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Alternative measures of the Federal Reserve banks' cost of equity capital

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  • Michelle L. Barnes
  • Jose Lopez

Abstract

The Monetary Control Act of 1980 requires the Federal Reserve System to provide payment services to depository institutions through the twelve Federal Reserve Banks at prices that fully reflect the costs a private-sector provider would incur, including a cost of equity capital (COE). Although Fama and French (1997) conclude that COE estimates are “woefully” and “unavoidably” imprecise, the Reserve Banks require such an estimate every year. We examine several COE estimates based on the CAPM model and compare them using econometric and materiality criteria. Our results suggests that the benchmark CAPM model applied to a large peer group of competing firms provides a COE estimate that is not clearly improved upon by using a narrow peer group, introducing additional factors into the model, or taking account of additional firm-level data, such as leverage and line-of-business concentration. Thus, a standard implementation of the benchmark CAPM model provides a reasonable COE estimate, which is needed to impute costs and set prices for the Reserve Banks’ payments business.

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Bibliographic Info

Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2005-06.

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Date of creation: 2005
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Handle: RePEc:fip:fedfwp:2005-06

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Keywords: Financial services industry ; Federal Reserve banks - Service charges ; Federal Reserve banks - Costs;

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References

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  1. Eugene F. Fama & Kenneth R. French, 2004. "The Capital Asset Pricing Model: Theory and Evidence," Journal of Economic Perspectives, American Economic Association, vol. 18(3), pages 25-46, Summer.
  2. James B. Thomson, 2001. "PSAF, economic capital, and the new Basel Accord," Working Paper 0111, Federal Reserve Bank of Cleveland.
  3. Fama, Eugene F. & French, Kenneth R., 1997. "Industry costs of equity," Journal of Financial Economics, Elsevier, vol. 43(2), pages 153-193, February.
  4. Graham, John R. & Harvey, Campbell R., 2001. "The theory and practice of corporate finance: evidence from the field," Journal of Financial Economics, Elsevier, vol. 60(2-3), pages 187-243, May.
  5. anonymous, 1990. "The Federal Reserve in the payments system," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), issue May, pages 293-298.
  6. Tara Rice & Kristin Stanton, 2003. "Estimating the volume of payments-driven revenues," Emerging Issues, Federal Reserve Bank of Chicago.
  7. R. Alton Gilbert & David C. Wheelock & Paul W. Wilson, 2002. "New evidence on the Fed's productivity in providing payments services," Working Papers 2002-020, Federal Reserve Bank of St. Louis.
  8. J. David Cummins & Richard D. Phillips, 2005. "Estimating the Cost of Equity Capital for Property-Liability Insurers," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 72(3), pages 441-478.
  9. Edward J. Green & Jose A. Lopez & Zhenyu Wang, 2003. "Formulating the imputed cost of equity capital for priced services at Federal Reserve banks," Economic Policy Review, Federal Reserve Bank of New York, issue Sep, pages 55-81.
  10. Michael C. Ehrhardt & Yatin N. Bhagwat, 1991. "A Full-information Approach for Estimating Divisional Betas," Financial Management, Financial Management Association, vol. 20(2), Summer.
  11. Hamada, Robert S, 1972. "The Effect of the Firm's Capital Structure on the Systematic Risk of Common Stocks," Journal of Finance, American Finance Association, vol. 27(2), pages 435-52, May.
  12. Jose A. Lopez, 2001. "Federal Reserve banks' imputed cost of equity capital," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue aug10.
  13. Paul D. Kaplan & James D. Peterson, 1998. "Full-Information Industry Betas," Financial Management, Financial Management Association, vol. 27(2), Summer.
  14. Bower, Dorothy H & Bower, Richard S & Logue, Dennis E, 1984. " Arbitrage Pricing Theory and Utility Stock Returns," Journal of Finance, American Finance Association, vol. 39(4), pages 1041-54, September.
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Cited by:
  1. Han, Yufeng, 2012. "State uncertainty in stock markets: How big is the impact on the cost of equity?," Journal of Banking & Finance, Elsevier, vol. 36(9), pages 2575-2592.
  2. Michael R King, 2009. "The cost of equity for global banks: a CAPM perspective from 1990 to 2009," BIS Quarterly Review, Bank for International Settlements, September.
  3. Marques Benton & Krista Blair & Marianne Crowe & Scott Schuh, 2007. "The Boston Fed study of consumer behavior and payment choice: a survey of Federal Reserve System employees," Public Policy Discussion Paper 07-1, Federal Reserve Bank of Boston.
  4. Pasaribu, Rowland Bismark Fernando, 2010. "Pemilihan Model Asset Pricing
    [Asset pricing model selection: Indonesian Stock Exchange]
    ," MPRA Paper 36978, University Library of Munich, Germany.
  5. Tomas Adam & Sona Benecka & Ivo Jansky, 2012. "Time-Varying Betas of Banking Sectors," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, vol. 62(6), pages 485-504, December.
  6. Grandes, Martin & Panigo, Demian T. & Pasquini, Ricardo A., 2010. "On the estimation of the cost of equity in Latin America," Emerging Markets Review, Elsevier, vol. 11(4), pages 373-389, December.

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