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

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.