-1-
Public
Prices -
Private Costs; The Federal
Reserve Bank
Competes With Itself
By
Betsy Hannah Gordon
B.A.,
Clark University, Worcester, Massachusetts
(1976)
Submitted to the Department of
Urban Studies and Planning
in Partial Fulfillment of the
Requirements of the Desree of
MASTER IN CITY PLANNING
at the
MASSACHUSETTS INSTITUTE OF TECHNOLOGY
1982
June
0) Betsy
Hannah Gordon,
1982
I I
Signature of Author:
..
.
.
.
...
Departm. t
Certified
s.
.aS
u
.. s
of Urban Studies and
May 15, 1982
Planning
by"..
Thesis Supervisor
Accepted
by:..
Chairman,
Departmental
Rotch
waSSAC8oSErTs ;Nsi
OF 1E1-" t%'
IRARlES
Graduate Committee
7
-2Public Prices The Federal
Private Costs;
Reserve Bank Competes With Itself
by
Betsy
Hannah Gordon
Submitted to the Department of Urban Studies and Planning
on May 157 1982 in Partial fulfilIment of the
requ i rements for the Deg ree of Master i n Ci ty P Iann i ns.
Course Concentration: Public Policy and Management
ABSTRACT
This thesis analyzes the Monetary Credit and Control
Act of 1980 Provision that the Federal Reserve Bank set
explicit fees for its services.
The Federal Reserve Bank
must besin to actively compete as a Public agency in a
private market for Payment services.
The act has required
the Federal Reserve Bank to reorient manasement focus and
institutional Priorities as a service Provider.
A discussion of the pricins
strategy adopted by the
Federal Reserve Bank reveals both how efficiently costs were
allocated
amons different
services in order to determine a
fee schedule, and the implication of cross-subsidization of
services.
In addition, Particular attention is siven to the
question of how a Public asency meets a mandate to set fees
that include a Proxy for "non-market" costs of capital.
The
issue of what is a "fair"
market Price with respect to
Public interest concerns is an overridins theme of this
thesis.
The specifics of this
analysis include an evaluation of
an averase cost versus marsinal cost Pricins
scheme, the
determination of a "fair" rate of return 7 and the way the
existins Federal Reserve Manasement and Budseting System was
used to assist in the implementation of a fee schedule.
Thesis Supervisors:
Dr. Leonard G. Buckle 7 Professor of Urban Studies, M.I.T.
Dr. Suzann R. Buckle 7 Professor of Urban Studies, M.I.T.
Dr. Herman B. Leonard, Professor of Public Policy, John F.
Kennedy School Of Government
-3-
ACKNOWLEDGEMENTS
I Wish to thank
individuals for
the followinS
their
substant ive and ed itor ia I comments.
Professor Francis M.
Government,
Bator, John F.
Kennedy School
of
Harvard Un i vers ity
Professor Leonard G.
Department
Buckle,
of Urban Studies
Massachusetts Institute of Technctlogy.
and Plann ins,
Professor Suzann R. Buckle, Department of Urban Studies
and Planning, Massachusetts Institute of Technology.
Mr.
Jim Gamel,
Doctoral
Candidate, Sloan School
Management, Massachusetts
Government,
Mr.
James Love,
Institute of Techno logy.
Leonard, John F.
Professor Herman B.
of
Kennedy School
of
Harvard University
Master
Kennedy School
in
of Government,
Professor Stewart C.
Myers,
Massachusetts Institute
Professor David H.
Public Administration,
Sherman,
John F.
Harvard University.
Sloan School
of Management,
of TechnologY.
Sloan School
of Management,
Massachusetts Institute of Technology.
-4-
TABLE OF CONTENTS
Pase
Abstract.................................................. 2
I.
Introduction...............................................6
II.
A Transition From Free to Priced Services, Federal
Reserve Bank Payment System Services........
.10
Issues of Federal Reserve Bank Membership
and Monetary Policy Considerations.......... .10
Reduction in the Reserve Base and Concerns
of the Treasury...............................
.. 14
Recent Trends Shapins the Provisions for
Federal Reserve Bank Pricins................
.. 17
Free Services and Efficiency Concerns........... .. 20
III.
The
IV.
The Private Sector Adjustment Factor
Why the PSAF................
Derivation of the PSAF......
Evaluating the PSAF.........
.. 8 ..
Capital Structure......
The Return to Capital..
Mark-up Pricing........
Federal Reserve System's Manasement and
Budsetins System: The Planning and Control
System (PACS):
Structure and Purpose....................
......
27
Planning and Control System Cost Allocati on
and Allocation to Priced Services... . ........
29
Evaluation of the Pricins Worksheet...... . ........
aa a33
38
39
43
44
48
56
V.
The Economics of Public Pricing at the
Federal Reserve Banks.........................56
Averase Cost Pricing and Intertemporal
Adjustment...................................58
Averase Cost versus Marginal Cost Pricing
Ramsey Pricing: A Second Best Solution.......64
VI.
Conclusion..........................................68
Footnotes.
.
.....................
89
Biblioeraphy................................................93
-5-
Pase
APPENDIX / EXHIBITS / TABLES
1
Fisure
Fisure 2
Step-down
of Fed Cost Data Under
Step-down Cost Allocation From
Priced Services........................
PACS....
PACS to
Imputed Capital
...32
Table
1
Weighted Cost of
Table
2
Cost of Capital
Table
3
Percent Chanses in Volume of Checks/
Commercial Bank Loans & Percent Change
ifn GNP 1973-1979.......................
Table 4
.............................
31
........
..... 42
With 60:40 Debt/Equity Ra tio..45
Chanses in the Volume of Checks and
Commercial Loans As a Function of GNP..
..... 53
.....
54
Glossary................................................73
Exhibit I:
Appendix
Description of Fed
I:
Check Processing Services.79
The Pricing Worksheet Cost Allocation
Method...........................................82
-6-
I
Introduction
The Depository Institution Deregulation and Monetary
Control
Act
March 27,
was signed
(MCA)
by President Carter on
in
the banking and
One of the Provisions of this
-finance industry.
discontinue
law
This act marks a new era
1980.
requires that
into
the Federal
Reserve System
law
Fed)
(The
its traditional Practice of offering Payment
services at zero cost to member banks?
services to all
depository
consequence of the MCA
distinction between
requiring the Fed
and offer
institutions.
is that there will
member and non-member
to price
priced
A fundamental
no
lonser be any
banks.
By
its services the Consress
intended that competitive forces shape the national
payments service market
with
banking services are delivered.
which
The task
of pricing the Federal
places enormous
and
and enhance the efficiency
banking
in
pressure on the Fed.
fact Prove the very
sector service Provider.
articulate,
role it
Reserve's services
It
must now
redefine
should Play as a Public
This means the Fed must not only
but also cope with a different organizational
-7-
Philosophy.
The way the Fed manipulates
management system in
Part,
shape this
its entire
setting prices for services,
Philosophy.
The Fed must
wi
reorient
operation towards a market sensitive approach as
its services,
and confront the existing
competitive market.
will
Any trade-off
depend upon
pricing Policy.
volume and
its
sel Is
the
increasing market
existins between
the flexibility
wilI
these two strategies
implied
its
In addition to
regulator, the Fed
in
n
The Fed must be deliberate about
strategies of maintaining
share.
forces
it
i
by the Fed's
traditional
role as
now take on a more overt
role as
compet i tor.
To the extent
back some of
response to
Potential
somewhat
its
its
that the Fed
is
service capacity
fee structure7
it
ultimately
to recognize the substantial
to cut
because of the market
must also face the
role as service Provider of
beyond the scope of this
forced
last
resort.
analysis,
it
is
Although
important
impact the mandate of Fed
Pricing will
have on the Fed's mode of operation as Provider
of financial
Payment services,
service Provider
relative
This Paper first will
to
its
and on
Private
its
status as a
sector competitors.
set out the historical
context
-8-
that
led to the formulation of the MCA and the specific
requirement
of Fed pricing.
existing management
Next,
it
will
analyze the
and budgeting system7
and explain
costs were allocated to priced services.
consider
on
its
Third,
how the Fed went about determining a
services given the MCA mandate to
it Will
rate of
include
how
in
return
the
fees
a mark-up representing the costs of taxes and financing that
the Fed would
incur as a Private entity.
Finally,
it
considers the pricing theory applicable to the Fed's
approach towards setting a fee structure for services.
will
include a discussion of the merits of
marginal
Judgements
its
average cost and
cost Pricing under different condit ions of supply
and demand.
in
Consideration of
these four aspects al low
to be made about how effective the Fed has been
effort
to Price services "so
as to enhance the
eff i: i ency of the nat ion' s Payments system. " 1 In
of the fundamental
Pricing
This
chanses which will
tu rn, some
improve the Fed's
scheme become evident.
An analysis of
strategy telIs
an
how the Fed determines
pricing
interesting story about an asency which at
once must grapple with
manasement
its
internal
and budset i nis system,
constraints of
a
requirement
its
that
own
it
Price
-9its services at
services
in
overriding
ful I cost7
the Shift
ifn
demand for
its own
response to settins explicit fees, and the
concern of the private sector that the Fed Price
its services "fairly".
-
10-
II A Transition From Free to Priced Services:
The formulation of the MCA was motivated
comb i nat i on of econom i c
po
it i
forces, which tosether cal led
Federal
both
of monetary
Pol
icy and
Payment services to member banks.
conversins
of these forces that accelerated
bank bai I-out,
intensif
ied
rather than the benefits of Fed
bank,
responsible
a "competitor",
It was the
the trend
membership
that made
inter-bank equitY,
on the movement towards the mandate of Fed
The MCA was ultimately a compromise
law
and the bankins community
in
variety
the at
Reserve,
seneral.
Issues of Fed Membership and Monetary Pricins
Over the Past decade,
and
Pricing.
incorporating
times conflictins agendas of Consress, the Federal
the Treasury,
of
the focus on the costs
increasingly apparent the issues of
spurred
by a
into question the role the
providins
member
Trends
a 1ca
, and technol og i ca I
Reserve should Play as the central
as a regulator
Historical
Considerations
the Consress has considered a
of approaches to financial
reform.
was on the Problem of member bank attrition
A Primary focus
from the Federal
-
impact
11-
on the ability of the Fed to
Reserve System and
its
carry out monetary
policy objectives.
member
leaving the system and the Percentase of total
banks
accounted
bank depos i ts
Over
decreased.
withdrawn from
Initially
for by member
the system,
and onlY
103 had
banks had
2
Joined.
it was mostly smaller banks, with assets
During
leaving the system.
larger banks with assets over one-hundred
the 1970's,
mi I I ion were
the
banks had stead i I y
the Past ten years 435 member
under fifty million, that were
underlying
Both the number of
leaving the system at
increasing
3
rates.
The
cause of this trend was the cost associated
reserve requirements
are non-interest
bearing
imposed on member
banks.
with
Reserves
in
accounts held with the Fed
exchange for free services and access to the discount
window.
These reserves are an opportunity cost of
alternative
that
interest bearing
investments and are something
banks naturally Wish to avoid.
Monetary Policy makes the reserve
important concern of the Federal
There
Consress.
reserves
in
is a direct
requirement
issue an
Reserve System and the
link between the amount of
the banking system and the Fed's ability
to
- 12-
control
market
the money supply and
operat ions,
the buy ins
securities, the Fed
system.
of
credit.
and se I I i ns of U. S.
influences the
Buyins sovernment
will
base
is
necessary
in
market operations.
order
lend.
the
supply and decrease the
A Predictable reserve
for the Fed to carry out
banks and a
nationwide deposits as Part of the Federal
has
in
Selling Government
credit.
With fewer
the Fed therefore,
reserves
increases the volume
tighten the money
volume of funds available for
of
level
securities
reserves with which banks can
securities
Throush the Fed's open
less abi I ity
its
open
lower amount
of
Reserve System,
to control
money
and
credit.
The role of
monetary Policy
debate.
in
substantial
asresates.
is an
1980,
held by member
reserve requirements
issue around which there
70% of all
banks.4
ability
in carrying out
commercial
is
continual
bank deposits were
This would seem to
by the Fed to control
imply a
monetary
However, the Consress was more concerned
the rate-of attrition and
its Potential
with
consequences.
Therefore, Proposals were called for which would stop the
trend of avoiding reserve requirements through attrition.
