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Federal Reserve Bank of Richmond
2004 ANNUAL REPORT

What’s Driving Wage Inequality?
The Effects of Technical Change on the Labor Market

TABLE OF CONTENTS
MESSAGE FROM THE PRESIDENT..........................................................................................1

WHAT‘S DRIVING WAGE INEQUALITY?
THE EFFECTS OF TECHNICAL CHANGE ON THE LABOR MARKET

By Aaron Steelman and John A. Weinberg..........................................................................4

BOARDS OF DIRECTORS AND ADVISORY GROUPS............................................................24

MESSAGE FROM MANAGEMENT ........................................................................................32

OFFICERS ...............................................................................................................................34

FINANCIAL STATEMENTS......................................................................................................36

SUMMARY OF OPERATIONS ................................................................................................56

MISSION
As a regional Reserve Bank, we work within the Federal Reserve System to foster the
stability, integrity, and efficiency of the nation’s monetary, financial, and payments
systems. In doing so, we inspire trust and confidence in the U.S. financial system.

VISION
We want to be a standard of excellence within the Federal Reserve System and continuously improve our service to our customers and the public. Because success depends on
each of us, we are striving to create a workplace where we all live our Bank’s values and
can reach our full potential.

MESSAGE FROM THE PRESIDENT
In 2004, the economic
recovery from the recession of
2001 began to set down firm
roots. Broad measures of economic activity showed healthy
gains, with real output, for
example, growing by roughly
4 percent over the year. We
saw continued strength in
consumption spending in
2004 and a significant acceleration in investment. At the
same time, inflation has
remained steady this past
year, and, just as importantly, inflation expectations have been contained.

Jeffrey M. Lacker
President

Perhaps the key improvement in 2004 has been the long-awaited pickup in net
job growth. As is well known, employment in this recovery has lagged behind the
pace of other postwar U.S. recoveries, but the rate of new hiring finally accelerated
in the spring. At the end of the year, employment was 2.2 million ahead of a year
ago, an average gain of 184 thousand workers per month. This 1.7 percent gain
comfortably exceeds the working-age population growth rate of just under
1 percent, and thus notable progress has been made toward absorbing the overhang of those who are willing to work. Yet there remains substantial anxiety
among workers, especially in sections of the Fifth District.

For instance, certain industries within the manufacturing sector—particularly, the
textile and furniture industries, which are largely located in the Carolinas—have
been hard hit by job losses. Tens of thousands of workers in these industries have
lost their jobs in the past several years, and many have little real hope of securing
similar positions, since those industries are unlikely to expand their workforces in
the near future. In addition, the new jobs that have been created recently in different industries for which those workers‘ skills are a good match often do not pay as
well. The workers are looking at significant and perhaps sustained income losses.

[ 1]

The relatively bright economic picture I described earlier must seem unreal or
at least irrelevant for many of the people affected by job losses. To them, the
economy appears to be moving in an unhealthy direction—one in which wellpaying jobs in traditionally powerful American industries are being lost, and one
in which the gap in wages between those at the top and those at the bottom of
the distribution is widening.

Empirically, there is some truth to these claims. Wage dispersion has been growing for almost 30 years, though that trend appears to have been slowing recently,
according to some measures. Also, the real wages of many workers have been
stagnant or falling during this extended period of growing wage inequality. Thus,
the concerns that many people have about the economy tend to be less about
aggregate performance and more about distributional consequences.

The following essay in our 2004 Annual Report considers what has been causing
the rise in wage inequality. It concludes that new technologies have improved the
productivity of skilled workers relative to unskilled workers and thus have fueled
wage inequality. Economists call such technologies “skill-biased,” and they refer to
their introduction as “skill-biased technical change.”

Many observers have pointed to the information technology revolution as a
prime example of skill-biased technical change in the late twentieth century.
Computers, after all, are good at doing certain types of tasks—tasks that can be
described by a “program,” which is just a set of rules. And often, these tasks were
previously more likely to be performed by less-skilled workers. IT-related skill-biased
technological change then appears to be an important part of the explanation for
rising wage inequality.

But there are other ways in which technology affects labor markets. Technological
change can be disruptive. New products and new ways of producing arrive, and
skills that were tied to the old ways of doing things lose value, sometimes dramatically. This is what economist Joseph Schumpeter famously called the “perennial
gale of creative destruction.” In this environment, some unskilled workers are
doubly unlucky. First, skill-biased technological change can lower the relative
demand for unskilled labor, reducing their wages relative to skilled workers. As
I argued earlier, this scenario is what happened in the late twentieth century.

[ 2]

Second, because less-skilled workers have less education, the skills they do have
tend to be based on the specific experience they have accumulated. When those
skills do not transfer well to other sectors, these workers are more vulnerable to
long-term earnings losses should their industries suffer declines.

Given the effects of technological change on labor markets, what types of public
policy responses should we pursue to ensure that all Americans have good employment opportunities? One response that has been suggested by many is to slow the
pace of globalization in order to protect U.S. workers from foreign competition.
But if the argument made in our essay is correct—that the growth in wage inequality has been fundamentally driven by skill-biased technological change—then trade
restrictions would likely do little to achieve their intended goal. Meanwhile, they
would likely lower aggregate income and overall social welfare. Instead, research
suggests that a more useful approach would be to increase emphasis on education—particularly on acquiring general, broadly applicable skills early in life.
Acquiring skills at a young age leads to rewards over the long term because
individuals can recoup their investment in human capital throughout their working
lives. In addition, such training tends to build on itself as acquiring skills early in life
makes it easier to acquire additional skills later in life.

The essay’s main intent, though, is not to provide detailed analyses of specific
policy responses. It is, rather, to emphasize the role of technological change and
the idea that the fundamental economic forces driving the increase in wage
inequality are the same forces raising our general standard of living. I think the
ideas put forth in the following pages provide essential insights about the factors
affecting our economy—both nationally and in the Fifth District.

Jeffrey M. Lacker
President

[ 3]

What’s Driving
Wage Inequality?
The Effects of Technical Change
on the Labor Market
By Aaron Steelman and John A. Weinberg

Most of the time, we assess an economy’s performance using
broad aggregate measures of output and wealth. In this
regard, the United States is doing quite well. It is the richest
country in the world. U.S. gross domestic product exceeded
$11 trillion last year—roughly $38,000 per capita. And despite
the slowdown associated with the 2001 recession, the
economy has expanded at an average annual rate of more
than 3 percent over the past 10 years. The way people
actually feel about the economy’s performance is shaped by
their individual experiences, however, and here there is always
great diversity. Indeed, there remains substantial anxiety
about the direction the economy is heading, especially
in regard to the growing disparity in income. The gap in
real wage rates between those at the higher end of the
distribution and those at the lower end has been widening
for some time. In addition, the real wages of workers at the
lowest part of the distribution were stagnant or falling during
much of this extended period of growing wage inequality.
This essay will explain why wage inequality has been increasing in the United
States; in doing so, we will draw upon the scholarly literature, including work done
by Richmond Fed economist Andreas Hornstein with Per Krusell of Princeton
University and Giovanni Violante of New York University. We also will discuss the
associated policy implications—that is, what can be done to better assure that all

Aaron Steelman is
editor of the Bank‘s
quarterly magazine
Region Focus and
John A. Weinberg
is Vice President
and Acting Director
of Research.
The views expressed
are the authors‘ and
not necessarily those
of the Federal
Reserve System.

Americans have the opportunity to secure well-paying jobs, as well as which policies
may hinder that goal.
Overall, we will argue that technical innovation has significantly affected the
wage distribution in the United States. But the direction of that effect has not
been uniform. In the early part of the twentieth century, various technical innovations had the effect of compressing the wage structure. Since the 1970s, however,
technical innovation—particularly the introduction and widespread use of information technology—has produced wage dispersion.
Another force to which many have attributed recent labor market developments
is globalization. We conclude that international trade and immigration, while
significant trends, are not by themselves the primary force behind growing wage
inequality. To some extent, globalization is itself a result of advances in information
technology, which allow the production of goods and services to take place over a
broader geographic area.

[ 5]

As for public policy, research suggests that increased emphasis on education is a
sound response to recent trends in wage inequality, particularly education early
in life and programs focusing on general, broadly applicable skills. Early skill
acquisition yields rewards over a relatively long period of time because individuals
can recoup their investment in human capital throughout their working lives. In
addition, such training tends to build on itself: acquiring skills early in life makes it
easier to acquire additional skills later in life. In contrast, policies that would aim
to slow the growth in wage inequality by imposing barriers to globalization, such
as trade restrictions, would likely do little to achieve their intended goal, while
lowering aggregate income and overall social welfare.
Before discussing why wage inequality has been growing and the steps policymakers may wish to consider in response, it is necessary to look at the facts. In the
next section, we present data on wage inequality from the early twentieth century
to the present.
THE FACTS

Most economists agree that wage inequality has been increasing in the United
States recently.1 But this has not always been so. Wage inequality was large during
the first part of the twentieth century, decreased during the middle part of the
century, and accelerated again toward the end of the century.
During the early part of the twentieth century, several factors contributed to a
decline in the demand for less-skilled workers. For instance, the widespread introduction of electricity and new hoisting equipment in the 1910s greatly reduced the need
for common laborers who moved goods to and within factories.2 The lower demand
for these workers’ services put downward

“

pressure on their wages. At the same

Wage inequality was large during the first

part of the twentieth century, decreased during

time, the rise of large businesses
increased the demand for the relatively
small subset of workers with higher

the middle part of the century, and accelerated
again toward the end of the century.

”

education to fill managerial roles, thus
driving up their wages. As a result, wage
inequality grew during the first quarter
of the twentieth century.

By the 1940s, wage structures began to change significantly, however, so much
in fact that Claudia Goldin and Robert Margo have called this period “The Great
Compression,” describing the general decline in wage inequality.3 On the supply
side, the once small number of college graduates began to face increased com-

[ 6]

petition, as thousands of American military personnel came back from World War II
and took advantage of the GI Bill. This influx of newly minted graduates most likely
helped depress the relative earnings of college-educated workers. In addition, the
quality of education at the high school level became less variable during this period,
meaning that the skill differentials between high school graduates in different parts
of the country probably decreased, thus reducing the disparity in wage rates among
this group of workers.

In the 1940s, wage
inequality decreased
as demand for lessskilled workers grew
in the nation’s
booming manufacturing sector.

On the demand side,
more low-skilled labor
was needed in the
nation’s industrial centers
to produce goods for the
war effort, therefore
driving up the relative
wages of these workers.
In addition, government
intervention through the
National War Labor
Board almost certainly
contributed to the
compression of the
wage structure.4
It is interesting to note that there is also evidence of wage compression in the
United Kingdom during the Industrial Revolution of the eighteenth and nineteenth
centuries. Goods that were once produced by artisans in relatively small numbers
over relatively long periods of time were produced in factories following industrialization.5 This meant that more-skilled workers were replaced by less-skilled workers,
who because of the introduction of interchangeable parts and other production
techniques could perform their tasks efficiently with little training. The demand for
low-skilled workers, then, increased during this period, demonstrating that not all
technological innovations are necessarily “skill-biased.” Some, in fact, have been
“skill-replacing.”
That brings us to the last half of the twentieth century. In particular, we will
focus on the period from 1970 onward. As stated earlier, this has been a period
of growing wage inequality. Consider the following observations.6

[ 7]

The 90-10 weekly wage ratio, which compares the wages of workers at the 90th
and 10th percentiles of the wage distribution, rose from 1.20 to 1.55 for males
and from 1.05 to 1.40 for females from 1965 to 1995. Similar growth in inequality was found elsewhere in the wage distribution, though dispersion in the lower
wage groups (for instance, the 50-10 ratio) seems to have stabilized recently.
Average and median real wages have changed little since the mid-1970s. But
real wages in the bottom 10 percent of the wage distribution fell sharply during
much of this period before experiencing modest growth recently. Meanwhile, the
real wages of those at the top of the distribution, especially the top 1 percent,
have risen sharply.
The returns gained from education fell in the 1970s, but have increased since.
The college wage premium—defined as the ratio between the average weekly
wage of a college graduate and a worker with a high school diploma or less—
was 1.35 in 1975, 1.5 in 1985, and 1.7 in 1995.
The returns from experience also grew in the 1970s and the 1980s but flattened
in the 1990s. For instance, the ratio of weekly wages between workers with
25 years of experience and workers with five years of experience increased from
1.3 in 1970 to 1.5 in 1995.

