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2001
Annual Report
The Economics of Financial Privacy:
To Opt Out or Opt In?
Federal Reserve Bank of
Richmond
MESSAGE FROM THE PRESIDENT AND FIRST VICE PRESIDENT
T
he year 2001 brought with it tragedy, change, and economic
uncertainty. It is impossible to reflect on the past year of activities in
our Bank and in the economy without recalling the terror and destruction that befell this country on September 11. Just as our attention had
focused on that Tuesday morning’s business, it was quickly diverted
to news of the horrific events that separated this day from any day before it.
Within minutes, our attention shifted to securing the safety of our employees
and maintaining public trust in the country’s financial system.
Although the Bank maintains aggressive contingency plans developed by
thinking the unthinkable, it is with the hope that there will never be a need to
activate them. On September 11, the unthinkable became reality. In the hours
and days that followed, staff across the Fifth District responded in a manner that
makes us very proud. Despite a natural desire to comfort family and mourn with
fellow citizens, our people rallied to support essential Federal Reserve operations. We will be forever grateful for their dedication and commitment.
Stability Maintained in the U.S. Financial System
Our Bank played a significant role in helping the Federal Reserve System stabilize the nation’s financial markets and avert a liquidity crisis. Staff in Loans,
Supervision and Regulation, Reserve Accounts, Cash, and Check Processing
Departments worked around the clock. The Bank provided substantial funds through
discount window loans and check-processing services. The volume of loans requested was unprecedented. On September 12, discount window loans at the Richmond Fed totaled $10.9 billion, about 25 percent of the credit extended by the
System that day. In comparison, $94 million in loans were made a week earlier.
Federal Reserve Bank of Richmond
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2001 Annual Report
It took collaboration and teamwork throughout the District and the Fed nationally to meet the challenge of September 11. One small electronic payments team
at the Richmond Office provided backup for colleagues at the New York Fed.
Within moments after the World Trade Center attacks, this team took over the
monitoring of critical large dollar funds and securities transfer services. Any interruption of these critical payments services obviously would have severely disrupted not only the financial system but also the broader economy.
Others manned Bank facilities and their perimeters. Security staff worked 12hour shifts and continuously tightened procedures to keep fellow employees safe.
Still others took to the road to deliver checks to branch offices and banks around
the District after air transportation was grounded, and many employees worked
extended shifts to process the enormous backlog of checks deposited by banks.
As the tragedy unfolded in New York City and Washington, we learned firsthand that, in a crisis, our ability to communicate well with our customers and the
public is paramount. Internally, constant communication among our officers and
staff provided a vital network for handling the situation. It also unified us, strengthened us, and enabled us to contribute effectively to the Fed’s overall effort to help
our country work through this especially difficult period in our recent history.
The crisis last fall was not the only time during the year that our emergency
preparedness was tested. On July 18 a fire in a Baltimore railway tunnel forced
most of the city’s nearby businesses to close because of the fumes and other potential dangers. While our Baltimore Office is located close to the tunnel, staff remained
on hand to maintain payment activities and other operations without disruption.
Changes in the Bank and the District
Every day, our staff is dedicated to improving service and increasing efficiency
in carrying out the Bank’s business. In this spirit, the Bank reorganized many of
its operations along functional lines in the spring of 2001. Overall, we expect
the reorganization to reduce costs and enable us to serve our customers better.
In particular, the functional management structure will help the Bank better support the Fed System’s Check Modernization Project, an effort to standardize and
reengineer the nation’s check processing infrastructure over the next several years.
2
Federal Reserve Bank of Richmond
Opening Message
These improvements were extremely important in 2001 as the structure of
our District’s banking industry also changed. With the merger of Charlotte-based
First Union Corporation and Winston-Salem-based Wachovia Corporation, the
Fifth District became headquarters for two of the nation’s four largest banking
organizations. As a result, the District now ranks second nationally in total bank
holding company assets owned. Accommodating these large banking organizations requires us to focus on retaining and attracting staff with a broad range
of experience and specialized skills to supervise the more complex and sophisticated activities of these institutions.
A Year of Economic Challenges
The Fed faced the extraordinary challenge of deciding how to respond with monetary policy in the aftermath of the September 11 attacks. Yet the year had
already been challenging from a policy perspective since the evolving economic
slowdown was a significant departure from the rapid growth of the late 1990s.
Signs of weakness had been increasingly apparent throughout much of the year
in some economic sectors such as manufacturing. The number of jobs in District
factories had been declining since the fall of 2000, but the losses accelerated
after the terrorist attacks. In all, 120,000 District manufacturing jobs were lost in
2001, many in traditional industries such as textiles, apparel, and furniture.
Despite economic weakness, jobs in the District’s non-manufacturing sector
generally grew during the first three quarters of 2001. During the week of September 11, however, business and retail activity came to a virtual standstill. Many
lost jobs when District airports closed and air travel ceased for a week or more.
Because of its proximity to Washington, Reagan National airport did not reopen
until early October. Not only were the airlines affected, but jobs related to travel, hotel, food services, and tourist activities were also lost. Not surprisingly,
jobs in the non-manufacturing sector declined in the fourth quarter. Moreover,
weaker overall economic conditions throughout the year in District states caused
state governments to fall short of anticipated tax revenues, which generated
substantial budgetary challenges. Despite these difficulties, by the end of 2001
many District businesspeople were optimistic that an economic upturn would
Federal Reserve Bank of Richmond
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2001 Annual Report
materialize in the region as well as the nation in 2002.
The events of September 11 highlighted the importance of our relationships
with the business community throughout the District. We routinely consult with
our directors at all three of our offices, our advisory council members, and our
other business contacts regarding current business conditions and the outlook.
We relied even more heavily on them in the aftermath of September 11 to keep
us abreast of emerging developments. Published statistics and databases simply
could not provide us with the up-to-the-minute information we needed to deal
effectively with the crisis. We thank our contacts for all their assistance during
that time and throughout the year.
Two Directors Conclude Their Terms
We would especially like to thank retiring directors Jim Culberson and Craig
Ruppert for their important contributions this year and in earlier years. Jim served
on the Richmond board from 1999 through 2001. He had previously served
as a director of our Charlotte Office from 1985 through 1990. While on the
Richmond board, Jim shared his extensive banking experience with us, which
made him a key contributor to the Bank’s Financial and Strategic Planning Committee during his term. He also served as a member of the Committee on Research,
Public Affairs, and Community Affairs for those three years and chaired the Committee in 2000 and in 2001.
Craig served two three-year terms on the Richmond board from 1996 through
2001. He was a member of the Committee on Buildings through both terms,
and was chairman of the Committee for five years. In that capacity, he provided valuable insights while overseeing the security enhancements to the Richmond
Office. He was also a member of the Executive Committee; the Committee on
Research, Public Affairs, and Community Affairs; and the Committee on Financial and Strategic Planning.
Financial Privacy Examined
In light of the many extraordinary events in 2001, it is easy to lose sight of more
routine but nonetheless important issues that were evolving in banking. Among
4
Federal Reserve Bank of Richmond
Opening Message
the most significant were the proposed changes in the way financial institutions
treat information regarding their customers. In late 1999, the Gramm-Leach-Bliley
Act was passed to modernize the way financial institutions are regulated. Among
other things, the Act imposed new regulations on financial firms’ sharing of customer information with outside companies.
According to the financial privacy provisions of Gramm-Leach-Bliley, which took
effect in mid-2001, if a financial institution shares nonpublic customer information
with third parties, it is required to give its customers an opportunity to “opt out.” Privacy advocates have argued for a stricter “opt-in” provision that would require
financial institutions to get explicit consent from consumers before sharing personal
information about them. State legislators in some states have proposed even tighter
regulations on sharing information within affiliated companies.
In “The Economics of Financial Privacy,” Jeff Lacker, Senior Vice President
and Director of Research, takes a look at the opt-out and opt-in debate from an
economist’s perspective. Fundamentally, the issue centers around the proper allocation of “rights” in a contractual relationship — a customer’s right to privacy
versus the right of a financial institution to share its information. The answer
economics provides is that whether regulations allocate the rights in accord with
opt-out or opt-in is irrelevant. Under an opt-out standard, banks could pay customers to refrain from opting out, while under an opt-in standard, banks could
pay customers for their information. In either regime, the market should deliver
an appropriate balance between consumers’ desire for privacy and the economic value of information sharing.
Interestingly enough, the debate is ongoing and fervent. Jeff’s article analyzes the debate and concludes that it is unnecessary.
J. Alfred Broaddus, Jr.
Walter A. Varvel
PRESIDENT
FIRST VICE PRESIDENT
Federal Reserve Bank of Richmond
5
The Economics of Financial Privacy:
To Opt Out or Opt In?
A
consumer’s financial
transactions give rise
to a wealth of very
personal data. Every
credit card purchase,
every ATM withdrawal, every loan payment, every
paycheck deposit leaves an electronic
trace at a person’s bank. Advances in
information technology now allow firms
to collate information from disparate
sources and compile comprehensive
profiles of individual behavior. The
resulting databases can allow businesses to target very specific consumer
categories — high-income, gun-owning dog lovers, for example — in ways
that were never before possible.
When should a bank be able to
share information about you with other
businesses? Some consumer advocates
want to protect consumers’ financial
privacy by restricting such information
sharing. New technologies, they say,
have encouraged increased intrusions
on consumer privacy, leading to more
junk mail, more telemarketing calls,
and a heightened risk of identity theft.
They argue for tough “opt-in” laws that
would require financial institutions to
obtain a consumer’s explicit consent
before sharing personal information
about them.
Banks and other financial service
providers point out that information
sharing provides benefits to consumers
by allowing for more targeted
marketing and services. The new technologies make it easier for businesses
to find consumers that would be
interested in buying their specialized
products and services — hunting-dog
training supplies, for example. Such
marketing directly benefits consumers
when it results in a voluntary purchase.
In addition, greater information sharing can reduce wasteful marketing to
consumers that are likely to be uninterested. With these benefits in mind,
financial service providers argue for
“opt-out” laws that merely require them
to give consumers the right to request
that their information not be shared.
After vigorous debate, Congress
adopted an opt-out requirement for
banks and other financial institutions
as part of the Gramm-Leach-Bliley Act
of 1999 (GLBA), legislation that was
designed to encourage financial modernization. Any financial institution
that intends to share nonpublic customer information with third parties
Jeffrey M. Lacker
The author is Senior Vice President and
Director of Research.
The views expressed are the author’s
and not necessarily those of the Federal
Reserve System.
Federal Reserve Bank of Richmond
7
2001 Annual Report
The deadline for compliance was July 1, 2001. For
more information on the
financial privacy provisions
of the GLBA, see the Federal
Trade Commission’s Web site
(Federal Trade Commission
2002). The privacy provisions
of the GLBA apply to any
institution engaged in activities that have been deemed
“financial in nature or incidental to such financial activities” under the Bank Holding
Company Act. This means
that whenever the Fed and
the Treasury determine that
an activity is financial in
nature and therefore a permissible activity for a financial holding company, the
entire financial industry is
brought under the privacy
provisions of the GLBA.
