federal reserve bank of richmond 2001 annual report, the .../media/richmondfedorg/...staff provided...

The Economics of Financial Privacy:To Opt Out or Opt In?

2001Annual Report

Federal Reserve Bank of

Richmond

Federal Reserve Bank of Richmond 1

The year 2001 brought with it tragedy, change, and economic uncertainty. It is impossible to reflect on the past year of activities inour Bank and in the economy without recalling the terror and destruc-tion that befell this country on September 11. Just as our attention hadfocused on that Tuesday morning’s business, it was quickly diverted

to news of the horrific events that separated this day from any day before it.Within minutes, our attention shifted to securing the safety of our employeesand maintaining public trust in the country’s financial system.

Although the Bank maintains aggressive contingency plans developed bythinking the unthinkable, it is with the hope that there will never be a need toactivate them. On September 11, the unthinkable became reality. In the hoursand days that followed, staff across the Fifth District responded in a manner thatmakes us very proud. Despite a natural desire to comfort family and mourn withfellow citizens, our people rallied to support essential Federal Reserve opera-tions. We will be forever grateful for their dedication and commitment.

Stability Maintained in the U.S. Financial SystemOur Bank played a significant role in helping the Federal Reserve System stabi-lize the nation’s financial markets and avert a liquidity crisis. Staff in Loans,Supervision and Regulation, Reserve Accounts, Cash, and Check ProcessingDepartments worked around the clock. The Bank provided substantial funds throughdiscount window loans and check-processing services. The volume of loans request-ed was unprecedented. On September 12, discount window loans at the Rich-mond Fed totaled $10.9 billion, about 25 percent of the credit extended by theSystem that day. In comparison, $94 million in loans were made a week earlier.

MESSAGE FROM THE PRESIDENT AND FIRST VICE PRESIDENT

2001 Annual Report

2 Federal Reserve Bank of Richmond

It took collaboration and teamwork throughout the District and the Fed nation-ally to meet the challenge of September 11. One small electronic payments teamat the Richmond Office provided backup for colleagues at the New York Fed.Within moments after the World Trade Center attacks, this team took over themonitoring of critical large dollar funds and securities transfer services. Any inter-ruption of these critical payments services obviously would have severely dis-rupted not only the financial system but also the broader economy.

Others manned Bank facilities and their perimeters. Security staff worked 12-hour shifts and continuously tightened procedures to keep fellow employees safe.Still others took to the road to deliver checks to branch offices and banks aroundthe District after air transportation was grounded, and many employees workedextended shifts to process the enormous backlog of checks deposited by banks.

As the tragedy unfolded in New York City and Washington, we learned first-hand that, in a crisis, our ability to communicate well with our customers and thepublic is paramount. Internally, constant communication among our officers andstaff provided a vital network for handling the situation. It also unified us, strength-ened us, and enabled us to contribute effectively to the Fed’s overall effort to helpour country work through this especially difficult period in our recent history.

The crisis last fall was not the only time during the year that our emergencypreparedness was tested. On July 18 a fire in a Baltimore railway tunnel forcedmost of the city’s nearby businesses to close because of the fumes and other poten-tial dangers. While our Baltimore Office is located close to the tunnel, staff remainedon hand to maintain payment activities and other operations without disruption.

Changes in the Bank and the DistrictEvery day, our staff is dedicated to improving service and increasing efficiencyin carrying out the Bank’s business. In this spirit, the Bank reorganized many ofits operations along functional lines in the spring of 2001. Overall, we expectthe reorganization to reduce costs and enable us to serve our customers better.In particular, the functional management structure will help the Bank better sup-port the Fed System’s Check Modernization Project, an effort to standardize andreengineer the nation’s check processing infrastructure over the next several years.


These improvements were extremely important in 2001 as the structure ofour District’s banking industry also changed. With the merger of Charlotte-basedFirst Union Corporation and Winston-Salem-based Wachovia Corporation, theFifth District became headquarters for two of the nation’s four largest bankingorganizations. As a result, the District now ranks second nationally in total bankholding company assets owned. Accommodating these large banking organi-zations requires us to focus on retaining and attracting staff with a broad rangeof experience and specialized skills to supervise the more complex and sophis-ticated activities of these institutions.