Log Earnings Ratio

90-10 Ratio of
Full-Time Weekly Earnings for Males Ages 16-64

Source: Autor, Katz, and Kearney (2004).

The returns from white-collar
occupations relative to blue-collar
occupations increased by about
20 percent from 1970 to 1995.

“

The evidence strongly suggests that
there has been skill-biased technical

Inequality across race and gender has

change that has benefited more-skilled

declined since 1970. The black-white

workers over the past 30 years.

differential and the male-female
differential have both dropped. Also,

”

labor force participation of women increased dramatically during this period.
The last three points all involve “between-group” comparisons—that is, comparisons of workers classified by observable characteristics, such as education, experience, occupation, race, and gender. But it is also true that wage inequality “within
groups”—that is, among workers with similar education or experience, for
instance—has risen. This trend seems to have started about a decade prior to the
trend of increasing returns from college education.7 Looking abroad, recent trends
in wage inequality in the United Kingdom tend to resemble those in the United
States. Things in continental Europe are quite different, though. There has been
almost no increase in wage inequality there. Indeed, wage inequality has even
declined in Belgium, Germany, and Norway.
THE ARGUMENT

What is driving the increasing disparity in wages in the United States? The
evidence strongly suggests that there has been skill-biased technical change that
has benefited more-skilled workers over the past 30 years. By skill-biased change,
we mean advancements in technology that have boosted the productivity of skilled
labor relative to that of unskilled labor.
To determine why this is the case, it is important to understand that the relative
wages of workers at different skill levels are determined by the relative supply of
and demand for those types of workers; that supply is determined by the relative
number of more-skilled and less-skilled workers; and that demand for those
workers’ labor is determined by the current state of technology, which in turn
largely determines the productivity of different types of labor.
At first, this explanation may appear to fit awkwardly with the facts. After all,
the relative supply of more-skilled workers, measured as a fraction of workers
with a college education, has risen sharply during this period. Wouldn’t this
increased supply tend to depress wages, as seemed to happen at mid-century?
Standard theory would suggest yes: with a given demand, more supply of a good

[ 9]

would tend to drive down its relative price. And for a while this seems to have
been the case with skilled labor. During the 1970s, the number of college
graduates rose sharply and effectively flooded the market, driving down the
returns gained from education. But by the 1980s, more-skilled workers were
able to command a wage premium.

Index of Mean of Real Wages (1963=100)

Earnings by Education for Males Ages 22-65

Postgraduate Degree
College Graduate
Some College
High School Graduate
High School Dropout

Source: Eckstein and Nagypál (2004).

What accounts for the change? In large measure, the development of new technology. In particular, information technology, which began to make its way into the
workplace in the 1970s but did not become widespread until the 1980s, the same
time as the returns from skill began to increase. What is it about information or
computer technology that increases the demand for skilled workers? According to
David Autor, Frank Levy, and Richard Murnane, two mechanisms—substitution and
complementarity—are at work:

[ 10 ]

Computer technology substitutes for workers in performing routine
tasks that can be readily described with programmed rules, while
complementing workers in executing nonroutine tasks demanding
flexibility, creativity, generalized problem-solving capabilities, and
complex communications. As the price of computer capital fell
precipitously in recent decades, these two mechanisms—substitution
and complementarity—have raised relative demand for workers who
hold a comparative advantage in nonroutine tasks, typically collegeeducated workers.8

Autor, Levy, and Murnane conclude that information technology can explain
between 60 and 90 percent of the estimated increase in relative demand for
college-educated workers from 1970 to 1998. So while the relative supply of moreskilled workers certainly increased during this period—which, all else being equal,
would have tended to depress the relative wages of such workers—the demand
for such labor increased even more because of technical change.
Consider a few examples that may help to illustrate their point. Advances in
manufacturing, such as the introduction of computer-controlled machinery, have
often meant fewer workers on the factory floor with those remaining needing a
higher level of skill to operate the increasingly sophisticated equipment. A similar
process is at work in the division of labor between architects and draftsmen. Before
the advent of computer-aided design—or “CAD”—a draftsman would create and
revise plans under the guidance of an architect. With CAD, however, the architect
can easily generate and manipulate plans on the computer, resulting in the
employment of fewer draftsmen, while boosting the productivity of the overall
design process.
Some economists have suggested that the increasing supply of skilled workers may
have actually induced the development and implementation of new technologies
that require higher levels of skills. In short, as Daron Acemoglu has argued, “When
developing skill-biased techniques is more profitable, new technology will tend to
be skill-biased.”9 Conversely, when developing skill-replacing techniques is more
profitable, new technology will tend to be skill-replacing. This, arguably, is what

With the
introduction of
computer technology into the
workplace, the
demand for
skilled workers
increased along
with their wages.

happened in England during the Industrial
Revolution. The migration of large numbers
of less-skilled workers to the English cities
from rural areas and Ireland made the
implementation of skill-replacing technologies
profitable. “So, it may be precisely the
differential changes in the relative supply of
skilled and unskilled workers that explain
both the presence of skill-replacing technical
change in the nineteenth century and skillbiased technical change during the
twentieth century.”10
Thus, overall, the best explanation for the increase in wage inequality appears
to be skill-biased technical change. But there are some potential challenges to
this theory.

[ 11 ]

THE CHALLENGERS
Trade between
the United States
and less-developed
countries has
increased over
the last 30 years.
But total trade
volume arguably
remains too small
to have greatly
affected U.S.
wage patterns.

Not all economists are persuaded that increasing returns from skill were the
principal driver of wage inequality during the 1970s. Some have offered competing
explanations, many of which are centered around institutional change.11 One
explanation, for example, is the erosion of the real value of the minimum wage
and the decline in unionization in the United States. Other theories focus on
globalization—specifically, increased trade with less-developed countries (LDCs) and
immigration of less-skilled workers to the United States. Finally, some point to evidence from other countries. If skill-biased technical change is causing growing
wage inequality in the
United States, they ask, why
isn’t wage inequality also
growing rapidly in Western
Europe, since all developed
countries have access to
basically the same technology? We will address those
issues in turn.
The nominal value of the
minimum wage remained
constant throughout much
of the 1980s, meaning that
as prices rose its real value
dropped. Because the minimum wage may be expected to raise the wages of low-paid workers, the decline in
its real value could be responsible for increased wage inequality.12 There are three
problems with this hypothesis, though. First, the number of U.S. workers—especially
male workers—affected by the minimum wage is quite small, less than 10 percent of
all workers between the ages of 18 and 65. Second, the erosion in the real value of
the minimum wage occurred in the 1980s, while the general trend of rising wage
inequality began in the 1970s. One would expect the two to coincide more closely if
the decline in the real value of the minimum wage were indeed a significant factor.
Third, a large share of the increase in wage inequality is due to rapid gains by workers at the top of the wage distribution. For these people, the minimum wage is not
a binding constraint.
Timing is also a problem in theories that focus on declining unionization.13 The
1950s, as we have discussed, was a time of wage compression, not growing wage
inequality. Yet it was during this decade that unionization began its steady decline.

[ 12 ]

To be sure, the decline of unionization in the private sector picked up pace during
the 1970s and 1980s. But at the same time, the public sector workforce became
increasingly unionized, compensating for some of the loss in the private sector. In
addition, wage inequality has increased quite rapidly in some sectors of the economy
that were never highly unionized, such as the legal and medical professions.
There is, however, some evidence that technical change may have been partially
responsible for the decline in unionization since the 1950s.14 Such a decline could
have caused the real wages of low-skilled workers to fall (a point that we will
return to in the next section), but its effect on increasing wage inequality would
have been only indirect, with technical change starting the whole process.
Popular opinion often attributes increased trade with LDCs as the principal cause
of increasing wage inequality in the United States—an explanation that some
economists have argued is consistent with the data. Indeed, standard trade theory,
based on the principle of comparative advantage, would seem to predict just that.
Since LDCs have relatively large numbers of unskilled workers, an increase in
trade would act like an increase in the relative supply of unskilled workers in the
United States, thus potentially increasing wage inequality. And trade between the
United States and the developing world has indeed increased substantially during
the past 30 years, the period during which wage inequality has been increasing.
The relative price of skill-intensive goods has not increased over the period of
rising inequality, however, as one would have expected if trade were a significant
factor in wage dispersion. Perhaps more telling, the total volume of trade with
LDCs is arguably too small to have had a significant effect on U.S. wages. The
effects of trade flows on “relative skill supplies have not been substantial enough
to account for more than a small proportion of the overall widening of the
wage structure over the past 15 years
and have played only a modest role in
the expansion of the college-high
school wage differential in the United

“

The total volume of trade with less-

developed countries is arguably too small to
have had a significant effect on U.S. wages.

States,” conclude George Borjas,
Richard Freeman, and Lawrence Katz.15

”

As for immigration, the total number of newcomers to the United States during
the period under review also is probably too small to have had a large effect on
the wage structure. For instance, during the 1970s, immigration added 2 million

[ 13 ]

new workers to the U.S. labor force. But because of the baby boom and the
increased participation of women in the workplace, roughly 20 million new native
workers also entered the labor force during that period. In addition, even during
the 1980s, a period of relatively high immigration, the immigrant share of the total
labor supply increased by only one percentage point, from seven to eight percent.
“These magnitudes can be taken to mean that immigration is unlikely to have
large effects on the overall distribution of wages,” concludes Robert Topel.16
Finally, some have argued that if technical change is a significant cause of wage
inequality, then it ought to have affected the wage structure in Western Europe in
the same way that it has in the United States, since those countries have access to
much of the same technology and arguably employ it in similar ways to American
firms. But, as we know, wage inequality has not increased as rapidly in Western
Europe as it has in the United States. Does this cause significant problems for the
skill-biased technical change explanation of wage inequality? Some have suggested
so. We think otherwise, however. The observations from Western Europe can be
explained by factors that do not contradict the skill-biased technical change argument.
As many commentators have noted, Western Europe has significantly less flexible
labor market policies than the United States, including more comprehensive
employment protection, longer and more generous unemployment benefits, and
greater restrictions on wage bargaining. Those policies likely have had the effect of
compressing wages. Thus, while similar technical change may have been introduced
at roughly the same time in the United States and Europe, different labor market
policies have resulted in different effects on the respective wage structures.17
In addition, Europe’s labor market policies combined with rapid technological
change arguably have led to greater unemployment. In the 1960s, the United
States and Europe had roughly the same unemployment rates. Since then, Europe’s
labor market policies have not changed substantially—those policies have been
restrictive for many decades—but its unemployment rate has risen sharply. Why?
Strict employment-protection laws make it difficult for companies to terminate
workers in Europe. But over time some workers will leave voluntarily, perhaps
encouraged by generous social-welfare benefits. Those workers’ skills become
dated quickly as technology changes, just as they do for unemployed workers in
the United States. But the principal difference is that the strict European employment-protection laws that made those same workers difficult to terminate in the
first place also have the effect of keeping them out of the workforce longer than
they would have been otherwise. Employers, knowing that all new hires are

[ 14 ]

possibly lifelong employees, will look very carefully for a good match. Those
workers whose skills are not up-to-date will have difficulty finding new employment. And the longer they are out of work, the more difficulty they will have,
because multiple generations of technology will have been introduced and replaced
during their absence from the workforce. Also, the generous welfare benefits those
workers receive reduce their incentives to acquire new skills on their own.
In the United States, where it is easier to terminate workers, employers do not
have to be as careful when hiring new employees. The cost of taking a chance on
a worker whose skills may be somewhat dated is potentially much smaller than in
Europe. As a result, the U.S. unemployment rate has not risen steadily over the
past 30 years, as it has in most European states.18

By the mid-1980s,
production
processes were
highly automated
and personal
computers were
commonplace.

THE PROBLEMS

We have argued that the most compelling single explanation for the rise of wage
inequality in the United States since the 1970s has been skill-biased technical
change. In addition, we have argued that other proposed explanations—such as
institutional change and globalization—do not appear very persuasive. Yet there
remain two unresolved issues.

