Miller, Robert Marquette, and Eileen Crean. Clockwise seated from bottom left: Alfreda Earnest, Dorothy Fox, Louise Lingenfelser, James Everhart, and Larry Stoner. * Not pictured 32 Federal Reserve Bank of Philadelphia Executive Committee Federal Reserve Bank of Philadelphia The Bank’s Executive Committee consists of the president, first vice president, and the key senior officers who report directly to them. They meet regularly to discuss important issues facing the Bank or the Federal Reserve System. Pictured clockwise from left are Milissa Tadeo, Senior Vice President; Michael Collins, Senior Vice President; Blake Prichard, Executive Vice President; Richard Lang, Executive Vice President; Anthony Santomero, President; and William Stone, First Vice President. www.philadelphiafed.org 33 Current Officers Federal Reserve Bank of Philadelphia Anthony M. Santomero President William H. Stone, Jr. First Vice President Richard W. Lang Executive Vice President D. Blake Prichard Executive Vice President Michael E. Collins Senior Vice President and Lending Officer Supervision, Regulation and Credit Loretta J. Mester Senior Vice President and Director of Research Research Milissa M. Tadeo Senior Vice President Cash Services and Treasury Services John G. Bell Vice President Financial Statistics Robert J. Bucco Vice President Wholesale Product Office Peter P. Burns Vice President and Director Payment Cards Center Theodore M. Crone Vice President and Economist Research Michael Dotsey Vice President and Senior Economic Policy Advisor Research Richard A. Elliott Vice President Facilities Management, Records, and Document Services 34 John D. Ackley Assistant Vice President Treasury Services Mary Ann Hood Vice President Human Resources Mitchell S. Berlin Assistant Vice President and Economist Research Camille M. Ochman Assistant Vice President Cash Services Donna Brenner Assistant Vice President Accounting Services Anthony T. Scafide, Jr. Assistant Vice President Customer Relations Jennifer E. Cardy Assistant Vice President and Assistant General Auditor Audit Stephen J. Smith Assistant Vice President and Assistant Counsel Legal Shirley L. Coker Assistant Vice President and Counsel Legal Eric A. Sonnheim Assistant Vice President Supervision, Regulation and Credit Cynthia L. Course Assistant Vice President Supervision, Regulation and Credit C. Danny Spriggs Assistant Vice President Protection Arun K. Jain Vice President Retail Payment Services William W. Lang Vice President Supervision, Regulation and Credit Edward M. Mahon Vice President and General Counsel Stephen A. Meyer Vice President and Senior Economic Policy Advisor Research Mary DeHaven Myers Vice President and Community Affairs Officer Community Affairs A. Reed Raymond, III Vice President and Chief Administrative Officer Supervision, Regulation and Credit Patrick M. Regan Vice President Information Technology Services Michelle M. Scipione Vice President Cash Services John J. Deibel Vice President and Chief Examination Officer Supervision, Regulation and Credit Donna L. Franco Vice President and Chief Financial Officer Faith P. Goldstein Vice President Public Affairs Richard A. Sheaffer Vice President and General Auditor Herbert E. Taylor Vice President and Corporate Secretary Vish P. Viswanathan Vice President and Discount Officer Supervision, Regulation and Credit Kei-Mu Yi Vice President and Economist Research Frank J. Doto Assistant Vice President Supervision, Regulation and Credit Michael T. Doyle Assistant Vice President Technical Services Officer Information Technology Services William L. Gaunt Assistant Vice President Supervision, Regulation and Credit Stephen G. Hart Assistant Vice President Human Resources Spyro Karetsos Assistant Vice President Enterprise Risk Management John P. Kelly Assistant Vice President Check Operations Retail Payment Services Elisabeth V. Levins Assistant Vice President Supervision, Regulation and Credit Alice Kelley Menzano Assistant Vice President Information Technology Services Marie Tkaczyk Assistant Vice President Information Technology Services Todd Vermilyea Assistant Vice President Supervision, Regulation and Credit Constance H. Wallgren Assistant Vice President Supervision, Regulation and Credit Aileen C. Boer Research Support Officer Research Maryann T. Connelly Assistant Counsel Legal Gregory Fanelli Treasury Payments Officer Retail Payments Suzanne W. Furr Wholesale Product Officer Wholesale Product Office Wanda Preston Check Adjustments Officer Retail Payment Services Includes promotions through March 2006 Federal Reserve Bank of Philadelphia Operating Statistics Federal Reserve Bank of Philadelphia In 2005, Philadelphia’s total volume of commercial checks processed de- creased 14 percent and the dollar value of transactions increased 13 percent. The volume of U.S. government checks increased 4 percent in 2005, but the dollar