1
8
Federal Reserve Bank of Richmond
(companies not related by ownership
ties) must give customers an opportunity to deny them permission to do so,
or opt out. In addition, financial institutions are required to provide customers with an annual statement of
their privacy policy. Consumers received a blizzard of notices in the mail
when those provisions were fully implemented in the summer of 2001.1
The controversy did not end with the
passage of the GLBA. The Act allows
individual states to adopt privacy
provisions that are stricter than the
federal standard if they so desire. California’s legislature recently considered
an opt-in law that would have required
financial institutions to obtain customer
permission before sharing information
with third parties. Moreover, banks
would have been required to give consumers the right to opt out of information sharing with affiliated companies
(companies related by ownership ties).
This essay examines the opt-out/optin debate from the perspective of the
economics of financial privacy. The
premise is that a financial institution’s
privacy policy is a characteristic of the
products and services the institution
offers. We can therefore apply the
well-understood principles governing
how markets work when there are
important differences in product characteristics. The result is surprising for
both sides of the issue: it doesn’t seem
to matter whether opt-out or opt-in is
adopted as the standard. Either way,
competitive forces should bring about
an economically efficient amount of
information sharing. In fact, even in
the absence of opt-out or opt-in laws,
the amount of information sharing
should be economically appropriate.
Opt-out/opt-in laws will be irrelevant
as long as financial institutions are not
prevented from offering customers a
range of desirable privacy options.
The broad and multifaceted issues
that surround privacy go well beyond
the opt-out/opt-in debate. Although this
essay is narrowly focused on the latter, the general principles outlined here
have a much wider application. At a
fundamental level, opt-out versus optin is really a question about the proper allocation of “rights” in contractual
relationships — a customer’s right to
privacy versus the right of a financial
institution to share its information. The
answer economics provides is that
whether rights are allocated in accord
with opt-out or opt-in is irrelevant, as
long as consumers and financial institutions are free to agree to an alternative arrangement if it suits them.
Most financial privacy questions
concern the specification of rights of
various parties in contractual relationships. The irrelevance result of this
essay thus should carry over to other
related settings; laws and regulations
Feature Article
providing more (or less) “privacy rights”
should generally have little effect on
consumers’ financial privacy.2
Privacy in the Financial
Marketplace
inancial privacy can be
thought of as a bundle of
characteristics associated
with a particular financial
service. A bank that does
not share nonpublic customer information with third parties is
providing its customers a service with
different characteristics from a bank
that does share such information. How
do markets work when products or
services differ in their characteristics?
In well-functioning competitive
markets, consumers selecting among
products with different bundles of
characteristics are willing to pay more
for products with characteristics they
value. Some characteristics make a
product more costly to provide.
Producers are willing to supply products with more costly characteristics
only if they are compensated for the
additional cost. One would expect to
see products with characteristics for
which a customer’s willingness to pay
exceeds the incremental production
cost. For example, some people are
willing to pay more for a car with a
built-in CD player, but CD players are
costly. It is logical then that consumers
F
whose willingness to pay exceeds the
cost of the CD player would own cars
with CD players.
Well-functioning markets generally
provide goods and services that are
appropriate when judged against the
benchmark of economic efficiency.
With regard to product characteristics,
economic efficiency means that a
given product characteristic is supplied
if and only if the value of that characteristic to consumers exceeds its cost
to society. When markets function
smoothly, the incentives of producers
and consumers are aligned with economic efficiency. Suppliers find it profitable to provide products with the
appropriate characteristics, since consumers are willing to pay at least the
additional cost. Characteristics for
which consumers’ valuations fall short
of the cost of production cannot be
profitably supplied.
Financial privacy is a service characteristic that some consumers prefer.
Many consumers harbor deep concerns about privacy in general and
financial privacy in particular. According to one recent poll, 56 percent of
consumers say they are “very concerned” about potential loss of
privacy.3 Overall, consumers seem to
have three main fears.4 They fear
being robbed or cheated by criminals
that obtain personal information. They
fear embarrassing revelations due to
For other economic analyses of financial privacy, see
Kahn, McAndrews, and
Roberds (2000) and Bauer
(forthcoming).
2
National Consumers League
(2000).
3
Research by Alan Westin,
as cited in Paul (2001).
4
Federal Reserve Bank of Richmond
9
2001 Annual Report
5
See Kovacevich (2000).
10
Federal Reserve Bank of Richmond
the disclosure of sensitive information.
And they dislike intrusive marketing
in the form of telephone calls or junk
mail. When financial institutions share
customer information with outside companies, it can erode customer privacy
on all three counts.
Providing greater financial privacy
can be costly for a financial service
provider because it means foregoing
the potential economic value of information sharing. Marketers can make
better decisions the more information
they have about prospective customers
and are therefore willing to pay banks
to get it. Better information helps marketers find customers who genuinely
may be interested in buying their
products and saves them the expense
of soliciting consumers who are not.
These benefits provide genuine economic value by increasing the probability of a successful buyer-seller match
and decreasing the probability of wasting marketing efforts on those who
would not be interested.
Consumers that place a high value
on financial privacy ought to be willing to pay for high-privacy financial
services. If consumers prefer that their
bank not share nonpublic information
about them with unaffiliated companies, they should be willing to pay for
this service characteristic implicitly
through lower deposit interest rates,
higher loan interest rates, or higher
account-related fees. More directly,
banks could offer direct inducements —
a bonus payment, coupon, or sweepstakes entry, for example — to customers that agree to information sharing. Many nonfinancial firms offer such
enticements to customers that return
“product registration cards” filled out
with their name, address, and other
information. Consumers that value
financial privacy would pay by foregoing their bank’s offer. Similarly,
many grocery stores offer cards to customers that qualify them for discounts
when they present the cards at checkout stations. In exchange, stores gather data on customer purchases.
Along the same lines, if sharing
nonpublic customer information with
third parties is economically beneficial,
financial institutions should be willing
to compensate their customers who
allow them to do so.5 The outside firms
with which the information is shared
should be willing to pay an amount
up to the information’s value to them.
The financial institution should then be
willing to pass this along to their
customers in the form of higher interest rates on savings, lower interest
rates on loans, or lower fees. More
directly, they should be willing to simply pay those customers who agree to
share an amount up to the incremental value of the information.
Ideally, the economic benefits of
Feature Article
financial privacy should be balanced
against the economic costs. When the
economic value of sharing nonpublic
customer information with third parties
falls short of the value consumers place
on preventing that information sharing,
economic efficiency would dictate that
no information sharing takes place.
Similarly, when the economic value of
sharing nonpublic customer information with third parties exceeds the
value consumers place on preventing
it, economic efficiency would dictate
that information sharing should take
place. If the market for financial privacy is well functioning, then we
should see an economically efficient
amount of financial privacy.
Does the Market for Financial
Privacy Work Well?
s there anything different about
financial privacy? Are the markets for financial privacy poorly
functioning in the sense that they
deliver outcomes that are not economically efficient? There does
not appear to be any plausible reason to think so.
For markets to misfunction in this
sense, one of two conditions must
exist: either a divergence between the
value of a product characteristic to
consumers and their willingness to pay
it, or a divergence between the cost
to suppliers of providing that charac-
I
teristic and the overall cost to society.
Divergences could be caused by externalities, monopoly power, or verification problems.
An externality occurs when an
action by one group affects the wellbeing of others that do not transact
with that group. For example, burning
leaves in my front yard raises the risk
of fire for my suburban neighbor.6
Externalities are often invoked to
explain a broad range of government
laws and regulations — prohibiting
suburban leaf burning, for example.
Is there an externality in the market
for financial privacy? No, it doesn’t
appear so. Sharing nonpublic customer
information about a consumer affects
that consumer’s privacy but not the privacy of other consumers. The sharing
institution is a counterparty of the affected customer, and either can withdraw
from the relationship. The two of them
have ample opportunity to take information sharing into account when setting the terms of their relationship. Thus
no parties are affected by the information sharing except those who are
participants in the transaction.
“Public goods” are a type of externality that can result in inefficiency and
are defined by two properties. They
are nonrivalrous, meaning that one
person’s use does not detract from the
ability of another to use it. And they
are nonexcludable, meaning that one
One could argue that the
two parties could negotiate
an efficient solution to this
problem; my neighbor can
simply pay me not to burn
leaves, or can sue me if the
fire spreads. For additional
explanation see the section
on the Coase Theorem.
6
Federal Reserve Bank of Richmond
11
Feature Article
cannot prevent people from using it.
A lighthouse is a classic example of a
public good: one ship’s use does not
prevent another ship’s use, and you
cannot prevent a ship from using it.7
Information is nonrivalrous because
one person’s use does not prevent
another from using the same information. But information is excludable
because you can prevent people from
obtaining it. Therefore financial information is not a public good.
Monopoly power is another possible cause of market misfunction.
When a firm is sheltered from
competitive pressures it can raise
prices and restrain supply. Similarly, a
protected monopolist may find it profitable to supply too little of a desired
product characteristic when customers
are prevented from seeking preferred
characteristics from other suppliers.
This problem may have been relevant
to the banking industry decades ago
when competition was severely limited by regulatory restrictions on pricing, entry, and geographic expansion,
but these restrictions have been largely dismantled. As a consequence, the
market for financial services is now
widely judged to be relatively competitive. Thus it seems unlikely that
banks or other financial institutions are
manipulating privacy policies because
of significant monopoly power.8
A third potential cause of market mis-
function stems from the difficulty of verifying whether a financial institution is
living up to its stated privacy policy.
A customer that receives junk mail or
telemarketing calls may have a hard
time discerning where the marketer
obtained the information. The spelling
of a name or address can be altered
slightly in order to trace information
sharing, but this technique is obviously
limited. In cases of identity theft it is often
impossible to determine exactly how the
identity was stolen after the fact.
Do verification problems interfere
with the efficiency of the market for
financial privacy? Not necessarily.
Note that there are a number of mechanisms to help ensure that an institution lives up to its privacy commitments,
despite the difficulty of observing
whether or not it has done so. First, an
institution that fails to comply with its
stated financial privacy policy may be
liable for “unfair and deceptive trade
practices.” If caught, the institution
would be subject to civil litigation as
well as regulatory action by the Federal Trade Commission. The potential
legal costs can deter noncompliance,
even if the probability of detection is
small. There is nothing particularly
unique about financial privacy in this
regard. Consumers often rely on hardto-verify commitments by the firms they
patronize — a commitment to product
quality, for example.
Coase (1974) pointed out,
however, that coastal lighthouses are often funded from
fees charged to ships using
nearby ports, so even the
services of lighthouses are at
times excludable. A lighthouse is therefore only a
public good when ships cannot be excluded from using its
services if they do not pay –
for example, in settings where
most ships are on longdistance voyages.
7
If financial institutions were
exercising market power and
this resulted in inefficient
financial product characteristics, a more appropriate remedy would be for regulators
to ensure effective competition
rather than regulate service
characteristics. Moreover, it
would appear inconsistent to
regulate service characteristics
on the grounds of impediments to competition while
not regulating service prices.