[ 15 ]

First, as we previously noted, the growth of wage inequality within groups,
sometimes referred to as “residual inequality,” is quite large and may not be
adequately explained by skill-biased technical change alone. Second, and also
mentioned earlier, real wages for those at the lowest end of the distribution
declined during much of the last 30 years. Yet, as Acemoglu has argued, it is unclear
how “sustained technological change can be associated with an extended period of
falling wages of low-skill workers.”19 How can these developments be explained?
Perhaps the most compelling explanation for the increase in residual inequality is
that there are unmeasured differences in the skills among workers within groups.
Consider, for example, two economists that have nearly identical profiles: both are
50-year-old, white males; hold graduate degrees from similar institutions; and have
worked as university professors for 20 years. To an outside observer, it is impossible
to distinguish between the two workers. But to their colleagues and students,
Unmeasured
differences in skill
between workers
with similar
demographic
profiles are largely
responsible for
the growth in
residual inequality.

there may be very substantial differences. One economist simply may have more
natural talent than the other, producing innovative research across a number of
fields. Or he may be a more gifted teacher who inspires students in the classroom.
In either case, he is a more valuable worker than his counterpart and consequently
may receive a higher wage. We should not be surprised by such a wage differential,
but according to our measures of worker characteristics, both economists fall into
the same group—thus leading to an
increase in residual inequality. Skill-biased
technical change increases the premium
paid to skilled workers, even if skills are
not well-measured by such characteristics
as education or experience.
Also, rising residual wage inequality
may be possible even without unmeasured skill differences. One possible explanation of this phenomenon involves the
role of vintage capital. Close examination
of the data suggests that the pace of
technological advancement has been
accelerating since the mid-1970s. Yet
different firms have adopted new technologies at different times and at different
levels; that is, firms employ technologies of different vintages. This has important
implications for the wage structure. In a model that includes labor market frictions—
meaning that the labor market is not fully competitive because, for instance, it
is costly to switch jobs—workers with the same skills can be expected to earn

[ 16 ]

different wages. More specifically, their wages will increase as the productivity of

the technology with which they are working increases. As a result, it is plausible
that technological acceleration may increase wage dispersion within groups, since
with more rapid technical change you have more vintages of technology in operation simultaneously.
But what about the drop in real wages
of less-skilled workers? In a world of relatively slow technical change, many skills
are easily transferable. Workers can move
from one company to another with little
trouble adapting to the machinery at
their new firm. In a world of rapid and

“

Skill-biased technical change increases

the premium paid to skilled workers, even
if skills are not well-measured by such

characteristics as education or experience.

accelerating technological change, however, such moves are more difficult since

”

fewer skills are transferable. Upon separation—that is, when workers leave a firm—those workers can expect to suffer
wage losses. This scenario is especially true of workers who have been using the
oldest technology, because they find that the skills they have acquired through
experience are even more outdated than those of workers in similar industries who
have been exposed to more modern technology. Thus, accelerating technological
change may help us explain both the rise in residual inequality and the decline in
real wages at the bottom of the distribution.20
It is important to note, though, that such conclusions are only tentative. Whereas
there seems to be overwhelming evidence and an emerging consensus about the
role of skill-biased technical change on the wage structure, there remains a good
deal of uncertainty about the cause(s) of residual inequality and the declining real
wages of less-skilled workers.
IMPLICATIONS FOR PUBLIC POLICY

What lessons should policymakers draw from our discussion of the causes of wage
inequality in the United States? We might start with a general principle that is
often associated with the medical profession but is applicable to public policy as
well: first, do no harm. There is understandably a great deal of anxiety among the
public about the changing nature of the American economy. Those forces which
create economic growth for us all also cause disruptions for some.21 As Joseph
Schumpeter famously noted, capitalism is characterized by “the perennial gale of
creative destruction.”22 And to many people, that gale—at least for the moment—
is associated with globalization.

[ 17 ]

Yet, as we have argued, increased trade with LDCs and immigration from abroad
likely have had little effect on wage inequality, while almost certainly adding to
the strength and vitality of the American economy.23 Efforts to slow the growth of
foreign goods or labor coming to our shores would be costly to Americans as a
whole, as well as to those people who seem to be hurt by globalization at the
present. As Jeffrey Sachs and Howard Shatz have written, “U.S. labor market
experience … teaches that the labor force will respond to the premium on education by increasing the investment in education, thereby narrowing the gap in
inequality in the future.”24 Insofar as barriers aimed to slow globalization dampen
the incentive to build skills, those barriers will tend to perpetuate wage inequality.
In addition, we should be wary of proposals to extend the duration of or expand
the generosity of unemployment insurance benefits to those workers who have lost
their jobs due to technical change. Such proposals would tend to increase the time
that displaced workers remain unemployed. Instead, we ought to encourage those
workers to reenter the labor force as quickly as possible. The problem, of course,
is that the jobs that such workers will be able to secure will likely pay significantly
less than their former positions. “Workers not only lose income when they are
unemployed, but many often suffer a drop in their earnings after finding new jobs.
Older workers—who tend to be less flexible adapting to new production techniques or who lack the educational background to transfer to well-paid service
economy jobs—bear the greatest losses,” write Lori Kletzer and Robert Litan.25
An alternative way to assist displaced

“

workers may be a simple transfer pro-

The evidence seems increasingly clear

gram that subsidizes their wages upon

that there is a relatively high level of return
on investments in education early in life.

”

reemployment.26 This policy would boost
recipients’ incomes, while allowing them
to allocate their financial resources
toward the mix of training opportunities
and general consumption they deem most

beneficial. Such a program would certainly have problems of its own, and policymakers would need to implement it in a way that would minimize distortions to labor
market conditions as much as possible. As we noted earlier, in the case of Europe,
government involvement in the labor market often can have undesirable effects.
Perhaps an even more promising option would be to increase public investment in
skill acquisition. As we have argued, the principal factor driving wage inequality is
skill-biased technical change. Thus, the most direct and arguably most effective way
to reduce such inequality would be to reduce the disparity in skills between workers.

[ 18 ]

What type of skills should we attempt to provide through public investment? The
evidence seems increasingly clear that there is a relatively high level of return on
investments in education early in life. As Pedro Carneiro and James Heckman write,
“Skill and ability beget future skill and ability.”27 Also, we might expect those
investments to yield larger benefits if they are directed toward broadly generalizable skills. The ability to think critically, for instance, is crucial to analyzing and
adapting to a number of situations. In contrast, the return on educational invest-

Investments in
skill acquisition
early in life
may lead to a
reduction in
wage inequality.

ments later in life, especially remedial education
or compensatory investments, tend to be smaller.
This is true for at least
two reasons. First, without a basic level of knowledge on which to build,
it will be difficult for
individuals to effectively
acquire new skills.
Second, by definition,
older workers have less
time to recoup the investment in education than
younger workers.
While this may make perfect sense analytically, it still may be difficult to accept.
Such reasoning implies that the people hurting the most now—those who have
been displaced from their jobs—may also have the most trouble building their
skills. What should we do to help those people? A good argument could be made
that the government should act as a clearinghouse of information about job
training programs, though we should be cautious about expanding such training
programs given their limited success.28 Similarly, we should be skeptical about
providing greater financial assistance to displaced workers seeking education at
community colleges and four-year institutions. There are already numerous
educational subsidies in place, which have substantially reduced potential credit
constraints for low- and middle-income people.29
Still, increased investment in skill acquisition is a policy option worth significant
consideration. If done properly, it may be an effective tool in reducing wage
inequality and could yield additional benefits to the economy, such as increasing
workers’ productivity.

[ 19 ]

CONCLUSION

Wage inequality in the United States is large and has been growing during the past
30 years. The main cause, it appears, is skill-biased technical change. Those workers
with high skill levels have experienced more rapid wage growth than less-skilled
workers, some of whom have seen an actual decline in their real wages.
This development is cause for concern to many people who fear that a large
share of the workforce no longer has a reasonable chance of achieving its goals,
monetary and otherwise. Such concern is understandable. Indeed, the evidence
suggests that, at present, less-skilled workers face formidable challenges in the
labor market. As a society, we ought to consider investing more funds in skill
development—especially early skill development—to ensure that as many
people as possible have the basic tools necessary to succeed.
But we also need to remember that technical change is not necessarily skillbiased. There have been significant episodes where technical innovation appears
to have been skill-replacing. From today’s vantage point, it seems unlikely that
we will return to such a world, but developments may lead us in that direction.
Market economies, though highly efficient, often move in surprising and
unpredictable directions.

Year 2000 Dollars

Real GDP Per Worker

Source: DeLong (2000).

Perhaps most important, we ought to focus not just on the distributional effects
of technical change—important as they may be—but also on aggregate well-being.
Technical change has fueled much of the economic growth of the past two centuries and raised living standards to levels once unimaginable.
J. Bradford DeLong has calculated that
real GDP per worker grew from roughly
$13,700 in 1890 to about $65,000 in 2000.
That's nearly a five-fold increase. And as
DeLong has noted, that significantly
understates our improvement in living

“

Despite the pain that technological

change can cause workers in certain segments
of the labor force, we should remember that,

standards. In 1890, people “could not buy
modern entertainment or communications
or transportation technologies.” There

on net, technical change is good for the
economy and good for people.

were “no modern appliances, no modern
buildings, no antibiotics, no air travel. An

”

income of $13,700 today that must be spent exclusively on commodities already in
use in the late 19th century is, for all of us, worth a lot less than $13,700.”30
It’s useful to consider the alternative to embracing technology. By 1400, China
had invented many of the technologies that triggered the Industrial Revolution
of the eighteenth century, such as moveable-type printing, the water-powered
spinning machine, and the blast furnace. Tight state controls impeded the spread
of those technologies, however, preventing them from being used to their full
potential and inhibiting further innovation.31 We are not suggesting that others are
seriously proposing blocking the development and distribution of new technologies
in the United States as China did centuries ago. But we do think it is important to
understand how powerful a force technology can be for human well-being—and
how counterproductive it can be to curtail its growth.
Despite the pain that technological change can cause workers in certain segments
of the labor force, we should remember that, on net, technical change is good for
the economy and good for people. We should not discourage or lament it.
Andreas Hornstein, Tom Humphrey, Ned Prescott, John Walter, and Alice Felmlee contributed valuable
comments to this article.

[ 21 ]

ENDNOTES
1. For an exception, see Lerman (1997).
2. Goldin and Katz (1999), p. 9.
3. Goldin and Margo (1992).
4. The National War Labor Board was created in 1942 in an effort to stabilize wages during World War II. According to two
authors who worked at the agency, “no changes in wage rates could be made except upon approval of the National War
Labor Board; and … the Board could approve wage increases only on four narrowly circumscribed grounds, and wage
decreases on only two grounds.” See Henig and Unterberger (1945), pp. 319–20.
5. For more on the introduction of new technology in England during the Industrial Revolution, see Mokyr (1994).
6. These observations are taken from Hornstein, Krusell, and Violante (2004), which surveys empirical work up to 1995.
Recently, Eckstein and Nagypál (2004) and Autor, Katz, and Kearney (2004) have updated some of these observations.
Instances in which the more recent observations differ from the older observations are noted in the text.
7. Juhn, Murphy, and Pierce (1993), p. 412.
8. Autor, Levy, and Murnane (2003), p. 1322.
9. Acemoglu (2002), p. 9.
10. Ibid., p. 12. Also, see Acemoglu (1998).
11. See, for instance, Card and DiNardo (2002).
12. Lee (1999) argues that this has, in fact, occurred.
13. For a recent paper that argues there is a significant relationship between unionization and wage inequality, see Card,
Lemieux, and Riddell (2003).
14. See Acemoglu, Aghion, and Violante (2001).
15. Borjas, Freeman, and Katz (1997), p. 67.
16. Topel (1997), p. 62.
17. See Krugman (1994).
18. For a complementary explanation, see Ljungqvist and Sargent (1998).
19. Acemoglu (2002), p. 13.
20. This section draws on Violante (2002).
21. Fears about the effect of technical change on the job market—in particular, the belief that technical innovation is a net
destroyer of jobs—are not new. David Ricardo and other classical economists addressed the issue. See Humphrey (2004).
22. Schumpeter (1942).
23. See Burtless, Lawrence, Litan, and Shapiro (1998) for a discussion of the benefits of open trade.
See Simon (1999) for a discussion of the benefits of liberal immigration policies.
24. Sachs and Shatz (1996), p. 239.
25. Kletzer and Litan (2001), p. 2.
26. Kletzer and Litan outline such a proposal that would work as follows. Once displaced workers found new jobs, they
would receive a subsidy to increase their current lower wage to a level more closely approximating their former higher
wage. The wage subsidy would be available for only a limited period of time following reemployment and there would
be an annual cap on payments. Ibid., p. 4.
27. Carneiro and Heckman (2003).
28. See Kletzer (1998), pp. 131–33.
29. See Carneiro and Heckman (2002).
30. DeLong (2000), pp. 14–15.
31. See Landes (1998), especially pp. 51–59.