value decreased 6 percent. In November, the Philadelphia Bank permanently assumed the processing of U.S government checks previously processed in Atlanta due to arrangements made in the wake of Hurricane Katrina. The Philadelphia Bank continued to be a major processor of cash in the Fed- eral Reserve System in 2005. While the volume of currency processed remained fairly constant in 2005, due to the processing of a significantly higher proportion of ones, the actual dollar value of currency processed decreased by 19 percent. In 2005, one of our larger customers began depositing coin directly to an off-site terminal; therefore, the volume of coin bags processed declined by 22 percent and the processed coin value decreased by 7 percent. In 2005, both the number and value of loans to depository institutions were lower than in the previous year. SERVICES TO DEPOSITORY INSTITUTIONS 2005 2005 2004 2004 Volume Dollar Value Volume Dollar Value Check processing: Commercial checks 969.0 million checks $2,256.4 billion 1,129.4 million checks $2,001.8 billion U.S. government 84.9 million checks $103.2 billion 82.0 million checks $109.6 billion Cash operations: Currency processed 2,351.4 million notes $36.1 billion 2,358.1 million notes $44.3 billion Coin paid and received 587.8 thousand bags $225.5 million 756.3 thousand bags $242.7 million Loans to depository institutions 110 loans $823.6 million 120 loans $1,393.6 million during the year www.philadelphiafed.org 35 Statement of 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 2005 was PricewaterhouseCoopers LLP (PwC). Fees for these services totaled $4.6 million. To ensure auditor independence, the Board of Governors requires that PwC be independent in all matters relating to the audit. Specifically, PwC 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 2005, the Bank did not engage PwC for any material advisory services. 36 Federal Reserve Bank of Philadelphia Financial Reports Contents Letter to Directors.............................................38 Report of Independent Accountants.................39 Report of Independent Auditors.......................40 Statements of Condition...................................41 Statements of Income......................................42 Statements of Changes in Capital....................43 Notes to Financial Statements.........................44 www.philadelphiafed.org 37 Letter to Directors Federal Reserve Bank of Philadelphia Letter 38 Federal Reserve Bank of Philadelphia Report of Independent Accountants Federal Reserve Bank of Philadelphia letter www.philadelphiafed.org 39 Report of Independent Auditors Federal Reserve Bank of Philadelphia 40 Federal Reserve Bank of Philadelphia Statements of Condition Federal Reserve Bank of Philadelphia As of December 31, 2005 and December 31, 2004 (in millions) 2005 2004 ASSETS Gold certificates $ 432 $ 382 Special drawing rights certificates 83 83 Coin 34 56 Items in process of collection 586 360 Loans to depository institutions - 5 U.S. government securities, net 26,613 21,581 Investments denominated in foreign currencies 473 624 Accrued interest receivable 207 151 Interdistrict settlement account 6,148 4,007 Bank premises and equipment, net 75 76 Interest on Federal Reserve notes due from U.S. Treasury 29 - Other assets 103 74 Total assets $ 34,783 $ 27,399 $ 24,725 LIABILITIES AND CAPITAL Liabilities: Federal Reserve notes outstanding, net $ Securities sold under agreements to repurchase 31,296 1,082 916 Deposits: Depository institutions 485 603 Other deposits 4 1 Deferred credit items 363 490 Interest on Federal Reserve notes due U.S. Treasury - 27 Accrued benefit costs 43 42 Other liabilities 22 7 Total liabilities 33,295 26,811 Capital paid-in 744 294 Surplus 744 294 Total capital 1,488 588 Capital: Total liabilities and capital $ 34,783 $ The accompanying notes are an integral part of these financial statements. www.philadelphiafed.org 41 27,399 Statements of Income Federal Reserve Bank of Philadelphia For the years ended December 31, 2005 and December 31, 2004 (in millions) 2005 2004 Interest income: Interest on U.S. government securities $ 958 $ 662 Interest on investments denominated in foreign currencies 7 8 Total interest income 965 670 28 9 937 661 Interest expense: Interest expense on securities sold under agreements to repurchase Net interest income Other operating income (loss): Income from services - Compensation received for check services provided 25 - Reimbursable services to government agencies 25 21 (70) 36 5 3 (15) 98 Foreign currency gains (losses), net Other income Total other operating income (loss) 38 Operating expenses: Salaries and other benefits 81 73 Occupancy expense 10 10 Equipment expense 11 13 Assessments by the Board of Governors 34 34 Other expenses 37 27 Total operating expenses 173 157 749 602 Net income prior to distribution $ $ Distribution of net income: Dividends paid to member banks $ Transferred to surplus 31 $ 17 450 35 268 550 749 602 Payments to U.S. Treasury as interest on Federal Reserve notes Total distribution The accompanying notes are an integral part of these financial statements. 