8
Federal Reserve Bank of Richmond
13
2001 Annual Report
The phrase appeared in television advertising for Capital One during November
2001. As of this writing, the
company’s home page
prominently features the following description of their
“New No-Hassle Card”:
“9.9% Fixed APR on Everything, No Telemarketing, No
Annual Fee.”
9
14
Federal Reserve Bank of Richmond
Second, institutions that wish to
attract customers for whom privacy is
important will want to convince those
customers of their organization’s
commitment to its privacy policy. Such
institutions will have an incentive to
cultivate and safeguard their reputation as a high-privacy entity. At least
one prominent bank has advertised a
“no telemarketing” promise, indicating that banks are capable of actively competing on the basis of their
privacy policies.9 Third parties can
evaluate a financial institution’s compliance, just as Consumer Reports
independently assesses the quality of
consumer products. The potential for
embarrassing media publicity also
motivates an institution to live up to its
commitments. Standard industry practice is for a firm that rents its mailing
list to approve every mailing or telemarketing script that is used. Evidently firms believe that at least some consumers could trace marketing contacts
to them, with possibly detrimental
effects on their customer relationships.
While reputational considerations
and laws on trade practices can go
partway toward ensuring that a firm is
faithful to its stated privacy policy, some
would argue that these mechanisms
are inherently limited and imperfect.
Enforcement is often costly and compliance is rarely 100 percent. Do these
imperfections warrant legislative restric-
tions aimed specifically at information
sharing? No. Any entity attempting to
verify and enforce a financial firm’s privacy commitments will confront the
same imperfections. A governmental
effort to enforce a ban on information
sharing, for example, will face the same
verification difficulties — costly enforcement and incomplete compliance — as
would any private parties. So a government ban on information sharing
would have no advantage; in fact, it
would have the disadvantage of possibly preventing economically useful
information sharing.
The market for financial privacy
therefore appears to work fairly well.
This means that we should expect economically efficient outcomes: information will be shared if and only if the
economic benefits of information sharing exceed the value consumers place
on preventing information sharing.
Opt-Out Versus Opt-In
rovided the market for
financial privacy works fairly well, it should not make
much difference whether we
adopt an opt-out law or an
opt-in law. Either way, an
economically efficient level of information sharing will result. Why is this so?
Under an opt-out law, banks that
value information sharing will be willing to provide inducements to get
P
Feature Article
high-privacy customers not to opt out
because information sharing can
lower the cost of providing banking
services. Similarly, automakers are
willing to discount the price of cars
without CD players, since these cars
are less costly to build. Banks will be
willing to pay an amount up to the
incremental value of sharing the customer’s nonpublic information. If that
falls short of the value the customer
implicitly places on privacy, then the
customer will decline the inducement
and opt out. In that case, the economic value of the information sharing is less than the cost to the customer
of yielding this bit of privacy, and
information sharing is not economically efficient. Alternatively, the customer may feel that the value of the
inducement exceeds the value of
preventing information sharing, in
which case the inducement is accepted and the customer does not opt out.
Here, the economic value of the
information sharing exceeds the cost
to the customer of yielding this bit of
privacy, and information sharing is
economically efficient.
Under an opt-in law, the reasoning and the result are exactly the
same. Banks will be willing to provide the same inducement to get a
customer to opt in as they would have
provided to get a customer to refrain
from opting out — up to the economic
value of the information sharing. If
that amount exceeds the value that
the customer places on preventing
information sharing, then information
sharing will take place and is
economically efficient. Otherwise the
customer will refuse the enticement;
in this case information sharing is not
economically efficient and will not
take place.
In fact, the same reasoning
applies in the absence of opt-out or
opt-in laws. If the law is silent on
whether banks need to seek permission to share nonpublic information
with third parties, banks nonetheless
could decide to do so on their own.
If some customers truly care about
information sharing with third parties,
they will seek out banks that give them
the option of preventing it. If information sharing is economically useful,
banks will find it more costly to serve
customers that insist on preventing it.
Competition will force banks to pass
along the increased cost to high-privacy customers. Ultimately, an economically appropriate amount of
information sharing will take place,
with or without opt-out or opt-in laws.
The difference between opt-out and
opt-in standards is like the difference
between treating CD players in cars
as standard equipment or as an addon option. If CD players are an
option, one would expect the price of
Federal Reserve Bank of Richmond
15
2001 Annual Report
10
16
Coase (1960).
Federal Reserve Bank of Richmond
the option to reflect the incremental
cost. If instead CD players are standard equipment, the discount for cars
without CD players should reflect the
incremental cost. It should not make
a difference whether car buyers have
to ask to get a CD player in their car
or ask not to have one. Either way we
should see a market-clearing quantity
of cars with CD players.
The debate between proponents of
opt-out and opt-in seems predicated
on the view that the choice would
affect how many consumers would
prevent information sharing. The
hypothesis seems to be that fewer consumers would opt out under an optout standard than would fail to opt in
under an opt-in standard. This could
well be the case, but it would be evidence that many consumers are relatively indifferent about information
sharing by their financial institution;
they would not bother to opt out, nor
would they bother to opt in. If this is
true, then little is at stake for these consumers. Those who would neither opt
out nor opt in evidently place little
value on preventing their financial
institution from sharing nonpublic information about them. The economic
efficiency implications of the choice
between opt-out and opt-in would
therefore be negligible for them as
well, even if participation rates differed significantly.
An Alternative Line of
Reasoning: The Coase Theorem
T
he knowledgeable reader may have noticed that
the logic of this essay is
closely related to the
insights that Ronald H.
Coase presented in his
celebrated paper “The Problem of
Social Cost.”10 (This paper was cited
by the Royal Swedish Academy of Sciences in awarding him the 1991
Nobel Prize in Economics.) Coase
wrestled with the issue of externalities,
the same issue as in my leaf-burning
example. Before Coase’s paper economists generally believed that, absent
government intervention, externalities
would result in inefficient outcomes
because one party (I, for example)
would ignore the cost (increased fire
hazard) that his action (leaf burning)
imposed on another party (my neighbor). The contribution of Coase was
to notice that the two parties could
negotiate an efficient solution to the
externality problem as long as the relevant rights were clearly assigned. For
example, if I am entitled to burn leaves,
my neighbor could offer to pay me not
to, or could offer to help me dispose
of them by some other method. Alternatively, if I am required to obtain my
neighbor’s permission to burn leaves,
I could offer to pay my neighbor. If the
value to me of burning leaves is less
Feature Article
than the value to my neighbor of my
not burning leaves, then my neighbor
will pay me not to do so in the first
case. In the second case, I will be
unwilling to offer my neighbor enough
money to get permission to burn
leaves. Either way we get an efficient
outcome; I don’t burn leaves. The general proposition is that (under certain
conditions) any well-defined allocation
of property rights leads to efficient outcomes. This result is often called the
Coase Theorem.
The application to financial privacy
should be clear. Opt-out and opt-in are
just different allocations of property
rights. Opt-out means financial institutions have the right to share information; customers can ask them to stop.
Opt-in means customers have the right
to no-information-sharing; financial
institutions can ask them for permission
to share. Either way, according to
Coase, the prediction is an efficient
amount of information sharing.
The Coase Theorem has its limitations, however. It is said to hold only
if “transaction costs” are zero; in other
words, any agreement that is in the
mutual interest of the parties is actually agreed upon. Transaction costs are
the difficulties associated with actually reaching an agreement among the
affected parties. It may be costly to
communicate and coordinate among
a large number of parties, for exam-
ple. When transaction costs are
significant, the assignment of property rights can affect efficiency. One
premise of this essay, as I discuss later,
is that the costs of opting out are negligible, in which case the Coase
Theorem applies.11
The logic of this essay, however,
differs subtly from Coase’s analysis.
Coase envisioned bargaining between
affected parties. As a result, the assignment of property rights could alter the
distribution of net benefits, even if that
assignment had no effect on efficiency.
For example, if I have the right to burn
leaves, I get paid not to burn them; yet
if I need permission, I earn nothing
when I don’t burn them. I am better off
in the first case, while my neighbor is
better off in the second case. The assignment of rights thus alters the relative wellbeing of my neighbor and me, even
though either assignment leads to efficient leaf-burning decisions. In competitive markets, in contrast, the assignment
of contractual rights generally does not
affect people’s well-being. The choice
between opt-out and opt-in determines
which rights are, by default, bundled
together with financial services. Under
either regime, competition and free
entry implies that both high-privacy and
low-privacy financial services will be
available at prices reflecting their true
cost. In competitive markets, the choice
of regime should have no effect on the
11 The costs are negligible in
part because of the regulations that require financial
institutions to provide customers with a “reasonable
means” of opting out. In a
sense, then, this part of the
allocation of property rights
has efficiency implications
consistent with the Coase
Theorem. The reasonablemeans provision appears to
be an efficient choice since it
minimizes the “transaction
costs” of opting out. Friedman (2000) applies Coase’s
approach to a broad array
of privacy issues in which
transaction costs are nonnegligible.
Federal Reserve Bank of Richmond
17
Feature Article
net cost of financial services with particular characteristics, just as a law
mandating that CD players be sold separately should have no effect on the total
price of cars with CD players. The efficiency implication of Coase’s famous
theorem carries over to competitive markets, however, and buttresses the case
made here: market mechanisms should
work well at providing an efficient level
of financial privacy.
Opt-Out in Practice: Few
Consumers Do
D
uring the first half of
2001, many banks
began mailing out the
privacy notices required
by the GLBA. Those
that share nonpublic
customer information with unaffiliated
companies are required to give their
customers the opportunity to opt out
of third-party information sharing.
Although there is only limited evidence
so far, press reports suggest that the
response rate is rather low. According
to the trade publication American
Banker, industry estimates of the number of consumers who have opted out
“hover around 5 percent.”12 One survey of savings banks showed that
more than half were experiencing an
opt-out rate of one percent or less.13
Opting out does not appear to be
very hard. The financial privacy reg-
ulations require that financial institutions give customers a “reasonable
means” of exercising their right to opt
out. The regulations even offer examples of acceptable and unacceptable
methods. Providing a toll-free number
to call or supplying a mail-in card for
a check-box response are deemed reasonable means. Requiring a customer
to write his or her own letter is not
deemed reasonable.
Despite these requirements, critics
claim that opting out is difficult because
privacy notices are complex, confusing, and hard to read.14 Food labels
are often cited, in contrast, as a simple, well-understood notice system.
Some financial institutions, however,
are actively working toward simpler
and clearer privacy notices.15 Apparently, they view that it is in their business interest to make their notices as
agreeable to their customers as possible. Many institutions sent privacy
notices for the first time in 2001, and
some experimentation and learning
seem to be taking place. Perhaps optout rates will rise as GLBA privacy
notices are refined and consumers
learn about what they contain.
Nevertheless, the fact that so few
bank customers are currently taking the
relatively easy step of opting out seems
to indicate that most consumers now
place a negligible value on preventing
financial institutions from sharing
12
Lee (2001).