A Year of Economic ChallengesThe Fed faced the extraordinary challenge of deciding how to respond with mon-etary policy in the aftermath of the September 11 attacks. Yet the year hadalready been challenging from a policy perspective since the evolving economicslowdown was a significant departure from the rapid growth of the late 1990s.

Signs of weakness had been increasingly apparent throughout much of the yearin some economic sectors such as manufacturing. The number of jobs in Districtfactories had been declining since the fall of 2000, but the losses acceleratedafter the terrorist attacks. In all, 120,000 District manufacturing jobs were lost in2001, many in traditional industries such as textiles, apparel, and furniture.

Despite economic weakness, jobs in the District’s non-manufacturing sectorgenerally grew during the first three quarters of 2001. During the week of Sep-tember 11, however, business and retail activity came to a virtual standstill. Manylost jobs when District airports closed and air travel ceased for a week or more.Because of its proximity to Washington, Reagan National airport did not reopenuntil early October. Not only were the airlines affected, but jobs related to trav-el, hotel, food services, and tourist activities were also lost. Not surprisingly,jobs in the non-manufacturing sector declined in the fourth quarter. Moreover,weaker overall economic conditions throughout the year in District states causedstate governments to fall short of anticipated tax revenues, which generatedsubstantial budgetary challenges. Despite these difficulties, by the end of 2001many District businesspeople were optimistic that an economic upturn would

Opening Message

2001 Annual Report


materialize in the region as well as the nation in 2002.The events of September 11 highlighted the importance of our relationships

with the business community throughout the District. We routinely consult withour directors at all three of our offices, our advisory council members, and ourother business contacts regarding current business conditions and the outlook.We relied even more heavily on them in the aftermath of September 11 to keepus abreast of emerging developments. Published statistics and databases simplycould not provide us with the up-to-the-minute information we needed to dealeffectively with the crisis. We thank our contacts for all their assistance duringthat time and throughout the year.

Two Directors Conclude Their TermsWe would especially like to thank retiring directors Jim Culberson and CraigRuppert for their important contributions this year and in earlier years. Jim servedon the Richmond board from 1999 through 2001. He had previously servedas a director of our Charlotte Office from 1985 through 1990. While on theRichmond board, Jim shared his extensive banking experience with us, whichmade him a key contributor to the Bank’s Financial and Strategic Planning Com-mittee during his term. He also served as a member of the Committee on Research,Public Affairs, and Community Affairs for those three years and chaired the Com-mittee in 2000 and in 2001.

Craig served two three-year terms on the Richmond board from 1996 through2001. He was a member of the Committee on Buildings through both terms,and was chairman of the Committee for five years. In that capacity, he provid-ed valuable insights while overseeing the security enhancements to the RichmondOffice. He was also a member of the Executive Committee; the Committee onResearch, Public Affairs, and Community Affairs; and the Committee on Finan-cial and Strategic Planning.

Financial Privacy ExaminedIn light of the many extraordinary events in 2001, it is easy to lose sight of moreroutine but nonetheless important issues that were evolving in banking. Among


Opening Message

the most significant were the proposed changes in the way financial institutionstreat information regarding their customers. In late 1999, the Gramm-Leach-BlileyAct was passed to modernize the way financial institutions are regulated. Amongother things, the Act imposed new regulations on financial firms’ sharing of cus-tomer information with outside companies.

According to the financial privacy provisions of Gramm-Leach-Bliley, which tookeffect in mid-2001, if a financial institution shares nonpublic customer informationwith third parties, it is required to give its customers an opportunity to “opt out.” Pri-vacy advocates have argued for a stricter “opt-in” provision that would requirefinancial institutions to get explicit consent from consumers before sharing personalinformation about them. State legislators in some states have proposed even tighterregulations on sharing information within affiliated companies.

In “The Economics of Financial Privacy,” Jeff Lacker, Senior Vice Presidentand Director of Research, takes a look at the opt-out and opt-in debate from aneconomist’s perspective. Fundamentally, the issue centers around the proper allo-cation of “rights” in a contractual relationship — a customer’s right to privacyversus the right of a financial institution to share its information. The answereconomics provides is that whether regulations allocate the rights in accord withopt-out or opt-in is irrelevant. Under an opt-out standard, banks could pay cus-tomers to refrain from opting out, while under an opt-in standard, banks couldpay customers for their information. In either regime, the market should deliveran appropriate balance between consumers’ desire for privacy and the eco-nomic value of information sharing.