42 Federal Reserve Bank of Philadelphia $ $ Statements of Changes in Capital Federal Reserve Bank of Philadelphia For the years ended December 31, 2005 and December 31, 2004 (in millions) Capital Paid-in Total Capital Surplus Balance at January 1, 2004 (5.2 million shares) $ Transferred to surplus Net change in capital stock issued (0.7 million shares) 258 $ 259 $ 517 - 35 35 36 - 36 Balance at December 31, 2004 (5.9 million shares) $ Transferred to surplus Net change in capital stock issued (9.0 million shares) 294 $ 294 $ 588 - 450 450 450 - 450 Balance at December 31, 2005 (14.9 million shares) $ 744 $ 744 $ 1,488 The accompanying notes are an integral part of these financial statements. www.philadelphiafed.org 43 Notes to Financial Statements Federal Reserve Bank of Philadelphia 1. Structure The Federal Reserve Bank of Philadelphia (“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 in Philadelphia serves the Third Federal Reserve District, which includes Delaware and portions of New Jersey and Pennsylvania. In accordance with the Federal Reserve Act, supervision and control of the Bank are 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, 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 of the Federal Reserve System (“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 System performs a variety of services and operations. Functions include formulating and conducting monetary policy; participating actively in the payments system including largedollar transfers of funds, automated clearinghouse (“ACH”) operations, and check processing; distributing coin and currency; performing fiscal agency functions for the U.S. Treasury and certain federal agencies; serving as the federal government’s bank; providing short-term loans to depository institutions; serving the consumer and the community by providing educational materials and information regarding consumer laws; supervising bank holding companies, state member banks, and U.S. offices of foreign banking organizations; and administering other regulations of the Board of Governors. The System also provides certain services to foreign central banks, governments, and international official institutions. 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. FRBNY is authorized to conduct operations in domestic markets, including 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, 44 Federal Reserve Bank of Philadelphia and the lending of U.S. government securities. FRBNY executes these open market transactions and holds the resulting securities, with the exception of securities purchased under agreements to Federal Reserve Bank of Philadelphia resell, 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 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 (“F/X”) and securities contracts for nine foreign currencies and to invest such foreign currency holdings ensuring adequate liquidity is maintained. In addition, FRBNY is authorized to maintain reciprocal currency arrangements (“F/X swaps”) with two 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, FRBNY may enter into contracts that contain varying degrees of off-balance-sheet market risk, because they represent contractual commitments involving future settlement and counter-party credit risk. The FRBNY controls credit risk by obtaining credit approvals, establishing transaction limits, and performing daily monitoring procedures. Although 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 competency centers, operations sites, and product or service 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, 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: Collateral Management System, Electronic Cash Letter System, Groupware Leadership Center, Subcommittee on Credit, Reserves, and Risk Management Administration Office, and Treasury Direct Central Business Administration Function. Beginning in 2005, the Reserve Banks adopted a new management model for providing check services to depository institutions. Under this new model, the Federal Reserve Bank of Atlanta (“FRBA”) has the overall responsibility for managing the Reserve Banks’ provision of check services and recognizes total System check revenue on its Statements of Income. FRBA compensates the other eleven Banks for the costs incurred to provide check services. This compensation is reported as “Compensation received for check services provided” in the Statements of Income. If the management model had been in place in 2004, the Bank would have reported $29 million as compensation received for check services provided and $38 million in check revenue would have been reported by FRB