One Proposal
would have required
interest
to be Paid on
-13-
reserves and another
called for a sraduated set of
requirements within a statutory
introduced
ranse.
A Proposal
by the House Bankins Committee Chairman Henry
Reuss as H.R.13847 called for
"universal
subsequent modifications which resulted
of uniform,
universal
requirement,
reguirements.
the total
introduced
in the MCA Provision
With the universal
amount of reserves
would be
spread across a broader base of depository
institutions.
There was also a
Proposal
the reserve
ratio, such that
the total
Fed would
be
.ower.
for
reduction
amount of
S.
reserve
reguirements".5 Both Senators Reuss and Proxmire
reserves
reserve
in
reserves held with the
-14,-
in the Reserve Base and the Concerns of the Treasury
Reduction
received this specific Provision
The bankins community
However7
favorably.
the formulation
in
involved
another
the Treasury,
the absolute
of the MCA 7
level
of
Party
intimately
was concerned about
reserves held
any decrease
in
nationwide:
Both the Treasury and the Consress recognized
that a
a
revenue
in
caused
The Treasury's support for
part was because the revenues senerated from
fees would offset the potential
by a
lower
loss
of
is best
considering the not so obvious I ink between
understood by
level
in earnings
revenue base.
The basis of the Treasury's viewpoint
the
asresate reserves and the cost of
the Treasury,
borrowins
and the flow of net earnings each year
the Fed to the Treasury.
reserves and the money supply.
it manipulates the
lower
total
from
level
of
The Fed draws down the
reserve base throush the Purchase of a sovernment
a
to
and
Throush the Fed's buying
selling of Government securities
If
into
of absolute reserves might translate
loss to the Treasury.
Fed Pricing
service
level
lower
reserve base exists,
the Fed Will
Proportionately fewer sovernment securities.
security.
hold
In turn,
the
-1 5-
Public will
hold
more.
To the extent that
held debt bids down the Price
yields
increase.
will
In
fewer
the Public--at the higher
debt
its
rate of
borrowins
costs to the Treasury.
It
is
change
in
the
Therefore,
in
increased
this
way that net
It should
earnings to the Treasury may decline.
out that the actual
by borrowing
interest.
reserves cause a by-product of
total
be forced
the Treasury will
turn,
to finance Proportionately more of
from
publicly
their correspondins
bonds,
of
more
be pointed
ratio of sovernment
securities at the Fed because of the induced change
is unlikely to be very substantial,
reserve base,
increased costs to the Treasury more obvious
relationship
its
and as a
any -
in the
and the
(A
quite small.
is between the net Treasury
revenues earned from the Fed7
from
if
held
and the Fed's own earnings
entire operation as regulator of monetary Policy
provider of
priced services.)
The reason the mandate of Fed Pricing was assumed to
helP offset the Potential
becomes
relatively
majority of
its
Prior to the MCA,
Treasury did not
loss of revenues to the Treasury
straishtforward.
The Fed
returns the
interest earnings each year to the Treasury.
the revenues the Fed funneled back to the
include the fees
(cost
recovery)
from
its
With the mandate of Fed Pricing and full
service operation.
cost
recovery,
source of
the Fed
in effect will
senerate an additional
income to contribute towards
operations.
Any savings
the service fees,
will
in operating
interest
will
be supporting a
Congressional
Pricing was,
That
income to cover
records
in
Part,
costs that
become an additional
revenue to the Treasury.
less
its cost of
lower
is,
its
source of
the Fed will
need to keep
operating costs because
cost of operation.
indicate that the
intended to offset
earnings to the Treasury.
result from
The
initiation
any
of
loss
in
Fed
it
-17-
Recent Trends Shapins the Provision for
Fed Pricing
There have also been various trends Which essentially
forced the
issue of Fed Pricing
Congressional
deliberations.
foresone
First,
interest
funds and Treasury Bills
period between
to 18.87%,
1971
and
rates rise and the cost of federal
For example, during the
increase.
1981,
and six month T-Bills
the prime rate rose from 5.72%
from 4.5% to 13.8%. 6
Second, member banks were Placed at
disadvantase With
of transaction
NOW'S,
This
POW'S,
recent financial
related
investment
reserve requirement are
opportunities because of the sterile
exacerbated when
of
into the forefront
a competitive
innovations
in
the form
interest bearins deposits such as
and telephone transfers from savings deposits.
development
fostered enormous
competitive pressure on
the bankins community for deposit funds.
Member banks,
squeezed from membership
being financially
less able to offer
burdens,
were
interest bearing accounts as an
inducement to customers.
Third,
the increased competition
industry and the
pressure to control
in
the bankins
operating costs made
-18-
the burden
of
reserve
requirements more onerous.
requirements are considered a significant
historic
Reserve
cause of the
earnings difference between member
and non-member
banks.
Fourth,
the cost of membership was
increased
enhanced quality and greater efficiency of
In
bank service Provision.
turn,
requiring
less Pre-sortins,
correspondent
some of the services
provided free by the Fed seemed of
Correspondents besan to offer
by the
check
less value.
collection services
less strinsent
cutoff
times for
check processsins,
and more
than did the Fed.
Respondent banks could therefore obtain
better service from
respondent
of their
their
immediate availability
correspondent banks.
remoteness
from a Federal
have increasingly
Reserve office.
relied
upon
improve the efficiency
in
its
check collection
throush the establishment of Resional
CRCPC's).
relative
However,
this
as wel I as members,
because
Member
correspondent
banks for the Provision of certain services.
non-members
Some
banks were Precluded from usins the.Fed
banks as well
Centers
of funds
The Fed did
service
Check Processins
service was avai lable to
and therefore7
costs associated with membership.
7
added to the
-19-
Finally, one of the more significant factors which
increasingly cal led attention to the costs and
inequities
associated with Fed membership was that any non-member
bank
had access to to the Fed services simply by operating
through
a member
correspondent.
bank
The correspondent bank
would access services free of charge from the Fed7
Ci.e. 7
check collection services, wire transfer services,
cash
A non-member
services).
could then
typically a respondent bank,
bank,
receive these services from their correspondent
either free of
charse or at a subsidized
larger correspondent
reserves and
respondent banks could take advantage of
reflected a hisher
it
of these factors
the mandate of
uniform.,
universal
Pricing received a very mixed
acceptance depended
reserves
in
the pre-
real
reserve
and postcosts
In
surprise that
requirements and
reaction;
The desree of
upon the relative burdens of holding
asainst the additional
Pr ic i ns.
is no
of
level
than would have been provided throush the Fed.
light of all
Fed
In this way,
banks could somewhat offset the cost of
cheaper services which at times
quality
rate.
MCA environment,
balanced
incurred because of Fed
-20-
Free Services and Efficiency Concerns
When the Federal
Reserve System was created
was charged with the responsibility of
elastic
currency,
commercial
to afford a means of
in
1914,
it
"furnishing an
rediscountins
papers, and establishins a more efficient
supervision of bankins".
In
functioning of the national
order to assure the efficient
Payments system the Federal
Reserve was authorized to Provide services free of charse or
at a subsidized
Provided were check
that
The very first services to be
rate.
col lection and discount services.
Since
time the number and volume of Fed services has steadily
increased.
Prior to the MCA the services Provided free of
to al I
member
banks and a few non-member
1) Operation of
Payments system,
charse
banks were:
including check
processins, and transportation,
2)
Automated clearins house services,
3)
Purchase7
sale,
securities,
safekeepins,
and clearing of federal
21-
-
4)
Wire transfers,
5)
Bank examinations for state member banks and holding
company
i nspect i ons,
6)
Pick up and delivery of coins and currency,
7)
Operation of the discount window7
1)
Operation of the Resional
9)
Provision of certain bank advisory services,
10)
Provision of a variety of business,
The availablity of
these services
maintainins membership
in
bank attrition
the Federal
were not foreseen
Althoush the Problems which were
With the
reserve requirements
mandate for Fed
Pricins,
grounds alone were
Reserve System.
in
1914 leading to
by Consress.
became causal lY
linked to the
arsuments focusins on efficiency
increasingly heard durins the Past
In 1974,
entitled
"Pr icins and the role of Fed
"The Federal
9
increasingly associated
decade.
transfer system."
and
is the primary advantase
The trends since the Fed was created
member
financial,
information on current economic events.
seneral
for
Check Processing Centers,
three Fed employees wrote an article
This article
in
an electronic funds
stated that:
Reserve must charse full
cost for all
-22-
services Provided
if
private orsanizations are to have
real options of developins
the Federal
increased
Pricins will
If
Reserve provided services free of charse,
it would undermine private
for
lower cost alternatives.
initiative which
is so vital
cost
innovation and efficiency... .Full
insure that the financial
community wil I
always have the option of developins alternative ways
of hand I ing t ransfe rs.
P rese rvat ion of Pub I ic
and
Private options should Provide insurance against the
almost
in
inevitable slussishness which tends to develop
larse service orsanizations."
Just how
inefficient the Fed
10
is as a service provider
because of the inherent characteristics of the Public sector
It
is debatable.
may be that the more
important variable
influencing efficiency
is the Pervasiveness of competition.
Nonetheless7
is
the Point
that offerins free services
results in the overuse of some services and
likely effort towards
inhibits the
lower cost Provision of services,
innovation, and more efficient ways of usins society's
scarce resources.
WiIIi amt
G.
Miller, then Secretary of the Treasury and
-23-
of the Board,
later Chairman
was actively involved
Paul
very arsument when he
used this
developins the terms of the MCA.
in
the efficiency of
Volker also supported the notion of
Fed Pricing.
This became crucial
in the deliberations with
the Treasury because of their concern with the potential
loss
in
reserve
Treasury
revenues resultins
requirements.1lMoreover, the banks themselves
Consider
besan
issue.
to raise the efficiency
for example the comments of the President of
the Philadephia First National
"In
from the universal
1976,
Bank:
Philadelphia National,
worked
the Johnstown7
its
to obtain new correspondent
competitive effort
business,
as Part of
out an arransement with
bankins
four banks in
PA, area to provide certain check
clearins and check transportation
services that were
then unavailable from the Federal
Reserve System and
which other private
competitively.
in
detail,
notified
of
institutions
After
had
it,
had been worked out
the agreement
the Philadephia Federal
Reserve Bank,
intervened and offered the
service to the four banks at no direct
Naturally,
chosen to offer
cost to them.
the four banks chose the Federal
offer over ours.
In
order
identical
Reserve's
to Prov ide the service,
the
Federal
Reserve had to
we could have met required to charse a
this
incur
costs that I am convinced
had the Federal
Reserve been
fair price for the service.
instance, the Federal
Reserve directly
In
undercut a
Private
initiative, Presumably to engender the sood
Will
four banks,
of
and
in
so doins Provided a de facto
subsidy
to
Federal
Reserve's profits on the
balance
required
those
institutions funded
to
includins ourselves."
Although
the Fed
did not
potentially
with
it
engase
the fact
"undermine such Private sector
alluded to the
local
reserve
by
district
in
such
12
typically
unscrupulous business Practices,
the
interest free
be maintained
members,
by
that
it could
initiatives"
realization that such Practices could become
more common as the Fed continued to experience a decline
both membership,
and demand
for some of
its
in
services.
Moreover, this experience made obvious the unfair
competitive advantase beins granted
sector
It
central
to the Fed as a Public
regulator of monetary Policy.
slowly became clear that the Fed's
bank could be detached from
its
role as the
role as a depository
-25-
institution.
That
is, the Fed's responsibilities as a
resu lator of monetary Po icy need not descr iminatel y impose
restictions and costs on depository
institutions throush the
reserve requirements so that these institutions may
benefit from the Provision of free Fed services.
same t i me,
it
in
turn
At the
was c lear that the Fed cou I d not adopt a
Policy of simultaneously
imposing costs of reserve
requirements and chargins for
create obvious interbank
its services.
inequity.
This would
Given the desire to
reduce the inefficiencies imposed by the Provision of
services at zero cost, and the need for stability
reserve base, a dual
in the
policy was required which would Provide
open access to Fed services and mandatory
reserve
requ i rements for al I depository inst itut ions.
