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Federal Reserve
Bank of Richmond

A n Analysis of Federal R eserve P ricing


H ighlights


Sum m ary of Operations


Com parative Financial Statements


D irectors





IS S N 0164-0798






Additional copies of this Annual Report may be obtained without charge from the
Public Services Department, Federal Reserve Bank of Richmond,
P. O. Box 27622, Richmond, Virginia

March 28, 1986

To O u r Mem ber Banks:
W e are pleased to present the 1985 Annual R eport o f the Federal R eserve Bank
of R ichm ond.

T h e R ep ort’s feature article describes and analyzes the methods the

Federal R eserve has developed to price its correspondent banking and payments
services. T he R eport also includes highlights of the y e a r ; a summary of op era tion s;
com parative financial statem ents; and current lists o f directors and officers of our
B altim ore, Charleston, Charlotte, Columbia, Culpeper, and R ichm ond O ffices.
O n behalf of our directors and staff, we wish to thank you fo r the cooperation
and support you have extended to us throughout the past year.

Sincerely yours,



A natoli Kuprianov*



T his article describes and evaluates the pricing

In 1981 the Federal R eserve System adopted a
new pricing policy for certain correspondent banking
and other services, such as check clearing and settle­
ment, supplied by Reserve Banks.

T h e new policy

was mandated by the M onetary C ontrol A ct of 1980,
which gave all depository institutions equal access to
Federal R eserve clearing services and required that
prices charged for those services be set so as to
reflect all costs of production, including an allowance

m ethods adopted by the Federal Reserve.


related to Fed pricing can be divided into tw o cate­

T he first pertains to the determination of

imputed private sector c o s ts ; the second to the allo­
cation o f those costs to individual service prices.
Sections II and I I I describe and analyze the methods
used in cost determination, while Sections I V and V
d o the same fo r cost allocation.

Conclusions are

stated in Section V I.

for taxes, a return to capital, and all other expenses a


private sector firm w ould bear.


Federal R eserve Banks have supplied corresp on ­





throughout m ost of their history.



B efore 1980 only

mem ber banks had direct access to all Federal R e ­
serve clearing services.

T h ey received these services

free of charge as partial com pensation for the cost of
the non-interest-bearing reserves they w ere required
to hold.

Private correspondent banks and clearing­

T h e cost o f capital is by far the m ost im portant of
the costs the Federal R eserve must impute to its
priced services.

A ccordin gly, most of the analysis of

cost determination focuses on capital financing costs.
A detailed description of the m ethods used to deter­
mine imputed costs follow s a review of some relevant
aspects of the theory of capital finance.

houses supplied clearing services to nonm em ber banks
and other depository institutions such as thrifts and

Factors Determining the Cost of Capital

credit unions.
W h en Congress granted equal access to Federal

Capital good s, by definition, yield a stream of

R eserve services it recognized that this action w ould

productive services over an extended length o f time.

put the F ed in m ore direct com petition with private

T h e cost o f capital refers to the price o f capital ser­

correspondent banks.


T he pricing requirements in­

A s the name suggests, the cost of capital

cluded in the act w ere intended to enable private

measures opportunity cost.

firm s to com pete with the Fed.


P ricin g was also

seen as a way of encouraging m ore rational resource
utilization, since there was little incentive to conserve
on the use of Fed services when no explicit prices
were charged.1



1 Another reason Congress required the Fed to price
certain of its services was to offset the cost to the U. S.
Treasury of the lower reserve requirements brought


that bear the same amount of risk.
Investors in financial markets determine the cost
o f capital.

Firm s finance capital investment through

the sale of financial assets such as equity shares, or
stocks, and bonds.

* This article grew out of a research project originally
undertaken with W ard McCarthy, formerly an economist
with the Federal Reserve Bank of Richmond, but cur­
rently associated with Merril Lynch Economics.
addition to Mr. McCarthy, the author wishes to acknowl­
edge helpful comments by Marvin Goodfriend, David
Humphrey, Tom Humphrey, David Mengle, Bruce Sum­
mers, and John W alter. Any remaining errors or omis­
sions are the sole responsibility of the author.

It is the expected rate

alternative investment

M arket prices o f those financial

about by the Monetary Control Act. Revenue considera­
tions were not responsible for the legislative provisions
requiring the Fed to recover imputed private sector costs,
Instead, those provisions were intended to
foster competition and promote efficient resource alloca­
tion, as noted in the text.
A detailed account of the
legislative debate over Federal Reserve pricing can be
found in Anatoli Kuprianov, “ The Monetary Control Act
and the Role of the Federal Reserve in the Interbank
Clearing Market,” Federal Reserve Bank of Richmond,
Economic Review 71 (July/A ugust 1985): 23-35.


assets reflect the return on capital the firm is e x ­

se rv ices), the assumed capital structure (the p rop or­

pected to earn. A ll other things equal, the low er the

tions o f equity and debt used to finance the asset

expected return the low er w ill be the market value

b a se), and the imputed rate of return to equity and

of a firm ’s outstanding financial assets.


interest rates on debt.


I summarizes the

investors typically demand a premium in exchange

capital structure assumptions applied to the priced

for greater risk, the cost o f capital is higher for firms

services asset base.

that undertake riskier investments.

determined by matching different types of assets with

A firm ’s cost of capital can be expressed as the
total expected return to investors divided by the

Overall capital structure is

separate funding sources.

T his matched-book capital

structure, as it is termed, treats long-term assets as


being financed by a m ix o f equity and long-term debt,

ratio, in turn, can be expressed as a weighted average

while short-term assets are assumed to be financed

of the expected rate o f return to equity and the

by short-term debt.

market value of outstanding financial assets.

interest rates paid on outstanding debt.

A ssets classified as long-term are physical assets,

In a market econom y prices allocate resources.

such as buildings and equipment.

Short-term assets

T h e cost o f capital, as determined in financial mar­

consist of w ork ing cap ital; that is, funds needed to

kets, determines how capital is allocated.

conduct a firm ’s day-to-day transactions.

A firm


will invest in capital if the expected rate of return on

expenses, materials and supplies, and receivable ac­

investment is at least equal to the cost o f capital at

counts reflect such funding needs.

the m a rg in ; otherwise, the market value of its out­

Im puted financing costs for the assets listed in

standing equity will fall until the expected rate of

Table I are recovered using tw o different methods.

return to shareholders once again equals the expected

T he F ed distinguishes between assets directly related

return on other investments bearing equivalent risks.

to the production of priced clearing services and

A ssum in g firm s attempt to m axim ize their market

other assets used to facilitate the clearing and settle­

value, capital will be allocated to investments with

ment o f payments transactions.

the highest expected return for a given amount of

long-term assets and w orking capital are determined


Financing costs for

A firm that is unable to earn a rate o f return

using a financial m odel of large bank holding com ­

at least equal to its cost of capital over the long run

panies and recovered through a m ark-up added to

will experience difficulty in attracting capital from

service prices.


and identifiable incom e streams apart from the fee in­

Self-financing assets earn separate

com e earned from the sale of priced clearing services.

The Cost of Capital to the Federal Reserve
Federal R eserve Banks, because of their unique
status as quasi-governm ental agencies, are not subject

T w o types o f self-financing assets are listed in
Table I.

T h e first is Federal R eserve float.

T he

cost of float is largely recovered through separate

to the same market forces con fron tin g private firms.

charges against institutions that receive credit for

A lthough they are legally privately ow ned institu­

checks and other items before the Fed receives the

tions, their stock is issued only to mem ber banks and

funds for those items. Clearing balances are deposits

cannot be bought or sold in financial markets. M o re ­

held with R eserve Banks (in addition to required

over, dividends paid on that stock are fixed by law

reserves) to facilitate the transfer o f funds associated

at a six percent annual rate, with all remaining reve­

with the transactions they process.2 Funds obtained

nues net of expenses turned over to the U . S. T rea ­

from clearing balance deposits are assumed to be


invested in short-term governm ent securities.

Thus, unlike a purely private firm , the cost of

T his

capital to the Fed is not determined in financial

Nevertheless, capital acquired by the Fed

does have an opportunity cost.

F o r capital used in

the production o f priced clearing services, that op p or­
tunity cost is reflected in the cost o f capital faced by
its com petitors in the private sector.

Capital Structure Assumptions
Total imputed financing costs for Federal R eserve
priced service operations are determined by the asset
base (th e value o f capital assets devoted to priced


2 Although the Monetary Control A ct imposes uniform
reserve requirements on all depository institutions, some
institutions may not hold sufficient reserves directly with
Reserve Banks to facilitate clearing and settlement. Situ­
ations such as this can arise because reserve requirements
can be satisfied by vault cash holdings or by reserve
accounts, known as pass-through reserve accounts, ad­
ministered by private correspondent banks for their
respondents. Institutions are required to hold separate
clearing balance deposits as a condition for receiving Fed
services in these cases to prevent the occurrence of over­
night overdrafts.
Banks that otherwise hold sufficient
reserves for clearing purposes can also hold clearing
balances in addition to required reserves.

Table I



Equity a n d long-term deb t 1

Prem ises
Furniture a n d e q u ip m e n t
Leases a n d lea se ho ld im p ro ve m e n ts

W o rk in g C apital:
Short-term deb t 1

R eceivables
M a te ria ls a n d su p p lie s
P re p a id exp e n se s
Se lf-F in a n cin g Assets:
Net item s in the process o f collection (float)
Im puted reserve req uirem en ts

B a la n c e s a ris in g from e a rly credit of uncollected item s 2

C le a rin g b a la n ce s 3

Investm ent in m a rk e ta b le securities
1 Im puted fin an cin g costs determ ined using the b a n k hold in g co m p an y model.
2 Im puted cost is the fed eral fu n d s rate.
3 Cost o f fu n d s determ ined by the earn in gs credit rate pa id on clearing b alan ce s deposited w ith Federal Reserve Banks.
Source: B oard o f G ove rn o rs
(N ovem ber 20, 1985).

o f the Federal

Reserve System , "F in a n c ia l

Results of





O p e ratio n s,"

assumption is reflected in the tw o asset accounts

then used to determine a targeted rate of return on

corresponding to clearing balance liabilities in Table

long-term assets and w ork ing capital.


T he Federal R eserve pays implicit interest on

above, imputed financing costs fo r these tw o cate­

designated clearing balances in the form of earnings

gories of assets are recovered through a mark-up

credits that can be used to pay for its priced services.

added to service prices.

Im puted earnings on the funds placed in the corre­

A s noted

T h e resulting targeted rate o f return is a pre-tax

sponding asset accounts offset the cost of these earn­


ings credits to the Federal R eserve.

return and corporate incom e taxes that would be

T h e treatment

It reflects both the im puted after-tax rate of

o f self-financing assets is described in greater detail

levied against the pre-tax return.

at the end of this section.

o f return to capital can be expressed as a weighted

T h e pre-tax rate

average of the pre-tax rate o f return to equity and

The Bank Holding Company Model
A financial model o f large bank holding companies

the interest rates paid on outstanding debt. Form ally
stated, that expression is

is used to impute a cost o f capital to the Federal R e ­
serve. T h e bank holding com pany m odel adopted by

r =



a2r2 +


the Fed uses financial data on the tw enty-five largest
bank holding com panies in the U nited States to esti­

where the variable r represents the aggregate pre-tax

mate the average pre-tax rate of return on capital

rate of return to capital, rx the after-tax rate of return

for the sample.3

to equity, t the average corporate tax rate, r2 the

That estimated rate o f return is

average interest rate paid on long-term debt, r3 the
average short-term interest rate, and ai, a2, and a3 the
3 Because of unique circumstances, one of the twentyfive largest bank holding companies was removed from
the sample used to calculate the targeted rate of return
for 1986, and another holding company was substituted
in its place. 50 Federal Register 47,624 (November 19,

proportions of equity, long-term debt, and short-term
debt used to finance capital investment.
A ccoun ting data taken from the financial state­
ments o f the bank holding com pany sample are used


to construct an estimate o f the average pre-tax rate
o f return.