REFERENCES

[ 22 ]

Acemoglu, Daron. 1998. “Why Do New Technologies Complement Skills? Directed Technical Change and
Wage Inequality.” Quarterly Journal of Economics 113 (November): 1055–89.
__________. 2002. “Technical Change, Inequality, and the Labor Market.” Journal of Economic Literature
40 (March): 7–72.
Acemoglu, Daron, Philippe Aghion, and Giovanni L. Violante. 2001. “Deunionization, Technical Change,
and Inequality.” Carnegie-Rochester Conference Series on Public Policy 55 (December): 229–64.
Autor, David H., Lawrence F. Katz, and Melissa S. Kearney. 2004. “Trends in U.S. Wage Inequality:
Re-Assessing the Revisionists.” Manuscript, MIT Department of Economics (August).
Autor, David H., Lawrence F. Katz, and Alan B. Krueger. 1998. “Computing Inequality: Have Computers
Changed the Labor Market?” Quarterly Journal of Economics 113 (November): 1169–213.

Autor, David H., Frank Levy, and Richard J. Murnane. 2003. “The Skill Content of Recent Technological
Change: An Empirical Exploration.” Quarterly Journal of Economics 118 (November): 1279–333.
Borjas, George J., Richard B. Freeman, and Lawrence F. Katz. 1997. “How Much Do Immigration and
Trade Affect Labor Market Outcomes?” Brookings Papers on Economic Activity (No. 1): 1–67.
Burtless, Gary T., Robert Z. Lawrence, Robert E. Litan, and Robert J. Shapiro. 1998. Globaphobia:
Confronting Fears about Open Trade. Washington, D.C.: Brookings Institution Press.
Card, David, and John E. DiNardo. 2002. “Skill-Biased Technological Change and Rising Wage Inequality:
Some Problems and Puzzles.” NBER Working Paper No. 8769 (February).
Card, David, Thomas Lemieux, and W. Craig Riddell. 2003. “Unionization and Wage Inequality:
A Comparative Study of the U.S., the U.K., and Canada.” NBER Working Paper No. 9473 (January).
Carneiro, Pedro, and James J. Heckman. 2002. “The Evidence on Credit Constraints in Post-Secondary
Schooling.” NBER Working Paper No. 9055 (July).
__________. 2003. “Human Capital Policy.” NBER Working Paper No. 9495 (February).
DeLong, J. Bradford. 2000. “Cornucopia: The Pace of Economic Growth in the Twentieth Century.”
NBER Working Paper No. 7602 (March).
Eckstein, Zvi, and Éva Nagypál. 2004. “The Evolution of U.S. Earnings Inequality: 1961–2002.”
Federal Reserve Bank of Minneapolis Quarterly Review 28 (December): 10–29.
Goldin, Claudia, and Lawrence F. Katz. 1999. “The Returns to Skill in the United States across the
Twentieth Century.” NBER Working Paper No. 7126 (May).
Goldin, Claudia, and Robert A. Margo. 1992. “The Great Compression: The Wage Structure in the
United States at Mid-Century.” Quarterly Journal of Economics 107 (February): 1–34.
Henig, Harry, and S. Herbert Unterberger. 1945. “Wage Control in Wartime and Transition.”
American Economic Review 35 (June): 319–36.
Hornstein, Andreas, Per Krusell, and Giovanni L. Violante. 2004. “The Effects of Technical Change on
Labor Market Inequalities.” Federal Reserve Bank of Richmond Working Paper No. 04-08 (December). Also:
Forthcoming in Handbook of Economic Growth, Philippe Aghion and Steven Durlauf (eds.). Amsterdam: NorthHolland.
Humphrey, Thomas M. 2004. “Ricardo Versus Wicksell on Job Losses and Technological Change.”
Federal Reserve Bank of Richmond Economic Quarterly 90 (Fall): 5–24.
Juhn, Chinhui, Kevin M. Murphy, and Brooks Pierce. 1993. “Wage Inequality and the Rise in Returns
to Skill.” Journal of Political Economy 101 (June): 410–42.
Kletzer, Lori G. 1998. “Job Displacement.” Journal of Economic Perspectives 12 (Winter): 115–36.
Kletzer, Lori G., and Robert E. Litan. 2001. “A Prescription to Relieve Worker Anxiety.”
Brookings Institution Policy Brief #73 (March).
Krugman, Paul. 1994. “Past and Prospective Causes of High Unemployment.”
Federal Reserve Bank of Kansas City Economic Review 79 (Fourth Quarter): 23–43.
Landes, David S. 1998. The Wealth and Poverty of Nations: Why Some Are So Rich and Some So Poor.
New York: W. W. Norton.
Lee, David S. 1999. “Wage Inequality in the United States During the 1980s: Rising Dispersion or
Falling Minimum Wage?” Quarterly Journal of Economics 114 (August): 977–1023.
Lerman, Robert I. 1997. “Reassessing Trends in U.S. Earnings Inequality.” Monthly Labor Review 120
(December): 17–25.
Ljungqvist, Lars, and Thomas J. Sargent. 1998. “The European Unemployment Dilemma.”
Journal of Political Economy 106 (June): 514–50.
Mokyr, Joel. 1994. “Technological Change, 1700–1830.” In Roderick Floud and Donald McCloskey (eds.),
The Economic History of Britain Since 1700, Volume I: 1700–1860 (2nd ed.). New York: Cambridge University Press.
Sachs, Jeffrey D., and Howard J. Shatz. 1996. “U.S. Trade with Developing Countries and Wage
Inequality.” American Economic Review 86 (May): 234–39.
Schumpeter, Joseph. 1942. Capitalism, Socialism, and Democracy. New York: Harper & Brothers.
Simon, Julian L. 1999. The Economic Consequences of Immigration (2nd ed.). Ann Arbor, Mich.:
University of Michigan Press.
Topel, Robert H. 1997. “Factor Proportions and Relative Wages: The Supply-Side Determinants of
Wage Inequality.” Journal of Economic Perspectives 11 (Spring): 55–74.
Violante, Giovanni L. 2002. “Technological Acceleration, Skill Transferability, and the Rise in
Residual Inequality.” Quarterly Journal of Economics 117 (February): 297–338.

[ 23 ]

FEDERAL RESERVE BANK OF RICHMOND BOARD OF DIRECTORS
Our Federal Reserve Bank of Richmond
Board of Directors, along with our boards
at our Baltimore and Charlotte Offices,
provide invaluable guidance and support
in the formulation of monetary policy and
the oversight of Bank operations. In recent
years, they have moved toward more
active involvement in governance following a trend throughout corporate America
in response to the Sarbanes-Oxley Act of
2002. We acknowledge our directors,
particularly our Richmond Board under the
leadership of Chairman Wes Williams, for
CHAIRMAN

their continued dedication and increased responsibility in helping us to excel for our

Wesley S.
Williams, Jr.
Partner
Covington
& Burling
Washington, D.C.

Fifth District constituents and within the Federal Reserve System in 2004.
By providing timely business and economic information about conditions in the
District, our directors provide the Bank president with first-hand perspectives for
use in the formulation of effective monetary policy. Understanding the value of
this responsibility, Williams believes “it is highly important for us to be on top of
the many voices that give us insights into the operation of the economy and the
state of things.” Our Richmond Board also recommends changes in the discount
rate for approval by the Board of Governors, further representing the private
sector in the policymaking process.
Our boards of directors also actively provide governance leadership and support
for all Bank operations. Our nine-member Richmond Board is responsible for the
soundness of our internal audits and provides oversight on all budgetary matters.
In keeping with their general responsibility for appointing the Bank president, first
vice president, and officers, this year the directors conducted a national search that
led to the appointment of Jeff Lacker as our new president.
We are especially grateful to those members of our boards of directors and our
Federal Advisory Council Representative whose terms ended in 2004.
Wesley S. Williams, Jr.; Eddie Canterbury; and Joe Edens from our Richmond Board
Owen E. Herrnstadt from our Baltimore Board
James F. Goodmon and William H. Nock from our Charlotte Board
Fred L. Green, III, Federal Advisory Council Representative

[ 24 ]

Thomas J. Mackell, Jr.
President and
Chief Operating Officer
The Kamber Group
Washington, D.C.

Eddie Canterbury
President and
Chief Executive Officer
Logan Bank & Trust
Company
Logan, West Virginia

Joe Edens
Chairman
Edens & Avant
Columbia, South Carolina

Barry J. Fitzpatrick
Chairman
Branch Banking &
Trust Company of
Virginia
Falls Church, Virginia

W. Henry Harmon
President and
Chief Executive Officer
Columbia Natural
Resources, LLC
Charleston, West Virginia

Ernest J. Sewell
President and
Chief Executive Officer
FNB Southeast
Greensboro, North Carolina

Kenneth R. Sparks
President and
Chief Executive Officer
Ken Sparks
Associates LLC
White Stone, Virginia

Theresa M. Stone
Chief Financial Officer
Jefferson-Pilot Corporation

Six members
of our Richmond
Board are elected
by banks in the
Fifth District
that are members
of the Federal
Reserve System,
and the remaining three are
appointed by
the Board of
Governors.

FEDERAL ADVISORY
COUNCIL REPRESENTATIVE

DEPUTY CHAIRMAN

President
Jefferson-Pilot Communications
Company
Greensboro, North Carolina

The Richmond
Board also
annually appoints
the District’s
representative
to the Federal
Advisory Council,
which consists of
one member
from each of the
Federal Reserve
Districts. The
Council confers
four times a year
with the Board
of Governors
on business conditions and issues
related to the
banking industry.

Fred L. Green, III
Vice Chairman
Synovus Financial Corp.
Chairman
The National Bank of
South Carolina
Columbia, South Carolina

[ 25 ]

Our Baltimore
and Charlotte
Offices have
seven-member
boards that oversee operations at
their respective
offices and, like
our Richmond
Board, contribute
to policymaking
and provide timely
business and
economic information. Four
directors on each
of these boards
are appointed
by the Richmond
directors and
three are appointed by the Board
of Governors.

BALTIMORE OFFICE BOARD OF DIRECTORS

CHAIRMAN

Owen E. Herrnstadt
Director, International
Department
International Association of
Machinists and Aerospace
Workers, AFL-CIO
Upper Marlboro, Maryland

William C. Handorf
Professor of Finance
School of Business and
Public Management
George Washington
University
Washington, D.C.

Cynthia Collins Allner
Principal
Miles & Stockbridge, P.C.
Baltimore, Maryland

Dyan Brasington
Retired President
Technology Council
of Maryland
Rockville, Maryland

Donald P. Hutchinson
President and
Chief Executive Officer
SunTrust Bank, Maryland
Baltimore, Maryland

Kenneth C. Lundeen
President
C. J. Langenfelder &
Son, Inc.
Baltimore, Maryland

Michael L. Middleton
Chairman and President
Community Bank
of Tri-County
Waldorf, Maryland

[ 26 ]

CHARLOTTE OFFICE BOARD OF DIRECTORS

CHAIRMAN

Michael A. Almond
President and
Chief Executive Officer
Charlotte Regional
Partnership
Charlotte, North Carolina

Michael C. Miller
Chairman and President
FNB Corporation and
First National Bank
and Trust Company
Asheboro, North Carolina

James F. Goodmon
President and
Chief Executive Officer
Capitol Broadcasting
Company, Inc.
Raleigh, North Carolina

Jim Lowry
Dealer Operator
Crown Automotive
High Point, North Carolina

William H. Nock
Chairman and
Chief Executive Officer
Wayfarer Financial Group
Sumter, South Carolina

Lucy J. Reuben
Former Provost and
Vice Chancellor for
Academic Affairs
North Carolina
Central University
Durham, North Carolina

Donald K. Truslow
Chief Risk Officer
Wachovia Corporation
Charlotte, North Carolina

[ 27 ]

Established in
1985, the Small
Business and
Agriculture
Advisory Council
advises the Bank
president and
other senior
officers on the
impact that monetary, banking,
and fiscal policies
have on the
District’s small
business and agricultural sectors.
The Council’s
12 members are
appointed by the
Bank’s president.