America’s Community
Bankers (2001).
13
14 See transcripts and supporting documentation from
the workshop on effective
privacy notices hosted by the
Federal Trade Commission
and the federal financial regulatory agencies (Federal
Trade Commission 2001).
15 See the presentations by
Marty Abrams, John Dugan,
Patricia Faley, and David M.
Klaus at the privacy notices
workshop along with the
public comments submitted
by Walter Kitchenman, Vance
Gudmundsen, and Steve
Bartlett in connection with the
event (Federal Trade Commission 2001).
Federal Reserve Bank of Richmond
19
2001 Annual Report
16 One could argue that consumers are just lazy, but this
reasoning leads to the same
conclusion; the value they
place on financial privacy is
not enough to motivate them
to opt out.
17 The three main credit
bureaus also offer a program
through their trade group
that allows consumers to opt
out of pre-approved credit
offers, but the credit bureaus
do not release statistics on
the number of consumers
opting out.
18 According to a recent survey, 24 percent of consumers
protect their privacy by disabling cookies (Harris Interactive Inc. 2001). An American
Bankers Association poll
found that 36 percent of consumers said they had read
their bank’s privacy notice
(American Bankers Association 2001).
19 America’s Community
Bankers (2001).
20
Federal Reserve Bank of Richmond
nonpublic information about them with
third parties. A small fraction of consumers feel strongly enough to take
advantage of the opt-out option. This
group appears to place a significant
value on guarding their financial privacy. But for a broad majority of Americans, the value they place on financial
privacy does not exceed the inconvenience of exercising their right to opt out.16
This pattern — about 5 percent of
people willing to take action to protect
their privacy — is consistent with other
evidence on consumers’ privacy preferences. The Direct Marketing Association, a marketing industry trade group,
offers consumers the ability to opt out
of telephone or mail marketing by their
members. The 4.2 million participants
in their telephone opt-out program represent about 4.2 percent of U.S. households with telephone service. The 4.0
million participants in their mail opt-out
program represent about 3.8 percent
of total U.S. households.17
A very low opt-out rate is also consistent with other choices consumers
make with regard to privacy. Few consumers disable cookies when browsing the Internet. (Cookies are small
files that a Web site places on a user’s
computer to enable tracking the user
on subsequent visits.) Few consumers
read privacy notices. Many consumers
readily provide their credit card number over the phone or to a waiter.18
The picture that emerges, then, is that
a few consumers place significant
value on preventing information sharing by their financial institutions, but
the broad majority of consumers are
relatively indifferent.
Opt-Out in Practice: Few
Banks Pay
F
inancial institutions do not
appear to be offering
inducements to customers to
get them to refrain from opting out. This suggests that
the economic value of
sharing nonpublic customer information is relatively low. Otherwise
financial institutions would find it
worthwhile to compensate their
customers for their cooperation. In
fact, not all institutions are even
engaged in information sharing that
would trigger the opt-out requirement.
A survey of savings banks found that
fewer than one-third needed to send
out opt-out notices.19
Banks do not lack opportunities
to share customer information. There
is an active market for consumers’
names, addresses, and other personal information. Individual merchants rent their customer lists to
marketers, often through list brokers.
Credit bureaus offer selections from
their databases based on age,
income, occupation, family status,
Feature Article
net worth, type of automobile, religion, and so on. According to its
Web site, Equifax even offers a
selection based on a person’s
carburetor type. American Express
offers customer lists selected on the
basis of purchase patterns — shoe
buyers that spend more than
$1,000 annually, for example. Lists
are available from magazines,
membership organizations, book
clubs, and merchants.20
Apparently, the market for consumer information does not provide
banks with sharing opportunities that
would make it worthwhile to offer
material rewards for consumer cooperation. A glance at the prices for
such information suggests why —
prices are relatively low. Rates for lists
of merchandise buyers, for example,
appear to be relatively consistent,
ranging from 8 cents to 13 cents per
name as of early 2001. Base prices
at one large credit bureau range from
1.65 to 4 cents per name per mailing, depending on volume, with addon charges for additional selection
criteria ranging from .25 cents per
name for length of residence, title,
or gender to 2 cents per name for net
worth. Thus the value to a financial
institution of sharing nonpublic customer information might not be large
enough to warrant offering a significant sum to customers.
Why Is Financial Privacy an
Issue Now?
A
pplying economics
to financial privacy
leads to the conclusion that financial
markets can provide
an appropriate balance between consumers’ desires for
privacy and the economic value of
information sharing. If this is true, then
why do surveys show widespread
consumer concern about privacy yet
few consumers taking action to opt out
of information sharing? And why has
there been such clamor for privacy
legislation in the past few years,
culminating in the financial privacy
provisions of the GLBA?
The dramatic changes in communications and computing technologies in
recent years might help explain why
so many recent surveys report consumer concern about privacy. Financial
institutions have always possessed
detailed information about their customers. Moreover, active markets for
customer lists have been around for
decades.21 Only recently, however, has
the collation and analysis of information from disparate sources become
highly automated. This technological
advance allows more targeted marketing efforts; a company can solicit
high-income, gun-owning dog lovers,
for example. The resulting improvement
20 For information on lists see
Equifax (2001), American List
Counsel (2002), and Worldata
(2002).
21 I recall my father managing
rentals of his company’s mailing list in the 1960s. The list
was kept on “addressograph
plates” — metal strips
embossed with names and
addresses. While these strips
could be linked together for
automated addressing of
mass mailings, any sorting or
selection had to be handled
manually. The list was rented
out through mailing houses
that handled the actual printing and distribution. All
rentals had to be approved by
list owners. Decoys — false
names and addresses — were
included in the list to provide
a means of verification by the
list owner.
Federal Reserve Bank of Richmond
21
Feature Article
in marketing success rates appears to
have led to an increase in the number
of mail and telephone solicitations.
Before the technological developments that lowered the cost of manipulating databases, assembling such
detailed consumer profiles was not economically feasible. Consumers came
to view the limited nature of information sharing by financial institutions as
an implicit part of their contractual relationship, relying on the practical obscurity of what other firms knew about
them.22 Since widespread information
sharing was impractical then, few surveys asked how consumers felt about
it. New technologies have dispersed
the fog of practical obscurity that formerly surrounded many consumer
transactions. The privacy concerns that
appear in consumer surveys could
represent ex post regret at the lack of
contractual constraints on information
sharing. This conflicts, however, with
the evidence cited earlier indicating
that most consumers do not feel strongly about information sharing. Alternatively, perhaps consumer preferences
haven’t changed, but consumers are
merely asked about them more often
today. Now that interfirm information
sharing is economically viable, we see
surveys on the subject.
Economists are often skeptical of
survey evidence on consumer preferences, but it is not the sincerity of
consumers’ responses that is in doubt.
Surveys rarely confront consumers with
the cost consequences of their choices.
When asked whether they desire
greater privacy without reference to
cost, they are likely to say “yes” —
more of a good is generally preferred
to less, after all. But when confronted
with real-life choices, many consumers
decide that the benefits of greater
privacy are outweighed by the
costs. One recent study found a
dramatic disparity between consumers’
stated privacy preferences and their
actual online behavior.23 Participants
answered many “highly personal”
questions, despite having stated that
privacy was important to them. The
discrepancy between widespread consumer “concern” and the willingness
of many consumers to readily compromise their privacy could well reflect
the gap between the artificial choices
implicit in survey questions and the
real choices consumers actually face.24
22
Gramlich (1999).
Spiekermann, Grossklags,
and Berendt (no date available).
23
24 Harper and Singleton
(2001).
Conclusion
he economics of financial
privacy is based on the
notion that a financial
institution’s privacy policy
is a characteristic associated with the products and
services the institution offers. In wellfunctioning markets, prices reflect product characteristics; consumers are
T
Federal Reserve Bank of Richmond
23
2001 Annual Report
willing to pay more for characteristics
they value, and producers charge more
for characteristics that are more costly
to supply. Consumers that value financial privacy ought to be willing to pay
for privacy policies that they prefer. And
if it is economically beneficial to share
information with other companies, financial institutions ought to be willing to
compensate their customers for permission to do so. The fact that few banks
seem to be paying customers not to opt
out is strong evidence that the economic
value of information sharing is relatively
small. And the fact that so few consumers are opting out, despite the low
cost of doing so, is evidence that few
consumers place a significant value on
preventing information sharing.
This line of reasoning also leads to
a stark and surprising conclusion: the
choice between opt-out and opt-in
standards is irrelevant. Under an opt-
24
Federal Reserve Bank of Richmond
out standard, banks could pay customers to refrain from opting out, while
under an opt-in standard, banks could
pay customers to opt in. Either way,
financial markets should deliver an efficient amount of information sharing.
One puzzle remains, however: Why
is financial privacy such a controversial issue if few consumers care enough
about preventing information sharing
to take simple steps to prevent it? Nevertheless, the economics of the issue is
clear —financial privacy laws like the
GLBA accomplish less than either privacy advocates or their critics presume.
This article benefited from the comments of my colleagues in the Bank’s
Research Department, especially John
Weinberg, Marvin Goodfriend, Laura
Fortunato, Ned Prescott, Aaron Steelman, and John Walter, and from the
assistance of Elise Couper.
Feature Article
References
American Bankers Association. 2001.
“ABA Survey Shows Nearly One Out of
Three Consumers Read Their Banks’ Privacy
Notices.” News Release (7 June).
American List Counsel. 2002.
http://www.amlist.com [17 January].
Gramlich, Edward M. 1999. “Statement to
the U.S. House Subcommittee on Financial
Institutions and Consumer Credit of the
Committee on Banking and Financial Services,” July 21, 1999. Federal Reserve
Bulletin 85 (September): 624-26.
America’s Community Bankers. 2001.
“ACB Privacy Compliance Survey.”
Manuscript (November).
Harper, Jim and Solveig Singleton. 2001.
“With a Grain of Salt: What Consumer
Privacy Surveys Don’t Tell Us.” Manuscript,
Competitive Enterprise Institute (June).
Bauer, Paul. “Consumer’s Financial Privacy
and the Gramm-Leach-Bliley Act.” Federal
Reserve Bank of Cleveland Economic
Commentary (forthcoming).
Harris Interactive Inc. 2001. “A Survey of
Consumer Privacy Attitudes and Behaviors.” Manuscript.
Coase, Ronald H. 1960. “The Problem of
Social Cost.” Journal of Law and Economics 3 (October): 1-44.
Kahn, Charles M., James McAndrews, and
William Roberds. 2000. “A Theory of
Transactions Privacy.” Working Paper
2000-22. Federal Reserve Bank of Atlanta.
____________. 1974. “The Lighthouse in
Economics.” Journal of Law and Economics
17 (October): 357-76.
Equifax. 2001. TotalSourceXLTM. Consumer
Database (Fall).
http://www.equifax.com/business_solutions/information_services/documents/
Fall_2001_TotalSource_XL_Rate_Card.pdf
[17 January 2002].