This
line of thinkins was formalized
in a 1976 report
by the Ad Hoc Task Force on Access to Services, which stated
that the most effective way of granting access to al I
financial
institutions was to charse explicit fees for
services and
require all depository
reserves with the Fed.
institutions to hold
This was intended to solve the
membership Problem, improve the efficiency of the national
Payments system,
and assist
in Prevent ins what were
-26-
practices.
considered unfair pricins
Consress
Passed the
Five Years
which,
landmark MCA,
its
amons
later
other things,
services and compete
provided that the Fed must
Price
"to enhance the efficiency
and effectiveness of the national
financial service mechanism and better monitor assregates."
The Provisions
facilitate the
1)
the act Which Will
of
directly
implementation of these obJectives are:
of Resulation Q through an orderly
The abolition
Phase-out and ultimate elimination of alI
on deposit
2)
Mandatory
limitations
interest rates.
reserve requirements for all
depository
institutions.
3)
Universal
that
they
access to Fed services and the
be explicity
The Fed's Present task
mandate of Fed Pricins.
manipulated
requirement
priced.1 3
is the
We will
implementation of the
now consider how the Fed
its existing manasement and budgetins system
order to determine the explicit fees for priced services.
in
-27-
III.
The Federal
-
------------------------------------------------------------
Reserve System's Manasement and Budset System
The Plannins and Control
System (PACS):Structure/Purpose
The Purpose of a cost accounting system
is to measure,
in monetary terms, the quantity of resources utilized to
carry out a specific
is,
therefore,
budsetins,
In
of
a management tool
Cost accountins
which can be used
in
Performance evaluation, or price setting.
1977 the Fed adopted the Planning and Control
(PACS) method
system,
objective or Purpose.
of
cost accounting.
which means that both direct
PACS
is a
full
System
cost
costs and a fair share
indirect costs are allocated to specific activity
centers.
Direct
costs are those expenses which are
solely to accomplish a specific objective.
are those expenses which are shared
Indirect
incurred
costs
by more than one
activity-- such as support services and other overhead
items.
Any
allocation
These are commonly
referred to as Joint costs.
cost accountins system must approximate the Proper
of the
indirect
costs because of
the difficulty
-28-
in
between the share of
distinguishins
such as square-foot of floor space,
may be used,
Somet i mes space and d i rect
or d i rect costs.
sa Ies,
Sometimes more sophisticated studies are undertaken
courSe,
costs.
indirect
more Precise allocations of
costs associated with gaining better
indirect
the true al location of
Problem
is
costs,
to weish the expense of
sophisticated and
costs
or proxies maybe used.
or some other combination
together,
items spent
A rule-of-thumb method of
on particular activities.
allocation
overhead
to make
There are, of
information on
and the management
implementins a more
complex system against the benefits of
having better cost data.
The Fed's PACS system was adopted
inception of the MCA,
internal
and thus was tai
In seneral,
is
PACS
broad budseting data and cost control
identifying the full
Part,
this
is
PACS provides
whereas
lored
to a set of
data needs that were somewhat different than those
that exist today.
at
Prior to the
better at Providing
information than
costs of specific services.
a Problem of
levels of
it
In
aggresation--because
information on whole categories of services
for pri'cing
Purposes
it
is
necessary
to unbundle
is
-29-
these catesories
items.
into more discrete
PACS Cost Allocation and Allocation to Priced Services
PACS itself
has three essential
levels of
into seven Output System Service
costs
broad catesories of
include:
its
First, the Fed breaks out
disassregation of cost data.
lines, which are the
responsibility of the Fed.
Monetary and Fiscal
They
Policy, Services to the United
States Treasury and Government Asencies, Services to
Financial
Institutions and the Public, Supervision and
Regulation, Support Services, and Overhead Services.
Amons the responsibilities of
Line
the Fed, only one System
breaks down Financial
Services
PACS
Services.
is to be priced--namelY, Financial
into six service
lines,
which
are the Prosrams to carry out the Fed's responsibilities.
They
Commercial
include:
Check Processins,
Coin and
Currency, Electronic Payments Mechanism.
Each of these service
which are the specific
into activities
to
carry
out
lines are finally broken down
the
the Commercial
Particular
programs.
operations
For
required
example,
under
Check Processing Service Line there are four
-30-
activities,
returns,
check
and adjustments.
After
"Pr icins
including:
processins,
(See Figure
the MCA was Passed
Pol icy Task Force" 7
in
(PPTF)
to assist the Fed
other things,
Amons
in
the
reviewed the PACS and designed a series of Pricing
Worksheets
it
Pase 31).
1,
1980, the Fed appointed a
meeting the mandates of the Act.
PPTF
fine sort,
is
which are used to step-down
useful
Priced
under
in
determining
the PACS data so that
costs for services to be
full
the MCA.
In essence, the pricing worksheets add an additional
level
can
of disassresation within the activities so that they
be broken down
different
costs.
commercial
into smaller categories which
For example,
check processing
catesories that will
schematical ly
that the
the Pricing worksheet
creates six
3Z.
level
one below the
"activity".
It
This
That
services from the Fed does not
level
is
shown
is worth noting
of cost disassresation
"activity" 7 althoush the relevant
for
smaller service
be separately priced.
in Fisure 2 on Pase
lowest
reflect
for
is still
pricing
the
is Just
is, the bank buying the
Pay
have checks Processed, adJusted7
four separate fees to
returned, and fine sorted,
-
FIGURE
31-
1
Step-Down
of Fed Cost Data Under PACS
Output System
Services Line
Output System
Service Line
To Be Priced
Service Line
I
Activity
Leve I
-32-
FIGURE 2
Step-Down Cost Allocation To Priced Services
Output System
Financial
Service Line
Line
Service Line
Service
Commercial
Overhead
Check
D i rect
Process i ng
Support
djustmen
Activity
Processing
Level
and Fine Sort
-
and
Retur
Priced Services
Deposit Types
City
Country
Other
RCPC
Fed
onMachinabl
ackas
G
Sort
S
Mi xed
PSAF
Per
Item Fees
%
x%
X%
X%
xx
xx
xx
xx
XxXxx
-33-
but
rather one fee for everything.
The activities are
simply the various things that the Fed does to provide a
The Fed
siven type of service.
charses for City checks
rather than four separate charses for the different things
it does to process City checks.
level of disassresation which
This new
developed with the Pricing worksheets
data
for
Pricing.
A service which
identified and broken out unbundled
linle"
by the PACS.
provided
is
has been
provides the best cost
soins to be priced is
from the
"service
larser
The costs of the various
activities are allocated downwards to the new service
catesory.
service.
This
is
the full
The Fed then takes the full
by the Private Sector
is
costs.
This
is
to
it up
impute
the unit price or fee
charsed.
Evaluation of
Whether
a
cost and marks
Adjustment Factor 7 (PSAF),
private sector capital
which
cost of Providing a particular
Price that
the Pricins Worksheet
or not this
Procedure wi I I provide the Fed with
reflects the true economic cost of Providing
the service depends on the method used to allocate activity
-34-
costs to the Priced services,
Plus the appropriateness of
the PSAF mark-up.
initial
An
review of
the Procedures used by the Fed
costs amons services reveaIs that
at locatirns the activity
cases simple rule-of-thumb
some
used, whereas
methods
a location
in
have been
in other cases the Fed has used more detailed
studies to determine the cost allocation.
commercial
in
For example, in
check processins, four out of the six
sub-catesories have activity costs allocated on the basis of
volume,
whi le two
have costs al located on the
catesories
(Refer to Appendix
basis of time-motion studies.
A closer
Pricing Worksheet for further detail.)
check processins
the cost
costs raises a number of questions about
at times,
a charse may
not associated
example of this
is
or
deposit types.
adJustments.
Processins
reflect
the costs of an
A particular
with its processins.
the allocation of
returns and adJustments.
alI
look at
accounting Procedures used.
First,
activity
I on the
the activity
costs for
These costs were allocated across
not all
However,
Therefore,
all
services must bear
items
require returns
users of the Fed's check
the costs for
returns and
-
adJ ustments even thoush at I
35-
users do not
i mpose such costs
on the processins operation.
Second,
there are some
instances where the same fees
are charsed
for
differences
in the respective processing costs.
slaring
an
example
is
Countryand RCPC,
that
three deposit
were all
purposes.(See glossary
Third,
but there are significant
item,
types,
Mixed7
lumPed tosether for
for definition
The most
pricing
of deposit types.)
the process employed for the al location of
overhead adheres strictly to the assumption that each
deposit type
resources.
resource
types,
requires the same
But,
of overhead
Just as there are variations
related
in the
requirements for processins different deposit
there are also differences
that should be reflected
types.
level
service
to the check activity
services,
of overhead
initially assresates overhead at
level,
the step-down of costs
first
and then across to the Priced
adds to an already somewhat arbitrary process of
overhead allocation.
allocation
line
the amount
in the separate charses for deposit
Given that the PACS
the output
in
To the extent
scheme should
Possible,
recognize different
an overhead
resource
-36-
requirements
for Providing services.For example 7
both
non-machinable cash letters and mixed cash letters require
that more resources be devoted to their processins than the
other deposit types.
The Present method of assignins
overhead costs to Priced services ends up not allocating
enoush costs to these items and too many costs to other
deposit
types.
Appendix
1 Provides a detailed discussion of the
Pricing Worksheet and exactly how costs were allocated to
Priced services.
The different kinds of
ratios used to
allocate the costs of various activities and the overhead
al location methods are explained.
Much of the Problem
in
derivins efficient Prices through the Pricins Worksheet
related to the way that the PACS
for the Fed's manasement Purposes
environment.
its
is
initially catesorized costs
in
the "pre-MCA"
As the Fed's management objectives chansed,
accountins and budsetins system must be reoriented as
well-- away from a one-sided focus on cost minimization
towards matching revenues and costs.
Some of the initial
Worksheet
i tse If
cou Id
restructuring of the Pricins
i mprove some of the a I Iocat ion of
-
costs to Priced services.
37-
The Fed
of the deposit types as "activities"
could also define certain
or Shift
to a more
uniform standard cost approach.1 5 1n seneraI,
recommended that all
it
is
deposit types be priced separately
because there are sufficient differences
in their processins
requirements to justify different charses for each deposit
type.
Havins observed the Problems of usins
the PACS to
allocate actual Fed costs to Priced services, and the
resulting Pitfalls,
question--namely,
it
is now appropriate to turn to another
how accurately does the Fed allocate
imputed costs to priced services?
costs
imputed
by the Fed?
That
is,
how are capital
-38-
IV The Private Sector Adjustment Factor
(PSAF)
Why the PSAF?
Accordins to the Monetary Control
price
Act,
the Fed must
its services so as "to give due regard to competitive
factors."
16
should not
This has been construed to mean that the Fed
price
according to
services strictly
its
its
costs, but should make certain adJustments to account
its non-market costs of capital.
does not have to raise capital
equity markets, and since
That
for
is, since the Fed
in the Private debt and
it does not Pay taxes, the cost of
its invested capital
is Much
the private sector.
In order to address this concern, the
Fed has
its competition
in
proposed a Private Sector AdJustment Factor, known
as the PSAF 7
that would
ent i ty.
lower than
which
imputes the cost of
have been
incurred,
if
financing and taxes
it were a private sector
-39-
Derivation of the PSAF
Once the decision was made to
financing for
for
services,
its
remained.
capital
averase of
twelve
the Fed
in
impute the costs of
determining
the task of
a
fair
Picking a Proper
the costs of debt and equity of a sample of
of services,
including some of
must price under the new
survey,
cost of
The Fed decided to use the weighted
large bank service corporations,
variety
Price to charse
regulatory
which Provide a
those that the Fed
laws.
Based on a
1979
the Fed estimated that the cost of short term debt
was 10.44%7
sross of
Next,
long term debt
income taxes,
was 22.7%.17
the Fed estimated
its total
be allocated to the priced services.
accounts were divided
assets which should
The Fed's asset
into short-lived and
catesories which were all
valued at
lons-lived asset
historic cost.
from the asset base were the value of all
Fed to carry out
return,
cost was 8.66% and equity
Excluded
assets used by the
its function as the central
supervisory and resulatory responsibilities7
bank,
and
its
its role as
-40-
a fiscal
agent of the Treasury.
The asset accounts chosen to represent assets used
in
the Production of priced services were the following:
SHORT-LIVED
Difference and Suspense, Net process of collection7
Adjustments, Net -
All
cash
itemS
including the
in the
float.
