Alternative Measures of the Federal Reserve Banks' Cost of Equity Capital

FRB of San Francisco Working Paper No. 2005-06

37 Pages Posted: 20 May 2005

See all articles by Michelle L. Barnes

Michelle L. Barnes

Federal Reserve Bank of Boston

Jose A. Lopez

Federal Reserve Bank of San Francisco

Multiple version iconThere are 2 versions of this paper

Date Written: April 2005

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 rices 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.

Keywords: Monetary Control Act of 1980, CAPM model

Suggested Citation

Barnes, Michelle L. and Lopez, Jose Antonio, Alternative Measures of the Federal Reserve Banks' Cost of Equity Capital (April 2005). FRB of San Francisco Working Paper No. 2005-06. Available at SSRN: https://ssrn.com/abstract=725909 or http://dx.doi.org/10.2139/ssrn.725909

Michelle L. Barnes (Contact Author)

Federal Reserve Bank of Boston ( email )

600 Atlantic Avenue
Boston, MA 02210
United States

Jose Antonio Lopez

Federal Reserve Bank of San Francisco ( email )

101 Market Street
San Francisco, CA 94105
United States
415-977-3894 (Phone)
415-974-2168 (Fax)

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