SMALL BUSINESS AND
AGRICULTURE ADVISORY COUNCIL
(CENTER, THEN LEFT TO RIGHT)

CHAIRMAN

James G. Patterson
Chairman and
Chief Executive Officer
Webb Patterson
Communications, Inc.
Durham, North Carolina
William F. Willard, Sr.
President
Willard Agri-Service of
Frederick, Inc.
Frederick, Maryland

R. Gerald Warren
President
Warren Farming
Company, Inc.
Warren Swine Farms
Newton Grove,
North Carolina

(LEFT TO RIGHT)

S. M. Bowling
President
Dougherty Company, Inc.
Charleston, West Virginia
Jane Tabb
Secretary
Lyle C. Tabb & Sons, Inc.
Kearneysville,
West Virginia

(LEFT TO RIGHT)

James B. Gates, Jr.
Senior Partner
The Ridge Animal
Hospital
Farmville, Virginia
Melvin L. Crum
Owner and Operator
Crum Farms
Rowesville,
South Carolina
Thomas B. O’Hanlan
President and
Chief Executive Officer
Sealevel Systems, Inc.
Liberty, South Carolina

[ 28 ]

B. Vance Carmean, Jr.
President
Carmean Grain, Inc.
Ridgely, Maryland
(NOT PICTURED)

Clinton A. Fields
Retired Executive
Director
Friends of the
National Zoo
Washington, D.C.
(NOT PICTURED)

Elijah B. Rogers
President and
Chief Executive Officer
Delon Hampton &
Associates, Chartered
Washington, D.C.

David Leonard
President
Leonard Companies, Ltd.
Lebanon, Virginia

COMMUNITY DEVELOPMENT
ADVISORY COUNCIL
(CENTER, THEN LEFT TO RIGHT)

CHAIR

Greta J. Harris
Senior Program Director
Local Initiatives Support
Corporation
Richmond, Virginia

Eric Stein
President
Center for Community
Self-Help
Durham, North Carolina

Sharon Walden
Executive Director
Stop Abusive Family
Environments
Welch, West Virginia

(LEFT TO RIGHT)

(NOT PICTURED)

James W. Middleton
Executive Director
Southside Community
Development & Housing
Corporation
Richmond, Virginia

Bernie Mazyck
President and
Chief Executive Officer
South Carolina
Association of Community
Development Corporations
Charleston, South Carolina

Raymond A. Skinner
President and
Chief Executive Officer
Skinner Group, LLC
Bowie, Maryland
Jane N. Henderson
Senior Vice President
and Director of
Community Development
Wachovia Corporation
Charlotte, North Carolina

The Bank
organized the
Community
Development
Advisory Council
in 1998 to
enhance communication between
the Bank and the
public concerning
community development issues.
The eight-member
Council provides
counsel to the
Bank president
and other senior
officers on community development concerns
and related policy
matters. Council
members are
appointed by the
Bank’s president.

(NOT PICTURED)

Peter J. Ponne
Senior Vice President
and Manager
SunTrust CDC,
Mid-Atlantic Region
SunTrust Bank
Baltimore, Maryland

[ 29 ]

The Operations
Advisory Committee
was established by
the Bank in 1978
to serve as a forum
for communication
with financial institutions about the
Federal Reserve's
financial services
and to help the
Bank respond to
the changing
needs of its banking constituency.
Committee members are appointed
by the Bank's first
vice president.

OPERATIONS ADVISORY COMMITTEE
(LEFT TO RIGHT)

CHAIRMAN

Martin W. Patterson
Senior Vice President
Enterprise Check
Services
SunTrust Bank
Richmond, Virginia
Cynthia B. Cervenka
Executive Vice President
Damascus Community
Bank
Damascus, Maryland

Tim Dillow
Senior Vice President
Branch Banking &
Trust Company
Wilson, North Carolina
James T. Riffe
Executive Vice President
and Chief Operating
Officer
Highlands Union Bank
Abingdon, Virginia

(LEFT TO RIGHT)

Kent B. Miller
Vice President
Operations and
Service Delivery
RBC Centura Bank
Rocky Mount,
North Carolina
Jay F. Hinkle
Senior Vice President
Wachovia Corporation
Glen Allen, Virginia

(LEFT TO RIGHT)

R. Allen Young
Executive Director
South Carolina Clearing
House Association, Inc.
Columbia,
South Carolina
Paul A. Slaby
Vice President and
Controller
Aberdeen Proving Ground
Federal Credit Union
Edgewood, Maryland

[ 30 ]

Ralph Reardon
Senior Vice President and
Chief Financial Officer
Coastal Federal Credit
Union
Raleigh, North Carolina
Kenneth L. Greear
Senior Vice President
United Bank
Charleston, West Virginia
John A. Harper
Vice President
Summit Financial Group
Moorefield, West Virginia

Donald G. Chapman
Senior Vice President
Internal Audit
Navy Federal Credit
Union
Merrifield, Virginia

(LEFT TO RIGHT)

Kenneth L. Richey
Executive Vice President
Operations Division
The National Bank of
South Carolina
Columbia,
South Carolina

William T. Johnson, Jr.
Executive Vice President
Citizens National Bank
Elkins, West Virginia

B. Martin Walker
Senior Vice President
Bank of America
Richmond, Virginia

(LEFT TO RIGHT)

James H. Thompson, III
Vice President and
Cashier
The National Capital
Bank of Washington
Washington, D.C.

Jimmy Graham
Executive Vice President
Coastal Federal Bank
Myrtle Beach,
South Carolina

Stephen R. Winston
Group Manager
Treasury Operations
Capital One Financial
Corporation
Glen Allen, Virginia

(NOT PICTURED)

(LEFT TO RIGHT)

E. Stephen Lilly
Senior Vice President
and Chief Operating
Officer
First Community
Bancshares, Inc.
Bluefield, Virginia

Terry Childress
Senior Vice President
VACORP Federal Credit
Union
Lynchburg, Virginia

W. K. Keener, Jr.
President and
Chief Executive Officer
Allegacy Federal Credit
Union
Winston-Salem,
North Carolina

(NOT PICTURED)

Helen Austin
Senior Vice President
CapitalBank
Greenwood,
South Carolina

(NOT PICTURED)

John DuBose
Executive Vice President,
Chief Operating Officer,
and Chief Technology
Officer
Carolina First Bank
Lexington,
South Carolina
Jay G. Fitzhugh
Senior Vice President
Strategic Directions
Provident Bank
Baltimore, Maryland

Gerald McQuaid
Senior Vice President
and Division Executive
Bank Operations
Chevy Chase Bank, FSB
Laurel, Maryland

(NOT PICTURED)

(NOT PICTURED)

Jack H. Goldstein
President and
Chief Executive Officer
NBRS Financial
Rising Sun, Maryland

Michael A. Tucker
President and
Chief Executive Officer
West Virginia Central
Credit Union
Parkersburg,
West Virginia

(NOT PICTURED)

[ 31 ]

MESSAGE FROM MANAGEMENT
MANAGEMENT COMMITTEE

For the Federal Reserve Bank of Richmond, 2004 was a year of transition, a time

(SEATED, LEFT TO RIGHT)

when a series of anticipated changes in organization and operations occurred. With

James McAfee
Claudia N. MacSwain
Malcolm C. Alfriend
Walter A. Varvel
Victor M. Brugh, II
Robert E. Wetzel, Jr.
Janice E. Clatterbuck

the departure of a president and the conclusion of a retirement program involving

(STANDING, LEFT TO RIGHT)

Marvin S. Goodfriend
Jeffrey S. Kane
Jeffrey M. Lacker
Marsha S. Shuler

a large number of officers and staff, the Bank lost a great deal of valuable knowledge and experience. At the same time, a new face of the Bank began to emerge,
with the succession of experienced leaders at all levels who demonstrate a strong
commitment to our core values.

In August, Al Broaddus retired after 11 years as the Bank’s president. We are
indebted to Al for his leadership and service and will miss his inspiring example. To
succeed him as president, our board appointed Jeff Lacker, an economist with the
Bank for 15 years and director of the Research Department for the last five years.
We welcome Jeff to his new role and look forward to his energy and vision for the
Bank’s future. More than 200 longtime employees left the Bank in 2004 as part of a
planned retirement program. In preparation for this change, the Bank several years
ago initiated leadership development efforts that identified future leaders and prepared them to take on additional responsibilities. In conjunction with these changes

[ 32 ]

in leadership, Bank management completed a restructuring and realignment of its
responsibilities to better reflect the direction we want to move as a Bank.

The growth and increased complexity of the banking industry in the Fifth District
has presented the Bank with greater challenges as well as expanded opportunities
to continue fulfilling our responsibilities in our daily interactions with financial
organizations and markets. Banking supervisors, research economists, and other
practitioners are working more closely on projects and are building a competency of
increased information sharing and collaboration throughout the Bank. Operations
of the new Federal Reserve System functions hosted by the Bank continued to
mature during the year, with the National Procurement Office developing Systemwide purchasing standards and the centralized payroll function absorbing payroll
responsibility for seven additional Reserve Banks.
In other business changes, the consolidation of our District check services was
completed and resulted in the closing of operations in Richmond; Columbia, South
Carolina; and Charleston, West Virginia, with our Baltimore and Charlotte Offices
growing to assume most of that work. The Charleston responsibilities were transferred to the Cincinnati Office of the Cleveland Fed. We also introduced new check
services to support the requirements of the Check 21 legislation.
Our vision—to be a Bank of excellence, making important contributions to the
System—led us to undertake initiatives to be more agile and able to adapt to
changing conditions in the industry and the larger economy. By drawing on broader
and more diverse input from around the Bank, our outlook is more inclusive, the
information we use is more relevant, and the decisions we make are more timely.
We are fulfilling our responsibility to the System to have the people in place who
can recognize and seize opportunities that allow the Bank to meet and excel at our
challenges.
In a broad sense, we have sought to integrate “thought leadership” with our
strategic goals—to employ the best people, work effectively, exert influence on
monetary policy, engage constructively with the District’s people and businesses,
and find ways to play important roles in the System. As we look ahead, we believe
we have a strong and solid base of experience upon which to build as we seek to
capitalize on the insights of our new and talented leadership and inspire Bank
employees to excel at all they do and to help make meaningful contributions to
the Federal Reserve.

Walter A. Varvel
First Vice President

[ 33 ]

OFFICERS
Jeffrey M. Lacker
President

Betty M. Fahed
Vice President

Constance B. Frudden
Assistant Vice President

Walter A. Varvel
First Vice President

A. Linwood Gill, III
Vice President

Joan T. Garton
Assistant Vice President

Malcolm C. Alfriend
Senior Vice President

Howard S. Goldfine
Vice President

Anne C. Gossweiler
Assistant Vice President

Victor M. Brugh, II
Medical Director

Sharon M. Haley
Vice President and
Secretary

Andreas L. Hornstein
Research Officer

Janice E. Clatterbuck
Senior Vice President
Marvin S. Goodfriend
Senior Vice President and
Policy Advisor
Claudia N. MacSwain
Senior Vice President and
Chief Financial Officer
James McAfee
Senior Vice President and
General Counsel
Marsha S. Shuler
Senior Vice President
Robert E. Wetzel, Jr.
Senior Vice President and
General Auditor
James M. Barnes
Vice President

Mattison W. Harris
Vice President
Richard L. Hopkins
Vice President

Gregory A. Johnson
Assistant Vice President
Thomas P. Kellam
Assistant Vice President

Eugene W. Johnson, Jr.
Vice President

Page W. Marchetti
Assistant Vice President and
Assistant Secretary

Malissa M. Ladd
Vice President

Jonathan P. Martin
Assistant Vice President

Edgar A. Martindale, III
Vice President and
Controller

Andrew S. McAllister
Assistant Vice President

Raymond E. Owens, III
Vice President
Gary W. Schemmel
Vice President

William R. McCorvey, Jr.
Assistant General Counsel
Diane H. McDorman
Assistant Vice President
Robert J. Minteer
Assistant Vice President

William A. Bridenstine, Jr.
Associate General Counsel

John A. Weinberg
Vice President and
Acting Director of
Research

Bradford N. Carden
Vice President

Howard S. Whitehead
Vice President

Barbara J. Moss
Assistant Vice President

Roland Costa
Vice President

Anthony Bardascino
Assistant Vice President

Edward B. Norfleet
Assistant Vice President

Alan H. Crooker
Vice President

Hattie R. C. Barley
Assistant Vice President

P. A. L. Nunley
Assistant General Counsel

B. Wayne Deal
Vice President and
Assistant General Auditor

Whitley K. Crane
Assistant Vice President

Lisa T. Oliva
Assistant Vice President

Burrie E. Eaves, III
Assistant Vice President

[ 34 ]