Interest Rates

A n imputed interest rate on lon g ­

A n estimated rate of return calculated on

term debt is determined by averaging the interest

the basis o f accounting data is termed a book rate o f

rates paid on all outstanding long-term debt for the


holding companies sampled.

B ook rates o f return can be contrasted with

T he short-term interest

market rates, which are calculated using market data

rate is estimated in the same way, except that demand

on actual returns earned by investors.

deposits and other deposits subject to interest rate


form al

derivation of the rate of return form ula used in the

ceilings are excluded from the calculation.

bank holding com pany model is presented in the

banks often pay implicit interest in the form o f free

shaded b o x on the opposite page.

A description o f

gifts or services fo r deposits subject to interest rate

how the variables appearing in that form ula are cal­

ceilings, explicit interest rates provide dow nw ardly

culated follow s.

biased estimates of the true cost o f these funds.


T h e procedure used to determine the average rate

Since implicit interest payments are difficult to esti­

o f return earned by the bank holding com pany sample

mate, all such deposits are excluded from the calcu ­

can be divided into three steps.

lation o f the cost o f short-term debt finance.

First, the pre-tax

rate o f return to equity, r i / ( l — t ) , is estimated. T his
term measures both the cost o f equity finance and
corporate incom e taxes.

Second, interest rates on

long-term debt, r2, and short-term debt, r3, are esti­

T hird , the assumed financial structure (r e ­

flected by the weights ai, a2, and a3) is determ ined.4

Capital Structure

T h e weights ai, a2, and a3 ap­

pearing in the bank holding com pany rate of return
form ula are determined on the basis of the m atchedbook capital structure assumption described earlier.
L ong-term assets are assumed to be financed by a
m ix o f equity and long-term debt.

P roportion s of

The Pre-Tax Rate of R eturn to E qu ity Determ in­

equity and long-term debt, represented by the vari­

ing the pre-tax rate o f return to equity requires three

ables ai and a2, are based on the corresponding p ro ­


portions observed fo r the bank holding com pany

In the first step the after-tax rate of return is

calculated by dividing after-tax profits by the book


value of outstanding equity.

equal the proportion of long-term assets in the bank

This yields an estimate

T h e sum ai -J- a2 is determined so as to

h olding com pany m odel asset base, which is com posed

of the variable ri.
A verage corporate incom e tax rates are estimated

o f long-term assets and w orking capital. T he variable

by dividing actual taxes paid, with an adjustm ent

a3 is the share of w ork ing capital in the asset base.

that adds back the tax benefits that banks get from

T h e cost o f finance fo r w orking capital is r3, the

holding municipal bonds, by gross income.

short-term interest rate.

D eferred

taxes are excluded from the estimated tax rate.

T he

imputed tax rate is then determined as a weighted
average o f the estimated tax rates for each o f the

Other Imputed Private Sector Costs
T he estimate of the pre-tax cost o f capital obtained

T h e weights used

using the bank holding com pany model includes an

to com pute the sample average are individual holding

imputed allowance for the cost of corporate incom e

holding com panies in the sample.

com pany profits divided by total profits for the entire



their nonprofit status, are also exem pt from certain

Finally, the pre-tax rate o f return to equity is

H ow ever, Federal R eserve Banks, because of

sales taxes that private firms are required to pay.


determined by dividing the after-tax rate, rj, by

separate allowance for such taxes is therefore added

( 1 — t ) , w here t denotes the average tax rate.

to the total cost recovery target.

T he

values of ^ and t used in this final step are threeyear m oving averages o f the sample averages.

Other imputed expenses include an allowance for
federal deposit insurance assessments, based on total
clearing balances, and Federal Reserve B oard staff
expenses attributable to priced services development.

4 Information on the bank holding company model was
gathered from a series of Federal Register notices pub­
lished by the Federal Reserve Board: 46 Federal Register
1,338 (January 6, 1981); 49 Federal Register 11,251
(March 26, 1984); 49 Federal Register 44,556 (N ovem ­
ber 7, 1984); and 50 Federal Register 47,624 (N ovem ­
ber 19, 1985).


A s part of this last allocation, a portion of B oard
assets are added to the priced services asset base.5

5 49 F ed era l R eg ister 11,251 (M a rch 26, 1984).

The Rate of Return to Capital as a W eighted Average of
Interest Rates and the Return to Equity
T h e financial model of large bank holding
com panies used by the Federal R eserve to
determine its imputed cost o f capital is based
on a form ula that breaks dow n the aggregate
rate o f return to capital into a weighted average
o f the pre-tax rate o f return to equity and the
interest rates paid on long- and short-term debt.
In the derivation that follow s, all variables
represent accounting data that appear in bank
h olding com pany financial statements.
Consider a firm that finances its investments
by issuing a m ix of equity shares, long-term
debt, and short-term debt. L et the variable s
represent the book value o f the firm ’s outstand­
ing equity, bi the book value o f long-term debt,
and b2 the value o f short-term debt. T h e aggre­
gate book value, v, o f all claims against the
firm ’ s revenues is
v =

s - f bi -f- b2 .

N o w let the variable q denote revenues net
of operating expenses. T h e pre-tax b ook rate
of return to capital, represented by the variable
r, is the ratio o f pre-tax earnings to the aggre­
gate book value o f all claims held by investors
against the firm ’ s incom e stream.
In form al

T axable profits, denoted by the variable n ,
are determined by subtracting total interest
payments on outstanding debt from net before­
tax revenues. I f Ci and c 2 represent outstanding
interest payment obligations on long- and short­
term debt, then taxable profits are

7 = q — Ci — c2 .
A fter-ta x profits are ( 1 — t)7r, where t repre­
sents the corporate incom e tax rate.
U sin g the definition o f taxable profits, the
p re-tax rate of return to capital can be alterna­
tively stated as
r =

t + Ci + c2
----- 1------- 1----- .

T h e last expression can be restated as a
w eighted average o f the pre-tax rate o f return
to equity and the average yields paid on long-

and short-term debt. T o see this, first note that
the pre-tax rate of return to equity, denoted by
the variable re, is the ratio o f pre-tax profits to
the value o f outstanding equity. Form ally,


T h e average yields on long-term debt, r2, and
short-term debt, r3, are defined as


N o w let ai, a2, and a3 denote the proportions o f
equity, long-term debt, and short-term debt the
firm uses to finance its investments. B y defi­

U sing these definitions, the pre-tax
return to capital can be expressed as
r =

rate o f

a ire - f a2r2 - f a3r3 .

A s a final step, let rx = ( 1 — t)7 r/s denote
the after-tax rate o f return to equity. Then,
the pre-tax rate o f return can be expressed as a
function o f the after-tax rate,

Substituting this last expression into the
weighted average rate o f return form ula derived
above yields
r =

ai ( y ~ ^ ) 4" a 2r2

a3^3 ,

which is the form ula stated in the text.


Self-Financing Assets

T h e remaining funds are allocated to the invest­
ment in marketable securities account. Funds
in that account are assumed to be invested in
three-m onth T reasury bills.

T hree o f the asset accounts listed in T able I
are classified as self-fin a n cin g: float, imputed
reserve requirements on clearing balances, and
investment in marketable securities. H o w fi­
nancing costs fo r these assets are determined
and recovered are described below.

Float is created when the Federal
R eserve makes the funds from a payments
transaction available to a receiving bank before
they are obtained from the payor. A s such, it
represents an extension o f credit to the banking
system and is included as a short-term asset on
the balance sheet of the Federal Reserve. A l­
m ost all float results from check-clearing ac­
tivities, although small amounts can also arise
from automated clearinghouse ( A C H ) trans­

Clearing Balances T h e accounts labeled im ­
puted reserve requirements on clearing balances
and investment in marketable securities shown
in T able I stem from clearing balances de­
posited with R eserve Banks by com m ercial
banks and other depository institutions. Clear­
ing balances held on deposit with the Federal
R eserve earn interest in the form o f earnings
credits that can be used to pay for clearing
services. Earnings credits accruing to clearing
balances are com puted at a rate o f interest that
approxim ates the com petitive rate private co rre ­
spondents w ould pay on equivalent deposits.
That interest rate is determined using the p re­
vailing federal funds rate, with an adiustm ent
to reflect the marginal cost o f the added reserve
requirements a correspondent bank w ould be
required to hold against such deposits. A c c o r d ­
ing to calculations perform ed b y the Federal
R eserve B oard staff, this adjustm ent reduces
the rate paid on clearing balances by seven
Correspondent banks are subject to a tw elve
percent required reserve ratio on balances d e­
posited by their respondents.
A ccordin g ly ,
tw elve percent o f the funds the Federal R eserve
receives from clearing balance deposits are allo­
cated to the imputed reserve requirements ac­
count, which is assumed to earn no interest.

T h e M onetary C ontrol A ct classifies float
as a separate service subject to pricing.
requires float to be valued at the prevailing
federal funds rate and recovered through p ric­
ing. T he cost o f float is recovered by a number
o f different methods depending on the factors
responsible for its creation and the choice of
payments options depository institutions make.
Funds for checks cleared through Federal
R eserve offices are made available according to
fixed availability schedules. F or example, funds
for checks drawn against institutions in the
same district are typically made available to the
receiving institution on the next business day.
W h en machinery breakdow ns or transportation
delays interrupt the scheduled collection of
funds for checks drawn against banks in the
same district, the cost o f the resulting float is
added to overhead expenses and recovered
through check collection fees.3

1 Although the marginal reserve requirement for
correspondent banks is twelve percent, deposits
held with a correspondent are snbtracted from a
respondent bank’s reservable liabilities. The Fed­
eral Reserve Board has argued that this subtraction
effectively raises the rate of interest paid on such
deposits and adjusts the rate paid on clearing bal­
ances accordingly.
49 Federal Register 11,251
(March 26, 1984).




2 A very small amount of float is also created in
connection with wire funds transfers and the trans­
fer of book-entry securities.
Float arising from
these types of transactions can be either debit or
credit float, which means that the cost to the Fed
can be negative.
For practical purposes, the net
amount of such float is negligible.
3 48

Federal Register 10,753 (March 14, 1983).

an opportunity to offer com peting services.

T he

second is to bring about an efficient use of econom ic

T w o ultimate goals underlie the pricing policy for

T o be able to com pete with the Federal Reserve,

Federal Reserve services mandated by the M onetary

private firms must perceive an opportunity to earn a

C ontrol A ct. T he first is to give private sector firms

rate o f return at least equal to their cost o f capital.


T h e cost o f capital is, by definition, the opportunity
cost o f capital.

A n opportunity cost is the cost of

foregon e alternatives. In a market econ om y decisions
regarding resource allocation are based on percep­
tions o f relevant opportunity costs.
O ther types of float are charged directly to
the parties receiving the resulting extension of
credit. Institutions that close during m idweek
must pay the cost o f float generated by such
closings.4 Banks receiving early credit for
checks drawn against banks in other districts
must pay for the resulting float.5
Because A C H transactions are not affected by
the same factors that can delay check collection,
A C H float is a smaller problem than check float.
W h en data processing problem s or network
transmission delays result in the creation of
A C H float, the associated costs are allocated to
A C H overhead expenses and recovered through
service fees.
Float resulting from m idweek
closings is priced in much the same way as
check float in corresponding cases.6
Financial institutions can ch oose am ong one
of tw o payments options for float. T hey can
either authorize the F ed to directly debit their
reserve or clearing accounts fo r the cost of float
arising from interterritorial check deposits or
from m idweek closings, or they can have their
reserve or clearing account balances adjusted
after the fact by the amount o f float received
over that period. T hese “ as o f” adjustments,
as they are termed, reduce the am ount of earn­
ings credits paid on clearing balances or, alter­
natively, require holding higher required
reserve balances in subsequent days to meet
average reserve requirements.