What in 1981 were catesorized as
Difference and Suspense accounts.
Accrued
service revenue -
A new post-MCA account
representins an accounts receivable for all
services.The account was not
included
in
the
Priced
1981
PSAF calculation.
Materials and Supplies priced services.
1981
Operating
This account was
Bank Premisesnet
Furniture and
real
left out of the
the PSAF calculations due to error.
LONG-LIVED ASSETS
Other
inventory for all
equipmentnet
estate
-41-
The next step was to calculate the share of
the total
asset base Which should be allocated to the priced services.
The Fed
accomplished this by allocating
its assets to
services on the basis of the ProJected operatins expenses.
That
is,
the ratio of the operating expenses for priced
services to the Fed's total
be a
is
operating expenses
fair Proxy for the Percent of the Fed's total
base devoted to usetfor the Priced services.
method the Fed estimated that 43% of
assumed to
asset
Using this
its total
asset
accounts would be allocated to Priced services.
The Fed's total
Of
$137.5 mi II ion are short-I ived and $522 mi I I ion were
this,
long-lived assets.
debt.to equity
30:70.
long-lived assets would be
Thus, the short-lived assets allocated to Priced
x.30 = 67;
x .70 =
Next, the Fed assumed that the Proper
ratio for the
services are $137.5
x.43
asset accounts are $660 mil lion.
158.18
x .43 = 59;
and the
imputed
the
imputed equity
lons term debt
is
is
$522
$522 x .43
-42-
Based on these Parameters the Fed estimated the total
costs of
capital
Table I:
for the priced services as follows:
Weighted Cost of
Imputed Capital
ASSET
Annual
capital
Short-Lived Assets
Imputed
cost of
short term debt
Annual
capital
as a %
$59. E
10.44%
67.5
8.66
cost of
$6.2
Lonser-Lived Assets
Imputed
lons-term debt
158.0
Imputed equity
5.8
35.9
22.7
285.0
47.9
Weighted Cost of Imputed Capital=47.9/284=16.8%
The PSAF, however,
is not the annual
allocated to the priced services
(16.8%)7
number which estimates the financine
operating costs.
cost of capital
That
is,
cost of
but
rather a
costs as a mark-up over
the figure derived for
($47.9) is divided by the annual
costs--rather than the asset base.
capital
the annual
operating
Based on cost estimates
from the Fed's accounting Division, operating
services are pesed at $310.7.
priced
PSAF of
15.4%,
(i.e.,
costs for the
This results
in a
310.7).
$47.9/
Evaluating the PSAF
"Pre-MCA" the Fed's role was unique amons financial
It provided services free of
service operations.
charge.
It did not have any need to calculate an asset base measured
bY the value of priced services, to determine an appropriate
rate of
return on its capital
to value assets at historic
assets, or to decide whether
or current
cost for
The use of the PSAF brings all
pricing.
these
of
Purposes
issues to the
forefront.
There are Probl ems associated with defining the
asset base;
and a
Plethora of approaches to setting a
considered adequate and
return
reasonable with respect to the asset
base.
Now that the Fed has embarked on a new strategy for
pricing
its services,
the question
approach?
need
remains,
capital structure?
capital
for
imputed capital
Just how suitable
First, has the Fed
Second, is
costs,
is the Fed's
To evaluate this question, three crucial
examination.
return on
its
including
imputed
issues
the correct
it Proper to use the pre-tax
equity of the twelve bank sample as the cost of
the priced services?
And thirdly,
should the
-44-
PSAF be a mark-up on operating
invested
costs rather than
capital?
Structure
The Capital
hypothetical
As noted above, the Fed has constructed a
From Table
debt equity structure for the priced services.
17
it can be seen that the capital
equity,
structure-consists of 55%
short term debt.
24% long term debt, and 21%
it did not simply adopt the actual
but
structure,
its capital
Fed used the 12 bank sample to derive
The
structure of
capital
the banks.
Banks finance assets through demand and savings
deposits as well
as debt and equity.
deposits are taken
When the PSAF was first
a much
larser share of debt
due to the small
capital
the Price of equity
in
This was a
is only 2%
in the
to 5%. 19
its hypothetical
asset base7
in the banks' actual
controversial
issue because
is based on pre-tax returns to
shareholders,
and typically
cost of debt.
A small
the PSAF mark-up.
equity and
proposed, the Fed wanted to use
amount of equity
structure.
debt,
into account, the share of equity
asset base of the twelve bank sample
.
When
runs from two to three times the
share of equity thus tended to
lower
-45-
A
better approach for the Fed would
debt-equity
is
which
ratio
be to estimate the
for the Portion of a bank's
related to the sale of correspondence services.
Koot and Walker susest
that this
60% debt and 40% equity." 2 0To
"would
Probably show about
illustrate how a difference of
this magnitude would chanse the PSAF mark-up,
costs are reconstructed using
capital
balance sheet
the Fed's
the same debt and
eqity Prices, but with the equity share reduced from 55% to
40%.
TABLE 2:
Cost of
Capital
Asset
With 60:40 Debt:Equity
Annual
cost of
capital
Short
Annual
as a %
Ratio
Cost of
capital
term debt
(Table
1,
line
1)
59.5
10.44
$6.2
8.66
$9.7
Lons term debt
(225.5 -
(285).4)
111.5
Equity
(285 X .4)
114.0
22.7
$25.9
285.0
Weighted cost of capital
PSAF = 41.8 /
Thus,
it
41.8
= 41.8 /
285 = 14.67%
310.7 = 13.45%
can be seen that a reduction
in
the
imputed
-46-
equity
share from 55% to 40% reduces the PSAF from 15.5%-to
holding
13.45%,
interest
The bankins community
Proposal,
however,
different
approach.
structure.
All
return to equity constant.
rates and
sucessfully
lobbied asainst this
First,
it
assumed a matched capital
of the Fed's short term assets were assumed
to be financed by short
term debt and al I
the
Iong term
debts were assumed to be financed by equity and
debt.
a
and ultimately the Fed adopted
long term
The rationale for this chanse was that the Fed's
imputed capital
structure should be related to the actual
the priced services.
assets devoted to the Provision of
As noted,
short term assets were assumed to be financed
by short term debt.
financed by
The
long term assets, however, were
both equity and debt,
how much would be hypothetical ly
the end7
the Fed simply took the
the entire deposit base?
term debt to equity.
Thus,
and
the Fed
has to decide
financed by each item.
12 bank sample,
In
eliminated
and then used the ratio of
long
This was as noted, 30:70. 21
the Fed started with the
12 bank sample to
22
determine the proper asset base, then abandoned the sample
-47-
to adopt the
returned
of
"matching" capital
final ly,
to the 12 bank sample to determine the Proper
long term debt to equity.
The result
is neither typical of the actual
nor truly
structure, and
capital
ratio
is a system which
structure of banks,
"matched" to the services Provided.
The Return to Capital
The question of
the Proper
return to capital
in the Provision of the priced services
has simply taken
is central.
for the Priced services.
twelve bank sample has an unusual
highly
leverased with deposits.
debt or equity under one capital
is the cost of
But, as noted earlier, the
structure which
capital
is
In addition, a price for
not
structure will
necessarily be appropriate for another one.
particularly
The Fed
returns for the
the averase debt and equity
twelve bank sample and assumed that this
capital
invested
This is
relevant here where the banks in the sample are
typically financed by
less than 5Y equity.
Moreover, the banks in the sample offer a broad ranse
of services which are not being offered by the Fed;
individual and business demand and savings deposits 7 CD'S7
commercial and consumer
cards,
loans, housins mortgages, credit
money orders and the I ike.
The data from the sample
are averased across different services.
to Provide some services than others,
will
If
it
is
more risky
the return to capital
also vary.
One method of evaluating the Proper
rate of
return
is
-49-
(CAPM).
CAPM
the Capital
Asset Pricing Model
theoretical
approach to measuring the expected
is a
return on a
given asset based on the relationship between the variance
investment and the variance of
Particular
of returns on a
Simply Put, CAPM assumes
returns to the market as a whole.
that
investors can
stocks, the fluctuations of a
holding several
however,
risk
Risk,
is not completely diversifiable, as the entire
and the Portfol io misht thus be
market has ups and downs,
subJect
particular
bY the variance of other stocks.
offset
is
Stock
Systematic
systematic and non-systematic.
whole, while non-systematic
is the unique risk
risk
particular business enterprise.
associated with a
are assumed to be rewarded for bearing systematic
not unsystematic
reward
risk which can
or risk
Premium for a siven
correlated with the market as a whole.
risk,
investment
but
The
is
a
is
The greater the
investment to move with the market, the
greater the non-diversifiable risk.
the vari-ance -
Investors
be diversified away.
function of the desree to which the stock variance
tendency for the
as a
the risk associated with the market
is
risk
CAPM divides
the business cycle.
in
to fluctuations
into two categories.
actual
By
reduce risk through diversification.
the
less risky
is the
The more
independent
investment.
-50-
More specifically, CAPM is used to derive a market cost
of capital
Cr),
risk
(rm),
which
Simply
7earned
Premium
by Pu.rchasing a U.S.
and beta,
rf),
(rt-
is a function of the risk
free
Treasury Bi
rate
1l
the
the degree of fluctuation
of a particular portfolio with resPect to the market as a
whole.
The premium
obtains by
represents the extra
return the
investor
holding some portion of the market portfolio, or
in other words,
by bearing systematic
beta of the Portfolio,
the lower Will
The
risk.
lower the
be the Premium earned
rate.
above the risk-free
Investments Which tend to be sensitive to the business
cycle contain a greater degree of systematic risk, and hence
require a greater risk
industrY,
include the computer
Primary
metal s7
as a whole.
all
Premium.
Examples of such
real
estate,
of which are dependent
Industries where
are not
related at all
theorY,
require a
risk
to the
or
upon the economy
of the economy,
Prem iumn of zero,
about the same as the T-Bi I t
automobi les,
risks are entirely
rest
industries
random,
would
and a rate of
and
in
return
rate.
A number of factors wi I I determine how much systematic
-51
-
if they were Provided
risk the Fed's services would face
For example, Just how volatile
the Private sector.
demand
chanses
for
check Processing services,
in economic
What are the characteristics of
used to process checks,
is the
and how much are
in demand correlated with changes
activity?
in
the technology
is the relatonship between
and what
the Fed's fixed and variable costs?
Perhaps more to the Point,
by the Fed
contain more or
average systematic
economy
or
in
seneral?
do the services to be priced
less systematic
risk than the
risk of the twelve bank sample or the
2
For example,
is check processing more
less sensitive to the business cycle than credit
possible to determine the
Processins
of
level
of
risk
inherent
checks with respect to the seneral
would be feasible to
impute a value for
economic activity.
check Processins
is a
low
If
it can
it
in
is
the
economY7
it
beta which would
reflect the fluctuation of check volume over
general
If
loans?
services such as consumer and business
related
time with
be speculated that
risk activitY,
then a
low estimate
of beta would be appropriate.
To set a first approximation for this question, we
-52-
compare the volume of check processing,
services offered
bank
loans, over
inspection of Table 3 sussests that the
initial
the Fed
a severe dip during the
the GNP and
check volume and
was constructed for both check
in
are shown
the GNP was the
volume and
independent
the chanses
in
regression model
variable.
volume,
The
where
results
in Table 4.
is
a very poor fit,
and an R-squared
bY
Less than 20% of the
in the volume of Check processins can be
On the other hand 7
changes in the GNP.
volume of commercial
Check
With a GNP coefficient of .6
value of .192.
variance of changes
explained
To
loan
The results of the regression are striking.
Processins
bank
1974-75.
recession of
volume, a
loan
at a steady
commecial
look at the relationship between
set a better
chanse
has grown
both the GNP and the volume of
while
loans took
loans are
constant dollars.
in
volume of checks Processed by
rate,
bank
Both the GNP and the commercial
in the GNP.
An
in check processing and
bank loans are compared to the Percentage chanses
commercial
expressed
In
1973 to 1979.