Interestingly enough, the debate is ongoing and fervent. Jeff’s article ana-lyzes the debate and concludes that it is unnecessary.

J. Alfred Broaddus, Jr.P R E S I D E N T

Walter A. VarvelF I R S T V I C E P R E S I D E N T


Aconsumer’s financialtransactions give riseto a wealth of verypersonal data. Everycredit card purchase,every ATM with-

drawal, every loan payment, everypaycheck deposit leaves an electronictrace at a person’s bank. Advances ininformation technology now allow firmsto collate information from disparatesources and compile comprehensiveprofiles of individual behavior. Theresulting databases can allow busi-nesses to target very specific consumercategories — high-income, gun-own-ing dog lovers, for example — in waysthat were never before possible.

When should a bank be able toshare information about you with otherbusinesses? Some consumer advocateswant to protect consumers’ financialprivacy by restricting such informationsharing. New technologies, they say,have encouraged increased intrusionson consumer privacy, leading to morejunk mail, more telemarketing calls,and a heightened risk of identity theft.They argue for tough “opt-in” laws thatwould require financial institutions toobtain a consumer’s explicit consent

before sharing personal informationabout them.

Banks and other financial serviceproviders point out that informationsharing provides benefits to consumersby allowing for more targeted marketing and services. The new tech-nologies make it easier for businessesto find consumers that would be interested in buying their specializedproducts and services — hunting-dogtraining supplies, for example. Suchmarketing directly benefits consumerswhen it results in a voluntary purchase.In addition, greater information shar-ing can reduce wasteful marketing toconsumers that are likely to be unin-terested. With these benefits in mind,financial service providers argue for“opt-out” laws that merely require themto give consumers the right to requestthat their information not be shared.

After vigorous debate, Congressadopted an opt-out requirement forbanks and other financial institutionsas part of the Gramm-Leach-Bliley Actof 1999 (GLBA), legislation that wasdesigned to encourage financial mod-ernization. Any financial institutionthat intends to share nonpublic cus-tomer information with third parties

The Economics of Financial Privacy:To Opt Out or Opt In?

Jeffrey M. Lacker

The author is Senior Vice President andDirector of Research.

The views expressed are the author’sand not necessarily those of the FederalReserve System.

2001 Annual Report


(companies not related by ownershipties) must give customers an opportu-nity to deny them permission to do so,or opt out. In addition, financial insti-tutions are required to provide cus-tomers with an annual statement oftheir privacy policy. Consumers re-ceived a blizzard of notices in the mailwhen those provisions were fully imple-mented in the summer of 2001.1

The controversy did not end with thepassage of the GLBA. The Act allowsindividual states to adopt privacy provisions that are stricter than the federal standard if they so desire. Cal-ifornia’s legislature recently consideredan opt-in law that would have requiredfinancial institutions to obtain customerpermission before sharing informationwith third parties. Moreover, bankswould have been required to give con-sumers the right to opt out of informa-tion sharing with affiliated companies(companies related by ownership ties).

This essay examines the opt-out/opt-in debate from the perspective of theeconomics of financial privacy. Thepremise is that a financial institution’sprivacy policy is a characteristic of theproducts and services the institutionoffers. We can therefore apply thewell-understood principles governinghow markets work when there areimportant differences in product char-acteristics. The result is surprising forboth sides of the issue: it doesn’t seem

to matter whether opt-out or opt-in isadopted as the standard. Either way,competitive forces should bring aboutan economically efficient amount ofinformation sharing. In fact, even inthe absence of opt-out or opt-in laws,the amount of information sharingshould be economically appropriate.Opt-out/opt-in laws will be irrelevantas long as financial institutions are notprevented from offering customers arange of desirable privacy options.