Susan Q. Moore
Assistant Vice President

Arlene S. Saunders
Assistant Vice President

David J. Zimmerman
Assistant Vice President

Jennifer R. Zara
Vice President

Rebecca J. Snider
Assistant Vice President

BALTIMORE OFFICE

T. Stuart Desch
Assistant Vice President

Daniel D. Tatar
Assistant Vice President

William J. Tignanelli
Senior Vice President

Ronald B. Holton
Assistant Vice President

Jeffrey K. Thomas
Assistant Vice President

David E. Beck
Vice President

Richard J. Kuhn
Assistant Vice President

Sandra L. Tormoen
Assistant Vice President

Amy L. Eschman
Assistant Vice President

Adam S. Pilsbury
Assistant Vice President

Mark D. Vaughan
Assistant Vice President

Patricia S. Tunstall
Assistant Vice President

Helen S. Williams
Assistant Vice President

Lauren E. Ware
Assistant Vice President

John I. Turnbull, II
Assistant Vice President

Terry J. Wright
Assistant Vice President

John N. Weiss
Assistant Vice President

CHARLOTTE OFFICE

William F. White
Assistant Vice President

Jeffrey S. Kane
Senior Vice President

Karen J. Williams
Assistant Vice President

R. William Ahern
Vice President

Julie Yoo
Assistant Vice President

Jennifer J. Burns
Vice President

Listing as of December 31, 2004

[ 35 ]

FINANCIAL STATEMENTS
MANAGEMENT ASSERTION .................................................................................................37
REPORT OF INDEPENDENT ACCOUNTANTS ........................................................................38
REPORT OF INDEPENDENT AUDITORS ................................................................................39
COMPARATIVE FINANCIAL STATEMENTS ............................................................................40
NOTES TO FINANCIAL STATEMENTS ...................................................................................43

The firm engaged by the Board of Governors for the audits of the individual
and combined financial statements of the Reserve Banks for 2004 was
PricewaterhouseCoopers LLP (PwC). Fees for these services totaled $2.0 million.
To ensure auditor independence, the Board of Governors requires that PwC be
independent in all matters relating to the audit. Specifically, PwC may not perform
services for the Reserve Banks or others that would place it in a position of auditing its own work, making management decisions on behalf of the Reserve Banks,
or in any other way impairing its audit independence. In 2004, the Bank did not
engage PwC for any material advisory services.

[ 36 ]

MANAGEMENT ASSERTION
MARCH 10, 2005

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, 2004 (the “Financial Statements”). The
Financial Statements have been prepared in conformity with the accounting principles, policies,
and practices established by the Board of Governors of the Federal Reserve System and as set forth
in the Financial Accounting Manual for the Federal Reserve Banks (“Manual”), and as such, include
amounts, some of which are based on judgments and estimates of management. To our knowledge,
the Financial Statements are, in all material respects, fairly presented in conformity with the
accounting principles, policies and practices documented in the Manual and include all disclosures
necessary for such fair presentation.
The management of the FRB 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, we
believe 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

Jeffrey M. Lacker
President

Claudia N. MacSwain
Senior Vice President and
Chief Financial Officer

Walter A. Varvel
First Vice President

[ 37 ]

REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors of the Federal Reserve Bank of Richmond:
We have examined management‘s assertion, included in the accompanying Management
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, 2004, based on criteria established in Internal
Control–Integrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission. FRB Richmond‘s management is responsible for maintaining effective
internal control over financial reporting and safeguarding of assets as they relate to the financial
statements. Our responsibility is to express an opinion on management‘s assertion based on
our examination.
Our examination was conducted in accordance with attestation standards established by the
American Institute of Certified Public Accountants and, accordingly, included obtaining an
understanding of internal control over financial reporting, testing and evaluating the design and
operating effectiveness of internal control, and performing 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 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 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, 2004 is fairly stated, in all material respects, based on criteria established
in Internal Control–Integrated Framework issued by the Committee of Sponsoring Organizations of
the Treadway Commission.
This report is intended solely for the information and use of management and the Board of
Directors and Audit Committee of FRB Richmond, and any organization with legally defined oversight responsibilities and is not intended to be and should not be used by anyone other than these
specified parties.

MARCH 16, 2005

[ 38 ]

REPORT OF INDEPENDENT AUDITORS
To the Board of Governors of the Federal Reserve System and
the Board of Directors of the Federal Reserve Bank of Richmond:
We have audited the accompanying statements of condition of the Federal Reserve Bank of
Richmond (the “Bank”) as of December 31, 2004 and 2003, and the related statements of income
and changes in capital for the years then ended, which have been prepared in conformity with the
accounting principles, policies, and practices established by the Board of Governors of the Federal
Reserve System. These financial statements are the responsibility of the Bank‘s management. Our
responsibility is to express an opinion on these financial statements based on our 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 described in Note 3, these financial statements were prepared in conformity with the
accounting principles, policies, and practices established by the Board of Governors of the Federal
Reserve System. These principles, policies, and practices, which were designed to meet the specialized accounting and reporting needs of the Federal Reserve System, are set forth in the Financial
Accounting Manual for Federal Reserve Banks 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, 2004 and 2003, and results of its operations
for the years then ended, on the basis of accounting described in Note 3.

MARCH 16, 2005

[ 39 ]

STATEMENTS OF CONDITION (in millions)
As of December 31,

2004

2003

ASSETS

Gold certificates
Special drawing rights certificates
Coin
Items in process of collection
U.S. government securities, net
Investments denominated in foreign currencies
Accrued interest receivable
Interdistrict settlement account
Bank premises and equipment, net
Other assets

$

819
147
62
341
55,147
5,009
386
—
252
125

$

808
147
83
714
51,954
4,915
388
2,793
267
118

Total assets

$ 62,288

$62,187

52,716
2,340

50,094
1,973

1,645
71
544
101
420
91
64

5,087
69
628
44
—
99
45

57,992

58,039

Capital:
Capital paid-in
Surplus

2,148
2,148

2,074
2,074

Total capital

4,296

4,148

$ 62,288

$62,187

LIABILITIES AND CAPITAL

Liabilities:
Federal Reserve notes outstanding, net
Securities sold under agreements to repurchase
Deposits:
Depository institutions
Other deposits
Deferred credit items
Interest on Federal Reserve notes due U.S. Treasury
Interdistrict settlement account
Accrued benefit costs
Other liabilities
Total liabilities

Total liabilities and capital
The accompanying notes are an integral part of these financial statements.

[ 40 ]

STATEMENTS OF INCOME (in millions)
For the years ended December 31,

2004

2003

$1,677

$1,722

63

64

1,740

1,786

23

16

1,717

1,770

Income from services
Reimbursable services to government agencies
Foreign currency gains, net
Other income

66
32
289
5

72
35
666
5

Total other operating income

392

778

Salaries and other benefits
Occupancy expense
Equipment expense
Assessments by Board of Governors
Other credits

215
32
88
102
(121)

232
30
84
110
(113)

Total operating expenses

316

343

$1,793

$2,205

Dividends paid to member banks
Transferred to surplus
Payments to U.S. Treasury as interest on
Federal Reserve notes

$ 125
74

$ 125
1

1,594

2,079

Total distribution

$1,793

$2,205

INTEREST INCOME

Interest on U.S. government securities
Interest on investments denominated in
foreign currencies
Total interest income
INTEREST EXPENSE

Interest expense on securities sold under
agreements to repurchase
Net interest income
OTHER OPERATING INCOME

OPERATING EXPENSES

Net income prior to distribution
DISTRIBUTION OF NET INCOME

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

[ 41 ]

STATEMENTS OF CHANGES IN CAPITAL (in millions)
For the years ended December 31, 2004
and December 31, 2003

Capital
Paid-in

Surplus

Total
Capital

$2,073
—

$2,073
1

$4,146
1

1

—

1

$2,074
—

$2,074
74

$4,148
74

74

—

74

$2,148

$2,148

$4,296

Balance at January 1, 2003
(41.5 million shares)
Transferred to surplus
Net change in capital stock issued
(.01 million shares)
Balance at December 31, 2003
(41.5 million shares)
Transferred to surplus
Net change in capital stock issued
(1.5 million shares)
Balance at December 31, 2004
(43.0 million shares)
The accompanying notes are an integral part of these financial statements.

[ 42 ]

NOTES TO FINANCIAL STATEMENTS
1. STRUCTURE
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. The Bank and its branches in Baltimore, Maryland, and Charlotte, North Carolina serve the
Fifth Federal Reserve District, which includes Maryland, North Carolina, South Carolina, Virginia, District of
Columbia, and portions of West Virginia. 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. 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
In accordance with the Federal Reserve Act, supervision and control of the Bank are exercised by a Board
of Directors. The Federal Reserve Act specifies the composition of the Board of Directors for each of the
Reserve Banks. Each board is composed of nine members serving three-year terms: three directors, including those designated as Chairman and Deputy Chairman, are appointed by the Board of Governors, and
six directors are elected by member banks. 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, the purchase of securities under agreements to resell, the
sale of securities under agreements to repurchase, and the lending of U.S. government securities. The
FRBNY is also authorized by the FOMC to hold balances of, and to execute spot and forward foreign
exchange (“F/X”) and securities contracts in, nine foreign currencies and to invest such foreign currency
holdings ensuring adequate liquidity is maintained. In addition, FRBNY is authorized to maintain reciprocal
currency arrangements (“F/X swaps”) with various central banks, and “warehouse” foreign currencies for
the U.S. Treasury and Exchange Stabilization Fund (“ESF”) through the Reserve Banks.

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 with the private sector. These
accounting principles and practices are documented in the Financial Accounting Manual for Federal
Reserve Banks (“Financial Accounting Manual”), which is issued by the Board of Governors. All Reserve
Banks are required to adopt and apply accounting policies and practices that are consistent with the
Financial Accounting Manual.

[ 43 ]

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 difference is the presentation
of all security holdings at amortized cost, rather than at the fair value presentation requirements of
GAAP. In addition, the Bank has elected not to present a Statement of Cash Flows. The Statement of Cash
Flows has not been included because 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. A
Statement of Cash Flows, therefore, would not provide any additional useful information. There are no
other significant differences between the policies outlined in the Financial Accounting Manual and GAAP.
Each Reserve Bank provides services on behalf of the System for which costs are not shared. Major
services provided on behalf of the System by the Bank, for which the costs were not redistributed to
the other Reserve Banks, include: Standard Cash Automation, Currency Technology Office, National
Procurement Office, Daylight Overdraft Reporting and Pricing, and the Payroll Central Business
Administration Function. Costs are, however, redistributed to other Reserve Banks for computing and
support services the Bank provides for the System. The Bank’s total reimbursement for these services
was $250 million and $216 million for the years ended December 31, 2004 and 2003, respectively, and
is included in “Other credits” on the Statements of Income.
The preparation of the financial statements in conformity with the Financial Accounting Manual
requires management to make certain estimates and assumptions that affect the reported amounts of
assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements,
and the reported amounts of income and expenses during the reporting period. Actual results could differ from those estimates. 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 on average Federal Reserve notes outstanding in each District.
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
SDR certificates, at the direction of the U.S. Treasury, for the purpose of financing SDR acquisitions or for
financing exchange stabilization operations. At the time SDR transactions occur, the Board of Governors
allocates SDR certificate transactions among Reserve Banks based upon Federal Reserve notes outstanding in each District at the end of the preceding year. There were no SDR transactions in 2004 or 2003.
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 Bank. Borrowers execute certain lending agreements and deposit sufficient collateral before
credit is extended. Loans are evaluated for collectibility, and currently all are considered collectible and
fully collateralized. If loans were ever deemed to be uncollectible, an appropriate reserve would be
established. Interest is accrued using the applicable discount rate established at least every fourteen days

[ 44 ]

by the Board of Directors of the Reserve Bank, subject to review by the Board of Governors. Loans to
depository institutions are reported as “Other assets.”
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.
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 the 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
the FRBNY on a daily basis, with additional collateral obtained as necessary. The securities lent are
accounted for in the SOMA.
F/X contracts are contractual agreements between two parties to exchange specified currencies, 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 prearranged maximum amount and for an agreed-upon period of time (up to twelve months), at an
agreed-upon interest rate. These arrangements give the FOMC temporary access to foreign currencies 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 that contain varying degrees of off-balance-sheet market risk, because they represent
contractual commitments involving future settlement and counter-party credit risk. The FRBNY controls
credit risk by obtaining credit approvals, establishing transaction limits, and performing daily monitoring
procedures.
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 may result in gains or losses when holdings are sold prior to maturity. Decisions regarding the securities and foreign currencies transactions, including their purchase and sale, are motivated by monetary
policy objectives rather than profit. Accordingly, market values, earnings, and any gains or losses resulting
from the sale of such currencies and securities are incidental to the open market operations and do not
motivate its activities or policy decisions.