W h en prices

reflect true opportunity costs, they give purchasers
incentives to use different good s and services only so
long as the value they place on those items is at least
as great as the cost to society o f produ cin g them.
T h e resulting outcom e is efficient in the sense that it
allocates resources to the production of goods and
services m ost valued by market participants.
T hese considerations suggest that the bank holding
com pany m odel can be evaluated on the basis o f how
well it estimates the cost of capital faced by private
firm s that com pete with the Federal Reserve.







Evaluation Criteria
Determ ining the appropriate targeted rate of return
to capital poses a number of difficult m ethodological
problem s.

T hese problem s, how ever, are not unique

to the Federal Reserve.


R egulatory agencies such as

com m issions


lon g


5 48
6 49

Federal Register 10,753 (M arch 14, 1983).
Federal Register 6,564 (February 22, 1984).


with a similar task. T hese agencies attempt to deter­
mine service prices that permit regulated firms to
earn rates o f return high enough to attract capital
without yielding m onopoly profits.
T h e pricing m ethodology adopted by the Federal
R eserve closely resembles the rate-setting methods
com m only used by regulatory agencies.


m ethods for regulated industries have received a
great deal o f attention from econom ists.

4 Nonstandard holidays are treated differently from
midweek closings, however. Nonstandard holidays
are state holidays during which Federal Reserve
Banks and most banks nationwide are open for
business. In cases where banks are legally required
to close for a state holiday, credit to the sender of
an item is deferred to the next business day. 12
C.F.R. Part 210 (Regulation J, Collection of Checks
and Other Items and W ire Transfer of Funds).


follow ing

It seems

reasonable, therefore, to apply the same evaluation
standards developed to analyze public utility pricing
to the m ethodology adopted by the Federal Reserve.
K olbe, R ead, and H all have proposed tw o theo­
retical evaluation criteria fo r analyzing rate-setting
m ethods used in public utility regulation.6 T h e first
is a test for consistency with econom ic theory.


test looks at the assumptions and procedures used to
estimate the cost of capital to determine whether they
are consistent with accepted econom ic theory. The
second criterion is a test o f the logical consistency of
the rate-setting procedure.

Its purpose is to deter­

That opportunity can exist only if the targeted rate

mine whether a rate-setting procedure can be log i­

of return to capital incorporated into Federal Reserve

cally expected to achieve certain goals.

service prices reflects the cost of capital faced by its
potential com petitors.
A pricing policy that encourages com petition is also
efficient from

the standpoint of econom ic theory.

6 A . Lawrence Kolbe
George R. Hall, The

and James


Read, Jr., with

Cost of Capital, Estimating the
Rate of Return for Public Utilities (Cambridge: The

M I T Press, 1984), chap. 3.


Consistency with Economic Theory

expected rate o f return.

C onsistency with econom ic theory is a useful evalu­
ation criterion because theory identifies the o p p or­
tunity costs relevant to decisions affecting resource

A great deal of published data, especially

accounting data, measure historical costs rather than
opportunity costs. Because market conditions change
over time, historical cost data generally provid e p oor
estimates of current opportunity costs.

U n fortu ­

nately, exact measures o f opportunity costs, such as
the cost of capital, are not always available.

In such

cases, econom ic theory can be used to develop esti­

Second, fluctuations in

market interest rates change the cost of issuing new
debt. T hird, tax laws do not, as a general rule, treat
different types o f capital investment eq u a lly ; m ore­
over, those laws are periodically revised so that effec­
tive marginal tax rates on new investment can differ
from tax rates on past investment. Finally, financing
decisions, reflected by the weights ai, a2, and a3, may
differ at the margin fo r new investments.

Each of

these issues must be considered in evaluating different
methods o f estimating the cost of capital.
E stim ating the Cost of E qu ity

A s residual claim ­

mation methods that are free from systematic bias.

ants to the incom e earned by a firm, shareholders

V iew ed from this perspective, the purpose of the

bear tw o types of risk.

test for

risk inherent to the activities a firm engages in ; i.e.,

consistency with


is to


Business risk refers to the

whether a rate-setting procedure utilizes the best

risk stemming from capital investment.

available methods to estimate true opportunity costs.

risk is created when investment is financed by b o r­

The Difference between Realized R eturns and the
Cost of Capital A s noted earlier, the pre-tax cost of
capital can be expressed as a weighted average of the
expected pre-tax rate of return to equity and the
interest rates paid on debt issued to finance new in­
vestment. T he cost of capital differs from the realized
return to capital in that it is an expected rate of



T h e m ore highly leveraged a firm is the

m ore variable are rates o f return earned by share­
holders and the greater is the risk o f default.


of these sources of variability in earnings determine
the risk premium demanded by shareholders.

F irm s

that bear similar business and financial risks should,
according to theory, face the same cost o f equity.

U sing the notation developed earlier, the

T he bank holding com pany model estimates the

p re-tax weighted average cost o f capital can be e x ­

historical cost o f equity to large holding com panies


by averaging past realized rates of return earned by a

pressed as

sample of firm s.
E (r ) =



a2r2 +

that approach.

a3r3 ,

T w o im plicit assumptions underlie
T he first is that the cost o f equity

faced by the nation’ s tw enty-five largest holding com ­
w here now

E (r )

denotes the expected aggregate

panies is the same. T h e second is that expected rates

p re-tax rate o f return to capital, or cost o f ca p ita l;

o f return to equity equal subsequent realized rates on

E (r x ) the expected return to equity, which measures


the cost of equ ity; t the marginal tax rate on new

econom ic research and, at least in the case o f market

investm ent; r2 and r3 the interest rates paid on long-

equity returns, appears to be em pirically justified.7

and short-term debt issued to finance new invest­

Because changes in market conditions can cause

T h e last assumption is com m only made in

ment ; and a1 a2, and a3 the targeted proportions of

rates of return to fluctuate over time, the bank

debt and equity used to finance new investment.

holding com pany model uses a three-year average of

T h e bank holding com pany model uses historical

past rates o f return to determine the imputed cost of

T w o implicit

equity. Basing the imputed cost o f equity on a simple

assumptions underlie that approach. T h e first is that

average o f historical rates assumes that the cost of

the average historical book rate o f return yields good

equity is constant over the sample period.

returns to estimate the cost o f capital.

T h e last

estimates o f the past cost of capital to the banking

T he second is that the historical cost o f

capital can be used to infer the cost of capital cu r­






com petitors.

W h eth er these assumptions are justified can be deter­
mined by exam ining available evidence on the be­
havior of capital markets.
T here are a num ber of reasons w hy the cost of
capital can differ from historical rates o f return.
First, past returns to equity can differ from


7 Studies have found that capital markets are efficient in
the sense that market prices of financial assets fully
incorporate all publicly available information about the
firms issuing those securities.
Under certain assump­
tions, market efficiency implies that discrepancies be­
tween realized and expected rates of return should be
zero on average.
See, for example, Eugene F. Fama,
“ Efficient Capital Markets: A Review of Theory and
Empirical W o r k ,” The Journal of Finance 25 (M ay
1970): 383-417. A more recent survey can be found in
Thomas E. Copeland and J. Fred W eston, Financial
Theory and Corporate Policy, 2d ed. (Reading, M ass.:
Addison-W esley Publishing Company, 1983), chap. 10.

assumption is a strong one, but has some empirical

Studies have found that market rates

First, the market value o f a firm ’ s equity will
typically differ from its b ook value.

A lthough there

of return for virtually all firms whose stocks trade in

is reason to believe that investors’ expectations are

organized markets are uncorrelated over time.

correct on average, realized returns in specific cases


gene Fama has noted that such behavior is consistent

can differ m arkedly from initial expectations. W h en a

with the join t hypothesis that markets are efficient,

firm ’s earnings fall short of expectations, for example,

in the sense that expected rates equal realized rates

the market value of its outstanding equity falls until

on average, and that the expected rate of return to

the expected rate of return to equity is once again

equity is constant over time.8

equated with the cost of equity.

A n alternative approach m ore com m only used to

Thus, when market

value is less than book value the book rate o f return

estimate the cost of equity to firms is based on the

will tend to understate the true rate.

Capital A sset P ricing M odel ( C A P M ) .

when market value exceeds book value the book rate

A sset P ricing

T h e Capital

M odel specifies rates of return to

risky assets as a function of their covariance with a
diversified market portfolio.

A principal result of


overstates the true rate.
Second, book rates o f return use accounting profits
to measure the return to equity.

A ccoun ting profits

that model is that only undiversifiable risk, that is,

may differ systematically from true econom ic returns,

the portion of the variation in equity returns corre­


lated with the returns to a fully diversified market

do not recognize changes in asset values, except when

p ortfolio, determines the risk premium demanded by

assets are disposed of. M oreover, depreciation sched­


ules used in standard accounting practices are arbi­


recent years



A sset

Standard accounting procedures typically

P ricing M odel has gained increasing acceptance in

trary from an econom ic point of view. T o the extent

public utility rate-setting hearings.

that accelerated depreciation schedules used for tax

purposes overstate the true rate of depreciation, for

begun to replace the C A P M as the dominant analyt­

example, accounting profits may understate profits.

M ore


A rbitrage

P ricing

T h eory

ical fram ew ork used in research into capital market



allow considerable discretion in the w ay incom e can

A rbitrage P ricing T h eory is m ore general





than the Capital A sset P ricing M odel in that it relates

be reported.

equity returns to a number o f other factors in addi­

firms that earn the same true incomes to report quite

It is thus theoretically possible for tw o

tion to the return earned on a diversified portfolio.

different accounting profits.

A s with the C A P M , A rbitrage P ricing T h eory can

evidence that these discrepancies will cancel out on

be used to estimate the cost o f equity to firm s.


T he

C A P M can be view ed as a special case o f A rbitrage
P ricing T heory.

M oreover, there is no

It w ould be a straightforward task to incorporate
market rates of return into the bank holding company

T h e above discussion has assumed that market

model. A vailable evidence suggests that market rates

rates of return are used to estimate the cost of equity.

w ould yield better estimates of the cost of capital

A s noted earlier, however, the bank holding com pany

than book rates.

m odel uses book rates of return based on accounting

D ifferences between book rates o f return and

The Cost of B orrow ing

market rates are exam ined below.

readily available.
M easuring Returns to E quity

U nlike the expected re­

turn to equity, data on market interest rates are
Interest rates paid on debt con ­

M arket rates of

tracted in the past do not reflect the cost of borrow ing

return earned by shareholders are the sum o f the

to finance new investm ent: current market interest

dividend yield, the ratio of dividends to the market

rates do.

value of equity, and any capital gains or losses to
shareholders resulting from changes in the market

should be based on currently prevailing market inter­

value of equity.

T herefore, estimates of the cost of capital

est rates.

M arket rates o f return are the
M easuring Effective Tax Rates T a x laws stipulate

theoretically correct measure of shareholder earnings.
B ook rates of return typically differ from market

both a legal or statutory tax rate and rules that


specify h ow taxable incom e for a firm must be co m ­

K olbe, Read, and Hall note tw o principal

puted. A ccou n tin g conventions required by tax laws

reasons for these discrepancies.
8 See Eugene F. Fama, Foundations of
Y o rk : Basic Books, Inc., 1976), chap. 5.