Atlanta rather than the Bank. 3. Significant Accounting Policies Accounting principles for entities with the unique powers and responsibilities of the nation’s central bank have not been formulated by the various accounting standard-setting bodies. The Board of Governors has developed specialized accounting principles and practices that it believes are appropriate for the significantly different nature and function of a central bank as compared www.philadelphiafed.org 45 Federal Reserve Bank of Philadelphia with the private sector. These accounting principles and practices are documented in the Financial Accounting Manual for Federal Reserve Banks (“Financial Accounting Manual”), which is issued by the Board of Governors. All Reserve Banks are required to adopt and apply accounting policies and practices that are consistent with the Financial Accounting Manual 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 those generally accepted 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 security holdings at amortized cost, rather than using the fair value presentation requirements in accordance with GAAP. Amortized cost more appropriately reflects the Bank’s security holdings given its 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 affect 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 security 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 its activities or policy decisions. 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 Bank’s unique powers and responsibilities. A Statement of Cash Flows, therefore, would not provide any additional meaningful information. Other information regarding the Bank’s activities is provided in, or may be derived from, the Statements of Condition, 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, 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. These gold certificates held by the Reserve Banks are required to be backed by the gold of the U.S. Treasury. The U.S. Treasury may reacquire the gold certificates at any time and the Reserve Banks must deliver them to the U.S. Treasury. At such time, the U.S. Treasury’s account is charged, and the Reserve Banks’ gold certificate accounts are lowered. The value of gold for purposes of backing the gold certificates is set by law at $42 2/9 a fine 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. 46 Federal Reserve Bank of Philadelphia Special drawing rights (“SDRs”) are issued by the International Monetary Fund (“Fund”) to its members in proportion to each member’s quota in the Fund at the time of issuance. SDRs serve Federal Reserve Bank of Philadelphia 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. At such time, equivalent amounts in dollars are credited to the account established for the U.S. Treasury, and the Reserve Banks’ SDR certificate accounts are increased. The Reserve Banks are required to purchase 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 Federal Reserve notes outstanding in each District at the end of the preceding year. There were no SDR transactions in 2005 or 2004. b. Loans to Depository Institutions All 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. 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. 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 by the Board of Governors. c. U.S. Government Securities and Investments Denominated in Foreign Currencies 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. Interest income is accrued on a straightline 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 (losses), net.” Activity related to U.S. government securities, including the related 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 interdistrict clearings that occurs in April of each year. The settlement equalizes Reserve Bank gold certificate holdings to Federal Reserve notes outstanding in each District. Activity related to investments in foreign-currency-denominated assets 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. U.S. Government Securities Sold Under Agreements to Repurchase and Securities Lending 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 carried in the Statements of Condition at their contractual amounts and the related accrued interest is reported as a component of “Other liabilities.” www.philadelphiafed.org 47 Federal Reserve Bank of Philadelphia U.S. government securities held in the SOMA are lent to U.S. government securities dealers and to banks participating in U.S. government securities clearing arrangements in order to facilitate the effective functioning of the domestic securities market. 