Year period of
the Percentage changes
table 3,
the major
to the volume of commercial
bY the Fed,
the seven
one of
bank
loans
is
shown
the
to be much more
-53-
TABLE 3
chanses
Percent
bank
commercial
. real
check Processins,
loans, and GNP 1973-1979.
chanse
GNP
in the volume of
- real
change check
volume
chanse
commercial
12.9
1973
5.8
17.6
1974
-. 6
8.0
1
5.6
-5.5
1975
-1.
loans
0.0
1976
5.4
7.9
5.0
1977
5.5
8.1
10.3
1978
4.8
6.0
11.2
1979
3.2
7.1
14.09
Sources:
Economic Report of the President,
January,
1981.
U.S Government Printins Office, Washinston. D.C.
Statistical
Commerce?
Federal
Abstract of the U.S.,
Bureau of the Census.
Reserve Bank of Atlanta,
of the Check Collection System"?
1980.
U.S.
Department of
P.539
"A Quantitative Description
Volume I,
p.
97-99.
-54-
TABLE 4
Changes
change
processing and
loans as a function of
bank
commercial
1) %
in the volume of check
changes
in
the GNP:
in volume of Fed check Processins
(% change
= 6.6 + .6
in
GNP)
R-Squared = .192
2)
% change
=
.224
in
volume of commercial
+ 2.04
(
change
in
bank
loans
GNP)
R-Squared = .67
Commercial
bank
loans and GNP are in
Data from the Years 1973-79.
constant dollars
When the Years
1972 were added to the check processins models
coefficient
fell
1970 to
the GNP
to .4 and variance value dropped
to .1.
-55-
dependent
upon chanses
the commercial
loan equation
is
The GNP coefficient for
2.047
and the r-squared
About two thirds of the variance in the
is .67.
value
in the GNP.
volume of bank
is related to chanses
loans
Although this
is
final
hardly the
word
the relative systematic risk for the two
in the GNP.
in
evaluating
lines of servi ces,
one can speculate that the check processing services are
indeed
less risky than commercial
assumptions of the CAPM model.
volatility
loans, Siven the
It also appears that
is associated with check processing than the
There
is
little correlation
economy
in general.
chanses
in check volume over time and chanses
in
seneral.
values for
less
This all
a
"fair"
implies that
the
likely
rate of return on Check
between
in the economy
ranse of
services,
that
the Fed might require, should approach the risk-free rate.
It may be that the Fed should monitor the risk-free rate and
adJust the
PSAF accordinsly--that
is,
With respect to the
check processing service line.
In seneral,
it would be a rather simple task for the
Fed to undertake a more thoroush review of the various
services offered by the Fed,
systematic
to assess the desree of
risk they carry, and to compare that to the
credit related services offered by commercial
banks.
If
-56-
further analysis supports the
the Priced
hypothesis that
less systematic risk than the average
services embody
services offered by the commercial
bank sample, the rate of
return should be adJusted downward.
Mark-up Pricing
One of the more
operating costs,
capital
rather
the Fed's
is the decision to make the PSAF a mark-up of
pricing policy
constructed a
interesting features of
rather than invested capital.
complicated system for
determining
The Fed has
its
structure, and the price of debt and equity.
than
imputed
But
use this data to explicitly allocate capital
costs to the various services, the Fed simply takes the
total
capital
by the total
the PSAF,
costs for all
services and divides this number
operating costs for all
services.
The
result,
is a number used to gross up averase operating
costs so that the margin of
cover the Fed's
Price over operating
imputed capital
costs will
costs.
Operating costs are likely to be easier to allocate
among services than capital,
and this alone Probably
-57-
But there
explains the PSAF system.
to
recommend
method.
the
is
It
is Precious little else
highly
that matter, any two,
services, or for
of operating to capital costs.
unlikely
that
alI
the
have the same ratio
This means that some
services are being priced too high, While others are Priced
too
Moreover, as the new prices induce changes for
low.
demand for services, the PSAF rate will
have to be revised.
If the services which are priced too high are effectively
priced out of
the market,
the total
capital
costs will
have
to be allocated among a narrower base of services, and to
the degree
that
disparities
in
the
ratio of
operating
to
capital expenses persist, Yet another sroup of services may
be priced out of
the market.
and
We have now considered the allocation of actual
imputed
costs to priced services.
aspect of the analysis.
Fed did al locate
should
it
Price
its
Next we turn to another
Specifically,
costs both actual
its services?
principles guide the Fed
in
That
is,
its overall
we ask, even
and
Just how
what economic
pricing scheme, and
would a change -in Pricing structure result
efficiency gains for society?
imputed,
if the
in welfare
-58-
V The Economics Of
Public Pricing
Cost Pricing and
Averase
Interteiporal
AdJustment
So far we have examined the historical
up to the MCAR
leading
in
its
the chanses the Fed has
implemented
cost accountins system to accomodate the new data
needs created by
Private sector
the Act7
capital
and the method used to
costs.
Consress wants the Fed to Phase
that will
impute
We have seen that the
in a fee for service system
promote efficiency and to encourase Private sector
provision of some or all
Fed.
developments
of the services now Provided by the
In this section we evaluate the Fed's use of a total
averase cost pricing strategy to achieve these objectives.
The easiest way to understand the rationale for averase
cost
little
Pricing by the Federal
Reserve,
is to observe that
or no consideration was siven to any alternatives.
The record sussests that the Fed was Primarily concerned
with the fundamental
question of whether or not to charse
any fees at al l, and once a decision was made on that
front,
-59-
the
averase total
fact that fees should equal
Indeed, much of the
taken as Siven.
initial
costs was
debate over the
fee setting mechanism concerned the Proper definition
total
of
costs.
For example, the PSAF discussed earlier, was created to
impute a
cost that was
ignored the special
system which
in allocative
could underprice
its competition
to Price
cost
need
not
advantases of
unfairly.
costs.
cover total
in such a way that
That
costs
is,
the Fed
it
The Fed wanted
its
Prices
in the short-run so long as the
longer and unspecified time frame.
banks
would cover
Proposed that
Pricins strategy was designed to cover total
correspondent
the Fed
A number of
issues were also discussed.
its services
Ions-run total
tax
inefficiencies, as the Fed
tended to result
other total
A
incurred by the private sector.
have opposed this.
The
costs over some
larse
Private
sector
They argued that
such an open ended restriction would allow the Fed to engase
in Predatory
the short
run
pricins practices as prices would
be dropped
in
in order to eliminate competition, and then
raised.
There were however,
at least two counter arsuments for
-60-
allowins
the Fed
prices.
First,
introduced
decline.
intertemporal
flexibility
in
setting
it was pointed out that once the Fed
fees, the demand for
its Present services would
For example, once fees were
introduced, the volume
of checks Processed by the Fed actually declined by
This sharp decline in demand
would have required
check processins
This
fees
and even more
the Fed to
increase
in order to Pay for the
in turn would have
demand,
left the Fed with excess
A policy of strict total
capacity for check processing.
cost pricins
led to Yet another
idle capacity.
marsinal
newly
idled capacity,
variable costs remained
policy of Pricing to meet the
allow the Fed
in
Thus, the Fed was
of Price
while both averase and
Only a
below the Price.
Ions-run total
cost would
to undertake an orderly adJustment
environment created by
its
idle capacity.
reduction
faced with the Prospect of a vicious spiral
increases and
about
to the new
its own Pricins policies.
The second counter arsument
concerned
new services and
new technolosies which enjoyed economies of scale over a
relevant
set
ranse of output.
prices
below their
The Fed needed the flexibility to
initial
total
costs,
so that
enough
-
61.-
be built up to allow the Fed to
volume could
realize those
costs, and thus to establish the new service.
lower unit
The debate over the PSAF and the time-frame for
was
recovery
important,
Place.
but bessed the question of whether
The Consress was
role as a supplier of
interested
interested
in
as
and
introducing more
banks, the Policy objective can be
increased efficiency.
the fees give a signal
costs are
phasing out the Fed's
Unless one assumes the Congress
First, overuse of Fed services
is,
the first
increasins the income of the shareholders
of private commercial
interpreted
in
free services,
Private sector competition.
was
in
cost pricing was ever Justified
or not total
cost
is discourased.
That
to users of the system that some
incurred, thus forcing users to economize on their
use of the services.
Secondly?
the fees will
create an
environment where Private sector firms can
compete with the
Fed.
Provide the
To the desree that private firms can
services at a
lower cost, society will
expansion of the
Averase total
Private sector
cost
(ATC)
benefit by the
role.
Pricins
can thus
be shown as
-62-
an
improvement over no prices.
A number of other pricing
options exist, however, softie of which are clearly superior
The most obvious
to ATC pricing on efficiency grounds.
marginal
alternative is strict
pricing.
cost (MC)
Since the
most efficient allocation of resources occurs when output
is
expanded to the point where the cost of Producing the last
unit
to its price, it
is Just equal
is widely recosnized by
economists that a first best pricing strategy sets price
equal
to marginal
When the
cost.
long
run cost curve
exhibiting constant returns to scale, the
cost
little
curve
is
equal
to the
Iong-run
rule
cost of production is
either
dec:reasins,
there will
lons-run marginal
ATC curve,
difference which pricing
marginal
is flat,
for a service
is
used.
and
it
makes
But where the
increasins or
be a diversence between the ATC and
the MC curve.
Where the supply curve is s loping upward,
and
experiencins diseconomies of sca le, the ATC Pr ice will
lower
than the MC Price.
If the supply curve
is
be
downward
sloping over the relevant ranse, and enjoyins economies of
scale, the MC price wi I I be less than the ATC Price.
Thus,
-63-
an ATC pricing
high or too
An
rule will
lead to Prices Which are either too
low, as Judged by efficiency criteria.
illustration of this Point
is offered
by usins a
translos Production function to derive supply curves for
three services offered by the
Automatic Clearing House
Processins
fed;
(AHC),
Check Processins,
and Wire Transfers.
Check
is seen to have diseconomies of scale, and an ATC
Pricing scheme would tend to underprice the service.
The
ACH has economies of scale, and an ATC scheme Would
overprice the service.
a constant
Finally,
wire transfers are roushly
cost service, and here ATC Would
be fine. 2 5
-64-
Averase Cost
Cost Pricing
Pricing Versus Marsinal
years there has
In recent
marginal
the applications of
been a
cost
pricing to the Public
this
sector, and the circumstances when modifications of
simple rule are
in
order.
Here
is
it
necessary
to raise Prices
The most
to
a
find
subsidy for
in excess of marginal
lump sum taxes on persons
losses
it
is
the
is
costs.
service,
the
costs.
unrealistical ly assumes that subsidies can
suffer some welfare
Problem
important
cost prices do not cover total
case where marginal
in
interest
renewed
or
Unless one
be financed by
inevitable that society will
regardless of the approach taken.
The efficiency question then
is to minimize the welfare
costs.
When the subsidy can come from any source,
tax revenues,
including
a number of financing strategies can be
Proposed, most of which also raise equity questions, as
money
is
taken from others to subsidize the users of bank
services.The common and relevant response is
constraint upon the service provider,
revenues must equal
approach would,
of
total
costs.
course,
meet
to impose a
such that total
The averase cost pricing
this
test.
-65-
There are also other ways of meetins the revenue
whi le setting prices
constraint,
losses.
in ways to minimize welfare
One such approach, Ramsey Pricing,
Pr i ces di verse from
mars ina I costs
the elasticity of demand
Ramsey Pricins or
in
requires that
Proport
ion to
Pricins,
not only
inverse
for the service.26
Inverse Elasticity
provides a systematic framework for settins Fed prices that
minimizes welfare
insights
losses, but
it also provides a number of
into how different Pricing stratesies will
affect
the total
revenue and service and the absolute Prices
charged.
For example, where the Fed
provides two services
which share Joint overhead fixed costs,
circumstances
it could
scrapping the Present
lower Prices for
Pricing
system,
overhead costs among the two services
to the demand elasticities.
This
service which has a hiShly elastic
greater total
price was
in some
both services
and al locate those
in
inverse Proportion
is siMPlY
because a
provide
demand misht
contribution to the overhead costs
lower
than would be the case if
allocated on the basis of sales as
is
An example of this principle can
by
if
its
the overhead
Presently done.
be found
in the
was
-66-
current
Pricing
practices of the commercial
"even
According to one source,
correspondent
own and
clear that these effects
of demand are
asgressive,
larse,
center
money
of
implicitly
correspondent
determ inins a marketing strategy for correspondent
Prices are set
is inelastic,
Where demand
services."
hisher.
it
conversations with
casual
cost-price elasticities
considered at
banks in
bankers make
banks.
is highly elastic, banks are acutely
Where demand
aware of the Penalty of raisins Prices too hish.
in a world where "it
is doubtful
Thus, even
(explicity formulas) are
used to determine ... Prices" managers intuitively sense the
advantages of demand sensitive Pricing.