Federal Trade Commission. 2001. Interagency public workshop entitled Get
Noticed: Effective Financial Privacy
Notices, 4 December, at The Ronald
Reagan Building and International Trade
Center, Washington, D.C.
http://www.ftc.gov/bcp/workshops/glb/
index.html [17 January 2002].
____________. 2002. “Gramm-Leach-Bliley
Act: Financial Privacy and Pretexting.”
http://www.ftc.gov/privacy/glbact/index.
html [17 January].
Kovacevich, Richard M. 2000. “Privacy
and the Promise of Financial Modernization.” The Region 14 (March): 27-29.
Lee, W. A. 2001. “Opt-Out Notices Give No
One a Thrill.” American Banker (10 July).
National Consumers League. 2000.
“Online Americans More Concerned about
Privacy than Health Care, Crime, and
Taxes, New Survey Reveals.” News
Release (4 October).
Paul, Pamela. 2001. “Mixed Signals.”
American Demographics 23 (March): 45-49.
Spiekermann, Sarah, Jens Grossklags, and
Bettina Berendt. No date available. “Stated Privacy Preferences versus Actual
Behaviour in EC environments: a Reality
Check.” Manuscript, Humboldt University.
Worldata. 2002. Worldata & WebConnect
Online Datacard Library. Online database,
http://www.worldata.com [17 January].
Friedman, David. 2000. “Privacy and
Technology.” Social Philosophy & Policy
17 (Summer): 186-212.
Federal Reserve Bank of Richmond
25
Financial Statements
Financial Statements
MANAGEMENT ASSERTION
DECEMBER 31, 2001
To the Board of Directors:
The management of the Federal Reserve Bank of Richmond (FRB Richmond) is responsible
for the preparation and fair presentation of the Statement of Financial Condition, Statement
of Income, and Statement of Changes in Capital as of December 31, 2001 (the “Financial
Statements”). The Financial Statements have been prepared in conformity with the accounting principles, policies, and practices established by the Board of Governors of the Federal
Reserve System and as set forth in the Financial Accounting Manual for the Federal Reserve
Banks, and as such, include amounts, some of which are based on judgments and estimates
of management.
The management of the FRB Richmond is responsible for maintaining an effective
process of internal controls over financial reporting including the safeguarding of assets
as they relate to the Financial Statements. Such internal controls are designed to provide
reasonable assurance to management and to the Board of Directors regarding the preparation of reliable Financial Statements. This process of internal controls contains self-monitoring mechanisms, including, but not limited to, divisions of responsibility and a code of
conduct. Once identified, any material deficiencies in the process of internal controls are
reported to management, and appropriate corrective measures are implemented.
Even an effective process of internal controls, no matter how well designed, has inherent limitations, including the possibility of human error, and therefore can provide only
reasonable assurance with respect to the preparation of reliable financial statements.
The management of the FRB Richmond assessed its process of internal controls over financial reporting including the safeguarding of assets reflected in the Financial Statements,
based upon the criteria established in the “Internal Control — Integrated Framework” issued
by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Based on this assessment, the management of the FRB Richmond believes that the FRB
Richmond maintained an effective process of internal controls over financial reporting including the safeguarding of assets as they relate to the Financial Statements.
Federal Reserve Bank of Richmond
J. Alfred Broaddus, Jr.
Walter A. Varvel
PRESIDENT
FIRST VICE PRESIDENT
Federal Reserve Bank of Richmond
35
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors of the Federal Reserve Bank of Richmond:
We have examined management’s assertion that the Federal Reserve Bank of
Richmond (“FRB Richmond”) maintained effective internal control over financial
reporting and the safeguarding of assets as they relate to the Financial
Statements as of December 31, 2001, included in the accompanying
Management’s Assertion. The assertion is the responsibility of FRB Richmond’s
management. Our responsibility is to express an opinion on the assertions
based on our examination.
Our examination was made in accordance with standards established by the
American Institute of Certified Public Accountants, and accordingly, included
obtaining an understanding of the internal control over financial reporting, testing,
and evaluating the design and operating effectiveness of the internal control,
and such other procedures as we considered necessary in the circumstances.
We believe that our examination provides a reasonable basis for our opinion.
Because of inherent limitations in any internal control, misstatements due
to error or fraud may occur and not be detected. Also, projections of any
evaluation of the internal control over financial reporting to future periods are
subject to the risk that the internal control may become inadequate because
of changes in conditions, or that the degree of compliance with the policies
or procedures may deteriorate.
In our opinion, management’s assertion that the FRB Richmond maintained
effective internal control over financial reporting and over the safeguarding
of assets as they relate to the Financial Statements as of December 31, 2001,
is fairly stated, in all material respects, based upon criteria described in “Internal
Control — Integrated Framework” issued by the Committee of Sponsoring
Organizations of the Treadway Commission.
March 4, 2002
36
Federal Reserve Bank of Richmond
Financial Statements
REPORT
OF INDEPENDENT
ACCOUNTANTS
To the Board of Governors of the Federal Reserve System and the Board of
Directors of the Federal Reserve Bank of Richmond:
We have audited the accompanying statements of condition of the Federal
Reserve Bank of Richmond (the “Bank”) as of December 31, 2001 and 2000,
and the related statements of income and changes in capital for the years
then ended. These financial statements are the responsibility of the Bank’s
management. Our responsibility is to express an opinion on the financial
statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that
we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management,
as well as evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 3, the financial statements were prepared in conformity with the accounting principles, policies, and practices established by
the Board of Governors of the Federal Reserve System. These principles,
policies, and practices, which were designed to meet the specialized
accounting and reporting needs of the Federal Reserve System, are set forth
in the “Financial Accounting Manual for Federal Reserve Banks” and constitute a comprehensive basis of accounting other than accounting principles
generally accepted in the United States of America.
In our opinion, the financial statements referred to above present fairly, in all
material respects, the financial position of the Bank as of December 31, 2001 and
2000, and the results of its operations for the years then ended, on the basis of
accounting described in Note 3.
March 4, 2002
Federal Reserve Bank of Richmond
37
2001 Annual Report
FEDERAL RESERVE BANK OF RICHMOND
STATEMENTS OF CONDITION
(IN MILLIONS)
As of December 31,
2001
2000
ASSETS
Gold certificates
$
741
Special drawing rights certificates
147
Coin
165
Items in process of collection
174
Loans to depository institutions
1
U.S. government and federal agency securities, net
33,556
Investments denominated in foreign currencies
3,544
Accrued interest receivable
341
Prepaid expense – interest on Federal Reserve notes to the U.S. Treasury
13
Interdistrict settlement account
13,211
Bank premises and equipment, net
232
Other assets
101
Total assets
$
750
147
117
658
5
30,437
4,121
355
584
2,402
202
102
$52,226
$39,880
45,208
34,048
3,191
76
109
83
45
1,641
47
683
76
27
48,712
36,522
Capital paid-in
Surplus
1,757
1,757
1,679
1,679
Total capital
3,514
3,358
$52,226
$39,880
LIABILITIES
AND
CAPITAL
Liabilities:
Federal Reserve notes outstanding, net
Deposits:
Depository institutions
Other deposits
Deferred credit items
Accrued benefit costs
Other liabilities
Total liabilities
Capital:
Total liabilities and capital
The accompanying notes are an integral part of these financial statements.
38
Federal Reserve Bank of Richmond
Financial Statements
FEDERAL RESERVE BANK OF RICHMOND
STATEMENTS OF INCOME
(IN MILLIONS)
For the years ended
December 31,
2001
2000
INTEREST
INCOME
Interest on U.S. government and federal agency securities
Interest on investments denominated in foreign currencies
Interest on loans to depository institutions
$1,756
80
1
$1,982
71
1
Total interest income
1,837
2,054
78
34
(354)
19
6
68
34
(371)
(5)
4
(217)
(270)
Salaries and other benefits
Occupancy expense
Equipment expense
Assessments by Board of Governors
Other credits
203
26
76
92
(59)
187
24
69
75
(34)
Total operating expenses
338
321
$1,282
$1,463
Dividends paid to member banks
Transferred to surplus
Payments to U.S. Treasury as interest on Federal Reserve notes
$
$
Total distribution
$1,282
OTHER
OPERATING INCOME (LOSS)
Income from services
Reimbursable services to government agencies
Foreign currency losses, net
U.S. government securities gains (losses), net
Other income
Total other operating loss
OPERATING
EXPENSES
Net income prior to distribution
DISTRIBUTION
OF NET INCOME
103
78
1,101
101
974
388
$1,463
The accompanying notes are an integral part of these financial statements.
Federal Reserve Bank of Richmond
39
2001 Annual Report
FEDERAL RESERVE BANK OF RICHMOND
STATEMENTS OF CHANGES IN CAPITAL
(IN MILLIONS)
For the years ended December 31,
2001 and December 31, 2000
Capital
Paid-in
Balance at January 1, 2000
(33.8 million shares)
Net income transferred to surplus
Surplus transfer to the U.S. Treasury
Net change in capital stock redeemed
(0.2 million shares)
Balance at December 31, 2000
(33.6 million shares)
Net income transferred to surplus
Net change in capital stock issued
(1.5 million shares)
Balance at December 31, 2001
(35.1 million shares)
The accompanying notes are an integral part of these financial statements.
40
Federal Reserve Bank of Richmond
Surplus
Total
Capital
$1,691
$1,691
$3,382
—
—
(12)
974
(986)
—
974
(986)
(12)
1,679
1,679
3,358
78
78
—
78
78
$1,757
$1,757
$3,514
Financial Statements
NOTES TO FINANCIAL STATEMENTS
1. Organization
The Federal Reserve Bank of Richmond (“Bank”) is part of
the Federal Reserve System (“System”) created by Congress
under the Federal Reserve Act of 1913 (“Federal Reserve
Act”) which established the central bank of the United States.
The System consists of the Board of Governors of the Federal Reserve System (“Board of Governors”) and twelve Federal Reserve Banks (“Reserve Banks”). The Reserve Banks
are chartered by the federal government and possess a
unique set of governmental, corporate, and central bank
characteristics. Other major elements of the System are the
Federal Open Market Committee (“FOMC”) and the Federal Advisory Council. The FOMC is composed of members
of the Board of Governors, the president of the Federal
Reserve Bank of New York (“FRBNY”) and, on a rotating
basis, four other Reserve Bank presidents.
Structure
The Bank in Richmond, Virginia, and its branches in Baltimore,
Maryland, and Charlotte, North Carolina, serve the Fifth Federal Reserve District, which includes Maryland, North Carolina, South Carolina, Virginia, the District of Columbia, and a
portion of West Virginia. In accordance with the Federal
Reserve Act, supervision and control of the Bank are exercised
by a Board of Directors. Banks that are members of the System include all national banks and any state chartered bank
that applies and is approved for membership in the System.
Board of Directors
The Federal Reserve Act specifies the composition of the
Board of Directors for each of the Reserve Banks. Each board
is composed of nine members serving three-year terms: three
directors, including those designated as Chairman and
Deputy Chairman, are appointed by the Board of Governors, and six directors are elected by member banks. Of the
six elected by member banks, three represent the public and
three represent member banks. Member banks are divided
into three classes according to size. Member banks in each
class elect one director representing member banks and one
representing the public. In any election of directors, each
member bank receives one vote, regardless of the number
of shares of Reserve Bank stock it holds.