Finance (New

9 See Kolbe, Read, and Hall,

The Cost of Capital, pp.


D e­

discussed by A uerbach are relevant to the evaluation

preciation schedules used for tax purposes, for e x ­

of the Federal R eserve’s m ethod of im puting taxes.

do not measure true econom ic costs, how ever.

ample, rarely correspond to true econom ic depreci­

Consequently, effective tax rates can differ

First, some firms may earn a rate o f return to
capital that is in excess o f a com petitive return. Such

E ffective tax

excess returns may reflect the entrepeneurial ability

rates can be either higher or low er than statutory

of management or the exercise of market pow er

systematically from statutory rates.

rates, depending on whether depreciation schedules

rather than a return to capital.

used to com pute taxable incom e understate or ov er­

these excess returns do not com e from depreciable

state true depreciation.

capital, they face a marginal tax rate o f 46 percent.

Special tax concessions, such as the investment tax

T o the extent that

A uerbach argues that the taxation o f excess returns

credit on purchases of new m achinery and equipment,

is not directly relevant to the incentives to invest in

also influence effective tax rates.

fixed capital, but is incorporated in measured average

Investment tax

credits act to low er effective marginal tax rates on
incom e earned from such investments.

tax rates.
Second, average tax rates reflect effective tax rates

Thus, although the m axim um statutory tax rate on
corporate incom e is 46 percent, recently liberalized

on different vintages o f capital.

T h e E conom ic R e­

covery T a x A ct o f 1981 and the T a x E quity and

depreciation allowances and investment tax credits

Fiscal R esponsibility A ct of 1982 have reduced effec­

produce effective marginal tax rates on incom e from

tive tax rates on incom e from

new investment that are much low er. A recent study

below rates prevailing in the pre-1981 period. Capital

by the U . S. Treasury reports estimates of effective

acquired before these tax law changes is effectively

marginal tax rates in the range of — 8 to 20 percent

taxed at higher rates than those applied to new capital

on equipment and 40 percent on structures.10
T he bank holding com pany m odel uses average tax

depreciable capital

M oreover, the depreciation allowances

permitted for tax purposes tend to overstate true

rates, calculated as the ratio o f taxes actually paid

econom ic depreciation.

(w ith an adjustm ent that adds back the tax benefits

taxable incom e is low er during the early years o f an

banks receive from

asset’s life and higher in later years.

holding municipal b on d s)


C om pared to true income,
A s a result,

pre-tax profits, to estimate the effective tax rate for

effective tax rates on incom e from older vintages of

the holding com pany sample.

capital tend to be higher than those on new invest­

A s with the imputed

cost of equity, the imputed tax rate is based on a


three-year average o f estimated historical tax rates

accounting data measure the average tax rate on

for the bank holding com pany sample.

different vintages of capital and thus d o not accu­

F o r 1986 the

imputed tax rate is 37.6 percent.11
W h ile average tax rates do reflect the aggregate

Estimates of effective tax rates based on

rately reflect the low er effective tax rate on income
from new investment.

T h e practice o f averaging

effects of depreciation allowances and investment tax

estimated tax rates over time further exacerbates

credits on total taxes paid by firm s, they d o not

this problem .

necessarily measure effective marginal tax rates on

T h e third and final point deals with asymmetries

incom e from new investment. Research on corporate

in the treatment of gains and losses. W h ile corporate

incom e taxation reveals that average tax rates have

earnings are taxed at a positive rate, the tax on

systematically overstated effective marginal tax rates

operating losses, which are negative earnings, is zero.

in recent years.

A n article by A lan A uerbach has

analyzed the reasons for this finding.12 T hree factors

Firm s that operate at a loss are unable to exploit tax
preference such as the investment tax credit.


average tax rates overstate the effective marginal tax
10 These estimates apply to equity-financed investments
and assume a four percent real rate of return to equity
and a five percent inflation rate. Effective tax rates for
different types of equipment vary with depreciable life­
times; effective tax rates are generally higher for assets
with longer depreciable lifetimes. In addition to longer
depreciable lifetimes, structures face a higher effective
tax rate because they are not eligible for the investment
tax credit. U. S. Treasury Department, Tax Reform for
Fairness, Simplicity, and Economic Growth, vol. 2 (N o ­
vember 1984), p. 156.
11 50

Federal Register 47,627 (November 19, 1985).

12 Alan J. Auerbach, “ Corporate Taxation in the United
States,” Brookings Papers on Economic Activity 2
(1983): 451-505.


rate on new investment. W h ile firms that incur losses
do have limited options to carry those losses over,
such options do not correct fo r the bias introduced
by the asymmetric treatment o f gains and losses.
T o conclude, estimates of tax rates that are based
on accounting data do not measure the effective m ar­
ginal tax rate on income from new investment.


relatively higher tax rates on incom e from past capital
investment reflected in such data represent sunk
costs, which are not relevant fo r current investment

Imputed tax rates applied to


R eserve priced service operations should be set so

The Problem of Circularity

A t present the F ed ­

as to reflect effective tax rates on new investment.

eral R eserve bases its targeted rate of return on the

Such a policy w ould be consistent with the goal of

average historical book rate of return earned by a

pricing in a manner that permits entry by private

sample o f firm s it view s as its principal competitors.

sector com petitors.

Rates of return earned by these com petitors are deter­

Using Effective M a rginal Tax Rates to Im pute
Taxes Im puted tax rates fo r Federal Reserve priced
services could be calculated using a m ethodology simi­
lar to that em ployed in econ om ic studies of effective
corporate tax rates on U . S. industry.13 T o start, im ­
plicit user costs w ould have to be calculated for each
type of asset.

T hese user costs w ould be com puted

so as to reflect the present value of tax benefits, such
as depreciation allowances and the investment tax
credit where applicable. T otal imputed financing and
tax costs could then be determined by aggregating
imputed earnings for each asset.
It should be noted that the procedure suggested
above does not correspond to rate-setting practices
em ployed by public utility com m issions.


utilities are permitted to recover actual tax liabilities
incurred as a result of past tax laws.

In com petitive

markets, how ever, prices are determined by prevail­
ing opportunity costs.

T h e cost o f new investment

does not depend on effective tax rates on capital pur­
chased in the past, but on current tax laws.


setting procedures that base prices on actual tax
liabilities effectively protect shareholders of regulated
firm s from capital gains and losses resulting from
changes in tax laws.

N onregulated firms, however,

are not protected from such risks.

T h e procedure

outlined above w ould therefore be m ore consistent

mined in part by the prices the Fed charges for its
services, how ever.

A recent congressional report on

Federal R eserve pricing practices noted that this
could lead to a potential circularity problem .14


targeted rates of return are set too low , as can happen
when book rates of return are below market rates,
correspondent bank earnings can be adversely affected
by Federal R eserve pricing policy.

T o the extent

that correspondent bank earnings are measurably
affected by Fed pricing policy, subsequent targeted
rates of return would be based on artificially de­
pressed earnings that are themselves a product of the
rate-setting procedure.

In this case, as lon g as tar­

geted rates continue to be based on book rates of
return, the rate-setting procedure cannot logically be
expected to target the true cost of capital.
It could be argued that the circularity problem is
unimportant as a practical matter because correspon­
dent banking services account for only a small share
of revenues earned by bank holding companies.

A c­

cordin g to this argument, revenues earned from ac­
tivities such as com m ercial lending, for example, are
likely to be relatively m ore im portant than revenues
from the sale of services such as check clearing
(w hich is the principal area o f com petition between
the Federal Reserve and com m ercial banks) in deter­
mining overall rates of return for the holding com ­
pany sample.

with econom ic theory.

This argument was acknowledged in the congres­
sional report.

Logical Consistency

That report, how ever, also noted that

the argument calls into question the assumptions
T h e test for logical consistency attempts to deter­

underlying the adoption of the bank holding company

mine whether a rate-setting procedure can be logically


expected to attain its goals.

T he ultimate goals of

predicated on the assumption that, because the largest

Federal Reserve pricing are to permit private sector

bank holding companies are the Federal R eserve’s

entry into the markets it serves and also to prom ote

principal com petitors, the cost of capital to those
firms should determine the targeted rate of return for

efficient resource allocation.

Both of these goals are

attained when the targeted rate of return to capital

U se of the bank holding com pany model is

reflects the true cost of capital faced by private sector

priced services.
But when a firm engages in a
number o f different activities its cost o f capital for

com petitors.

different investment projects will, as a general rule,

T herefore, the logical consistency of

the Federal R eserve’s rate-setting procedure can be

differ because different projects do not carry the same

ju dged by whether it can be expected to produce


targeted rates of return that equal the true cost of

on overall rates of return earned by bank holding

Thus, an estimate o f the cost o f capital based

capital on average.
13 A review of these methods is contained in Alan J.
Auerbach, “ Taxation, Corporate Financial Policy and the
Cost of Capital,” Journal of Economic Literature 21
(September 1983): 905-40.

1 The Role and Activities of the Federal Reserve Sys­
tem in the Nation’s Check Clearing and Payments Sys­
tem, Report of The Subcommittee on Domestic Monetary
Policy of the Committee on Banking, Finance and Urban
Affairs, 98 Cong. 2d sess., pp. 41-43.


com panies might not reflect the cost of capital for

T hese suggestions appear to offer a means of

payments services even if the bank holding com pany

im proving the current procedure. H ow ever, the p ro­

sample does include the Federal R eserve’s m ajor

posed m ethodology is not without its ow n short­

com petitors.

Im plicitly, then, the bank holding co m ­

com ings. First, the C A P M has itself been subject to

pany model assumes that the cost of capital for in­

criticism on theoretical grounds because it assumes

vestment projects related to payments services is the

that the covariance of returns with the market port­

same as the average cost of capital faced by large bank

folio is the only factor determining the risk premium

holding companies. This is a strong assumption, and

expected by shareholders.

one that is difficult to either prove or disprove.

trage P ricing T h eory is not subject to the same

It is

w orth noting, how ever, that bank holding com panies

A s noted earlier, A rb i­


are not the F e d ’s only com petitors. In the market for

Second, adoption of the method described above

automated clearinghouse services, for example, a non­

would also require the Fed to resolve a num ber of

banking firm has recently begun to com pete with the

difficult problem s not norm ally encountered in other







w eighted-

average cost o f capital depends not only on the cost




Problem s

o f equity finance, but also on the cost of issuing debt

with circularity are not unique to Federal Reserve

and the overall financial structure.


allowable rates o f return for privately ow ned public

T hey are also encountered with rate-setting


com m only

com m issions.


em ployed





m ethodology

In determining

utilities, the firm ’s financial structure need not be
assumed or imputed.

T h e amount o f outstanding

adopted by the Federal R eserve is based on such

debt, the interest rates paid on that debt, and the

com m only used procedures.

debt-equity ratio are all given.

T h e problem o f circu ­

larity is therefore a familiar one to regulatory econ ­

In contrast, estimating the appropriate cost of
equity finance for the Federal R eserve is only the

A s an alternative to the bank holding com pany

first step in determining the overall imputed cost of

m odel, the congressional report cited earlier sug­

capital. If bank holding companies are not used as a

gested using the Capital A sset P ricing M odel in con ­

model of financial structure, then som e other model

junction with data on market rates of return for a

must be adopted.

broad-based sample of U . S. industry. T he proposed

immediately evident, however.

m ethodology outlined in the report is one that has

financial structure of banks tends to differ from that

gained increasing acceptance am ong public utility

of other types of firms, it could prove difficult to

com m issions in recent years.15

Finally, because the

select a sample of firms from other industries that

A doption of a broad-based sample of U . S. indus­
try was suggested as a means o f dealing with the
potential problem of circularity.

A m ore appropriate m odel is not

bear com parable business and financial risks. F or the
present, these latter issues remain unresolved.

