CUNA Comment Letter

Private Sector Adjustment Factor

April 6, 2001

Ms. Jennifer Johnson
Secretary
Board of Governors of the Federal Reserve System
20th and C Streets, NW
Washington, D.C. 20551

Private Sector Adjustment Factor Docket: No. R-1095

Dear Ms. Johnson:

The Credit Union National Association (CUNA) appreciates the opportunity to comment on proposed changes to the formula for the private sector adjustment factor (PSAF), which affects the prices for the Federal Reserve's payments services. As a national trade association, CUNA represents more than 90 percent of the nation’s 10,600 state and federal credit unions.

This proposal, which was published in the Federal Register on December 28, 2000, modifies the formula for calculating the PSAF, which affects the prices that Federal Reserve Banks (Reserve Banks) charge depository institutions for payments services such as check and ACH processing. The PSAF is required by The Monetary Control Act of 1980. This law requires that the Reserve Banks set fees for their services that recoup their actual costs and the PSAF. The PSAF equals the costs the Reserve Banks would have incurred and the profits that they would have retained had they been a private sector firm. As a result, altering the PSAF affects the fees that credit unions pay for payments services. According to the Federal Reserve, the proposed changes in the PSAF formula would produce a negligible change (less than 2 percent) in the Reserve Banks' prices for payment services.

In calculating the PSAF, the target return on equity (ROE) for Reserve Bank priced services is based on the average of three models. The first model is the Comparable Accounting Earnings Model (CAE). This model uses historical data from the two to seven years before the target year to predict future earnings and is based on book values rather than market values. The Capital Asset Pricing Model (CAPM) estimates the imputed bank holding company ROE from the return on a stock portfolio of the fifty largest BHCs over a one-year period. The Discounted Cash Flow Model (DCF) assumes that a firm's stock price is equal to the present discounted value of all expected future dividends. If the stock price and expected future dividends are known, the implied discount rate for the firm can be calculated and is considered to be the firm's equity cost of capital.

The Federal Reserve proposes to alter calculations of the PSAF by modifying the method for imputing debt and equity; providing that $ 4 billion of clearing balances be considered available to finance long-term assets; changing the method for determining the target rate of return on equity; and continuing its use of data from the fifty largest bank holding companies as a proxy.

SUMMARY
CUNA supports this proposal to modify estimation of the PSAF. Below, is a summation of our comments on various aspects of the proposal.

DISCUSSION
CUNA supports the Federal Reserve's proposal to create a priced-services balance sheet because it will assist the Federal Reserve in pricing services as though it were a private entity. The Federal Reserve states that its proposal to create a priced-services balance sheet would use real assets and liabilities, impute liability and equity only to the extent necessary, and better reflect the risk inherent in priced-services activities.

CUNA supports the Federal Reserve's proposal to establish $4 billion of initial core-clearing balances, from a total of $ 7 billion, as a source of financing long-term assets. All financial institutions have some level of core deposits or balances that are maintained by consumers for transaction purposes. Although the $4 billion threshold is presently reasonable, CUNA suggests that the Federal Reserve re-evaluate this level at least annually, so it can make changes that reflect the market interest rates and the market behavior of financial institutions.

All three economic models, (the CAE, DCF, and CAPM) are theoretically sound and helpful in calculating the PSAF and return on equity. CUNA supports the three calculation methods, including the capitalization weights for each of these models. At this same time, none of the three approaches is perfect. Averaging will produce a desirable moderating influence on the results that will help for the purpose of calculating the PSAF. CUNA believes that usage of all three models should improve the Federal Reserve's calculation of the PSAF. The Federal Reserve may want to evaluate this averaging methodology at the end of the first year.

CUNA believes that it would be appropriate for the Federal Reserve to use a smaller BHC peer group. Currently, the Federal Reserve uses the fifty largest bank holding companies as a reasonable data peer group for Reserve Bank priced services activities. Due to the number of bank mergers in recent years, however, a smaller peer group, such as one comprised of the top 10 or 25 bank holding companies may be sufficient for the Federal Reserve's purposes. A smaller peer group would adequately cover the majority of banking assets nationwide, and it would be reliable enough to minimize fluctuations caused by a single bank's performance. In addition, CUNA believes that the bank holding company data should not be adjusted. Instead, the Federal Reserve should keep the bank holding company data intact and adjust its calculations to more closely resemble the activities of the bank holding companies.

CUNA supports this proposal and believes that the PSAF should be changed as necessary to fulfill the requirements of the Monetary Control Act of 1980, regardless of the effect of these changes on prices. If you have any further questions, please contact Michelle Profit at (202) 682-4200.

Sincerely,

Michelle Q. Profit
Assistant General Counsel