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 or bank a fee for borrowing securities and the fees are reported as a component of “Other Income” in the Statements of Income. Activity related to U.S. government securities sold under agreements to repurchase and securities lending is allocated to each Reserve Bank on a percentage basis derived from the annual settlement of interdistrict clearings. Securities purchased under agreements to resell are allocated to FRBNY and not to the other Banks. e. Foreign Currency Swaps and Warehousing F/X swap arrangements are contractual agreements between two parties to exchange specified currencies, at a specified price, on a specified date. The parties agree to exchange their currencies up to a pre-arranged maximum amount and for an agreed-upon period of time (up to twelve months), at an agreed-upon interest rate. These arrangements give the FOMC temporary access to the foreign currencies it may need to intervene to support the dollar and give the counterparty temporary access to dollars it may need to support its own currency. Drawings under the F/X swap arrangements can be initiated by either FRBNY or the counterparty (the drawer) and must be agreed to by the drawee. The F/X swaps are structured so that the party initiating the transaction bears the exchange rate risk upon maturity. FRBNY will generally invest the foreign currency received under an F/X swap in interest-bearing instruments. Warehousing is an arrangement under which the FOMC agrees to exchange, at the request of the 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. Foreign currency swaps 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 allocated to FRBNY and not 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 estimated useful lives of assets ranging from two to fifty years. Major alterations, renovations, and improvements are capitalized at cost as additions to the asset accounts and are amortized over the remaining useful life of the asset. Maintenance, repairs, and minor replacements are charged to operating expense in the year incurred. Capitalized assets including software, building, leasehold improvements, furniture, and equipment are impaired when it is determined that the net realizable value is significantly less than book value and is not recoverable. Costs incurred for software, either developed internally or acquired for internal use, during the application development stage are capitalized based on the cost of direct services and materi- 48 Federal Reserve Bank of Philadelphia als 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, Federal Reserve Bank of Philadelphia which range from two to five years. g. Interdistrict Settlement Account At the close of business each day, each Reserve Bank assembles the payments due to or from other Reserve Banks as a result of the day’s transactions that involve depository institution accounts held by other Districts. Such transactions may include funds settlement, check clearing, and ACH operations. 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) to the Reserve Banks upon deposit with such agents of certain classes of collateral security, typically U.S. government securities. These notes are identified as issued to a specific Reserve Bank. The Federal Reserve Act provides that the collateral security tendered by the Reserve Bank to the Federal Reserve agent must be equal to the sum of the notes applied for by such Reserve Bank. Assets eligible to be pledged as collateral security include all Bank assets. The collateral value is equal to the book value of the collateral tendered, with the exception of securities, whose 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 of 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, as obligations of the United States, Federal Reserve notes are backed by the full faith and credit of the United States government. The “Federal Reserve notes outstanding, net” account represents the Bank’s Federal Reserve notes outstanding, reduced by the currency issued to the Bank but not in circulation, of $6,130 million, and $7,973 million at December 31, 2005 and 2004, respectively. i. Items in Process of Collection and Deferred Credit Items The balance in the “Items in process of collection” line in the Statements of Condition primarily represents amounts attributable to checks that have been deposited for collection by the payee depository institution and, as of the balance sheet date, have not yet been collected from the payor depository institution. 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 fluctuate and vary significantly from day to day. j. Capital Paid-in The Federal Reserve Act requires that each member bank subscribe to the capital stock of www.philadelphiafed.org 49 Federal Reserve Bank of Philadelphia 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. By law, each 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. A member bank is liable for Reserve Bank liabilities up to twice the par value of stock subscribed by it. k. Surplus The Board of Governors requires Reserve Banks to maintain a surplus equal to the amount of capital paid-in as of December 31. This amount is intended to provide additional capital and reduce the possibility that the Reserve Banks would be required to call on member banks for additional capital. Pursuant to Section 16 of the Federal Reserve Act, Reserve Banks are required by the Board of Governors to transfer to the U.S. Treasury as interest on Federal Reserve notes excess earnings, after providing for the costs of operations, payment of dividends, and reservation of an amount necessary to equate surplus with capital paid-in. 