Firm s included in

this larger sample should ideally bear risks that are



com parable to those facing suppliers of correspondent
T o some extent, the C A P M could

A s the nation’ s central bank, the Federal R eserve

be used to adjust for differences in financial risk

System bears responsibility for discharging a variety

banking services.
across the sample.

U sin g market rates of return could help mitigate

o f tasks.

F ed services are grouped into four general


(1 )

any potential problem s with circularity because m ar­

and R egulation,

M onetary P olicy, ( 2 )
(3 )


Treasury, and ( 4 )


ket forces cause equity prices to adjust until the

Institutions and the Public.

expected return to equity and the cost of equity are

characterized as a nonexcludable public g ood , and


w ould therefore be difficult to price explicitly since

Thus, to the extent that Federal R eserve

M onetary policy can be

pricing policy does affect correspondent bank earn­

everyone benefits whether they pay or not.

ings, subsequent realized rates would not deviate

supervision has some attributes o f a public good ,

systematically from expected rates as book rates of

although the Federal R eserve is the only federal bank

return would.


regulatory agency that does not charge for exam i­
nations. Treasury, or fiscal agency functions, are not
priced because the Federal Reserve routinely turns

15 It is also the methodology that appears to be favored
by regulatory economists. See, for example, Kolbe, Read,
and Hall, The Cost of Capital, chap. 3.


over all surplus revenues to the T reasury.

C orre­

spondent banking and payments services fall into the

fourth category. T h e M onetary Control A ct requires
these services to be p riced.16

P ricing is feasible for

these services because they have the characteristics of

Cost Accounting Methods

private goods.
Because not all services are priced, costs attribut­
able to priced services must be identified and sepa­
rated from other costs.

Sales o f priced services vary

am ong R eserve Banks, so individual cost recovery
targets must be set for each Bank.

Finally, separate

cost recovery targets must be set fo r each individual
priced service line.

The Private Sector Adjustment Factor
O perating expenses are allocated to different ser­
vices using a cost accounting system know n as P A C S
(P lan n in g and Control S ystem ).

P A C S also deter­

mines the value of capital assets devoted to priced

(S e e insert for more details.)


financing costs and other imputed private sector costs
are distributed to the different priced service lines
using a uniform mark-up over operating expenses
known as the Private
(P S A F ).

Sector A djustm ent


A s a first step in calculating the P S A F , total
capital financing costs are determined using ( 1 ) the
estimated financial cost o f capital from
holding com pany model, and ( 2 )

the bank

the value o f the

priced services asset base obtained from the P A C S
accounting system.

If the variable r represents the

imputed pre-tax cost of capital and K the value of
the asset base, then total imputed capital and c o r ­
porate incom e tax costs, denoted by the variable CC,
are given b y :
CC =

rK .

O ther P S A F adjustm ents include allowances for
sales taxes, federal deposit insurance assessments,
and a portion of expenses incurred by the staff o f the
B oard of G overnors. Strictly speaking, these imputed


be classified

as operating expenses.

H ow ever, the P S A F cost allocation procedure groups
them together with imputed capital and incom e tax

F or purposes of this discussion, therefore, the








capital costs plus the other imputed private sector
costs m entioned above.
16 The fourth category also includes a number of ser­
vices that are not priced. The basic service lines subject
to the pricing requirements of the Monetary Control Act
are: (1) currency and coin services, (2) check clearing
and collection services, (3) wire transfer services, (4)
automated clearinghouse services, (5) settlement services,
(6) securities and safekeeping services, (7) float, and any
new services the Federal Reserve offers.

T he Federal R eserve’s Planning and C ontrol
System ( P A C S ) was designed initially as a
budget expense and con trol system, but was
modified to serve as a cost accounting system
capable of meeting the requirements o f pricing.
P A C S perform s three basic tasks.
First, it
identifies all direct expenses incurred as a result
of separate activities. Second, it allocates ov er­
head expenses to different service lines. T hird,
it allocates capital assets to different services so
that imputed capital financing costs can be
Identifying the direct expenses incurred in
producing different services is, at least in prin­
ciple, a straightforward task, and one that
P A C S was originally designed to perform .
Like other cost accounting systems, P A C S
allocates direct expenses, such as wages and
salaries, to different services.
A llocating indirect, or overhead, expenses
poses a m ore difficult problem . E xam ples of
overhead activities include Bank administration,
personnel administration (inclu din g recruiting
and placement and w age and salary adm ini­
stration), and protection (secu rity services).
P A C S uses estimates o f the proportion of ov er­
head expenses attributable to each activity to
allocate overhead expenses. F or exam ple, costs
associated with personnel administration are
allocated according to the ratio o f personnel
employed by each service, w hile cost alloca­
tions for Bank administration are determined
by the ratio o f direct expenses incurred by
different priced services.
E xpen ses arising
from security services, on the other hand, are
allocated according to a survey o f the percent­
age o f manhours devoted to protection o f valu­
T he priced services asset base is determined
using a direct determination m ethod that allo­
cates all single purpose assets directly to the
activity em ploying them. S om e capital assets,
termed joint-pu rpose assets, are used for a
variety of different purposes. A g ood exam ple
of a joint purpose asset w ould be a Federal
Reserve Bank building, which typically houses
all activities perform ed by the Bank.
Jointpurpose assets are allocated to different services
in much the same w ay as overhead e x p e n se s;
that is, based on estimates o f usage. Assets
used in overhead activities are allocated to in­
dividual services based on overhead expense
allocation ratios.


T h e P S A F procedure groups direct operating e x ­
penses together with overhead expenses measured
and calculated by


Let the variable O E


P S A F x OEij

< W )3[CC'

w h ere:

represent total operating expenses, including non ­
capital overhead expenses, allocated to priced ser­

T h e P S A F m ark-up is the ratio of imputed

s s OE‘i =



private-sector costs to all other operating e x p e n se s:
T h e ratio ( O E j j/O E ) represents the share o f the

total direct expenses incurred by R eserve Bank j in


p roviding some p rojected amount of service i. F rom
the above expression it is evident that using the same

N otice that m ultiplying this ratio by total operating

system wide P S A F to impute capital and tax costs to

expenses, O E , w ould just recover total imputed costs.

separate activities amounts to w eighting total imputed

In calculating the P S A F , aggregate cost data for

costs by the ratio of expenses incurred in providing

all the Federal R eserve Banks and all priced services
are used. T h e resulting mark-up is applied uniform ly

service i at bank j to expenses for the system as a
whole. Consequently, those services that are rela­

to all services offered by Reserve Banks to arrive at

tively costly to provide in terms o f noncapital e x ­

separate cost recovery targets. T o see how the p ro ­
cedure w orks, let O E jj denote total expenses allocated

penditures are also allocated a relatively larger share

to activity i (w h ere activity i represents a particular

Similarly, regional Reserve Banks having relatively

priced service) at bank j.

high noncapital costs in relation to other Reserve
Banks are required to bear a relatively larger share

Then, total private sector

expenses imputed to that activity are determined by

of capital and other imputed private sector costs.

of imputed private sector costs.

the produ ct P S A F x OEjj.
F or services such as check clearing, for which
prices may vary by region, separate cost recovery

T he resulting cost

allocation may or may not accurately reflect true
underlying costs.

targets are determined for each R eserve Bank. Other
services such as electronic funds transfer have prices
set uniform ly on a nationwide basis.

Cost recovery



targets fo r those services are determined on the basis
o f aggregate system wide costs incurred in producing
the service, calculated by summing service costs
across all R eserve Banks.


L ike the bank holding com pany m odel, the P S A F
cost allocation method resembles rate-setting methods
com m only used in public utility regulation.

N otice that the P S A F cost allocation procedure is
not intended to recover “ overhead” expenses in the


methods are reviewed and evaluated below and the
analysis is applied to the P S A F m ethodology.

sense that that term is usually understood. T he F e d ’s





Fully Distributed Cost Pricing Methods

other than capital costs together with other routine
operating expenses in the variable O E .

In contrast,

Fully distributed cost pricing refers to a variety

the overhead m ark-ups used by private-sector firms

of average cost pricing methods.

U nder this type o{

typically include all indirect overhead expenses (such

pricing, total projected

as the cost o f personnel management services) to­
gether with capital financing costs in the num erator

fully distributed on a per-unit cost basis and prices

of the m ark-up ratio. T he P S A F ratio is often m is­
takenly interpreted as representing such a mark-up.

pricing methods are com m only used in public utility

It should be clear from the preceding discussion that

cost recoveries and other join t production costs to

this is not the case.

revenue requirements are

are set so as to satisfy those requirements.


proceedings to allocate targeted capital

different types of services.17

T h e P S A F mark-up

used by the Federal R eserve is an exam ple o f fully

Allocation of Imputed Costs
N o w consider the effects o f this allocation p roce­
dure on individual cost recovery targets. N otice that
the im puted cost allocation to service i at bank j can
be equivalently stated a s :


distributed cost pricing.

17 For a more complete description of different fully
distributed cost pricing methods used in public utility
regulation, see Alfred E. Kahn, The Economics of Regu­
lation: Principles and Institutions, vol. 1 (N ew York:
John W iley and Sons, Inc., 1970), pp. 150-58.

O ne reason for the widespread use of fully dis­

portion to demand elasticities.20 A second-best solu­

tributed cost pricing methods lies with their relative

tion involves either tw o-part pricing (e .g ., an access


A second reason for the popularity of

charge plus a per-unit service fee reflecting marginal

these methods stems from the widespread perception

c o sts), or setting prices proportional to marginal

that they allocate costs fairly.

B y definition, fully

distributed cost pricing im poses equal mark-ups on all
services. It thus avoids the appearance of discrim ina­
tory treatment of different classes of customers.

costs so that total costs can be recovered w hile leaving
price ratios equal to ratios o f m arginal costs.
F or firms that produce a single output the last
method amounts to average cost pricing.

firm produces m ore than one output, how ever, p ro ­

Evaluation of Fully Distributed
Cost Pricing Methods

duction may involve join t costs.

Prices perform the task of allocating resources in a

econom y.

E conom ists



different pricing m ethods according to whether re­
source allocations resulting from those methods are

W h en a

In addition to econom ic efficiency, policy­

Joint costs exist

when the same productive inputs are used to produce
more than one type o f o u tp u t; fo r exam ple, Reserve
Bank buildings in the case of the Fed.

W h en p r o ­

duction is subject to join t costs, marginal costs are
determined according to causal responsibility.


makers are also concerned with the issue of equity.

marginal cost of a good or service is the cost that

Discrim inatory pricing policies are prohibited under

could be avoided if the last unit o f output were not

existing antitrust laws.

T h e analysis that follow s

evaluates fully distributed cost pricing methods ac­
cord in g to the criteria o f efficiency and equity.
Economic Efficiency



Unfortunately, marginal costs may be difficult to

A s a general rule econom ic





attained when prices are set so as to reflect under­
lying marginal costs.

M arginal costs measure the

opportunity cost of the resources used to produce
different goods and services.

Efficient resource allo­

cation requires that the ratio of prices charged for
different goods and services equal the corresponding
ratio of marginal costs, or that prices be proportional
to marginal costs.

W h en these conditions are satis­

fied, prices charged for different good s and services
reflect the true cost to society o f producing those

F rom an operational standpoint, then, differ­

ent pricing methods can be evaluated using depart­
ures from marginal costs as a guide to losses in e co ­
nom ic efficien cy.18
A special case arises when production is subject to
econom ies of scale.
public utilities.

produced, holding production o f all other outputs

T his is typically the case for

Certain services produced by the

Fed also appear to be subject to econom ies o f scale.19
W h en scale econom ies exist, marginal costs are below
average costs so that strict marginal cost pricing will
not recover total costs. In this case, efficient resource
allocation is attained by setting prices in inverse p ro ­

determine when production relies on join t inputs.
F or


reason, fully




methods are often used to allocate jo in t production

In general, fully distributed cost allocations

differ from marginal costs.