The broad and multifaceted issuesthat surround privacy go well beyondthe opt-out/opt-in debate. Although thisessay is narrowly focused on the lat-ter, the general principles outlined herehave a much wider application. At afundamental level, opt-out versus opt-in is really a question about the prop-er allocation of “rights” in contractualrelationships — a customer’s right toprivacy versus the right of a financialinstitution to share its information. Theanswer economics provides is thatwhether rights are allocated in accordwith opt-out or opt-in is irrelevant, aslong as consumers and financial insti-tutions are free to agree to an alter-native arrangement if it suits them.Most financial privacy questions concern the specification of rights of various parties in contractual relation-ships. The irrelevance result of thisessay thus should carry over to otherrelated settings; laws and regulations

1 The deadline for compli-ance was July 1, 2001. Formore information on thefinancial privacy provisionsof the GLBA, see the FederalTrade Commission’s Web site(Federal Trade Commission2002). The privacy provisionsof the GLBA apply to anyinstitution engaged in activi-ties that have been deemed“financial in nature or inci-dental to such financial activ-ities” under the Bank HoldingCompany Act. This meansthat whenever the Fed andthe Treasury determine thatan activity is financial innature and therefore a per-missible activity for a finan-cial holding company, theentire financial industry isbrought under the privacyprovisions of the GLBA.

providing more (or less) “privacy rights”should generally have little effect onconsumers’ financial privacy.2

Privacy in the FinancialMarketplace

Financial privacy can bethought of as a bundle ofcharacteristics associatedwith a particular financialservice. A bank that doesnot share nonpublic cus-

tomer information with third parties isproviding its customers a service withdifferent characteristics from a bankthat does share such information. Howdo markets work when products orservices differ in their characteristics?

In well-functioning competitivemarkets, consumers selecting amongproducts with different bundles ofcharacteristics are willing to pay morefor products with characteristics theyvalue. Some characteristics make aproduct more costly to provide.Producers are willing to supply prod-ucts with more costly characteristicsonly if they are compensated for theadditional cost. One would expect tosee products with characteristics forwhich a customer’s willingness to payexceeds the incremental productioncost. For example, some people arewilling to pay more for a car with abuilt-in CD player, but CD players arecostly. It is logical then that consumers

whose willingness to pay exceeds thecost of the CD player would own carswith CD players.

Well-functioning markets generallyprovide goods and services that areappropriate when judged against thebenchmark of economic efficiency.With regard to product characteristics,economic efficiency means that agiven product characteristic is suppliedif and only if the value of that char-acteristic to consumers exceeds its costto society. When markets functionsmoothly, the incentives of producersand consumers are aligned with eco-nomic efficiency. Suppliers find it prof-itable to provide products with theappropriate characteristics, since con-sumers are willing to pay at least theadditional cost. Characteristics forwhich consumers’ valuations fall shortof the cost of production cannot beprofitably supplied.

Financial privacy is a service char-acteristic that some consumers prefer.Many consumers harbor deep con-cerns about privacy in general andfinancial privacy in particular. Accord-ing to one recent poll, 56 percent ofconsumers say they are “very con-cerned” about potential loss of privacy.3 Overall, consumers seem tohave three main fears.4 They fearbeing robbed or cheated by criminalsthat obtain personal information. Theyfear embarrassing revelations due to


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2 For other economic analy-ses of financial privacy, seeKahn, McAndrews, andRoberds (2000) and Bauer(forthcoming).

3 National Consumers League(2000).

4 Research by Alan Westin,as cited in Paul (2001).


the disclosure of sensitive information.And they dislike intrusive marketingin the form of telephone calls or junkmail. When financial institutions sharecustomer information with outside com-panies, it can erode customer privacyon all three counts.

Providing greater financial privacycan be costly for a financial serviceprovider because it means foregoingthe potential economic value of infor-mation sharing. Marketers can makebetter decisions the more informationthey have about prospective customersand are therefore willing to pay banksto get it. Better information helps mar-keters find customers who genuinelymay be interested in buying theirproducts and saves them the expenseof soliciting consumers who are not.These benefits provide genuine eco-nomic value by increasing the proba-bility of a successful buyer-seller matchand decreasing the probability of wast-ing marketing efforts on those whowould not be interested.