Ramsey
Pricing
is an
important alternative to both the
Fed's current average cost Pricins
cost Pricing.
marsinal
Fed would
overall
and strict
Policy,
Under the Ramsey pricing option,
begin with marginal
costs,
and then allocate any
revenue shortfall amons services
able to meet the mandate for total
in
inverse
The Fed would still
proportion to demand elasticities.
cost
pricing each service at no less than
the
recovery,
its marsinal
be
whi le
cost, and
thus discourasing excess use of service lines which have
-67-
diseconom ies of
resuIted
in
cost
if
prices, wouId
any,
which
be at Iocated
a such a way as to minimize welfare
That such a Pricing stratesy was not even
considered
durins the recent rulemaking
on ly beg inn i ng ou r
efficient
Revenue shortfal Is,
from the marsinaI
amons services
losses.
scale.
Jou rney toward a more
pricing strategy for the Fed.
sussests
rat iona I
that we are
and
-68VI Conclusion
We have observed the
Congressional
mandate that the Federal
explicit fees for
identified.
implementation of the
its services.
Reserve System set
Three key aspects were
The first was that the Fed relied on data from
the Planning and Control
System
(PACS) to allocate
costs of service operations to priced services.
PACS
represents a manasement and
for the Fed's manasement
of the MCA,
it
was not
priced services.
It
re-examine the way
is
More
unbundle
objectives Prior
to the
inception
readily equipped to Properly cost out
recommended therefore,
it categorizes costs.
importantly,
its, costs
Because the
budgeting system designed
sense that the Fed define some of the Priced
activities.
its own
that the Fed
It would make
services'as
the Fed must begin to
in order to Provide
information necessary
to identify the capital to operating ratios for discrete
services.
This would mean that the Fed adopt a standard
cost approach to
oriented
its accounting system, which could be
towards the objective of breaking out fixed and
variable costs across service lines.
costs
in
this
The need to unbundle
way becomes obvious when a system must
-69simultaneously apply a fair
services being
pricing scheme;
incur
if
return to each of the
Priced.
This brings
measuring
rate of
us to the second element of the Fed's
the mark-up of
its
service fees by a
the costs of taxes and financing that
it
were a
Private sector
firm.
it
factor
would
Althoush this
mark-up, called the Private sector adjustment factor, makes
sense conceptually, the entire approach to deriving
fundamental ly wrong.
therefore
This resulted in an
it was
inaccurate and
inefficient distribution of the costs of providins
Particular services.
It
was determined that the PSAF was an
incorrect Proxy for the Fed's cost of capital.
The capital
neither the Fed's
structure from which the PSAF derives
capital
structure,
or the capital
structure of a sample of banks assumed to
service mix of the Fed's operation.
Fed's effort to create a capital
in
represent the
Rather, through the
structure
its attempt to match sources and
is
uses of
it
became mired
funds.
The cost
of funds the Fed used was based on an assumption about the
debt to equity ratio of the twelve bank sample.
Fed applied this cost to
its own operating
Then the
rather than
-70-
capital
costs.
The rate of
return that the Fed came up with
was then applied equally to all
differentials
Asset
lines resardless of
in the capital-to-operatins-cost
these services.
the Fed
service
As an alternative
it
ratios of
recommended
is
that
consider some of the applications of the Capital
Pricing Model
to determine a fair
its invested capital.
rate of
The CAPM approach would
Fed to distinguish between the
levels of
return on
Permit the
risk and
return
unique to the provision of the discrete services,
rather
than continuins
its
current Practice of overcharsins for
some services and undercharsins for for others different
levels of risk
between services.
Finally, we reviewed the uncritical
Fed of an averase cost Pricins scheme.
well
accepted notion of marsinal
which may
acceptance by the
We considered the
cost Pricins,
considered a departure from marginal
Ramsey pricins,
ignoring
cost
and then
pricins called
be an even better second best
If
the Fed adhered
to Ramsey
solution
for the Fed to try.
Pricins,
it could distribute costs that would diverse from
the marsinal
costs of services
in
respective elasticities of demand.
Fed, and
banks
in seneral
inverse Proportion to the
The services that the
offer, have varying
levels of
-71-
demand
With the
elasticities.
costs equal
that total
by Congress,
revenue constraint,
revenue,
total
imPosed
the most
way to allocate costs, Justify cross-subsidies,
efficient
and minimize welfare
demand
is
be to vary Prices the most
may
cost where service demand
from marsinal
vary Prices
losses,
the
from marsinal
least
more elastic
is
less elastic and
cost where service
.
We have come down hard on the Fed's ways of
implementing
erred,
its
Pricing Policy.
But althoush the Fed has
two considerations deserve mention.
First, the Fed
was responding to a Congressional mandate that not only
required
full
cost recovery,
revenues and expenses,
and asked
that the Fed match
but also imposed an extremely
time-frame within which the Fed had to meet these
strinsent
requirements.
This did not allow the Fed
adJustments
certain
in
its
the time to make
operations that may have earl ier
reconciled some of the pitfalls we have uncovered.
Second, the MCA has fostered
the way
that the Fed approaches
change and
innovation
in
its service operations, both
internal I y and w i th respect to the ent i re bank i ns commun ity.
The Fed
is asking more questions about efficient ways to
-72Price services, ways to unbundle
very
role
Payments service system and better serve the
interest.
community
and about the
costs1
should Play so as to enhance the efficiency of
it
the national
Public
its
Moreover, the MCA has led the bankins
in seneral
to confront these issues more
aggressively than they have in the Past.
So, what on the
one hand can be viewed Justifiably as an outcome somewhat
lacking
in
efficiency, can on the other hand be considered
as a maJor step forward.
Change
is
an
including making and undoing mistakes.
been set for an
incremental
The stase has surely
improved Payments mechanism.
We eagerly
await the development of the next round of Pricin
debates.
process,
reform
-73-
Glossary
Avai labi I ity:
The amount of time it takes for the Fed to credit the
account of the depository institution which is col lecting
sent to the Fed for processins.
money on the checks it
Automated Clearing House (ACH):
The national electronic Payment services includins direct
deposits and pre-authorized transfers amons customers'
regions of the United States.
demand deposit accounts to all
There are 36 AHC facilities.
AdJustment Activity:
This is one of the cost catesories for check Processins
which is included in the Fed's Planning and Control System
AdJustments are required any time there is an error
(PACS).
of accounts during the check Collection
in the creditins
There are controlled adjustments which result from
process.
by the Fed and there are uncontrol led
misroutins or error
adjustments which result from Processing errors made by
institutions.
other financial
Adjustments, Net:
This is a balance sheet account of the Federal Reserve
System and was included as one of the asset accounts
comprisins the asset base used in the derivation of the
Private Sector Adjustment Factor.
Bank of First Deposit:
This is the bank which has accepted deposits from its
customers either drawn on itself (on-us) or on other banks.
All checks drawn on other banks (on other) are channeled
system, eventually, to the
throush the check collection
Payor bank.
Cash Letter:
A bundle of checks wrapped in a letter stating the face
value of all the items enclosed. Cash letters are typically
differentiated
on
local
referred
by
the types of
checks
inside
(checks drawn
banks only).
These cash
letters
to as deposit
types.
is the deposit
It
are common ly
types
that
are subject to fees under the MCA mandate of Fed Pricing.
Collecting Institution:
Also referred to as the deposi ting institution, this bank is
seekins Payment of the checks it has on deposit.
This bank
may also be the bank of first
deposit, acting as the entry
Point for checks into the coll ection system.
Commercial Bank:
This term wil I be used to refer to a state or federal ly
chartered bank and would include a bank of first deposit 7
depositing institution, Payor bank, Payee bank, and
correspondent bank.
Correspondent:
This term refers to a Particular functional relationship
between two banks - one which provided the check services to
The correspondent is typically
the other (respondent) bank.
The trend towards
a larger bank within a metropolitan area.
regional correspondents means that financial institutions
are mersins in order to Provide a wider ranse of
services to a larger geographic area.
Credit:
This term wil l refer to the Fed's crediting of an account.
The account is increased by the amount of the borrowed
funds.
Debit:
This term wilI
refer to the Fed's debiting an account. The
account is decreased by the appropriate amount.
Depositing Institution:
The bank which brings its
context
of
this
Paper,
refer to the bank which
services from the Fed.
a
business to the Fed.
depositing
institution
is Purchasing the
In
the
will always
ion
check co Illect
Deposit Types:
Also referred to as cash letters.
These are the categories
of the services which are subJect to fees under the MCA
mandate of Fed pricing.
The specific
deposit types are
City, Country, Mixed, Non-Machinable, Package Sort, Group
Sort.
Deferred AvailablitY:
When availability is not "immediate"(same-day) it is
referred to as "deferred".
Usual ly this means a delay of
-75-
1.5 days.
Deferred Credit:
This is a balance sheet account which represents the face
value of the checks that are in process of collection and
have been granted availabi.lity within an agreed upon time.
This account is not Part of the Float.
Depos it ing Institution:
This is the institution that is depositins the check for
This check is drawn on the Payor bank (Drawee
cot lect ion.
banks).
Difference Account:
This is a balance sheet account which refers to the
uncol lectable/ unpayable amounts because of an
out-of-balance situation arising primarily from:
1) Mistakes made by the commercial bank in reportins the
exact amount of the checks deposited for collection.
2) Any difference rePorted during the shipment between
federal reserve banks.
3) Internal settlement operations includins balancing paid
savings bonds, cafeteria receiPts, and Postmaster's
deposits.
Drawee Bank:
The entity responsible for Payment of the amount designated
on the check.
Drawer Bank:
The entity presenting the check.
El ectronic Fund Transfer (EFT)
the electronic
A communications network which facil itates
fl ow of funds; this flow may be via mire transfers, ACH,
or Automated TelIler Machines.
End-Po i nt
Refers to an individual bank. Usually this is the bank which
check which the
be responsible for Payment of the
will
Fed for Processins.
the
to
submitted
institution
depositing
End-Point Sorting
This aspect of check processing refers to the task Performed
by a high speed reader sorter which sorts all the checks
wi I1 end-point sort
A Fed facility
"down" to Payor banks.
-76-
certain types of deposits.
The Fed will not end-point sort
checks for Payor banks in other Fed districts; In this case
the local Fed will send checks to the second Fed for
end-point sorting.
Equivalent items:
Equivalent items represent the number of items Processed
during their first time throush a reader-sorter Plus .25
times the number of items that must be Processed a second or
more times through a reader-sorter.
Ordinari ly items in
various deposit types must be Processed more than once
because they could not be sorted to their
final
destination
on their first run (first run throush the machine).
This
situation usually arises because the number of destinations
in the deposit types exceed the number of sorting Pockets in
a reader/sorter.
Consequently, high volume destinations are
sorted on the first
run through a machine, and several
Pockets, which were used to collect lower volume
destinations, are run again and sorted to final destination.
Equivalent items are used to allocate Processing expenses
among deposit types.
Its calculation incorporates the
Processing characteristics of how many extra times an item
is Processed on a reader-sorter times 24%.
The reason a
factor of 100% was not used is because check Processing is
not all
machine related and this
method of cost allocation
more accurately reflects
the resources used in check
processing.
For example, non-machine activities include
receiving checks from couriers,
manual ly segregating cash
letters
into deposit types, Pre-reader/sorter Preparation,
Pre-settlement Preparation, actual setttlement, check
wrapping, and Presentation to courier or local clearing
house.
Since non-machine activities
are done onlyonce for a
check, Fed officials believe it inappropriate to use the
absolute number of items Processed when chechs must be run
throush a machine two or more times when al locating costs
across deposit types.
The 25% factor, therefore, sives
weight to the non-machine activities in allocating expenses.
Fed Facility:
Any Federal Reserve Bank site which Provides check
processins services.
Fed, FR Bank, FR Facility, FRB.
All these abbreviations are used interchangeably to refer to
a Federal Reserve Bank.
The term Federal Reserve would
include all banks in the Federal Reserve System.