[ 45 ]

U.S. government securities and investments denominated in foreign currencies comprising the SOMA are
recorded at cost, on a settlement-date basis, and adjusted for amortization of premiums or accretion of
discounts on a straight-line basis. Securities sold under agreements to repurchase are accounted for as
secured borrowing transactions with the associated interest expense recognized over the life of the transaction. Such transactions are settled by FRBNY. Interest income is accrued on a straight-line basis. 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. Foreign-currencydenominated assets are revalued daily at current foreign currency market exchange rates in order to
report these assets in U.S. dollars. Realized and unrealized gains and losses on investments denominated in
foreign currencies are reported as “Foreign currency gains, net.”
Activity related to U.S. government securities bought outright, securities sold under agreements to
repurchase, securities loaned, investments denominated in foreign currency, excluding those held under
an F/X swap arrangement, and deposit accounts of foreign central banks and governments above core
balances are allocated to each Reserve Bank. U.S. government 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.
In 2003, additional interest income of $61 million, representing one day‘s interest on the SOMA
portfolio, was accrued to reflect a change in interest accrual calculations, of which $4.8 million was
allocated to the Bank. The effect of this change was not material; therefore, it was included in the 2003
interest income.
e. Bank Premises, Equipment, and Software
Bank premises and equipment are stated at cost less accumulated depreciation. Depreciation is calculated
on a straight-line basis over estimated useful lives of assets ranging from two to fifty years. Major alterations, renovations, and improvements are capitalized at cost as additions to the asset accounts and are
amortized over the remaining useful life of the asset. Maintenance, repairs, and minor replacements are
charged to operations in the year incurred. Costs incurred for software, either developed internally or
acquired for internal use, during the application development stage are capitalized based on the cost of
direct services and materials associated with designing, coding, installing, or testing software. Capitalized
software costs are amortized on a straight-line basis over the estimated useful lives of the software applications, which range from two to five years.
f. Interdistrict Settlement Account
At the close of business each day, all Reserve Banks and branches 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 (the Chairman of the Board of Directors of each Reserve Bank) to the
Reserve Banks upon deposit with such agents of certain classes of collateral security, typically U.S. government securities. These notes are identified as issued to a specific Reserve Bank. The Federal Reserve Act
provides that the collateral security tendered by the Reserve Bank to the Federal Reserve agent must be
equal to the sum of the notes applied for by such Reserve Bank.
Assets eligible to be pledged as collateral security include all Federal Reserve Bank assets. The collateral
value is equal to the book value of the collateral tendered, with the exception of securities, whose collateral value is equal to the par value of the securities tendered. The par value of securities pledged for
securities sold under agreements to repurchase is similarly deducted.
The Board of Governors may, at any time, call upon a Reserve Bank for additional security to
adequately collateralize the Federal Reserve notes. To satisfy the obligation to provide sufficient collateral
for outstanding Federal Reserve notes, the Reserve Banks have entered into an agreement that
provides for certain assets of the Reserve Banks to be jointly pledged as collateral for the Federal Reserve
notes of all Reserve Banks. In the event that this collateral is insufficient, the Federal Reserve Act provides

[ 46 ]

that Federal Reserve notes become a first and paramount lien on all the assets of the Reserve Banks.
Finally, as obligations of the United States, Federal Reserve notes are backed by the full faith and credit
of the United States government.
The “Federal Reserve notes outstanding, net” account represents the Bank‘s Federal Reserve notes
outstanding reduced by its currency holdings of $12,275 million, and $9,855 million at December 31, 2004
and 2003, 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 Reserve Bank stock must be adjusted. Member banks
are 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.
The Financial Accounting Standards Board (FASB) has deferred the implementation date for SFAS No.
150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” for
the Bank. When applicable, the Bank will determine the impact and provide the appropriate disclosures.
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.
Pursuant to Section 16 of the Federal Reserve Act, Reserve Banks are required by the Board of
Governors to transfer to the U.S. Treasury as interest on Federal Reserve notes excess earnings, after
providing for the costs of operations, payment of dividends, and reservation of an amount necessary to
equate surplus with capital paid-in.
In the event of losses or an increase in capital paid-in, payments to the U.S. Treasury are suspended
and earnings are retained until the surplus is equal to the capital paid-in. Weekly payments to the U.S.
Treasury may vary significantly.
In the event of a decrease in capital paid-in, the excess surplus, after equating capital paid-in and
surplus at December 31, is distributed to the U.S. Treasury in the following year. This amount is reported
as a component of “Payments to U.S. Treasury as interest on Federal Reserve notes.”
j. 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.
k. Taxes
The Reserve Banks are exempt from federal, state, and local taxes, except for taxes on real property. The
Bank‘s real property taxes were $2.2 million for each of the years ended December 31, 2004 and 2003,
and are reported as a component of “Occupancy expense.”
l. Restructuring Charges
In 2003, the System started the restructuring of several operations, primarily check, cash, and Treasury
services. The restructuring included streamlining the management and support structures, reducing staff,
decreasing the number of processing locations, and increasing processing capacity in the remaining locations. These restructuring activities continued in 2004.
Footnote 10 describes the restructuring and provides information about the Bank‘s costs and
liabilities associated with employee separations and contract terminations. The costs associated with

[ 47 ]

the write-down of certain Bank assets are discussed in footnote 6. Costs and liabilities associated with
enhanced pension benefits for all Reserve Banks are recorded on the books of the FRBNY.

4. U.S. GOVERNMENT SECURITIES
Securities bought outright are held in the SOMA at the FRBNY. An undivided interest in SOMA activity
and the related premiums, discounts, and income, with the exception of securities purchased under
agreements to resell, is allocated to each Reserve Bank on a percentage basis derived from an annual settlement of interdistrict clearings that occurs in April of each year. The settlement equalizes Reserve Bank
gold certificate holdings to Federal Reserve notes outstanding. The Bank‘s allocated share of SOMA balances was approximately 7.600 percent and 7.690 percent at December 31, 2004 and 2003, respectively.
The Bank‘s allocated share of U.S. government securities, net held in the SOMA at December 31, was as
follows (in millions):
2004
Par value:
U.S. government:
Bills
Notes
Bonds
Total par value
Unamortized premiums
Unaccreted discounts
Total allocated to Bank

19,987
27,425
7,146

$ 18,828
24,868
7,573

54,558

$

2003

51,269

715
(125)
$

55,148

754
(69)
$ 51,954

The total of the U.S. government securities, net held in the SOMA was $725,584 million and $675,569
million at December 31, 2004 and 2003, respectively.
The maturity distribution of U.S. government securities bought outright and securities sold under
agreements to repurchase, that were allocated to the Bank at December 31, 2004, was as follows
(in millions):

Maturities of Securities Held

Securities
U.S.
Sold Under
Government
Agreements to
Securities
Repurchase
(Par value) (Contract amount)

Within 15 days
16 days to 90 days
91 days to 1 year
Over 1 year to 5 years
Over 5 years to 10 years
Over 10 years

$

2,329
13,556
12,952
15,829
4,133
5,758

$

2,340
—
—
—
—
—

Total

$

54,557

$

2,340

At December 31, 2004 and 2003, U.S. government securities with par values of $6,609 million and $4,426
million, respectively, were loaned from the SOMA, of which $502 million and $340 million were allocated
to the Bank.
At December 31, 2004 and 2003, securities sold under agreements to repurchase with contract amounts
of $30,783 million and $25,652 million, respectively, and par values of $30,808 million and $25,658 million, respectively, were outstanding. The Bank‘s allocated share at December 31, 2004 and 2003 was
$2,340 million and $1,973 million, respectively, of the contract amount and $2,342 million and $1,973
million, respectively, of the par value.

[ 48 ]

5. INVESTMENTS DENOMINATED IN FOREIGN CURRENCIES
The FRBNY, on behalf of the Reserve Banks, holds foreign currency deposits with foreign central banks
and the Bank for International Settlements and invests in foreign government debt instruments. Foreign
government debt instruments held include both securities bought outright and securities purchased
under agreements to resell. These investments are guaranteed as to principal and interest by the foreign
governments.
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 23.442 percent and 24.740 percent at December 31, 2004 and 2003, respectively.
The Bank‘s allocated share of investments denominated in foreign currencies, valued at current foreign
currency market exchange rates at December 31, was as follows (in millions):
2004
European Union Euro:
Foreign currency deposits
Securities purchased under agreements to resell
Government debt instruments

$

Japanese Yen:
Foreign currency deposits
Government debt instruments

1,421
502
900

2003
$

1,699
509
503

361
1,796
29

Accrued interest
Total

$

365
1,816
23

5,009

$

4,915

Total System investments denominated in foreign currencies were $21,368 million and $19,868 million at
December 31, 2004 and 2003, respectively.
The maturity distribution of investments denominated in foreign currencies which were allocated to
the Bank at December 31, 2004, was as follows (in millions):
Maturities of Investments
Denominated in Foreign Currencies

European Euro

Japanese Yen

Total

Within 1 year
Over 1 year to 5 years
Over 5 years to 10 years
Over 10 years

$

2,105
705
43
—

$

2,156
—
—
—

$

4,261
705
43
—

Total

$

2,853

$

2,156

$

5,009

At December 31, 2004 and 2003, there were no material open foreign exchange contracts.
At December 31, 2004 and 2003, the warehousing facility was $5,000 million, with no balance
outstanding.

[ 49 ]

6. BANK PREMISES, EQUIPMENT, AND SOFTWARE
A summary of bank premises and equipment at December 31 is as follows (in millions):
Maximum Useful
Life (in years)
Bank premises and equipment:
Land
Buildings
Building machinery and equipment
Construction in progress
Furniture and equipment
Subtotal

N/A
50
20
N/A
10

2004

2003

$

22.5
138.5
50.1
2.6
311.6

$

22.6
133.6
49.1
4.9
315.7

$

525.3

$

525.9

Accumulated depreciation

(273.7)

(259.0)

Bank premises and equipment, net

$

251.6

$

266.9

Depreciation expense, for the years ended

$

44.5

$

39.9

Bank premises and equipment at December 31 include the following amounts for leases that have been
capitalized (in millions):
2004

2003

Bank premises and equipment
Accumulated depreciation

$

10
(5)

$

8
(5)

Capitalized leases, net

$

5

$

3

The Bank leases unused space to outside tenants. Those leases have terms ranging from one to 4 years.
Rental income from such leases was $1.4 million and $1.6 million for the years ended December 31, 2004
and 2003, respectively. Future minimum lease payments under noncancelable agreements in existence at
December 31, 2004, were (in millions):

2005
2006
2007
2008
2009
Thereafter

$

1.3
1.3
—
—
—
—

$

2.6

The Bank has capitalized software assets, net of amortization, of $84 million and $57 million at
December 31, 2004 and 2003, respectively. Amortization expense was $27 million and $29 million for
the years ended December 31, 2004 and 2003, respectively.
Assets impaired as a result of the Bank‘s restructuring plan, as discussed in footnote 10, include furniture and equipment. There were no asset impairment losses in 2004. Asset impairment losses of $163,299
for the period ending December 31, 2003 were determined using fair values based on quoted market
values or other valuation techniques and are reported as a component of “Other credits.”