Consumers that place a high valueon financial privacy ought to be will-ing to pay for high-privacy financial services. If consumers prefer that theirbank not share nonpublic informationabout them with unaffiliated compa-nies, they should be willing to pay forthis service characteristic implicitlythrough lower deposit interest rates,higher loan interest rates, or higher

account-related fees. More directly,banks could offer direct inducements —a bonus payment, coupon, or sweep-stakes entry, for example — to cus-tomers that agree to information shar-ing. Many nonfinancial firms offer suchenticements to customers that return“product registration cards” filled outwith their name, address, and otherinformation. Consumers that valuefinancial privacy would pay by fore-going their bank’s offer. Similarly,many grocery stores offer cards to cus-tomers that qualify them for discountswhen they present the cards at check-out stations. In exchange, stores gath-er data on customer purchases.

Along the same lines, if sharingnonpublic customer information withthird parties is economically beneficial,financial institutions should be willingto compensate their customers whoallow them to do so.5 The outside firmswith which the information is sharedshould be willing to pay an amountup to the information’s value to them.The financial institution should then bewilling to pass this along to their customers in the form of higher inter-est rates on savings, lower interestrates on loans, or lower fees. Moredirectly, they should be willing to sim-ply pay those customers who agree toshare an amount up to the incremen-tal value of the information.

Ideally, the economic benefits of

5 See Kovacevich (2000).

2001 Annual Report


financial privacy should be balancedagainst the economic costs. When theeconomic value of sharing nonpubliccustomer information with third partiesfalls short of the value consumers placeon preventing that information sharing,economic efficiency would dictate thatno information sharing takes place.Similarly, when the economic value ofsharing nonpublic customer informa-tion with third parties exceeds thevalue consumers place on preventingit, economic efficiency would dictatethat information sharing should takeplace. If the market for financial pri-vacy is well functioning, then weshould see an economically efficientamount of financial privacy.

Does the Market for FinancialPrivacy Work Well?

Is there anything different aboutfinancial privacy? Are the mar-kets for financial privacy poorlyfunctioning in the sense that theydeliver outcomes that are not eco-nomically efficient? There does

not appear to be any plausible rea-son to think so.

For markets to misfunction in thissense, one of two conditions mustexist: either a divergence between thevalue of a product characteristic toconsumers and their willingness to payit, or a divergence between the costto suppliers of providing that charac-

teristic and the overall cost to society.Divergences could be caused by exter-nalities, monopoly power, or verifi-cation problems.

An externality occurs when anaction by one group affects the well-being of others that do not transactwith that group. For example, burningleaves in my front yard raises the riskof fire for my suburban neighbor.6

Externalities are often invoked toexplain a broad range of governmentlaws and regulations — prohibitingsuburban leaf burning, for example.

Is there an externality in the marketfor financial privacy? No, it doesn’tappear so. Sharing nonpublic customerinformation about a consumer affectsthat consumer’s privacy but not the pri-vacy of other consumers. The sharinginstitution is a counterparty of the affect-ed customer, and either can withdrawfrom the relationship. The two of themhave ample opportunity to take infor-mation sharing into account when set-ting the terms of their relationship. Thusno parties are affected by the infor-mation sharing except those who areparticipants in the transaction.

“Public goods” are a type of exter-nality that can result in inefficiency andare defined by two properties. Theyare nonrivalrous, meaning that oneperson’s use does not detract from theability of another to use it. And theyare nonexcludable, meaning that one

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6 One could argue that thetwo parties could negotiatean efficient solution to thisproblem; my neighbor cansimply pay me not to burnleaves, or can sue me if thefire spreads. For additionalexplanation see the sectionon the Coase Theorem.


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7 Coase (1974) pointed out,however, that coastal light-houses are often funded fromfees charged to ships usingnearby ports, so even theservices of lighthouses are attimes excludable. A light-house is therefore only a public good when ships can-not be excluded from using itsservices if they do not pay –for example, in settings wheremost ships are on long-distance voyages.

8 If financial institutions wereexercising market power andthis resulted in inefficientfinancial product characteris-tics, a more appropriate rem-edy would be for regulatorsto ensure effective competitionrather than regulate servicecharacteristics. Moreover, itwould appear inconsistent toregulate service characteristicson the grounds of impedi-ments to competition whilenot regulating service prices.

cannot prevent people from using it.A lighthouse is a classic example of apublic good: one ship’s use does notprevent another ship’s use, and youcannot prevent a ship from using it.7

Information is nonrivalrous becauseone person’s use does not preventanother from using the same informa-tion. But information is excludablebecause you can prevent people fromobtaining it. Therefore financial infor-mation is not a public good.