Reference
will be made to a Fed facility in the context of the check
ProcessinS service only.
-77-
F I oat:
In the most narrow sense7 the Fed float refers to the
dollar value of all items which have been credited to the
appropriate account based upon the asreed upon availability
schedule, but which are not actual ly received by the Fed
from the Payor bank by the time availability has been
The value of the Fed float can be calculated from
granted.
two balance sheet accounts by subtracting the deferred
avai labi I ity account from the Items in the Process of
Collection account.
Under the MCA the Fed is required to either price or
The
has chosen the latter course.
It
eliminate the Float.
negative
and
positive
to
according
float
categorizes
Fed
is seeking to eliminate negative float.
It
float.
or debit float occurs when the Fed can not
float
Negative
the same day on which credit was passed!
on
funds
collect
Positive float is created when the
money.
owed
is
the Fed
than the funds have been granted
sooner
funds
Fed collects
to the deposit bank.
Handlin :
Any operation required in the processing of the checks.
This term is used interchangeably with "processing".
Immediate Avai lability:
When credit is
Also referred to as same day availabiliv.
with the
deposited
is
item
the
granted on the same day as
Fed facility.
Item-Pass Ratio:
of the number of extra times a check must pass
A ratio
through a high-speed reader-sorter relative to the fixed
number of individual items received by the Fed facility.
Items:
Refers to an
individual
check.
Local Clearing House:
A clearing house which is located in an area which includes
Checks drawn on the
banks.
the paying and collecting
at the clearing
are exchanged daily
respective institutions
house.
National / Nations Payments Mechanism:
Refers to the network/system of institutions/individuals
types of Payment system
all
essentially
facilitating
transactions (flow of funds) between and among institutions
and individuals.
-78-
Non-Par Bankins Practices:
Non-par bankins occurs when a Percentase
from the face value of the checks Prior
the funds.
deduction is taken
to the delivery of
NOW:
A NOW Draft Account or Nesotiable Order Withdrawal
demand deposit account which earns interest.
is a
On-Others:
Checks drawn on a bank other than the one Processing the
checks.
On-Us:
Checks drawn on the bank which also does the Processins of
the check.
Payee bank:
The entity which
is owed the face value of the check.
Payor Bank:
Same as the
The bank responsible for making the payment.
funds upon
the
has
which
This is the institution
drawee.
the check
Once
checks.
the
which its customers have drawn
the
(i.e.,
asent
its
is Presented by the depositing bank, or
the check must be Paid by the Payor bank.
Fed),
Presentment:
The process of a depositins bank or its
check to the Payor bank for payment.
asent
presenting a
Return:
Refers to the expenses in the handling of checks which are
These items may have been Processed by an
returned unpaid.
RCPC branch or Fed office.
Settlement:
Refers to any activity related to the balancins of work
comins in and soins out of the Fed.
-79-
Exhibit
I:
Check Deposit Types and Characteristics
Deposit Type
Characteristics
City:
Location & Transportation: Payor banks located
within Fed city.
No transportation since
checks are picked up at clearing house.
Processing Characteristics: Low machine use
since often the number of city
banks is
similar to the number of Pockets (24)
in a
machine.
Many Points can be end-point
sorted on a first Pass.
Availability: Immediate since checks can be
Presented soon after
processing.
Price: Price is relatively
low reflectins
low
machine use and no transportation costs.
RCPC:
Location & Transportation: Payor banks located
in RCPC zone, beyond Perimeter of city
area.
Distance therefore requires that
transportation be used to Present checks.
Processing Characteristics: More machine use
because there are ususally a greater
number
of end Points relative to Pockets on a
machine (24),
thereby requiring many checks
to so throush a machine before beins
end-point sorted.
Availabi lity: Immediate, distance is not that
sreat to Prevent Presentation of the checks
on the same day as received by the Fed.
Price: Price is moderate reflectins higher
machine use and transportation
costs.
Country:
Location & Transportation: Payor banks located
beyond Perimeter of city and RCPC areas.
Di stance, therefore, requ i res transportation
for Presentment.
Processing Characteristics: Same as for RCPC.
Availability: Next day. Distance Prevents
Presentation of checks the same day as
received by the Fed.
Other Fed:
Location & Transportation: Payor bank located in
another Fed district,
therefore requiring
extensive transportation to send checks to
receiving Fed district
office.
-80-
Processins Characteristics: Machine use is
moderate since there can be as many as 49
Points to sort down to (i.e.
Various Fed
offices
located throushout the U.s.)
AIso,
processing is required to end Point sort at
receivins Fed.
Availability: Next day. Distance prevents
Presentation of checks the same day as
received by the Fed.
Price: Price is high reflecting
processins costs
at bis Fed offices
and transportation
betweeen initial
receiving Fed and second
Fed that makes Presentation.
Mixed:
Location & Transportation:
Location and
transportation vary because this deposit
type is comprised of city, RCPC, country,
and other Fed checks.
Processing Characteristics: Machine use is hish
since cash letter must first be sorted down
to deposit type before they are end point
sorted to Payor bank.
Availability:
Typically next
day after
deposit.
Price: Reflects the hish machine use and also
Possible extensive transportation to Present
checks.
Non-machinable:
Location & Transportation: These characteristics
vary because Payor banks are in city,
RCPC,
country or other Fed areas.
Processins Characteristics: Very labor
intensive since most items must be hand fed
into low speed Proof machines.
Availability: Next day or two days. Labor
intensive aspect Prevents quick processing. Two
day appi ies to country and other Fed
endpoints.
Price: Is highest of all Prices due to labor
intensive characteristics.
Packase Sort:
Location & Transportation: Payor bank located
city,
country, RCPC, and other Fed areas.
Transportation, therefore, also varies
according to location.
Processing Characteristics: No Fed Processins
in
-81
-
since depositing bank as endpoint sorted
Also, later deposit
checks to Payor banks.
deadline because of pre-processins.
Credit Passed according to same
Avai lability:
availability schedule for city, RCPC,
country, and other Fed schedules listed
above.
Price:
Lowest price, which reflects non-machine
processins by Fed.
Group Sort:
Location & Transportation: Payor banks located
RCPC, country, and other Fed areas.
in city,
Transportation, therefore, varies according
to location.
Processing Characteristics: Limited Fed
Processing since depositing bank has sorted
checks down to banks represented in the
Also, later deposit
designated group.
deadline because of pre-processing.
Availability: Credit Passed according to
avai labi I ity schedule for city, country,
above.
RCPC, and other Fed schedules listed
since
sort,
Packase
higher than
Price: A little
of
number
items were sorted to a
institutions rather than one end-point.
However,, lower to reflect some
Pre-processing.
-82-
APPENDIX
1
How data from the Planning and
The Pricing Worksheet:
used to derive unit fees.
is
System
Control
check processins services
The pricing of commercial
involves the establishment of explicit
deposit types on a Per
fully
explained
cash
Basic Steps Involved
AlI
1.
in Exhibit
items, mixed
country
item basis.
They
fees for different
These deposit types are
include city
letters, other Fed,
items,
RCPC's,
and Packase sort.
in Calculatins Unit Prices
based on PACS budseted/projected 1981
data are
expenses and vol ume counts.
Step
I:
Asresating
total
expenses to be allocated to Priced
services.
A)
The total
check
expenses are recorded for the commercial
Processins service
support,
line which
includes direct,
and overhead expenses for all
processins and fine
sort/
adjustments/
activities'
returns.
-83-
B)
Subtracting Out
of Shipping Related Expenses
in
1) Expenses for shipments between Fed offices
same district and
between Fed offices
in
districts are subtracted out from total
calculated
in Step 1,A.
costs/
expenses Per
different
expenses
These expenses are added
back after the PSAF has been applied
of
deposit
type.
to the subtotal
Since
services are contracted out to a Private
provider
already
It
reflected
in
the shipping
at
service
charges to
the
would therefore be double counting to
include the shipping costs for
and,
shippins
the tax and financing costs are assumed to
be
Fed.
the
the same time,
each deposit type,
apply the PSAF to these
costs.
2)
The reimbursement
to depository
expenses which had been granted
institutions
(pre-MCA)
for
of direct sends, are also subtracted out.
expenses will
not
3)
incurred
not
in
In-house mail
expenses
be added back,
the Pricin
makins use
These
because they are
environment.
expenses are subtracted
relate to the cost of
out.
These
handling consolidated
shipments only.
districts it
is susested that each Fed Office
estimate the
in-house trai I expenses which would
include overhead,
Step
Because these costs'vary across
II:
equipment, Personnel , etc.
Step Down Allocation of
Commercial
Check
Processing Service Line Expenses to the Activity
Level.
The expense figure for the commercial
check
service line
in
less shippinS determined
represents the total
Processing
Step I
be allocated
expenses Which Will
to each check activity and ultimately to each deposit
tYpe.
A)
All
direct, supports
and District
Project expenses
are first allocated to each check activity.
Processins and fine
sort
are combined
Purposes of the pricins exercise.
for the
The other
activities are returns and adJustments.
Step
III:
Estimate of Check Volume/Number
of
Items
Processed
A)
A
total
volume
amount
is
determined.
This
includes
-85-
items
alI
Processed by a Federal
either shipped to another office
Reserve Office,
in the same
district, or to an office outside the district which
1)
includes the Payor bank.
In order to estimate the
it
items received by consolidated shipment
number of
is sussested that the Fed assume that there are 352
items Per pound.
B)
The total
This
volume of
is an estimate of the next year 7 s
based on
the current year's actual
is
break-out by deposit type
C)
(Defined as number of
A total
determined.
This
is
equal
Percent
This
is
in order to
items by deposit
items Processed.)
of equivalent
for the number
Then,
volume.
calculated.
arrive at the Projected number of
recorded.
volume, a
applied to the Projected volume total
type.
is
items Processed
to the total
items
number
is
also
of
items actually Processed, Plus a Percentase mark-up
which accounts for the additional
item must
items
D)
by
be resorted
individual
The total
in
order
amount of times an
to separate out all
account.
number of equivalent
items
is
al located
to deposit types according to the same ratio used
Step II,
B.
in
-86Step IV:
Allocation
of Activity Expenses to Deposit
Types/Priced
Services
A)
The totals for returns and adjustments activity
recorded
in
Step IIA
deposit types
of
items
in
number of
is
based on
the volume
ratio
of the number
each deposit type to the total
items Processed.
Projected
The equivalent
item ratio
not used here because the amount of adjustment and
return activity
is
Proportional
to the number
of
checks received for Processins.
individual
B)
are allocated across all
For the allocation of check processins and fine
sort expenses, all
expenses for activities are first
al located only to the non-machinable and Package sort
deposit types.
"internal
This allocation
records",
resources
costs,
required
of all
C)
etc.
In
i. e.
this
way,
for Processins this
type are are more accurately
al location.
based on actual
for each Fed Off ice.
number hours/Personnel
actual
is
reflected
in
the
the
deposit
cost
Non-machinables are the most expensive
Processins activities.
The expenses which remain after the subtraction of
expenses associated with non-machinable and Packase
sort,
are then allocated to the group sort deposit
-87-
type.
This allocation
D)
AI
items.
remain ing expenses after
subtract ins out
expenses associated with non-machinable,
sort?
and group sort,
the volume
ratio
based on the volume
items for group sort to the total
of equivalent
equivalent
is
ratio
of
Package
are then allocated according to
the equivalent number of
Per deposit type to the total
items
number of equivalent
items.
Step V:
A)
of Overhead Expense
Allocation
The total
Processins
overhead expense for
line is
check
allocated to each deposit type
according to an expense ratio.
on the total
the commercial
This ratio is based
expense for each activity less shippins
by deposit type to the total expense for all
activities.
(i.e.
of expenses which
The subtotal
has been calculated for each deposit type based on
the Particular volume ratio and expenses sesresated
by activitY,
is
the numerator.
The denominator
the summation of expenses for all
activities
commercial check Processins service
is
in the
line.
Step VI: Application of the Private Sector AdJustment Factor
A)
The subtotal
of the total
expenses
is
calculated for
-88each deposit type.
support costs,
adJustments,
These expenses
for processi ns,
and returns,
overhead which were all
B)
This subtotal
Step VII:
then
fine-sort,
and the adjustment
determined
increased
allocated
in Steps I-VI.
by the PSAF.
shipping costs determined
allocated
not
ratio.
mixed,
type.
number of
These
are
items do
Shipping expenses for
non-machinable,
country,
Packase and group sort
are allocated according to a volume
of
Step I
Shippins expenses are not
to the city deposit
require shipment.