2. Operations and Services
The System performs a variety of services and operations.
Functions include: formulating and conducting monetary policy; participating actively in the payments mechanism, including large-dollar transfers of funds, automated clearinghouse
(“ACH”) operations and check processing; distributing coin
and currency; performing fiscal agency functions for the
U.S. Treasury and certain federal agencies; serving as the
federal government’s bank; providing short-term loans to
depository institutions; serving the consumer and the community by providing educational materials and information
regarding consumer laws; supervising bank holding companies and state member banks; and administering other
regulations of the Board of Governors. The Board of Governors’ operating costs are funded through assessments on
the Reserve Banks.
The FOMC establishes policy regarding open market operations, oversees these operations, and issues authorizations
and directives to the FRBNY for its execution of transactions.
Authorized transaction types include direct purchase and sale
of securities, matched sale-purchase transactions, the purchase
of securities under agreements to resell, and the lending of
U.S. government securities. The FRBNY is also authorized by
the FOMC to hold balances of and to execute spot and forward foreign exchange and securities contracts in nine foreign currencies, maintain reciprocal currency arrangements
(“F/X swaps”) with various central banks, and “warehouse”
foreign currencies for the U.S. Treasury and Exchange Stabilization Fund (“ESF”) through the Reserve Banks.
Federal Reserve Bank of Richmond
41
2001 Annual Report
3. Significant Accounting Policies
Accounting principles for entities with the unique powers and
responsibilities of the nation’s central bank have not been
formulated by the Financial Accounting Standards Board.
The Board of Governors has developed specialized accounting principles and practices that it believes are appropriate
for the significantly different nature and function of a central
bank as compared to the private sector. These accounting
principles and practices are documented in the Financial
Accounting Manual for Federal Reserve Banks (“Financial
Accounting Manual”), which is issued by the Board of Governors. All Reserve Banks are required to adopt and apply
accounting policies and practices that are consistent with the
Financial Accounting Manual.
The financial statements have been prepared in accordance with the Financial Accounting Manual. Differences
exist between the accounting principles and practices of the
System and accounting principles generally accepted in the
United States of America (“GAAP”). The primary differences
are the presentation of all security holdings at amortized
cost, rather than at the fair value presentation requirements
of GAAP, and the accounting for matched sale-purchase
transactions as separate sales and purchases, rather than
secured borrowings with pledged collateral, as is generally required by GAAP. In addition, the Bank has elected not
to present a Statement of Cash Flows. The Statement of Cash
Flows has not been included as the liquidity and cash position of the Bank are not of primary concern to the users of
these financial statements. Other information regarding the
Bank’s activities is provided in, or may be derived from, the
Statements of Condition, Income, and Changes in Capital.
Therefore, a Statement of Cash Flows would not provide
any additional useful information. There are no other significant differences between the policies outlined in the Financial Accounting Manual and GAAP.
Effective January 2001, the System implemented proce-
42
Federal Reserve Bank of Richmond
dures to eliminate the sharing of costs by Reserve Banks for
certain services a Reserve Bank may provide on behalf of
the System. Data for 2001 reflects the adoption of this policy. Major services provided for the System by this bank,
for which the costs will not be redistributed to the other
Reserve Banks, include Standard Cash Automation and the
Currency Technology Office.
The preparation of the financial statements in conformity
with the Financial Accounting Manual requires management
to make certain estimates and assumptions that affect the
reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial
statements and the reported amounts of income and expenses during the reporting period. Actual results could differ
from those estimates. Certain amounts relating to the prior
year have been reclassified to conform to the current-year
presentation. Unique accounts and significant accounting
policies are explained below.
a.
Gold Certificates
The Secretary of the Treasury is authorized to issue gold
certificates to the Reserve Banks to monetize gold held by
the U.S. Treasury. Payment for the gold certificates by the
Reserve Banks is made by crediting equivalent amounts in
dollars into the account established for the U.S. Treasury.
These gold certificates held by the Reserve Banks are
required to be backed by the gold of the U.S. Treasury.
The U.S. Treasury may reacquire the gold certificates at any
time and the Reserve Banks must deliver them to the U.S.
Treasury. At such time, the U.S. Treasury’s account is charged
and the Reserve Banks’ gold certificate accounts are lowered. The value of gold for purposes of backing the gold
certificates is set by law at $42 2/9 a fine troy ounce. The
Board of Governors allocates the gold certificates among
Reserve Banks once a year based upon average Federal
Reserve notes outstanding in each District.
Financial Statements
b.
Special Drawing Rights Certificates
Special drawing rights (“SDRs”) are issued by the International Monetary Fund (“Fund”) to its members in proportion to each member’s quota in the Fund at the time of
issuance. SDRs serve as a supplement to international monetary reserves and may be transferred from one national
monetary authority to another. Under the law providing
for United States participation in the SDR system, the Secretary of the U.S. Treasury is authorized to issue SDR certificates, somewhat like gold certificates, to the Reserve
Banks. At such time, equivalent amounts in dollars are
credited to the account established for the U.S. Treasury,
and the Reserve Banks’ SDR certificate accounts are
increased. The Reserve Banks are required to purchase
SDRs, at the direction of the U.S. Treasury, for the purpose
of financing SDR certificate acquisitions or for financing
exchange stabilization operations. At the time SDR transactions occur, the Board of Governors allocates amounts
among Reserve Banks based upon Federal Reserve notes
outstanding in each District at the end of the preceding
year. There were no SDR transactions in 2001.
c.
Loans to Depository Institutions
The Depository Institutions Deregulation and Monetary Control Act of 1980 provides that all depository institutions that
maintain reservable transaction accounts or nonpersonal time
deposits, as defined in Regulation D issued by the Board of
Governors, have borrowing privileges at the discretion of the
Reserve Banks. Borrowers execute certain lending agreements
and deposit sufficient collateral before credit is extended. Loans
are evaluated for collectibility, and currently all are considered
collectible and fully collateralized. If any loans were deemed
to be uncollectible, an appropriate reserve would be established. Interest is accrued using the applicable discount rate
established at least every fourteen days by the Board of Directors of the Reserve Banks, subject to review by the Board of
Governors. Reserve Banks retain the option to impose a surcharge above the basic rate in certain circumstances.
d.
U.S. Government and Federal Agency Securities and
Investments Denominated in Foreign Currencies
The FOMC has designated the FRBNY to execute open market transactions on its behalf and to hold the resulting securities in the portfolio known as the System Open Market
Account (“SOMA”). In addition to authorizing and directing operations in the domestic securities market, the FOMC
authorizes and directs the FRBNY to execute operations in
foreign markets for major currencies in order to counter disorderly conditions in exchange markets or to meet other
needs specified by the FOMC in carrying out the System’s
central bank responsibilities. Such authorizations are reviewed
and approved annually by the FOMC.
Matched sale-purchase transactions are accounted for as
separate sale and purchase transactions. Matched sale-purchase transactions are transactions in which the FRBNY sells
a security and buys it back at the rate specified at the commencement of the transaction.
The FRBNY has sole authorization by the FOMC to lend
U.S. government securities held in the SOMA to U.S. government securities dealers and to banks participating in U.S.
government securities clearing arrangements on behalf of
the System, in order to facilitate the effective functioning of
the domestic securities market. These securities-lending transactions are fully collateralized by other U.S. government securities. FOMC policy requires FRBNY to take possession of
collateral in excess of the market values of the securities
loaned. The market values of the collateral and the securities loaned are monitored by FRBNY on a daily basis, with
additional collateral obtained as necessary. The securities
loaned continue to be accounted for in the SOMA.
Foreign exchange (“F/X”) contracts are contractual agreements between two parties to exchange specified currencies,
Federal Reserve Bank of Richmond
43
2001 Annual Report
at a specified price, on a specified date. Spot foreign contracts normally settle two days after the trade date, whereas the settlement date on forward contracts is negotiated
between the contracting parties, but will extend beyond two
days from the trade date. The FRBNY generally enters into
spot contracts, with any forward contracts generally limited
to the second leg of a swap/warehousing transaction.
The FRBNY, on behalf of the Reserve Banks, maintains renewable, short-term F/X swap arrangements with two authorized
foreign central banks. The parties agree to exchange their currencies up to a pre-arranged maximum amount and for an
agreed upon period of time (up to twelve months), at an agreed
upon interest rate. These arrangements give the FOMC temporary access to foreign currencies that it may need for intervention operations to support the dollar and give the partner
foreign central bank temporary access to dollars it may need
to support its own currency. Drawings under the F/X swap
arrangements can be initiated by either the FRBNY or the partner foreign central bank, and must be agreed to by the drawee.
The F/X swaps are structured so that the party initiating the
transaction (the drawer) bears the exchange rate risk upon
maturity. The FRBNY will generally invest the foreign currency
received under an F/X swap in interest-bearing instruments.
Warehousing is an arrangement under which the FOMC
agrees to exchange, at the request of the Treasury, U.S. dollars for foreign currencies held by the Treasury or ESF over
a limited period of time. The purpose of the warehousing
facility is to supplement the U.S. dollar resources of the Treasury and ESF for financing purchases of foreign currencies
and related international operations.
In connection with its foreign currency activities, the FRBNY,
on behalf of the Reserve Banks, may enter into contracts which
contain varying degrees of off-balance sheet market risk,
because they represent contractual commitments involving future
settlement and counter-party credit risk. The FRBNY controls
credit risk by obtaining credit approvals, establishing transaction limits, and performing daily monitoring procedures.
44
Federal Reserve Bank of Richmond
While the application of current market prices to the securities currently held in the SOMA portfolio and investments denominated in foreign currencies may result in values substantially
above or below their carrying values, these unrealized changes
in value would have no direct effect on the quantity of reserves
available to the banking system or on the prospects for future
Reserve Bank earnings or capital. Both the domestic and foreign components of the SOMA portfolio from time to time involve
transactions that can result in gains or losses when holdings are
sold prior to maturity. However, decisions regarding the securities and foreign currencies transactions, including their purchase and sale, are motivated by monetary policy objectives
rather than profit. Accordingly, earnings and any gains or
losses resulting from the sale of such currencies and securities
are incidental to the open market operations and do not motivate its activities or policy decisions.
U.S. government and federal agency securities and investments denominated in foreign currencies comprising the
SOMA are recorded at cost, on a settlement-date basis,
and adjusted for amortization of premiums or accretion of
discounts on a straight-line basis. Interest income is accrued
on a straight-line basis and is reported as “Interest on U.S.
government and federal agency securities” or “Interest on
investments denominated in foreign currencies,” as appropriate. Income earned on securities lending transactions is
reported as a component of “Other income.” Gains and
losses resulting from sales of securities are determined by
specific issues based on average cost. Gains and losses
on the sales of U.S. government and federal agency securities are reported as “U.S. Government securities gains
(losses), net.” Foreign-currency-denominated assets are revalued daily at current market exchange rates in order to
report these assets in U.S. dollars. Realized and unrealized
gains and losses on investments denominated in foreign
currencies are reported as “Foreign currency losses, net”.