Monopoly power is another pos-sible cause of market misfunction.When a firm is sheltered from competitive pressures it can raiseprices and restrain supply. Similarly, aprotected monopolist may find it prof-itable to supply too little of a desiredproduct characteristic when customersare prevented from seeking preferredcharacteristics from other suppliers.This problem may have been relevantto the banking industry decades agowhen competition was severely limit-ed by regulatory restrictions on pric-ing, entry, and geographic expansion,but these restrictions have been large-ly dismantled. As a consequence, themarket for financial services is nowwidely judged to be relatively com-petitive. Thus it seems unlikely thatbanks or other financial institutions aremanipulating privacy policies becauseof significant monopoly power.8

A third potential cause of market mis-

function stems from the difficulty of ver-ifying whether a financial institution isliving up to its stated privacy policy. A customer that receives junk mail ortelemarketing calls may have a hardtime discerning where the marketerobtained the information. The spellingof a name or address can be alteredslightly in order to trace informationsharing, but this technique is obviouslylimited. In cases of identity theft it is oftenimpossible to determine exactly how theidentity was stolen after the fact.

Do verification problems interferewith the efficiency of the market forfinancial privacy? Not necessarily.Note that there are a number of mech-anisms to help ensure that an institu-tion lives up to its privacy commitments,despite the difficulty of observingwhether or not it has done so. First, aninstitution that fails to comply with itsstated financial privacy policy may beliable for “unfair and deceptive tradepractices.” If caught, the institutionwould be subject to civil litigation aswell as regulatory action by the Fed-eral Trade Commission. The potentiallegal costs can deter noncompliance,even if the probability of detection issmall. There is nothing particularlyunique about financial privacy in thisregard. Consumers often rely on hard-to-verify commitments by the firms theypatronize — a commitment to productquality, for example.


Second, institutions that wish toattract customers for whom privacy isimportant will want to convince thosecustomers of their organization’scommitment to its privacy policy. Suchinstitutions will have an incentive tocultivate and safeguard their reputa-tion as a high-privacy entity. At leastone prominent bank has advertised a“no telemarketing” promise, indicat-ing that banks are capable of active-ly competing on the basis of theirprivacy policies.9 Third parties canevaluate a financial institution’s com-pliance, just as Consumer Reportsindependently assesses the quality ofconsumer products. The potential forembarrassing media publicity alsomotivates an institution to live up to itscommitments. Standard industry prac-tice is for a firm that rents its mailinglist to approve every mailing or tele-marketing script that is used. Evident-ly firms believe that at least some con-sumers could trace marketing contactsto them, with possibly detrimentaleffects on their customer relationships.

While reputational considerationsand laws on trade practices can gopartway toward ensuring that a firm isfaithful to its stated privacy policy, somewould argue that these mechanisms are inherently limited and imperfect.Enforcement is often costly and com-pliance is rarely 100 percent. Do theseimperfections warrant legislative restric-

tions aimed specifically at informationsharing? No. Any entity attempting toverify and enforce a financial firm’s pri-vacy commitments will confront thesame imperfections. A governmentaleffort to enforce a ban on informationsharing, for example, will face the sameverification difficulties — costly enforce-ment and incomplete compliance — aswould any private parties. So a gov-ernment ban on information sharingwould have no advantage; in fact, itwould have the disadvantage of pos-sibly preventing economically usefulinformation sharing.

The market for financial privacytherefore appears to work fairly well.This means that we should expect eco-nomically efficient outcomes: informa-tion will be shared if and only if theeconomic benefits of information shar-ing exceed the value consumers placeon preventing information sharing.

Opt-Out Versus Opt-In

Provided the market forfinancial privacy works fair-ly well, it should not makemuch difference whether weadopt an opt-out law or anopt-in law. Either way, an

economically efficient level of informa-tion sharing will result. Why is this so?

Under an opt-out law, banks thatvalue information sharing will be will-ing to provide inducements to get

9 The phrase appeared in tel-evision advertising for Capi-tal One during November2001. As of this writing, thecompany’s home pageprominently features the fol-lowing description of their“New No-Hassle Card”:“9.9% Fixed APR on Every-thing, No Telemarketing, NoAnnual Fee.”