[ 50 ]

7. COMMITMENTS AND CONTINGENCIES
At December 31, 2004, the Bank was obligated under noncancelable leases for premises and equipment
with terms ranging from one to approximately five years. These leases provide for increased rental payments based upon increases in real estate taxes, operating costs, or selected price indices.
Rental expense under operating leases for certain operating facilities, warehouses, and data processing
and office equipment (including taxes, insurance and maintenance when included in rent), net of sublease rentals, was $38 million for each of the years ended December 31, 2004 and 2003. Certain of the
Bank‘s leases have options to renew.
Future minimum rental payments under capital leases, net of sublease rentals, with terms of one year
or more, at December 31, 2004, were (in millions):
Capital
2005
2006
2007
2008
2009
Thereafter

$

0.1
0.1
0.1
0.1
0.1
—
0.5
(0.0)

$

0.5

Amount representing interest
Present value of net minimum lease payment

Future minimum rental payments under noncancelable operating leases, net of sublease rentals, with
terms of one year or more, at December 31, 2004 were not material.
At December 31, 2004, the Bank, acting on its own behalf, had other commitments and long-term obligations extending through the year 2007, with a remaining amount of $16.7 million. As of December 31,
2004, none of the commitments were recognized. Purchases of $24.6 million and $9.3 million were made
against these commitments during 2004 and 2003, respectively. These commitments represent outsourcing costs associated with the hardware and software platforms for a web infrastructure project as well as
Virtual Private Network (VPN) services and have variable and fixed components. The variable portion of
the commitments is for support services related to the web infrastructure as well as monthly connection
charges and other incremental charges for ad hoc services associated with the VPN. The fixed payments
for the next five years under these commitments are (in millions):
Fixed Commitment
2005
2006
2007
2008
2009

$

11.2
3.7
1.7
—
—

In addition, at December 31, 2004, the Bank, acting on behalf of the Reserve Banks, had contractual
commitments extending through the year 2011 with a remaining amount of $81.7 million. As of
December 31, 2004, $36.3 million of these commitments was recognized. Purchases of $35.0 million and
$32.8 million were made against these commitments during 2004 and 2003, respectively. It is estimated
that the Bank‘s allocated share of these commitments will be $7.7 million. These commitments represent
maintenance of currency processing machines and have variable and fixed components. The variable portion of the commitment is for consumable parts and incremental maintenance above the minimum basis.

[ 51 ]

The fixed payments for the next five years under these commitments are (in millions):
Fixed Commitment
2005
2006
2007
2008
2009

$

36.3
33.5
9.2
0.7
0.7

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 one
percent of the capital paid-in of the claiming Reserve Bank, up to 50 percent of the total capital paid-in
of all Reserve Banks. Losses are borne in the ratio that a Reserve Bank‘s capital paid-in bears to the 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, 2004 or 2003.
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”). In addition, certain Bank officers participate in the Supplemental Employee
Retirement Plan (“SERP”).
The System Plan is a multi-employer plan with contributions fully funded by participating employers.
Participating employers are the Federal Reserve Banks, the Board of Governors of the Federal Reserve
System, and the Office of Employee Benefits of the Federal Reserve Employee Benefits System. No separate accounting is maintained of assets contributed by the participating employers. The FRBNY acts as a
sponsor of the Plan for the System and the costs associated with the Plan are not redistributed to the
Bank. The Bank‘s projected benefit obligation and net pension costs for the BEP and the SERP at
December 31, 2004 and 2003, and for the years then ended, are not material.
Thrift Plan
Employees of the Bank may also participate in the defined contribution Thrift Plan for Employees of
the Federal Reserve System (“Thrift Plan”). The Bank‘s Thrift Plan contributions totaled $8 million for
each of the years ended December 31, 2004 and 2003, and are reported as a component of “Salaries
and other benefits.”

9. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS AND POSTEMPLOYMENT BENEFITS
Postretirement Benefits other than Pensions
In addition to the Bank‘s retirement plans, employees who have met certain age and length of service
requirements are eligible for both medical benefits and life insurance coverage during retirement.
The Bank funds benefits payable under the medical and life insurance plans as due and, accordingly,
has no plan assets. Net postretirement benefit costs are actuarially determined using a January 1 measurement date.

[ 52 ]

Following is a reconciliation of beginning and ending balances of the benefit obligation (in millions):
2004
Accumulated postretirement
benefit obligation at January 1

$ 107.8

Service cost-benefits earned during the period

$

87.1

2.0

$

2.1

5.5
(8.0)
—
—
0.8
(5.2)
(9.2)

Interest cost of accumulated
benefit obligation
Actuarial (gain)/loss
Curtailment loss
Special termination loss
Contributions by plan participants
Benefits paid
Plan amendments
Accumulated postretirement benefit
obligation at December 31

2003

5.7
11.7
3.7
0.6
0.6
(3.7)
—

93.7

$

107.8

At December 31, 2004 and 2003, the weighted-average discount rate assumptions used in developing the
postretirement benefit obligation were 5.75 percent and 6.25 percent, respectively.
Following is a reconciliation of the beginning and ending balance of the plan assets, the unfunded
postretirement benefit obligation, and the accrued postretirement benefit costs (in millions):
2004

2003

Fair value of plan assets at January 1
Actual return on plan assets
Contributions by the employer
Contributions by plan participants
Benefits paid

$

—
—
4.4
0.8
(5.2)

$

—
—
3.1
0.6
(3.7)

Fair value of plan assets at December 31

$

—

$

—

Unfunded postretirement benefit obligation
Unrecognized prior service cost
Unrecognized net actuarial loss

$

93.7
10.8
(27.7)

$

107.8
9.9
(36.6)

Accrued postretirement benefit costs

$

76.8

$

81.1

Accrued postretirement benefit costs are reported as a component of “Accrued benefit costs.”
For measurement purposes, the assumed health care cost trend rates at December 31 are as follows:
2004
Health care cost trend rate assumed for next year
Rate to which the cost trend rate is assumed
to decline (the ultimate trend rate)
Year that the rate reaches the ultimate trend rate

2003

9.00%

10.00%

4.75%
2011

5.00%
2011

[ 53 ]

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, 2004 (in millions):
One Percentage
Point Increase
Effect on aggregate of service and interest
cost components of net periodic
postretirement benefit costs
Effect on accumulated postretirement
benefit obligation

One Percentage
Point Decrease

$

$

0.7
9.6

(0.6)
(7.8)

The following is a summary of the components of net periodic postretirement benefit costs for the
years ended December 31 (in millions):
2004
Service cost-benefits earned
during the period
Interest cost of accumulated
benefit obligation
Amortization of prior service cost
Recognized net actuarial loss
Total periodic expense

$

$

5.5
(1.1)
0.9
$

Curtailment (gain)/loss
Special termination loss
Net periodic postretirement benefit costs

2.0

2003

7.3

5.7
(1.0)
1.0
$

(7.2)
—
$

0.1

2.1

7.8
2.9
0.6

$

11.3

At December 31, 2004 and 2003, the weighted-average discount rate assumptions used to determine net
periodic postretirement benefit costs were 6.25 percent and 6.75 percent, respectively.
Net periodic postretirement benefit costs are reported as a component of “Salaries and other benefits.”
A plan amendment that modified the credited service period eligibility requirements created curtailment gains. The recognition of special termination losses is primarily the result of enhanced retirement
benefits provided to employees during the restructuring described in footnote 10. Because the special
termination loss is less than $50,000, the amount is not displayed in the tables above.
The Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “Act”) was enacted
in December 2003. The Act established a prescription drug benefit under Medicare (“Medicare Part D”)
and a federal subsidy to sponsors of retiree health care benefit plans that provide benefits that are at
least actuarially equivalent to Medicare Part D. Following the guidance of the Financial Accounting
Standards Board, the Bank elected to defer recognition of the financial effects of the Act until further
guidance was issued in May 2004.
Benefits provided to certain participants are at least actuarially equivalent to Medicare Part D. The
estimated effects of the subsidy, retroactive to January 1, 2004, are reflected in actuarial gain in the accumulated postretirement benefit obligation and net periodic postretirement benefit costs.
Following is a summary of the effects of the expected subsidy (in millions):
2004
Decrease in the accumulated postretirement benefit obligation
Decrease in the net periodic postretirement benefit costs

[ 54 ]

$
$

15.8
2.2

Expected benefit payments (in millions):
Without Subsidy

With Subsidy

2005
2006
2007
2008
2009
2010-2014

$

4.8
4.9
5.0
5.1
5.2
28.2

$

4.8
4.4
4.5
4.6
4.6
24.5

Total

$

53.2

$

47.4

Postemployment Benefits
The Bank offers benefits to former or inactive employees. Postemployment benefit costs are actuarially
determined using a December 31, 2004 measurement date and include the cost of medical and dental
insurance, survivor income, and disability benefits. For 2004, the Bank changed its practices for estimating
postemployment costs and used a 5.25 percent discount rate and the same health care trend rates as
were used for projecting postretirement costs. Costs for 2003, however, were estimated 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, 2004 and 2003, were $13.8 million and $17.6 million, respectively. This cost is included as a component of “Accrued benefit costs.” Net
periodic postemployment benefit costs included in 2004 and 2003 operating expenses were ($1.9) million
and $3.5 million, respectively.

10. BUSINESS RESTRUCTURING CHARGES
In 2003, the Bank announced plans for restructuring to streamline operations and reduce costs, including
consolidation of check operations and staff reductions in various functions of the Bank. In 2004, additional consolidation and restructuring initiatives were announced in the savings bonds operations. These
actions resulted in the following business restructuring charges:
Major categories of expense (in millions):
Total
Estimated
Costs

Accrued
Liability
12/31/03

Total
Charges

Total
Paid

Accrued
Liability
12/31/04

Employee separation
Contract termination

$

6.1
0.3

$

5.6
—

$

0.5
—

$ 1.8
—

$

4.3
—

Total

$

6.4

$

5.6

$

0.5

$ 1.8

$

4.3

Employee separation costs are primarily severance costs related to identified staff reductions of approximately 193, including 115 staff reductions related to restructuring announced in 2003. These costs are
reported as a component of “Salaries and other benefits.” Contract termination costs include the charges
resulting from terminating existing lease and other contracts and are shown as a component of “Other
credits.”
Restructuring costs associated with the write-downs of certain Bank assets, including furniture and
equipment are discussed in footnote 6. Costs associated with enhanced pension benefits for all Reserve
Banks are recorded on the books of the FRBNY as discussed in footnote 8. Costs associated with enhanced
postretirement benefits are disclosed in footnote 9.
The Bank anticipates substantially completing its announced plans by June 2005.

[ 55 ]

SUMMARY OF OPERATIONS (unaudited)
Dollar Amount
Year-to-Date December

2004

Volume

2003

2004

2003

50.9 Billion

50.6 Billion

3.1 Billion

3.2 Billion

Currency destroyed

5.9 Billion

6.2 Billion

Coin bags received
and counted

33.5 Million

Commercial checks
processed
Commercial checks,
packaged items
handled

CASH
Currency received
and counted

496.1 Million

514.8 Million

57.1 Million

100.1 Thousand

154.3 Thousand

1.3 Trillion

1.5 Trillion

1.3 Billion

1.6 Billion

361.2 Billion

382.5 Billion

NONCASH PAYMENTS

U.S. government
checks processed

.0

587.4 Million

41.8 Billion

.0

80.7 Million

.47

676.5 Million
27.8 Million

LOANS TO DEPOSITORY
INSTITUTIONS
Discount window
loans made

474.6 Million

.35

SERVICES TO
U.S. TREASURY AND
GOVERNMENT AGENCIES
Issues, redemptions,
and exchanges of
U.S. savings bonds
Food stamps redeemed

[ 56 ]

1.0 Billion
70.0 Thousand

2.2 Billion
79.4 Million

4.5 Million
28.0 Thousand

6.2 Million
15.5 Million

The Federal Reserve Bank of Richmond 2004 Annual Report was produced by the Research
Department, Publications Unit and the Public Affairs Department, Graphics Unit.
Director of Publications
John A. Weinberg
Editor
Alice Felmlee
Designer
Cecilia Bingenheimer

Portrait Photographers
Larry Cain, Ailsa Long,
Geep Schurman
Editorial Photographs
cover and sidebars: Getty
Images and PhotoSpin
page 4: Getty Images
page 7: Getty Images
page 11: Getty Images
page 12: Jon Brenneis/
Getty Images

page 15: AP/Wide World
Photos
page 16: Charles Thatcher/
Getty Images
page 19: Getty Images
Printer
Federal Reserve Bank of
Richmond

This Annual Report is also available on the Federal Reserve Bank of Richmond's Web site at
www.richmondfed.org. For additional print copies, contact the Public Affairs Department,
Federal Reserve Bank of Richmond, P.O. Box 27622, Richmond, VA 23261, or call (804)697-8109.

Fifth Federal Reserve District Offices
Richmond
701 East Byrd Street
Richmond, Virginia 23219
(804) 697-8000

www.richmondfed.org

Baltimore
502 South Sharp Street
Baltimore, Maryland 21201
(410) 576-3300

Charlotte
530 East Trade Street
Charlotte, North Carolina 28202
(704) 358-2100

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