Foreign currencies held through F/X swaps, when initiated by the counter-party, and warehousing arrangements
Financial Statements
are revalued daily, with the unrealized gain or loss reported by the FRBNY as a component of “Other assets” or
“Other liabilities,” as appropriate.
Balances of U.S. government and federal agency securities bought outright, securities loaned, investments denominated in foreign currency, interest income, securities lending fee income, amortization of premiums and discounts
on securities bought outright, gains and losses on sales of
securities, and realized and unrealized gains and losses
on investments denominated in foreign currencies, excluding those held under an F/X swap arrangement, are allocated to each Reserve Bank. Income from securities lending transactions undertaken by the FRBNY are also allocated to each Reserve Bank. Securities purchased under
agreements to resell and unrealized gains and losses on
the revaluation of foreign currency holdings under F/X
swaps and warehousing arrangements are allocated to the
FRBNY and not to other Reserve Banks.
Statement of Financial Accounting Standards No. 133, as
amended and interpreted, became effective on January 1, 2001.
For the periods presented, the Reserve Banks had no derivative
instruments required to be accounted for under the standard.
e.
Bank Premises and Equipment
Bank premises and equipment are stated at cost less accumulated depreciation. Depreciation is calculated on a straightline basis over estimated useful lives of assets ranging from
2 to 50 years. New assets, major alterations, renovations
and improvements are capitalized at cost as additions to the
asset accounts. Maintenance, repairs and minor replacements are charged to operations in the year incurred. Internally developed software is capitalized based on the cost
of direct materials and services and those indirect costs associated with developing, implementing, or testing software.
f.
Interdistrict Settlement Account
At the close of business each day, all Reserve Banks and branch-
es assemble the payments due to or from other Reserve Banks
and branches as a result of transactions involving accounts residing in other Districts that occurred during the day’s operations.
Such transactions may include funds settlement, check clearing
and ACH operations, and allocations of shared expenses. The
cumulative net amount due to or from other Reserve Banks is
reported as the “Interdistrict settlement account.”
g.
Federal Reserve Notes
Federal Reserve notes are the circulating currency of the United States. These notes are issued through the various Federal
Reserve agents to the Reserve Banks upon deposit with such
Agents of certain classes of collateral security, typically U.S.
government securities. These notes are identified as issued to
a specific Reserve Bank. The Federal Reserve Act provides that
the collateral security tendered by the Reserve Bank to the Federal Reserve Agent must be equal to the sum of the notes applied
for by such Reserve Bank. In accordance with the Federal
Reserve Act, gold certificates, special drawing rights certificates,
U.S. government and federal agency securities, triparty agreements, loans to depository institutions, and investments denominated in foreign currencies are pledged as collateral for net
Federal Reserve notes outstanding. The collateral value is equal
to the book value of the collateral tendered, with the exception
of securities, whose collateral value is equal to the par value
of the securities tendered. The Board of Governors may, at
any time, call upon a Reserve Bank for additional security to
adequately collateralize the Federal Reserve notes. The Reserve
Banks have entered into an agreement which provides for certain assets of the Reserve Banks to be jointly pledged as collateral for the Federal Reserve notes of all Reserve Banks in
order to satisfy their obligation of providing sufficient collateral for outstanding Federal Reserve notes. In the event that this
collateral is insufficient, the Federal Reserve Act provides that
Federal Reserve notes become a first and paramount lien on
all the assets of the Reserve Banks. Finally, as obligations of
the United States, Federal Reserve notes are backed by the full
Federal Reserve Bank of Richmond
45
2001 Annual Report
faith and credit of the United States government.
The “Federal Reserve notes outstanding, net” account represents Federal Reserve notes reduced by currency held in
the vaults of the Bank of $10,230 million, and $16,797
million at December 31, 2001 and 2000, respectively.
h.
Capital Paid-in
The Federal Reserve Act requires that each member bank
subscribe to the capital stock of the Reserve Bank in an
amount equal to 6 percent of the capital and surplus of the
member bank. As a member bank’s capital and surplus
changes, its holdings of the Reserve Bank’s stock must be
adjusted. Member banks are those state-chartered banks that
apply and are approved for membership in the System and
all national banks. Currently, only one-half of the subscription is paid-in and the remainder is subject to call. These
shares are nonvoting with a par value of $100. They may
not be transferred or hypothecated. By law, each member
bank is entitled to receive an annual dividend of 6 percent
on the paid-in capital stock. This cumulative dividend is paid
semiannually. A member bank is liable for Reserve Bank
liabilities up to twice the par value of stock subscribed by it.
Federal Reserve Bank of Richmond transferred $987 million
to the U.S. Treasury. Reserve Banks were not permitted to
replenish surplus for these amounts during fiscal year 2000
which ended September 30, 2000; however, the surplus
was replenished by December 31, 2000.
In the event of losses or a substantial increase in capital,
payments to the U.S. Treasury are suspended until such losses or increases in capital are recovered through subsequent
earnings. A portion of the payments made to the U.S. Treasury earlier in the year are classified as “Prepaid expenseinterest on Federal Reserve notes to the U.S. Treasury.”
Weekly payments to the U.S. Treasury may vary significantly.
j.
k.
i.
Surplus
The Board of Governors requires Reserve Banks to maintain a
surplus equal to the amount of capital paid-in as of December
31. This amount is intended to provide additional capital and
reduce the possibility that the Reserve Banks would be required
to call on member banks for additional capital. Reserve Banks
are required by the Board of Governors to transfer to the U.S.
Treasury excess earnings, after providing for the costs of operations, payment of dividends, and reservation of an amount
necessary to equate surplus with capital paid-in.
The Consolidated Appropriations Act of 2000 (Public Law
106-113, Section 302) directed the Reserve Banks to transfer to the U.S. Treasury additional surplus funds of $3,752
million during the Federal Government’s 2000 fiscal year.
46
Federal Reserve Bank of Richmond
Income and Costs related to Treasury Services
The Bank is required by the Federal Reserve Act to serve
as fiscal agent and depository of the United States. By
statute, the Department of the Treasury is permitted, but not
required, to pay for these services. The costs of providing
fiscal agency and depository services to the Treasury
Department that have been billed but will not be paid are
immaterial and included in “Other credits.”
Taxes
The Reserve Banks are exempt from federal, state, and local
taxes, except for taxes on real property, which are reported
as a component of “Occupancy expense.”
4. U.S. Government and Federal Agency Securities
Securities bought outright are held in the SOMA at the
FRBNY. An undivided interest in SOMA activity, with the
exception of securities held under agreements to resell and
the related premiums, discounts and income, is allocated
to each Reserve Bank on a percentage basis derived from
an annual settlement of interdistrict clearings. The settlement,
performed in April of each year, equalizes Reserve Bank
gold certificate holdings to Federal Reserve notes outstanding. The Bank’s allocated share of SOMA balances
Financial Statements
was 5.974 percent and 5.870 percent at December 31,
2001 and 2000, respectively.
The Bank’s allocated share of securities held in the
SOMA at December 31, that were bought outright, were
as follows (in millions):
2001
Par value:
Federal agency
U.S. government:
Bills
Notes
Bonds
$
Total par value
Unamortized premiums
Unaccreted discounts
Total allocated to Bank
1
2000
$
8
10,877
15,887
6,193
10,492
14,099
5,447
32,958
30,046
675
(77)
$33,556
571
(180)
$30,437
Total SOMA securities bought outright were $561,701 million and $518,501 million at December 31, 2001 and
2000, respectively.
The maturity distribution of U.S. government and federal
agency securities bought outright, which were allocated to the
Bank at December 31, 2001, were as follows (in millions):
Par Value
Maturities of
Securities Held
U.S.
Government
Securities
Federal
Agency
Obligations
Total
Within 15 days
16 days to 90 days
91 days to 1 year
Over 1 year to 5 years
Over 5 years to 10 years
Over 10 years
$
638
7,440
7,804
9,150
3,186
4,739
$—
—
—
1
—
—
$
638
7,440
7,804
9,151
3,186
4,739
Total
$32,957
$ 1
$32,958
At December 31, 2001 and 2000, matched sale-purchase
transactions involving U.S. government securities with par
values of $23,188 million and $21,112 million, respectively,
were outstanding, of which $1,385 million and $1,239 million were allocated to the Bank. Matched sale-purchase transactions are generally overnight arrangements.
At December 31, 2001 and 2000, U.S. government securities with par values of $7,345 million and $2,086 million, respectively, were loaned from the SOMA, of which
$439 million and $122 million were allocated to the Bank.
5. Investments Denominated in Foreign Currencies
The FRBNY, on behalf of the Reserve Banks, holds foreign
currency deposits with foreign central banks and the Bank
for International Settlements and invests in foreign government debt instruments. Foreign government debt instruments held include both securities bought outright and
securities held under agreements to resell. These investments are guaranteed as to principal and interest by the
foreign governments.
Each Reserve Bank is allocated a share of foreign-currency-denominated assets, the related interest income, and
realized and unrealized foreign currency gains and losses, with the exception of unrealized gains and losses on
F/X swaps and warehousing transactions. This allocation
is based on the ratio of each Reserve Bank’s capital and
surplus to aggregate capital and surplus at the preceding
December 31. The Bank’s allocated share of investments
denominated in foreign currencies was approximately
24.344 percent and 26.301 percent at December 31,
2001 and 2000, respectively.
Federal Reserve Bank of Richmond
47
2001 Annual Report
The Bank’s allocated share of investments denominated
in foreign currencies, valued at current exchange rates at
December 31, were as follows (in millions):
2001
Accrued interest
Total
$ 1,118
656
$ 1,218
714
460
1,294
724
1,446
16
19
$3,544
$4,121
Total investments denominated in foreign currencies were
$14,559 million and $15,670 million at December 31,
2001 and 2000, respectively.
The maturity distribution of investments denominated in foreign currencies which were allocated to the Bank at December 31, 2001, was as follows (in millions):
Maturities of Investments Denominated in Foreign Currencies
Within 1 year
Over 1 year to 5 years
$3,339
98
Over 5 years to 10 years
107
Over 10 years
—
Total
$3,544
At December 31, 2001 and 2000, there were no open
foreign exchange contracts or outstanding F/X swaps.
At December 31, 2001 and 2000, the warehousing facility was $5 billion, with zero outstanding.
48
2000
Accumulated depreciation
$ 19.7
122.6
44.1
0.3
292.8
479.5
(247.5)
$ 16.2
117.9
35.1
8.5
253.4
431.1
(229.1)
Bank premises and equipment, net
$232.0
$202.0
Bank premises and equipment:
Japanese Yen:
Foreign currency deposits
Government debt instruments
including agreements to resell
2001
2000
European Union Euro:
Foreign currency deposits
Government debt instruments
including Agreements to resell
6. Bank Premises and Equipment
A summary of bank premises and equipment at December
31 is as follows (in millions):
Federal Reserve Bank of Richmond
Land
Buildings
Building machinery and equipment
Construction in process
Furniture and equipment
Depreciation expense was $31 million and $30 million for the
years ended December 31, 2001 and 2000, respectively.
