Alternative measures of the Federal Reserve Banks’ cost of equity capital |
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| Affiliation: | 1. Economic Research Department, Federal Reserve Bank of Boston, P.O. Box 55882, Boston, MA 02205, United States;2. Economic Research Department, Federal Reserve Bank of San Francisco, 101 Market Street, MS 1130, San Francisco, CA 94105, United States;1. Leonard Stern School of Business, New York, University, New York, USA;2. School of Business, University of Alberta, Edmonton, Alberta, Canada;1. School of Economics and Statistics, Milan-Bicocca University, via Bicocca degli Arcimboldi, 8, 20126 Milan, Italy;2. Department of Economics, Università di Genova, v. Vivaldi 5, Genova, Italy;1. School of Management, Huazhong University of Science and Technology, Wuhan (430074), Hubei, China;2. Department of Accounting & Information Systems, Comilla University, Comilla (3506), Bangladesh;3. International School, East China Jiao Tong University, Nanchang (330013), Jiangxi, China;4. International Institute for Financial Studies, Jiangxi University of Finance and Economics, Nanchang (330013), Jiangxi, China;5. School of Business, Department of AIS, University of Chittagong, Chittagong (4331), Bangladesh;1. Aston Business School, Aston University, Birmingham, England, B4 7ET, UK;2. Department of Economics, Management and Institutions, University of Naples “Federico II”, Monte S. Angelo University Campus, via Cinthia, 80126, Naples, Italy;3. Bangor Business School, UK;4. IRES, Universite Catholique de Louvain, Belgium;1. School of Banking and Finance, Università Cattolica del Sacro Cuore, Largo Gemelli 1, 20123 Milan, Italy;2. Department of Accounting, London School of Economics and Political Science, Houghton Street, WC2A 2AE London, UK;3. Bangor Business School, Bangor University, Bangor, LL57 2DG Wales, UK |
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| Abstract: | The Monetary Control Act of 1980 requires the Federal Reserve System to provide payment services to depository institutions through the 12 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 [Fama, E.F., French, K.R., 1997. Industry costs of equity. Journal of Financial Economics 43, 153–193] 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 suggest 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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