RCPC,
in
across each deposit type according to the
appropriate volume
ratio
of the
items Per deposit type to the total
number
items Processed.
Step VIII:
A)
for
Adding Back Shipping Costs
The total
A)
is
include direct and
Calculation of Per Unit Cost
The total
expenses for each deposit
of the PSAF,
number of
typ~es
Plus shipping costs,
individual
type,
inclusive
are divided by the
items Processed Per deposit
-89-
FOOTNOTES:
1)
Federal Reserve Press Release, Board of Governors
(Washinston, D.C) December 31,
Federal System.
of the
1980.
2)
Chairman, Board of
William Miller,
Statement of G.
Consress,
Governors, Federal Reserve Board, U.S.
Urban Affairs,
and
Housins
Bankins,
on
Senate Committee
Requirements
Reserve
Federal
"The
S.3304,
Hearings on
August
Session,
2nd
Consress,
Act of 1978", 95th
Printins
Government
U.S.
14,1978 (Washinston, D.C.,
Office, 1978) p.7-9
3)
Ibid.
4)
Peter Merrill Associates, Inc., "The Federal Reserve
Membership Problem, Impact on Banks", Boston, 1979.
13
p.
p.
27
p.
15
5)
Ibid.
6)
"Economic Report of the President", January, 1981.
Wash inston, D.C.
Government Printing Office.
7)
Robert Mcpherson, Public Relations,
Mr.
Interviews:
Federal Reserve Bank of Boston, March 15, 1982.
Mr. Bruce Craig, Assistant Vice President,
Marketins Divisi on, Federal Reserve Bank of Boston,
February, 1982.
8)
"The Federal Reserve System,
Washinston, D.C., 1974.
9)
and Walker, David H.; "The Mark-up in
Koot, Ronald S.
Issues in Bank
pricing of Federal Reserve Services".
Resu I at ion, Published by the Bank Administration
Institute.
Summer, 1980.
U.S.
Purposes and Functions."
10)
Munrel I, Alicia and Weiss,
Eisenmenser, Robert W.,
"Pricine and the Role of the Federal Reserve
Steven.
in an Electronic Funds Transfer System," Conference
Federal Reserve Bank.
Series # 13.
11)
Eisenmenser,
Robert W.
Conference Speech Given by Mr.
Federal
President,
Vice
Director of Research and Senior
Reserve
of
Federal
"Pricing
of
Boston.
Bank
Reserve
Bank Services, "
-90-
12) Koot, Ronald S.
and Walker, David H.; "The Mark-up in
Pricing of Federal Reserve Services", Issues in Bank
Resulation.
Published by the Bank Administration
Institute.
Summer,
1980.
13) Public Law, 96-221,March 31,
1980. Sec. 102.
14) Althoush the nature of overhead allocation schemes
Precludes a direct and exact distribution of costs,
certain of the overhead allocation by the PACS results
in a disproportionate amount of costs being allocated
to the commercial check Processing line.
To the extent
that this is true, the allocation of overhead expenses
from the service line level to the priced deposit items
will reflect
this
misallocation.
For example,
telephone and telegraph overhead expenses are
distributed across all output service lines under the
dol lar ratio basis.
This allocation scheme computes a
Percentase ratio for each output service line which
is
based on the expense per output service (commercial
check processing)
divided
by
the total
expenses for
all
outPut services (cash, wire7 ACH, etc.).
This ratio is
then used to allocate overhead costs to each individual
output service.
Because the commercial check
processing service line includes approximately 40% of
the total expenses for all services, usage of the
dollar ratio method forces the check service line to
bear the maJority of overhead expenses.
However, wire
transfer service uses a greater Percentase of the
telephone and telegraph expenses.
It would make sense,
therefore,
to allocate more of the telephone and
telegraph overhead expense to wire transfer services.
(A time motion study could be conducted to determine
the proportion of this expense used by activity.)
A
similar situation exists with regard to Protection
overhead.
The Fed has recognized that most of this
expense is associated with guarding the money stored at
the Fed.
The check processing activity
requires far
less Protection service and should not bear a
disproportionate cost of Protection overhead.
15) Through time motion studies a standard cost allocation
system could be developed.
Costs regularly associated
with a
Particular
deposit
type could
be
identified
with
the same deposit type. Such a system would essentially
rely on; A) Internal information (number of Personnel,
-91.-
labor costs, machine usage), B) Surveys conducted to
identify
the unique costs of a siven deposit type and,
C) Surveys conducted to identify the variability of one
cost Ci.e.
Personnel) With respect to all deposit
types:
This would provide information on how labor
intensive are deposit types.
Because costs are fixed
only within a relevant time period, it will be
necessary to resurvey particular activities on a
continued basis.
16) Federal Reserve Press Release, Board of Governors of the
Federal Reserve System.
(Washinston. D.C.)
December
31,
17)
1980.
Federal Reserve System Docket No.
and Pricing Principles.
R-0324, Fee Schedules
18) Office Correspondence, The 1982 Private Sector
AdJustment Factor, December 21, 1981.
19) Statistical
Department
Abstract of the U.S.,
1979.
U.S.
of Commerce, Bureau of Census.
20) Koot, Ronald S.
and Walker, David H.; "The Mark-up in
Pricing of Federal Reserve Services", Issues in Bank
Regulation, Published by Bank Administration Institute,
Summer, 1980.
21)
Appendix I,
22)
Ibid.
23)
The CAPM typically
looks at the risk
associated with a
siven Portfolio with respect to the market return as
measured by the Standard and Poors 500 composite index.
This index is based on expected returns, not actual
returns.
In order to use a comparable base to compare
the volatility of check volume to the economy,
a
contemporaneous measure of the economy should be used.
Rather than derive a lassed measure for
the S.& P.
index, Percent chanse in real GNP was chosen as an
approximate measure of fluctuation
in the economy.
24)
Humphrey, David B. ; "Cost scale economies, competition
and Product mix in the U.S.
Payments System."
1977,
Financial Studies Section, Division of Research and
Statistics, Board of Governors, Federal Reserve System,
Washinston.
D.C.
Federal
Reserve Docket No.
R-0324
-92-
25)
Ibid.
William J., and Bradford, David F.,"Optimal
Departures from Marginal Cost Pricing", Volume 60,
26) Baumol,
December, 1970.
pp.
265-283.
27) One overall obJection to Ramsey Pricing is that it
results in uncompensated transfers of Costs to the
users of services with the more inelastic
demand.
However, this
criticism
is somewhat missuided when
considering the application of Ramsey Pricing to the
pricing of Fed services.
A Ramsey allocation scheme
can in fact improve the allocation of costs with
respect to all Parties by leading to a reduction in
Prices; As a result of initial Price discrimination,
given the condition of declining marginal costs or
constant costs, demand may increase for services Priced
closer to marginal cost, and therefore induce lower
unit costs and hence, Prices.
Moreover, bank services
are typically viewed as Packages of services sold to a
Particular customer.
As such, the Policy of
cross-subsidization resulting from Ramsey Pricing need
not necessarily create direct subsidies to only certain
users, and in turn greater burden for others.
Rather,
Ramsey pricing may Permit cross-subsidies between
services,
cost/price
that are offset with respect to the total
of
these services.
-93-
BIBLIOGRAPHY
Books,
Published Reports, and
Pamphlets:
Brealey, Richard and Meyers, Stewart. Principles of
Corporate Finance, Mcgraw-Hill Book Company, 1981
Economic Report of the President; January 1981. U.S.
Government Printirns Office, Washinston, D.C.
Federal Reserve Bank of Atlanta. "A Quantitative Description
of the Check Collection System", Volume I, Co-sponsored
bY the American Bankers Association, Bank
Administration Institute; Federal Reserve System.
Federal Reserve Bank of New York 7
Operations", 1978.
Paul
Meek,
"Open
Market
Statistical Abstract of the United States, 1980, U.S.
Department of Commerce, Bureau of the Census. p.539
U.S.
Kahn,
Department of Housins and Urban Development,
of Mortsase Credit, 1970-1979
Alfred E.
Inst i tut
The Economics of Regulation:
7
ions.
The Supply
Principles and
Lipsey, R.G.,
and Lancaster, Kelvin, "The General Theory of
Second Best", Review of Economic Studies (1956)
XXIV:11-32
Musgrave, Richard A., and Musgrave, Pessy B., Public Finance
in Theory and Practice, Mcgraw-Hill Book Company.1980.
Nelson, James R. ; "Marginal Cost Pricing In Practice",
1964.
Prentice Hall, Inc., Enslewood Cliffs, N.J.,
Peter Merrill Associates, Inc.,
Impact
Membership Problem,
The Federal Reserve
on Banks, Boston, 1979.
Scott, John Troy; "Price and Non-price Competition in
Bankins Markets", Federal Reserve Bank of Boston,
Research Report 62.
-94-
Periodicals
Anthony, Robert N., "Recognizing the Cost of
Equity", Harvard Business Review, January-February
1982, pp.91-94
Bauftol, William J.,
"Optimal Departures From Marsinal Cost
Volume 60,
Pricing", Ameri can Economic Review.
265-283.
PP.
December,
1970.
and Rademacher, Hollis
Benkler, Gordon B.,
How to Deal With the Fed's New Role",
W.;
ABA
"Evaluating
Burger, Al bert E. 7 "Does the Federal Reserve Invest Member
Bank Reserves?", Federal Reserve Bank Review, St Louis,
July 1978.
Cocheo, Syeve, "What
1981.
DIDC Decided and How?"
ABA,
April,
and Pejovich, Svetozar; "Property Ri shts and
Furboton, Eirik
Economic Theory: A Survey of Recent Literature.
Journal of Economic Literature. December 1972, Vo Iume
X, No. 4, pp. 1137-1162.
Kinzer, Donald; "Economic Consequences of Deregulation of
Interest Rates", American Bankins Masazine.October,
pp.149-151
Ike and Loy, David; "The Pricing and Quality of
Mathur,
Commercial Bank Services", The Bankers Magazine,
July-August 1981 pp. 32-38.,
Sull ivan, Michael P., "Bank Marketing Strategy, Past,
Present and Future" The Bankers Magazine, July-August
1982, pp.28-32.
Wallace, Donald A.; "Joint and Overhead Cost and Railway
Policy" Quarterly Journal of Economics CAugust, 1934)
XLVIII: 583-619.
Wentworth, Howard B.";"The Monetary Control Act and Account
Analysis", The Masazine of Bank Administration, January
1982.
p9.24-29.
-95-
Speeches:
Eisenmenser, Robert W., Director of Research and Senior Vice
President, Federal Reserve Bank of Boston. "Pricing of
Federal Reserve Bank Services"
Correspondence:
The
1982 Private Sector Adjustment Factor, December 21,
1981.
Statutes:
96-221
Public Law
(1980)
Government
Documents:
Report to the Ad Hoc Task Force on Access to Federal Reserve
Services. Washinston, D.C.: Board of Governors of the
1976.
Federal Reserve System, January1
Unpublished
Reports:
and Kwast, Myron C.;
Brundy, James M.,
Humphrey, David B.,
"Check Processins at Federal Reserve Offices",
Financial Studies Section.
Division of Research and
Statistics.
Verified Statement of Alfred E. Kahn on behalf of the
Interstate
National Coal Association. Ex Parte #34.
16, 1981.
Sept.
Commerce Commission.
-96-
Interviews conducted at the Federal
Boston,
durins the months of February
Reserve Bank of
throush April,
1982.
Mr.
Bruce Crais;
Assistant Vice President,
Marketins
Division.
Mr.
Ronald Currie;
Vice President,
Accountins
and Control
Division.
Mr.
Robert Eisentnenser;
Director
of Research and Senior Vice
President.
Ms. Jane Gebeaux;
Control
Assistant Vice President, Accountins
and
Division.
Gibson;
Economist,
Research Division.
Ms.
Kathrine
Mr.
Robert Listfield, Vice President, Marketing Division.
Mr.
Robert Mcpherson;
Mr.
Edward Smith;
Support.
Public Relations.
Operations AnalYst, Payments Mechanism