But because marginal

costs can be difficult to measure, precise measures of
efficiency losses resulting from the use o f fully dis­
tributed cost allocation m ethods are difficult to deter­
mine. Indeed, the cost o f im plem enting true marginal
cost pricing can exceed the econom ic value of effi­
ciency gains resulting from such a policy. Thus, total
econom ic costs may be low er under fully distributed
cost pricing than under marginal cost pricing.

T his

could occur if, for exam ple, departures o f fully dis­
tributed costs from marginal costs are small while
the added cost of im plem enting marginal cost pricing
is large.
A rgum ents such as the one above are frequently
made to justify the use o f fully
pricing methods.

distributed cost

Unless som e attempt to measure

marginal costs is made, how ever, there may be no
way to ju d ge whether these m ethods really are rela­
tively efficient.
E quity

Price discrim ination occu rs when price

differentials do not reflect differences in the under­
18 This is the approach taken by Kahn, The Economics
of Regulation, in his analysis of fully distributed cost
pricing methods.

lying cost of selling to different purchasers.

19 See David B. Humphrey, “ Costs, Scale Economies,
Competition, and the Product M ix in the U . S. Payments
Mechanism,” Staff Studies 115 (Board of Governors of
the Federal Reserve System, 1982).

20 For a more complete discussion of efficient pricing see
William J. Baumol and David E. Bradford, “ Optimal
Departures from Marginal Cost Pricing,” American Eco­
nomic Review 60 (June 1970): 265-83.



definition, then, marginal cost pricing is not dis­

Debate over appropriate standards of equity and

crim inatory.21 A s noted by A lfred Kahn, “ It is fair,

efficiency that should guide Fed pricing policy is a

as a general rule, to impose costs on people when and

less contentious issue because the Fed must com pete

to the extent that they impose costs on society.” 22

with private sector suppliers.

A s long as aggregate

A ntitrust laws generally permit firms to charge

imputed costs are estimated correctly, an inappropri­

price differentials when those differentials are based

ate allocation o f costs between different service lines

on differences in cost. M arginal cost pricing is there­

w ould result in som e services becom ing relatively

fore perm issible under those laws.

In view of the

above considerations, marginal costs can be used as a
standard to evaluate the fairness o f different pricing
m ethods in cases where marginal cost pricing


A lth ou gh fully distributed cost pricing methods are

overpriced while others are underpriced.

If that

happened, the Fed w ould find it difficult to retain
market share fo r those services that are relatively
overpriced, thus making it difficult to continue indi­





generally view ed as being fair, econom ic theory would

Thus, the presence of com petition makes it difficult

classify them as discrim inatory to the extent that the

for the Fed to adhere to a pricing policy that might

resulting prices depart from marginal costs.

otherwise result in inefficient resource allocation or

Im p os­

ing equal m ark-ups may appear to be fair, but it does
not always insure that purchasers pay the true cost
of the g ood s and services received.

T he perception

that fully distributed cost pricing methods are equi­

unequitable treatment of certain customers.
Market-Sensitive P ricing

In response to market

forces and to m inimize the distortionary effects of

table continues to en joy widespread, if m isguided,

fully distributed cost pricing the F ed has instituted

acceptance, how ever, and such pricing practices have

market-sensitive pricing fo r individual services w ith­

not been found to violate antitrust laws.

in a service line. W h ile overall cost recovery targets
for broadly defined service lines, such as com m ercial

A n Evaluation of Federal Reserve
Pricing Practices
T h e preceding discussion suggests that fully dis­

check clearing and A C H , are partly determined by
the P S A F m ark-up, prices for individual services
com prising those service lines are set in response to

tributed cost pricing methods can produce outcom es

market forces.

that are less than ideal from the standpoint of e co ­

to the extent that the P S A F m ark-up allocates total

nom ic theory.

imputed capital costs to each service line appropri­

In the case of Fed pricing policy,

how ever, the existence of com petition provides an

M arket-sensitive pricing is efficient


independent check o f cost allocation practices and

A feasible alternative to the current practice of

mitigates the distortionary effects o f inappropriate

allocating costs using a uniform m ark-up w ould be to

p ricing decisions when they occur.

set targeted cost recoveries based directly on capital

E con om ic theory predicts that firms operating in

assets allocated to each service line by the P A C S

purely com petitive markets will price according to

accounting system, in effect creating a separate m ark­

marginal costs.

U n der these conditions the issues o f

efficiency and equity are resolved by the market. In
contrast, com petition is restricted in regulated m ar­
kets such as those served by public utilities so that
regulatory agencies take the place o f the market in
determ ining prices.

Rate-setting methods used by

up, or P S A F , fo r different service lines. T h e result­
ing cost allocation should m ore closely approxim ate
true marginal costs.
Im p u te d Deposit Insurance Costs T here is at least
one other area, namely imputed deposit insurance

those agencies are shaped by the goals of efficiency


and equity, but the definition o f equitable pricing
behind the adoption of those methods do not always

could be applied to Fed pricing. A t present, these
expenses are allocated together with imputed capital

agree with the econom ist’s notion of that term.

costs using the P S A F mark-up. Since they are deter­

w here

marginal cost



mined by the level o f clearing balances held with
21 For a more detailed discussion of price discrimination,
see F. M . Scherer, Industrial Market Structure and Eco­
nomic Performance 2d ed. (Boston: Houghton Mifflin
Company, 1980), chap. 21.
22 Alfred E. Kahn, “ The Road to More Intelligent Tele­
phone Pricing,” Yale Journal of Regulation 1 (1984): 146.


R eserve Banks, it w ould seem m ore appropriate to
charge imputed deposit insurance costs against the
profits earned on clearing balances.

require a dow nw ard

T h is would

adjustm ent

interest rate paid on clearing balances.



pricing, it should not be surprising that the F e d ’s
Because the Federal R eserve is a nonprofit insti­
tution, its cost of capital is not determined in capital
markets as is the case with purely private, profitm aking firm s.

Nevertheless, the M onetary Control

A ct requires the Fed to earn a return to capital com ­
parable to that earned by private firm s.

C onse­

pricing m ethodology is patterned after rate-setting
methods developed for public utility regulation.
Rate-setting methods for regulated industries have
received a great deal of attention from econom ists.
Research on this topic has dealt with the problem s of
identifying appropriate operational goals and develop­
ing methods of evaluating different rate-setting p ro ­

quently, the Fed is faced with the task of determining


an appropriate rate of return to capital fo r its priced

utility regulation are not identical in all respects to


those connected with Federal R eserve pricing, som e

A similar problem arises in connection with public
utility regulation.

W h ile most utilities are privately

Although problem s encountered in public

of the methods developed to analyze such rate-setting
procedures can be used to evaluate Federal R eserve

ow ned, their return to capital is determined by regu­


latory fiat rather than by market forces.

veloped in this article represents a first step tow ard

Given the

similarity between public utility and Federal Reserve




fram ew ork

d e­

that goal.



Earnings and Capital Accounts

On O ctober 7, the B oard of G overn ors o f the

N et earnings before payments to the United States
T reasury increased in 1985 by $170,052,685.71 to

S ix percent statutory dividends

am ounting to $5,149,817.38 were paid to Fifth D is­
trict member banks, and the sum o f $1,481,448,481.64
was turned over to the U nited States Treasury.
Capital stock rose by $10,451,800 to $90,812,250

Federal R eserve System adopted a revised schedule
for the frequency and scope o f exam inations of State
member banks and the inspections o f bank holding

These guidelines generally increase the

frequency of examination o f the larger institutions
and those exhibiting problem s. T h e revised schedule,
which calls for an annual exam ination o f all institu­
tions, became effective January 1, 1986.

as member banks increased their shareholdings in this
Bank, as required by law, to reflect the rise in their
ow n capital and surplus accounts.

T h e Bank’s sur­

plus account increased $10,451,800 to $90,812,250.

Technological Innovations
In 1985 the R ichm ond O ffice began participating
in a pilot p roject to determine the feasibility of check

Discount Rate

truncation, a process in which vital inform ation cap ­

O n M ay 20 the discount rate was reduced from
8 percent to 7y2 percent.

T his action was taken

against the background of a relatively flat level of



im ports and a strong dollar.

the impact of rising
O n O ctober 11 the

directors of the R ichm ond Bank, with the approval
of the Board of G overnors, established a flexible rate
for extended credit.

F or the year as a whole, the

volum e of activity in the D iscount and Credit D e ­
partment increased substantially above its level of the
previous year largely as a result of borrow ings by
nonfederally insured savings and loan associations in

tured from the magnetic en codin g o f checks is trans­
mitted to paying banks electronically rather than
through the physical m ovem ent o f checks themselves.
T he year also saw the application o f new technology
to the handling of cash orders and the detection of
unfit currency.

T o facilitate the processing o f cash

orders received by telephone, the Bank installed an
automated telephone answering service linked to a

Financial institutions having access to

this system need only transmit their orders by touchtone




com puter


processing this inform ation, preparing the necessary
documents, and charging the orderin g institution’s

M aryland and N orth Carolina.


A nother technological advance occurred

during the year with the installation o f im proved


sensors to better detect unfit currency.

Besides im ­

Beginning in M arch the E xam ining Department

proving the overall quality o f cu rren cy outstanding

became involved in the em erging savings and loan

and thus providing depository financial institutions

crises in the states o f O hio, M aryland, and N orth

with bills acceptable for use in automated teller m a­


Initially, exam iners assisted the Federal

Reserve Bank of Cleveland in responding to the O hio

Later, after facilities o f the discount w indow

had been made available to




( A T M ) , this new equipment includes en­

hanced counterfeit detection capabilities.
A key com ponent of the new payments technology
deployed by the Bank in 1985 was the F ed Online

institutions in M aryland and at the request of the

X change

state supervisory authorities, department personnel

with a pilot program fo r fou r participating District

conducted examinations o f certain M aryland state


savings and loans starting in A pril.

obtain electronic access to F ed services and inform a­


( F O X ) , which started in O ctober


V ia F O X , depository institutions can

they coordinated the exam inations of institutions in

tion through m icrocom puters linked to the B ank’s

M aryland and assisted in N orth Carolina in con ­

computer. This connection allows banks to send and

nection with the filing of applications for deposit

receive funds transfers, to originate and receive A C H

insurance with the Federal Savings and Loan Insur­

transactions, and to obtain accounting inform ation

ance Corporation. T hree M aryland institutions were

and other useful services electronically.

acquired by Chase Manhattan C orporation and were

vides substantial price reduction since the automated

converted to a single mem ber state bank effective

on-line transaction fees are significantly low er than

N ovem ber 1.

those for off-line services.

F O X p ro ­

E ig h ty -six institutions

cam e on line to the Fifth District Communications
System in 1985.


Baltimore O ffice

T hree on-line institutions m erged






T he m ost significant development at the Baltim ore
O ffice involved the Savings and Loan crisis in M a ry ­

bringing the net total to 208.
A n oth er service initiated in 1985 came as a result
of a change in Regulation J requiring paying insti­
tutions to notify the institution of first deposit of
their intention to dishonor any check over $2,500.
U sin g the B ank’s new service, returning institutions
electing not to provide such notification directly may
instead do so indirectly either through the Bank’ s
on-line netw ork, or by having the Bank initiate the
return notice fo r them by telephone.


F ollow in g a similar occurrence in O h io earlier

in the year, a run on several privately-insured S& Ls
in M ay led to the closing of some institutions and to
deposit-withdraw al limitations on all others.