Bank premises and equipment at December 31 include the following amounts for leases that have been capitalized (in millions):
2001
2000
Bank premises and equipment
Accumulated depreciation
$20
(13)
$33
(22)
Capitalized leases, net
$7
$11
The Bank leases unused space to outside tenants. Those leases have terms ranging from 1 to 5 years. Rental income from
such leases was $1.3 million for each of the years ended
December 31, 2001 and 2000. Future minimum lease payments under noncancellable agreements in existence at
December 31, 2001, were (in millions):
2002
2003
2004
2005
2006
Thereafter
$1.1
1.2
1.2
1.2
1.2
0.0
$5.9
Financial Statements
7. Commitments and Contingencies
At December 31, 2000, the Bank was obligated under noncancelable leases for premises and equipment with terms
ranging from 1 to approximately 4 years. These leases provide for increased rentals based upon increases in real estate
taxes, operating costs or selected price indices.
Rental expense under operating leases for certain operating facilities, warehouses, and data processing and office
equipment (including taxes, insurance and maintenance when
included in rent), net of sublease rentals, was $40 million
and $37 million for the years ended December 31, 2001
and 2000, respectively. Certain of the Bank’s leases have
options to renew.
Future minimum rental payments under noncancelable operating leases and capital leases, net of sublease rentals, with
terms of one year or more, at December 31, 2001, were
(in millions):
Operating
2002
2003
2004
2005
Thereafter
Amount representing interest
Present value of net minimum
lease payment
Capital
$1.4
1.2
1.0
0.4
0.0
$1.4
0.9
0.8
0.1
0.0
$4.0
3.2
(0.2)
a Reserve Bank’s capital paid-in bears to the total capital
paid-in of all Reserve Banks at the beginning of the calendar
year in which the loss is shared. No claims were outstanding under such agreement at December 31, 2001 or 2000.
The Bank is involved in certain legal actions and claims
arising in the ordinary course of business. Although it is difficult to predict the ultimate outcome of these actions, in management’s opinion, based on discussions with counsel, the
aforementioned litigation and claims will be resolved without material adverse effect on the financial position or results
of operations of the Bank.
8. Retirement and Thrift Plans
Retirement Plans
The Bank currently offers two defined benefit retirement plans
to its employees, based on length of service and level of
compensation. Substantially all of the Bank’s employees participate in the Retirement Plan for Employees of the Federal
Reserve System (“System Plan”) and the Benefit Equalization
Retirement Plan (“BEP”). The System Plan is a multi-employer plan with contributions fully funded by participating
employers. No separate accounting is maintained of assets
contributed by the participating employers. The Bank’s projected benefit obligation and net pension costs for the BEP
at December 31, 2001 and 2000, and for the years then
ended, are not material.
$3.0
At December 31, 2001, there were no other commitments
and long-term obligations in excess of one year.
Under the Insurance Agreement of the Federal Reserve
Banks dated as of March 2, 1999, each of the Reserve Banks
has agreed to bear, on a per incident basis, a pro rata share
of losses in excess of 1 percent of the capital paid-in of the
claiming Reserve Bank, up to 50 percent of the total capital
paid-in of all Reserve Banks. Losses are borne in the ratio that
Thrift Plan
Employees of the Bank may also participate in the defined
contribution Thrift Plan for Employees of the Federal Reserve
System (“Thrift Plan”). The Bank’s Thrift Plan contributions
totaled $6 million for each of the years ended December
31, 2001 and 2000, and are reported as a component of
“Salaries and other benefits.”
Federal Reserve Bank of Richmond
49
2001 Annual Report
9. Postretirement Benefits Other Than Pensions
and Postemployment Benefits
Following is a reconciliation of beginning and ending balances
of the plan assets, the unfunded postretirement benefit obligation, and the accrued postretirement benefit costs (in millions):
Postretirement benefits other than pensions
In addition to the Bank’s retirement plans, employees who
have met certain age and length of service requirements are
eligible for both medical benefits and life insurance coverage during retirement.
The Bank funds benefits payable under the medical and
life insurance plans as due and, accordingly, has no plan
assets. Net postretirement benefit costs are actuarially determined using a January 1 measurement date.
Following is a reconciliation of beginning and ending balances of the benefit obligation (in millions):
Accumulated postretirement benefit obligation at January 1
Service cost-benefits earned during the period
Interest cost of accumulated benefit obligation
Actuarial loss
Contributions by plan participants
Benefits paid
Plan amendment/settlement
Accumulated postretirement benefit
obligation at December 31
50
Federal Reserve Bank of Richmond
2001
2000
$71.0
2.3
5.6
12.5
0.4
(3.4)
(11.0)
$63.8
1.9
4.7
3.0
0.3
(2.7)
—
$77.4
$71.0
2001
2000
Fair value of plan assets at January 1
Actual return on plan assets
Contributions by the employer
Contributions by plan participants
Benefits paid
$ —
—
3.0
0.4
(3.4)
$ —
—
2.4
0.3
(2.7)
Fair value of plan assets at December 31
$ —
$ —
Unfunded postretirement benefit obligation
Unrecognized prior service cost
Unrecognized net actuarial loss
$77.4
11.6
(20.1)
$71.0
0.7
(7.9)
Accrued postretirement benefit costs
$68.9
$63.8
Accrued postretirement benefit costs are reported as a component of “Accrued benefit costs.”
At December 31, 2001 and 2000, the weighted average
discount rate assumptions used in developing the benefit obligation were 7.0 percent and 7.5 percent, respectively.
For measurement purposes, a 10.00 percent annual rate
of increase in the cost of covered health care benefits was
assumed for 2002. Ultimately, the health care cost trend rate
is expected to decrease gradually to 5.00 percent by 2008,
and remain at that level thereafter.
Financial Statements
Assumed health care cost trend rates have a significant
effect on the amounts reported for health care plans. A one
percentage point change in assumed health care cost trend
rates would have the following effects for the year ended
December 31, 2001 (in millions):
Effect on aggregate of service and interest
cost components of net periodic postretirement
benefit costs
1 Percentage 1 Percentage
Point
Point
Increase
Decrease
$1.7
$(1.3)
Effect on accumulated postretirement benefit obligation 5.6
(7.7)
The following is a summary of the components of net periodic postretirement benefit costs for the years ended December 31 (in millions):
2001
2000
Service cost benefits earned during the period
Interest cost of accumulated benefit obligation
Amortization of prior service cost
Recognized net actuarial loss
$2.3
5.6
(0.1)
0.3
$1.9
4.7
(0.1)
0.1
Net periodic postretirement benefit costs
$8.1
$6.6
Net periodic postretirement benefit costs are reported as a
component of “Salaries and other benefits.”
Postemployment benefits
The Bank offers benefits to former or inactive employees.
Postemployment benefit costs are actuarially determined and
include the cost of medical and dental insurance, survivor
income, and disability benefits. Costs were projected using
the same discount rate and health care trend rates as were
used for projecting postretirement costs. The accrued postemployment benefit costs recognized by the Bank at December
31, 2001 and 2000, were $13.6 million and $11.8 million, respectively. This cost is included as a component of
“Accrued benefit costs.” Net periodic postemployment benefit costs included in 2001 and 2000 operating expenses
were $2.6 million and $2.4 million, respectively.
Federal Reserve Bank of Richmond
51
2001 Annual Report
FEDERAL RESERVE BANK OF RICHMOND
SUMMARY OF OPERATIONS
(UNAUDITED)
Year-to-Date December
Dollar Amount
Volume
2001
2000
2001
2000
48.1 Billion
6.7 Billion
60.1 Million
47.6 Billion
8.7 Billion
68.8 Million
3.2 Billion
719.0 Million
131.5 Thousand
3.0 Billion
1,168.9 Million
110.9 Thousand
1.4 Trillion
720.2 Billion
1.3 Trillion
706.3 Billion
1.7 Billion
784.9 Million
1.7 Billion
814.5 Million
43.5 Billion
40.8 Billion
37.7 Million
28.8 Million
602.0 Billion
276.6 Billion
21.6 Trillion
856.4 Billion
387.1 Billion
19.6 Trillion
208.0 Million
2.2 Million
11.9 Million
264.7 Million
3.2 Million
10.8 Million
14.7 Billion
2.5 Billion
66
160
246.9 Billion
226.7 Billion
N/A
N/A
11.7 Trillion
11.1 Trillion
699.7 Thousand
655.8 Thousand
1,736.5 Million
1,022.3 Million
6.2 Million
5.9 Million
412.0 Million
330.1 Million
81.9 Million
66.7 Million
CASH
Currency received and counted
Currency destroyed
Coin bags received and counted
NONCASH PAYMENTS
Commercial checks processed
Commercial checks, packaged
items handled
U.S. government checks processed
Automated Clearing House transactions:
Commercial1
Government1
Fedwire funds transfers
LOANS
TO
DEPOSITORY INSTITUTIONS
Discount window loans made
SECURITIES SERVICES
Safekeeping balance of book-entry
securities as of December 31
Fedwire securities transfers
SERVICES
TO
U.S. TREASURY
AND
GOVERNMENT AGENCIES
Issues, redemptions, and exchanges
of U.S. savings bonds
Food stamps redeemed
N/A = not applicable
ACH operations were consolidated in September 2001, and the statistics
are now reported from the consolidation site at the Federal Reserve Bank of Atlanta.
1
52
Federal Reserve Bank of Richmond
Editor:
Elaine Mandaleris
Managing Editor: Alice Felmlee
Design Firm:
AURAS Design, Inc.
Stuart Greenwell, Designer
Robert Sugar, Creative Director
Illustrator:
Richard Tuschman
Photographers:
Larry Cain and Geep Schurman
Printer:
Federal Reserve Bank of Richmond
Circulation:
Joyce Eberly and Scottie Woody
Special thanks to Laura Fortunato, Lisa Oliva, and
Martha Schneider for editorial comments, and
Rebecca Martin for fact-checking assistance.
This Annual Report is also available on the
Federal Reserve Bank of Richmond’s Web site
at www.rich.frb.org. For additional print copies,
contact the Public Affairs division, Federal Reserve
Bank of Richmond, P.O. Box 27622, Richmond, VA 23261.
Fifth Federal Reserve District Offices
RICHMOND
701 East Byrd Street
Richmond, Virginia 23219
(804) 697-8000
BALTIMORE
502 South Sharp Street
Baltimore, Maryland 21201
(410) 576-3300
CHARLOTTE
530 East Trade Street
Charlotte, North Carolina 28202
(704) 358-2100
CHARLESTON
1200 Airport Road
Charleston, West Virginia 25311
(304) 353-6100
COLUMBIA
1624 Browning Road
Columbia, South Carolina 29210
(803) 772-1940
www.rich.frb.org
@FedFRASER