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. Weekly payments to the U.S. Treasury may vary significantly. In the event of a decrease in capital paid-in, the excess surplus, after equating capital paidin and surplus at December 31, is distributed to U.S. Treasury in the following year. This amount is reported as a component of “Payments to U.S. Treasury as interest on Federal Reserve notes”. l. 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. The Treasury and other government agencies reimbursement process for all Reserve Banks is centralized at the Bank. Each Reserve Bank transfers its Treasury reimbursement receivable to the Bank. The reimbursement receivable is reported in “Other assets” and totaled $67 million and $53 million at December 31, 2005 and 2004, respectively. The cost of unreimbursed Treasury services, is reported in “Other expense” and totaled $19 thousand and $10 thousand at December 31, 2005 and 2004, respectively. m. 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. The Board of Governors also assesses each Reserve Bank for the expenses incurred for the U.S. Treasury to issue 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 previous year. n. 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 both years ended December 31, 2005 and 2004 and are reported as a component of “Occupancy expense.” 50 Federal Reserve Bank of Philadelphia o. Restructuring Charges In 2003, the System began the restructuring of several operations, primarily check, cash, Federal Reserve Bank of Philadelphia and U.S. Treasury services. The restructuring included streamlining the management and support structures, reducing staff, decreasing the number of processing locations, and increasing processing capacity in the remaining locations. These restructuring activities continued in 2004 and 2005. 4. U.S. Government Securities, 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 3.547 percent and 2.974 percent at December 31, 2005 and 2004, respectively. The Bank’s allocated share of U.S. Government securities, net, held in the SOMA at December 31, was as follows (in millions): 2005 2004 Par value: U.S. government: Bills Notes $ 13,484 9,623 $ 10,732 7,822 Bonds 3,293 2,796 Total par value 26,400 21,350 Unamortized premiums 313 280 Unaccreted discounts (100) (49) Total allocated to Bank $ 26,613 $ 21,581 The total of the U.S. government securities, net held in the SOMA was $750,202 million and $725,584 million at December 31, 2005 and 2004, respectively. At December 31, 2005 and 2004, the total contract amount of securities sold under agreements to repurchase was $30,505 million and $30,783 million, respectively, of which $1,082 million and $916 million, were allocated to the Bank. The total par value of the SOMA securities pledged for securities sold under agreements to repurchase at December 31, 2005 and 2004 was $30,559 million and $30,808 million, respectively, of which $1,084 million and $916 million was allocated to the Bank. www.philadelphiafed.org 51 Federal Reserve Bank of Philadelphia The maturity distribution of U.S. government securities bought outright and securities sold under agreements to repurchase, that were allocated to the Bank at December 31, 2005, was as follows (in millions): U.S. Government Securities Sold Under Maturities of Securities Agreements to Repurchase Securities Held (Par value) (Contract amount) Within 15 days $ 1,455 $ 1,082 16 days to 90 days 6,111 - 91 days to 1 year 6,608 - Over 1 year to 5 years 7,476 - Over 5 years to 10 years 2,011 - Over 10 years 2,739 - Total $ 26,400 $ 1,082 At December 31, 2005 and 2004, U.S. government securities with par values of $3,776 million and $6,609 million, respectively, were loaned from the SOMA, of which $134 million and $197 million, respectively, were allocated to the Bank. 5. Investments Denominated in Foreign Currencies The FRBNY, on behalf of the Reserve Banks, holds foreign currency deposits with foreign central banks and 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 foreign governments. The Bank’s allocated share of investments denominated in foreign currencies was approximately 2.497 percent and 2.923 percent at December 31, 2005 and 2004, respectively. The Bank’s allocated share of investments denominated in foreign currencies, including accrued interest, valued at current foreign currency market exchange rates at December 31, was as follows (in millions): 2004 European Union Euro: Foreign currency deposits $ Securities purchased under agreements to resell 48 62 Government debt instruments 89 115 Japanese Yen: 52 2005 136 $ 178 Foreign currency deposits 65 45 Government debt instruments 135 224 Total 473 624 Federal Reserve Bank of Philadelphia $ $ Total System investments denominated in foreign currencies were $18,928 million and $21,368 million at December 31, 2005 and 2004, respectively. Federal Reserve Bank of Philadelphia The maturity distribution of investments denominated in foreign currencies which were allocated to the Bank at December 31, 2005, was as follows (in millions): Maturities of Investments Denominated in European Japanese Foreign Currencies Euro Yen Total Within 15 days 16 days to 90 days 64 17 91 days to 1 year 52 25 77 Over 1 year to 5 years 71 93 164 Over 5 years to 10 years 1 - 1 $ 85 Total $ 273 $ 65 $ $ 150 81 200 $ 473 At December 31, 2005 and 2004, there were no material open or outstanding foreign exchange contracts. At December 31, 2005 and 2004, the warehousing facility was $5,000 million, with no balance outstanding. 6. Bank Premises, Equipment, and Software A summary of bank premises and equipment at December 31 is as follows (in millions): Useful Life Range (in Years) 2004 2005 Bank premises and equipment: Land N/A $ 3 $ 3 Buildings 1-21 78 74 Building machinery and equipment 1-19 12 12 Construction in progress N/A 1 2 Furniture and equipment 1-10 66 65 Subtotal $ 160 $ (85) 156 Accumulated depreciation (78) Bank premises and equipment, net $ 75 $ 76 Depreciation expense, for the years ended $ 10 $ 9 www.philadelphiafed.org 53 Federal Reserve Bank of Philadelphia The Bank leases space to an outside tenant with a lease term of 5 years. Rental income from such lease was $1 million for both years ended December 31, 2005 and 2004. Future minimum lease payments under the noncancelable agreement in existence at December 31, 2005, were (in millions): 2006 $ 2007 2008 2009 2010 1 1 1 1 1 $ 5 The Bank has capitalized software assets, net of amortization, of $10 million and $8 million at December 31, 2005 and 2004, respectively. Amortization expense was $1 million for both years ended December 31, 2005 and 2004. Capitalized software assets are reported as a component of “Other assets” and related amortization is reported as a component of “Other expenses.” Assets impaired either as a result of the Bank’s restructuring plan, as discussed in footnote 10, or the Bank’s decision to increase efficiency, included equipment. Asset impairment losses of $466 thousand for the period ending December 31, 2005 was determined using fair values based on quoted market values or other valuation techniques and are reported as a component of “Other expenses.” The Bank had no impairment losses in 2004. 7. Commitments and Contingencies At December 31, 2005, the Bank was obligated under noncancelable leases for premises and equipment with terms of approximately one year. 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 $1 million for both years ended December 31, 2005 and 2004. Certain of the Bank’s leases have options to renew. The Bank has no capital leases. Future minimum rental payments under noncancelable operating leases with terms of one year or more, at December 31, 2005, were not material. At December 31, 2005, the Bank, acting on behalf of the Reserve Banks, had a contractual commitment extending through the year 2008 totaling $7 million. As of December 31, 2005, $7 million of this commitment was recognized. This commitment represents software licenses and maintenance. The fixed payments under this commitment are $2 million for both years 2006 and 2007. Under the Insurance Agreement of the Federal Reserve Banks, each Reserve Bank 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 that a Reserve Bank’s capital paid-in bears to the 54 Federal Reserve Bank of Philadelphia 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 such agreement at December 31, 2005 or 2004. Federal Reserve Bank of Philadelphia 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. 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 Bank officers participate in the Supplemental Employee Retirement Plan (“SERP”). The System Plan is a multi-employer plan with contributions fully funded by participating employers. Participating employers are the Federal Reserve Banks, the Board of Governors of the Federal Reserve System, and the Office of Employee Benefits of the Federal Reserve System. No separate accounting is maintained of assets contributed by the participating employers. The FRBNY acts as a sponsor of the System Plan and the costs associated with the Plan are not redistributed to other participating employers. The Bank’s benefit obligation and net pension costs for the BEP and the SERP at December 31, 2005 and 2004, and for the years then ended, are