300 exam iners from all the federal bank and thrift
supervisory agencies participated in em ergency exam ­
inations o f over

A utom ation Plan, new software systems for securi­

100 institutions.

T h e Baltim ore

O ffice provided logistical support to this extraord i­
nary effort.

Consistent with the Federal R eserve’s L on g Range

A t the

request of the G overn or o f M aryland, approxim ately

In addition, virtually all of its depart­

ments w ere involved in dealing with the operational
problem s resulting from the crisis.

ties transfers and A C H processing w ere installed in

D u ring 1985 the Baltim ore O ffice participated in a

1985 and plans w ere made for the installation o f a

System p roject to develop and test second generation

new funds transfer system in early 1986. In addition,

automated currency processing systems. A prototype


from the firm of Giesecke and Devrient of Germ any

processing and safekeeping of definitive se­

curities w ere consolidated in the Richm ond O ffice

was delivered to the Baltimore O ffice in June.

during 1985 to achieve greater efficiency in op er­

the end o f the year, accountability tests had been


com pleted and throughput and sustained-production
tests had begun.

In addition to testing all aspects of

the G& D prototype system, the Baltim ore staff is

Community Affairs and
Economic Information

responsible for the developm ent of ergonom ics stan­
dards and test plans for all three prototypes being

In executing the Bank’s function o f inform ing
lenders and com m unity organizations about the C om ­
m unity R einvestm ent A ct, the Com m unity A ffairs
O ffice sponsored tw o conferences in R ichm ond on
n eighborhood reinvestment.


In addition, a con fer­

ence entitled “ Com m unity Redevelopm ent for the
Carolinas” was sponsored by the Charlotte O ffice.
Several new publications were developed and dis­

tested by the System.

T he entire p roject is under

the general direction of the staff of the Culpeper
T h e B altim ore O ffice agreed to participate in a
Partnership P rogram between Baltim ore City schools
and the business com m unity.

T his program , spon­

sored by the Greater Baltim ore Committee, involves
the “ adoption” o f city schools by local businesses w ho
will provide various kinds of nonfinancial support

tributed as a part of the Bank’s econom ic information

and assistance.

program . T hese publications included consum er-type

O ffice will be paired with Carver V ocational T e ch ­

brochures and a 30-page booklet entitled “ H om e-

nical School.

U n der the program the Baltim ore

ow nership.”
F ollow in g recomm endations from

the B oard


G overn ors, this Bank established a Small Business
and A gricu ltu re A d v iso ry Council to im prove co m ­

Culpeper Office
In 1985 the Culpeper O ffice com pleted the factory

m unications with small businesses, as well as agri­

developm ent of three prototype Second Generation

cultural and other groups.

H igh Speed C urrency H andling Systems, w hich are
now undergoing site testing at Baltim ore and tw o

New Building - Charlotte
T h e conceptual design of the new building was

other Federal R eserve O ffices.

Other key projects

com pleted during the year included ( 1 ) the installa­
tion of advanced currency fitness and denomination

There will be three floors

detectors in all Federal R eserve Banks, ( 2 ) the suc­

and a full basement, encompassing 265,000 gross

cessful testing of a covert anticounterfeiting system,

square feet.

and ( 3 ) the installation o f a new anticounterfeiting

com pleted in September.

Gilbane Building Com pany was selected

in O ctob er as the preconstruction consultant.


laboratory in Culpeper.

Federal Reserve Membership

P ow er Company, Charlotte, N orth Carolina, w hose
term expired Decem ber 31, 1984. G loria L . Johnson,

T h e follow in g newly chartered institutions in the
Fifth D istrict opened for business during 1985 as
members of the Federal R eserve System :




Com pany,

Baltim ore,

Maryland, was named in Septem ber to fill the va ­
cancy created on the B altim ore B oard by the resigna­
tion of Thom as H . M ad d u x o f Baltim ore, M aryland.

National Banks

In O ctober, James E. B ostic, Jr., D ivision General

Bay National Bank
Annapolis, Maryland

April 1

M anager, Convenience P roducts D ivision, G eorgiaPacific Corporation, A ik en ,


Carolina, was

appointed to fill the vacancy created on the Charlotte

Summerville National Bank
Summerville, South Carolina

May 20

Hilton Head Bank & Trust Company, N .A .
Hilton Head Island, South Carolina

June 17

Board by the resignation o f R obert L . A lbright,
President, Johnson C. Smith U niversity, Charlotte,
North Carolina.
The election, by Fifth D istrict mem ber banks, of

One Valley National Bank of Hurricane
September 23
Hurricane, W e st Virginia

one Class A and one Class B director to three-year

Bank 2000, National Association
McLean, Virginia

in the fall.

terms on the R ichm ond B oard o f D irectors was held
October 18

K . Donald M enefee, Chairman of the

Board & Chief E xecutive O fficer, M adison National
Bank, and Chairman of the B oard & President, James

tate Banks

M adison Limited, W ashington, D . C., was elected a

Peoples Bank of Virginia
Chesterfield County, Virginia

January 28

Class A director by banks in G roup 2 to succeed
W illard H . Derrick, President and Chief E xecutive

Hallmark Bank and Trust Company of Virginia
February 4
Springfield, Virginia

O fficer, Sandy Spring N ational Bank and Savings

Highlands Union Bank
Abingdon, Virginia

expired at the end of 1985.
April 27

Institution, Sandy Spring, M aryland, w hose term
E dw ard H . Covell,

President, T he Covell Com pany, Easton, M aryland,
was elected by banks in G roup 3 as a Class B director

The Bank of Tidewater
Virginia Beach, Virginia

July 8








Johnson, Smith, H ibbard, Cleveland, W ildm an and

Fairfax Bank and Trust Company
Fairfax, Virginia

July 22

Dennis, Spartanburg, South Carolina, w hose term
expired Decem ber 31, 1985.

Princess Anne Commercial Bank
Virginia Beach, Virginia

August 26

T he Richm ond B oard of D irectors appointed H .
Grant Hathaway, Chairman of the B oard, Equitable

South Boston Bank
South Boston, Virginia

Bank, N .A ., Baltimore, M aryland, to a three-year
October 11

term on the Baltimore B oard.

H e succeeded H u gh

D . Shires, Senior V ice President

Chase Bank of Maryland
Baltimore, Maryland

November 1

T he follow in g nonm em ber bank converted to m em ership in the Federal R eserve System during 1985:
Albemarle Bank and Trust Company
Charlottesville, Virginia





(R e tir e d ), T h e

M aryland,

Cum berland,

Maryland, whose term expired at the end of 1985.
T he Board of D irectors also appointed Joseph W .
M osmiller, Chairman of the B oard, L oy ola Federal
Savings and Loan A ssociation, B altim ore, M aryland,

November 1

to a three-year term to succeed H ow a rd I. Scaggs,
Chairman of the Board, A m erican National Building

Changes in Directors

and Loan Association, B altim ore, M aryland, w hose

T he B oard of G overnors of the Federal Reserve
System made three appointments to fill vacancies
that were created during 1985.
M errim an,


In June, H anne

Charlotte Board for three-year terms w ere J. D onald
Collier, President and Chief E xecu tive O fficer, First
National Bank, O rangeburg,

South Carolina, and

W ashington,

James G. Lindley, Chairman, South Carolina N a ­

D . C., was appointed as a Class C director on the

tional Corporation, and Chairman and President, T he

R ichm ond B oard to succeed W illiam S. Lee, Chair­


man of the B oard and Chief E xecutive O fficer, Duke


G arfinckel’s,

term expired Decem ber 31, 1985. R eappointed to the




Colum bia,



The Board of Governors redesignated Leroy T.
Canoles, Jr., President, Kaufman & Canoles, Norfolk,
Virginia, as Chairman of the Richmond Board for
1986. Robert A. Georgine, President, Building &
Construction Trades Department, AFL-CIO, Wash­
ington, D. C., was reappointed to a three-year term
as Class C director and renamed Deputy Chairman
of the Board for 1986.
Thomas R. Shelton, President and Chief Oper­
ating Officer, Perdue Farms, Incorporated, Salisbury,
Maryland, was appointed by the Board of Governors
to a three-year term on the Baltimore Board, effective
January 1, 1986. Mr. Shelton succeeded Edward H.
Covell, President, The Covell Company, Easton,
Maryland, whose term expired December 31, 1985.
Reappointed to the Charlotte Board for a three-year
term was G. Alex Bernhardt, President, Bernhardt
Industries, Inc., Lenoir, North Carolina.
Robert L. Tate, Chairman, Tate Industries, Balti­
more, Maryland, was reelected Chairman of the
Baltimore Board for 1986; similarly, Wallace J.
Jorgenson, President, Jefferson-Pilot Communica­
tions Company, Charlotte, North Carolina, was re­
elected Chairman of the Charlotte Board.

Federal Advisory Council
John G. Medlin, Jr., Chief Executive Officer of
First Wachovia Corporation, The Wachovia Cor­
poration, and Wachovia Bank and Trust Company,
N.A., Winston-Salem, North Carolina, was reap­
pointed by the Richmond Board of Directors as the
Fifth Federal Reserve District representative to the
Federal Advisory Council for a one-year term,
beginning January 1, 1986.
The twelve-member
Council, consisting of one member from each of the
Federal Reserve Districts, meets in Washington at


least four times a year with the Board of Governors
of the Federal Reserve System to discuss business
conditions and other topics of current interest.

Changes in Official Staff
John F. Rand, Senior Vice President, elected to
take early retirement on March 1 after 18 years of
service in the Federal Reserve System. Also on
March 1 James D. Reese was promoted to Senior
Vice President in charge of the Bank’s Computer
Planning, Data Processing, Computer Services,
Budget & Control, and Accounting Departments; R.
Wayne Stancil was promoted to Vice President; and
Edgar A. Martindale III, was transferred from the
Baltimore Office and promoted to Budget & Control
On April 1 James Parthemos, Senior Vice Presi­
dent and Director of Research, retired after nearly
25 years of service and J. Alfred Broaddus, Jr., was
promoted to assume his position.
Victor Turyn, Vice President at the Baltimore
Office, retired May 1. On June 1 Samuel W . Powell,
Jr., was promoted to Vice President and transferred
from the Baltimore Office to the Charlotte Office.
Walter A. Varvel rejoined the Richmond Bank as
Vice President on June 10 after a period in private
In December the following promotions were an­
nounced to be effective January 1, 1986: at the Rich­
mond Office, J. Lander Allin, Jr., to Vice President,
Sharon M. Haley to Assistant Vice President and
Secretary, Michael W . Newton to Assistant Vice
President, Marsha S. Shuler to Planning Officer, and
Arthur J. Zohab, Jr., to Examining Officer; at the
Culpeper Office, James J. Florin III, was promoted
to Assistant Vice President.

Summary of Operations
Currency Received and Verified
Number of pieces_________________
Dollar amount ____________________































Currency Verified and Destroyed
Number of pieces___________________
Dollar amount ______________________

Coin Received and Verified
Number of coin _____________
Dollar amount ____

Checks Handled
U. S. Government checks
Number _______________
Dollar amount
Postal money orders
Number __________
Dollar amount
Commercial checks - processed*
Number ______________________
Dollar amount
Commercial checks - packaged items
Number ___________________________
Dollar amount ___________________

Collections Items Handled
U. S. Government coupons paid
Number ______________________
Dollar amount ______________
Noncash items
Number ______________________
Dollar amount

Fiscal Agency Activities
Issues, Redemptions, and Exchanges of U. S. Securities:
Definitive securities
Number _______________________________________________
Dollar amount
Number ______
Dollar amount

Transfer of Funds
Number of transfers sent and received
Dollar amount __________________________

Food Stamps Redeemed
Number _________________
Dollar amount __________

Number ______
Dollar amount
* Excluding checks on this Bank.