2001 Annual Report


high-privacy customers not to opt outbecause information sharing canlower the cost of providing bankingservices. Similarly, automakers arewilling to discount the price of carswithout CD players, since these carsare less costly to build. Banks will bewilling to pay an amount up to theincremental value of sharing the cus-tomer’s nonpublic information. If thatfalls short of the value the customerimplicitly places on privacy, then thecustomer will decline the inducementand opt out. In that case, the eco-nomic value of the information shar-ing is less than the cost to the customerof yielding this bit of privacy, andinformation sharing is not economi-cally efficient. Alternatively, the cus-tomer may feel that the value of theinducement exceeds the value of preventing information sharing, inwhich case the inducement is accept-ed and the customer does not opt out.Here, the economic value of the information sharing exceeds the costto the customer of yielding this bit ofprivacy, and information sharing iseconomically efficient.

Under an opt-in law, the reason-ing and the result are exactly thesame. Banks will be willing to pro-vide the same inducement to get acustomer to opt in as they would haveprovided to get a customer to refrainfrom opting out — up to the economic

value of the information sharing. Ifthat amount exceeds the value thatthe customer places on preventinginformation sharing, then informationsharing will take place and iseconomically efficient. Otherwise thecustomer will refuse the enticement;in this case information sharing is noteconomically efficient and will nottake place.

In fact, the same reasoningapplies in the absence of opt-out oropt-in laws. If the law is silent onwhether banks need to seek permis-sion to share nonpublic informationwith third parties, banks nonethelesscould decide to do so on their own.If some customers truly care aboutinformation sharing with third parties,they will seek out banks that give themthe option of preventing it. If informa-tion sharing is economically useful,banks will find it more costly to servecustomers that insist on preventing it.Competition will force banks to passalong the increased cost to high-pri-vacy customers. Ultimately, an eco-nomically appropriate amount ofinformation sharing will take place,with or without opt-out or opt-in laws.

The difference between opt-out andopt-in standards is like the differencebetween treating CD players in carsas standard equipment or as an add-on option. If CD players are anoption, one would expect the price of

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the option to reflect the incrementalcost. If instead CD players are stan-dard equipment, the discount for carswithout CD players should reflect theincremental cost. It should not makea difference whether car buyers haveto ask to get a CD player in their caror ask not to have one. Either way weshould see a market-clearing quantityof cars with CD players.

The debate between proponents ofopt-out and opt-in seems predicatedon the view that the choice wouldaffect how many consumers wouldprevent information sharing. Thehypothesis seems to be that fewer con-sumers would opt out under an opt-out standard than would fail to opt inunder an opt-in standard. This couldwell be the case, but it would be evi-dence that many consumers are rela-tively indifferent about informationsharing by their financial institution;they would not bother to opt out, norwould they bother to opt in. If this istrue, then little is at stake for these con-sumers. Those who would neither optout nor opt in evidently place littlevalue on preventing their financialinstitution from sharing nonpublic infor-mation about them. The economic efficiency implications of the choicebetween opt-out and opt-in wouldtherefore be negligible for them aswell, even if participation rates dif-fered significantly.

An Alternative Line ofReasoning: The Coase Theorem

The knowledgeable read-er may have noticed thatthe logic of this essay isclosely related to theinsights that Ronald H.Coase presented in his

celebrated paper “The Problem ofSocial Cost.”10 (This paper was citedby the Royal Swedish Academy of Sci-ences in awarding him the 1991Nobel Prize in Economics.) Coasewrestled with the issue of externalities,the same issue as in my leaf-burningexample. Before Coase’s paper econ-omists generally believed that, absentgovernment intervention, externalitieswould result in inefficient outcomesbecause one party (I, for example)would ignore the cost (increased firehazard) that his action (leaf burning)imposed on another party (my neigh-bor). The contribution of Coase wasto notice that the two parties couldnegotiate an efficient solution to theexternality problem as long as the rel-evant rights were clearly assigned. Forexample, if I am entitled to burn leaves,my neighbor could offer to pay me notto, or could offer to help me disposeof them by some other method. Alter-natively, if I am required to obtain myneighbor’s permission to burn leaves,I could offer to pay my neighbor. If thevalue to me of burning leaves is less