not material. Thrift Plan Employees of the Bank may also participate in the defined contribution Thrift Plan for Employees of the Federal Reserve System (“Thrift Plan”). The Bank’s Thrift Plan contributions totaled $3 million for both years ended December 31, 2005 and 2004 and are reported as a component of “Salaries and other benefits.” The Bank matches employee contributions based on a specified formula. For the years ended December 31, 2005 and 2004, 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. www.philadelphiafed.org 55 Federal Reserve Bank of Philadelphia Following is a reconciliation of beginning and ending balances of the benefit obligation (in millions): 2005 Accumulated postretirement benefit obligation at January 1 $ 41.9 2004 $ 50.4 Service cost-benefits earned during the period 1.0 1.1 Interest cost of accumulated benefit obligation 2.4 2.4 Actuarial (gain) loss 3.2 (5.5) Contributions by plan participants 1.0 0.8 Benefits paid (3.3) (2.8) Plan amendments - (4.5) Accumulated postretirement benefit obligation at December 31 $ 46.2 $ 41.9 At December 31, 2005 and 2004, the weighted-average discount rate assumptions used in developing the postretirement benefit obligation were 5.50 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): 2005 Fair value of plan assets at January 1 $ Actual return on plan assets - 2004 $ - - - Contributions by the employer 2.3 2.0 Contributions by plan participants 1.0 0.8 Benefits paid (3.3) (2.8) Fair value of plan assets at December 31 $ - $ - Unfunded postretirement benefit obligation $ 46.2 $ 41.9 Unrecognized prior service cost 6.2 Unrecognized net actuarial loss (15.3) Accrued postretirement benefit costs $ 37.1 $ 7.5 (13.1) 36.3 Accrued postretirement benefit costs are reported as a component of “Accrued benefit costs.” 56 Federal Reserve Bank of Philadelphia For measurement purposes, the assumed health care cost trend rates at December 31 are as follows: 2005 Health care cost trend rate assumed for next year Federal Reserve Bank of Philadelphia 2004 9.00 % 9.00 % Rate to which the cost trend rate is assumed to decline (the ultimate trend rate) 5.00 % 4.75 % Year that the rate reaches the ultimate trend rate 2011 2011 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, 2005 (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 0.4 $ 4.3 (0.4) (4.2) The following is a summary of the components of net periodic postretirement benefit costs for the years ended December 31 (in millions): 2005 Service cost-benefits earned during the period $ 1.0 2004 $ 1.1 Interest cost of accumulated benefit obligation 2.4 2.4 Amortization of prior service cost (1.3) (1.7) Recognized net actuarial loss 1.0 0.4 3.1 2.2 Total periodic expense $ $ Curtailment gain - (7.7) Net periodic postretirement benefit costs (credit) 3.1 (5.5) $ $ Net postretirement benefit costs are actuarially determines using a January 1 measurement date. At January 1, 2005 and 2004, the weighted-average discount rate assumptions used to determine net periodic postretirement benefit costs were 5.75 percent and 6.25 percent, respectively. Net periodic postretirement benefit costs are reported as a component of “Salaries and other benefits.” www.philadelphiafed.org 57 Federal Reserve Bank of Philadelphia A plan amendment that modified the credited service period eligibility requirements created curtailment gains in 2004. 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 by 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 gain in the accumulated postretirement benefit obligation and in actuarial loss in the net periodic postretirement benefit costs. Following is a summary of expected benefit payments (in millions): Expected benefit payments: Without Subsidy $ 2006 2007 2.9 2.5 2008 3.0 2.6 2009 3.1 2.6 2010 3.2 2.7 2011-2015 17.5 14.5 Total 32.5 27.4 $ 2.8 With Subsidy $ $ 2.5 Postemployment Benefits The Bank offers benefits to former or inactive employees. Postemployment benefit costs are actuarially determined using a December 31, 2005 measurement date and include the cost of medical and dental insurance, survivor income, and disability benefits. The accrued postemployment benefit costs recognized by the Bank at December 31, 2005 and 2004 were $5 million and $6 million, respectively. This cost is included as a component of “Accrued benefit costs.” Net periodic postemployment benefit costs included in 2005 and 2004 operating expenses were $20 thousand and ($1) million, respectively and are recorded as a component of “Salaries and other benefits.” 10. Business Restructuring Charges In 2005, the System announced plans for consolidation and restructuring to streamline operations and reduce costs, including consolidation of operations and staff reductions in various functions of several Banks. The Bank’s costs associated with the restructuring were not material. 58 Federal Reserve Bank of Philadelphia