Comparative Financial Statements

December 31, 1985

Gold certificate account

December 31,1984





Special Drawing Rights certificate account



Coin _______________ _________________________



Loans to depository institutions_________



Federal agency obligations ______________



B i l l s ______________________



N o t e s _____________________



Bonds ---------------------------------









Cash items in process of collection



Bank premises ____________________




U . S. Government securities:

Furniture and equipment, net



Other assets ---------------------------



Interdistrict settlement account
Accrued service income_________
T O T A L A SSE T S ____________









Federal Reserve notes
d e p o s it s :

Depository institutions



F o r e ig n _______________



Other _________________





Deferred availability cash items _________________



Other liabilities ___________________________________



T O T A L LIA B IL IT IE S ___________________



Capital paid in —








t o t a l d e p o s it s

Capital Accounts:



Earnings and Expenses


Loans to depository institutions__________________________________________





Interest on U. S. Government securities________________________________



Foreign currencies _______________________________________________________



Income from services_____________________________________________________



Other earnings____________________________________________________________

_______ 756,264.70

_______ 597,344.85

TOTAL CURRENT EARNINGS ____________________________________________



Operating expenses (including depreciation on bank premises) after
deducting reimbursements received for certain Fiscal Agency and
other expenses__________________________________________________________



Cost of earnings credits _________________________________________________



NET EXPENSES _________________________________________________ _____



C U RRENT N E T E A R N IN G S _____________________________________



Profit on sales of U. S. Government securities (net) ________________



Profit on foreign exchange transactions______________________________



All other _________ ____________________________________ _________________


TOTAL ADDITIONS _____________________________________________________

_______________ 4,997.44






All other ______________________________________________________________

Losses on foreign exchange transactions______________________________



TOTAL DEDUCTIONS ___________________________________________________

_______ 571,148.99


N E T A D D IT IO N S OR D E D U C T IO N S ____________________________



Assessment for expenses of Board of Governors________________________



Federal Reserve currency c o sts__________________________________________








Dividends paid ___________________________________________________________



Payments to U. S. Treasury (interest on Federal Reserve notes) ____



Transferred to surplus __________________________________________________



TO T AL ______________________________________________________________





Surplus A ccou n t
Balance at close of previous y e a r _______________________________________
Addition of profits for y e a r ___________ ______ ___________________________
B A L A N C E A T CLOSE OF CURRENT Y E A R ___________________









Capital Stock A ccou n t
(Representing amount paid in, which is 50% of amount subscribed)
Balance at close of previous y e a r _______________________________________


Issued during the year __________________________________________________


B A L A N C E A T CLOSE OF CURRENT Y E A R ___________________


Cancelled during the y e a r ________________________________________________



_______ 542,650.00

_______ 535,200.00







(December 31,1985)

Leroy T. Canoles, J r . ___________ Chairman of the Board
Robert A . G eorgine_____________ Deputy Chairman of the Board

Class A
Robert F. Baronner_____________ Chairman of the Board & Chief Executive Officer

One Valley Bancorp of West Virginia, Inc. and
Kanawha Valley Bank, N.A.
Charleston, West Virginia
(Term expires December 81,1987)
Robert S. Chiles, S r . ____________ President/Chief Executive Officer, Greensboro National Bank

Greensboro, North Carolina
(Term expires December SI, 1986)
Willard H. Derrick _____________President and Chief Executive Officer

Sandy Spring National Bank and Savings Institution
Sandy Spring, Maryland
(Term expired December 81,1985)
Succeeded b y: E . Donald Menefee
Chairman of the Board & Chief Executive Officer
Madison National Bank
Chairman of the Board & President
James Madison Limited
Washington, D . C.
(Term expires December 81,1988)

Class B
Thomas B. Cookerly_____

President, Broadcast Division, Allbritton Communications
Washington, D. C.
(Term expires December 81,1986)

Floyd D . Gottwald, Jr. _

Chairman of the Board & Chief Executive Officer
Ethyl Corporation
Richmond, Virginia
(Term expires December 81,1987)

George Dean Johnson, Jr.

Partner, Johnson, Smith, Hibbard, Cleveland, Wildman and Dennis
Spartanburg, South Carolina
(Term, expired December 81,1985)
Succeeded by: Edward H. Covell
The Covell Company
Easton, Maryland
(Term expires December 81,1988)

Class C
Leroy T. Canoles, J r ._______ ____ President, Kaufman & Canoles

Norfolk, Virginia
(Term expires December 81,1986)
Robert A . G eorgine________ ___ President, Building & Construction Trades Department, AFL-CIO

Washington, D. C.
(Term, expires December 81,1988)
Hanne M errim an ___________ ____President, Garfinckel’s

Washington, D. C.
(Term expires December 81,1987)

Member of Federal Advisory Council
John G. Medlin, J r . _____________ Chief Executive Officer, First Wachovia Corporation, The Wachovia Corporation,

Wachovia Bank and Trust Company, N.A.
Winston-Salem, North Carolina
(Term expires December 81,1986)


E d w a r d H . C o v e l l ____________

President, The Covell Company
Easton, Maryland
(Term expired December 31, 1985)
Succeeded by: Thomas R. Shelton
President and Chief Operating Officer
Perdue Farms, Incorporated
Salisbury, Maryland
(Term expires December 31, 1988)

Raymond V . Haysbert, Sr.

President and Chief Executive Officer
Parks Sausage Company
Baltimore, Maryland
(Term expires December 31, 1987)

Charles W . H o ff III ________

President and Chief Executive Officer, Farmers and Mechanics National Bank
Frederick, Maryland
(Term expires December 31, 1986)

Gloria L. J oh n so n ____________

President, Hutzler Brothers Company
Baltimore, Maryland
(Term expires December 31, 1987)

Howard I. Scaggs ___________

Chairman of the Board, American National Building and Loan Association
Baltimore, Maryland
(Term expired December 31, 1985)
Succeeded by: Joseph W . Mosmiller
Chairman of the Board
Loyola Federal Savings and Loan Association
Baltimore, Maryland
(Term expires December 31, 1988)

Hugh D . Shires _____________

Senior Vice President (Retired), The First National Bank of Maryland
Cumberland, Maryland
(Term expired December 31, 1985)
Succeeded by: H . Grant Hathaway
Chairman of the Board
Equitable Bank, N.A.
Baltimore, Maryland
(Term expires December 31, 1988)
Chairman, Tate Industries
Baltimore, Maryland
(Term expires December 31, 1986)

*Robert L. T a t e ________________

C h a rlotte
G. A lex B e r n h a r d t___________

President, Bernhardt Industries, Inc.
Lenoir, North Carolina
(Term expires December 31, 1988)

James E . Bostic, Jr. ________

Division General Manager, Convenience Products Division
Georgia-Pacific Corporation
Aiken, South Carolina
(Term expires December 31, 1987)

J. Donald Collier ____________

President and Chief Executive Officer, First National Bank
Orangeburg, South Carolina
(Term expires December 31, 1988)

James M. Culberson, Jr. ___

Chairman and President, The First Natioyial Bank of Randolph County
Asheboro, North Carolina
(Term expires December 31, 1987)

John A . H a r d in ___________ ___

Chairman of the Board and President, First Federal Savings Bank
Rock Hill, South Carolina
(Term expires December 31, 1986)

*W allace J. J org e n so n ________

James G. Lindley ____________

President, Jefferson-Pilot Communications Company
Charlotte, North Carolina
(Term expires December 31, 1986)
Chairman, South Carolina National Corporation
Chairman and President, The South Carolina National Bank
Columbia, South Carolina
(Term expires December 31, 1988)

*Branch Board Chairman.



(J a n u a r y 1, 1986)

R ic h m o n d
Robert P. Black,


Jimmie R. Monhollon,

First Vice President

Senior Vice President and
Director of Research
W elford S. Farm er, Senior Vice President
Roy L. Fauber, Senior Vice President
James D. Reese, Senior Vice President
Bruce J. Summers, Senior Vice President

J. A lfred Broaddus, Jr.,

Vice President
Vice President
Lloyd W . Bostian, Jr., Vice President
Tim othy Q. Cook, Vice President
W illiam E . Cullison, Vice President
Donna G. Dancy, Vice President
W y a tt F. Davis, Vice President
John M. Denkler, Advisor
George B. Evans, Vice President
W illiam C. Fitzgerald, Associate General Counsel
W illiam C. Glover, Vice President
Marvin S. Goodfriend, Vice President
Robert L. Hetzel, Vice President
Thomas M. Humphrey, Vice President
W illiam D. M artin III, Vice President and
General Counsel
A rthur V . M yers, Jr., Vice President
Joseph C. Ramage, Vice President
John W . Scott, Vice President
R. W ayne Stancil, Vice President
Andrew L. Tilton, Vice President
James F . Tucker, Vice President
W alter A . Varvel, Vice President
J. Lander Allin, Jr.,
Fred L. Bagwell,

David B. Ayres, Jr.,
Thomas P. Kellam,

Public Services Officer
Examining Officer
Betty M. Fahed, Statistical Officer
Frances R. Hurdle, Loan Officer
Eugene W . Johnson, Jr., Examining Officer
Ed gar A . Martindale III, Budget and Control Officer
Joseph F. Morrissette, Public Services Officer
Lawrence P. Nuckols, Examining Officer
Virginius H. Rosson, Jr., Computer Services Officer
Gary W . Schemmel, Computer Planning Officer
Marsha S. Shuler, Planning Officer
W illiam F . W hite, Examining Officer
Howard S. Whitehead, Integrated Accounting System
Project Officer
A rthur J. Zohab, Jr., Examining Officer
Kemper W . Baker, Jr.,

Floyd M. Dickinson, Jr.,

General Auditor
Audit Officer
C h a rlotte

B a ltim o re
Robert D. McTeer, Jr.,
Ronald B. Duncan,

Senior Vice President

Vice President
Vice President

W illiam E . Pascoe III,
Gerald L. W ilson,
Ronald E . Gould,
Robert A . Perry,
John S. Frain,

Assistant Vice President
Assistant Vice President
W illiam A . Bridenstine, Jr., Assistant General Counsel
Bradford N . Carden, Assistant Vice President
Michael Dotsey, Research Officer
H . Lewis Garrett, Assistant Vice President
Sharon M. Haley, Assistant Vice President
and Secretary
Harold T. Lipscomb, Assistant Vice President
Yash P. Mehra, Research Officer
Michael W . Newton, Assistant Vice President
G. Ronald Scharr, Assistant Vice President
Jesse W . Seamster, Assistant Vice President
James R. Slate, Assistant Counsel
Roy H . Webb, Research Officer
Jack H . W y att, Assistant Vice President
Bobby D. W ynn, Assistant Vice President
W illiam H . Benner, Jr.,

Jackson L. Blanton,

Vice President
Assistant Vice President
Assistant Vice President

Operations Officer

C h a rleston

Albert D. Tinkelenberg,

Vice President

Assistant Vice President
Assistant Vice President
Francis L. Richbourg, Assistant Vice President
H arry B. Smith, Assistant Vice President
Robert F . Stratton, Assistant Vice President
W oody Y . Cain,

M arsha H . Malarz,

John G. Stoides,
James G. Dennis,

Senior Vice President
Assistant Vice President
Assistant Vice President

James J. Florin III,

C olu m b ia


Vice President
Vice President

Samuel W . Powell, Jr.,
Jefferson A . W alker,

C u lp e p e r

Richard L. Hopkins,

Boyd Z. Eubanks,

Senior Vice President

Vice President