10 Coase (1960).

2001 Annual Report


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11 The costs are negligible inpart because of the regula-tions that require financialinstitutions to provide cus-tomers with a “reasonablemeans” of opting out. In asense, then, this part of theallocation of property rightshas efficiency implicationsconsistent with the CoaseTheorem. The reasonable-means provision appears tobe an efficient choice since itminimizes the “transactioncosts” of opting out. Fried-man (2000) applies Coase’sapproach to a broad arrayof privacy issues in whichtransaction costs are nonneg-ligible.

than the value to my neighbor of mynot burning leaves, then my neighborwill pay me not to do so in the firstcase. In the second case, I will beunwilling to offer my neighbor enoughmoney to get permission to burnleaves. Either way we get an efficientoutcome; I don’t burn leaves. The gen-eral proposition is that (under certainconditions) any well-defined allocationof property rights leads to efficient out-comes. This result is often called theCoase Theorem.

The application to financial privacyshould be clear. Opt-out and opt-in arejust different allocations of propertyrights. Opt-out means financial institu-tions have the right to share informa-tion; customers can ask them to stop.Opt-in means customers have the rightto no-information-sharing; financialinstitutions can ask them for permissionto share. Either way, according toCoase, the prediction is an efficientamount of information sharing.

The Coase Theorem has its limita-tions, however. It is said to hold onlyif “transaction costs” are zero; in otherwords, any agreement that is in themutual interest of the parties is actual-ly agreed upon. Transaction costs arethe difficulties associated with actual-ly reaching an agreement among theaffected parties. It may be costly tocommunicate and coordinate amonga large number of parties, for exam-

ple. When transaction costs are significant, the assignment of proper-ty rights can affect efficiency. Onepremise of this essay, as I discuss later,is that the costs of opting out are neg-ligible, in which case the Coase Theorem applies.11

The logic of this essay, however, differs subtly from Coase’s analysis.Coase envisioned bargaining betweenaffected parties. As a result, the assign-ment of property rights could alter thedistribution of net benefits, even if thatassignment had no effect on efficiency.For example, if I have the right to burnleaves, I get paid not to burn them; yetif I need permission, I earn nothingwhen I don’t burn them. I am better offin the first case, while my neighbor isbetter off in the second case. The assign-ment of rights thus alters the relative well-being of my neighbor and me, eventhough either assignment leads to effi-cient leaf-burning decisions. In compet-itive markets, in contrast, the assignmentof contractual rights generally does notaffect people’s well-being. The choicebetween opt-out and opt-in determineswhich rights are, by default, bundledtogether with financial services. Undereither regime, competition and freeentry implies that both high-privacy andlow-privacy financial services will beavailable at prices reflecting their truecost. In competitive markets, the choiceof regime should have no effect on the


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net cost of financial services with par-ticular characteristics, just as a lawmandating that CD players be sold sep-arately should have no effect on the totalprice of cars with CD players. The effi-ciency implication of Coase’s famoustheorem carries over to competitive mar-kets, however, and buttresses the casemade here: market mechanisms shouldwork well at providing an efficient levelof financial privacy.

Opt-Out in Practice: FewConsumers Do

During the first half of2001, many banksbegan mailing out theprivacy notices requiredby the GLBA. Thosethat share nonpublic

customer information with unaffiliatedcompanies are required to give theircustomers the opportunity to opt out of third-party information sharing.Although there is only limited evidenceso far, press reports suggest that theresponse rate is rather low. Accordingto the trade publication AmericanBanker, industry estimates of the num-ber of consumers who have opted out“hover around 5 percent.”12 One sur-vey of savings banks showed thatmore than half were experiencing anopt-out rate of one percent or less.13

Opting out does not appear to bevery hard. The financial privacy reg-

ulations require that financial institu-tions give customers a “reasonablemeans” of exercising their right to optout. The regulations even offer exam-ples of acceptable and unacceptablemethods. Providing a toll-free numberto call or supplying a mail-in card fora check-box response are deemed rea-sonable means. Requiring a customerto write his or her own letter is notdeemed reasonable.

Despite these requirements, criticsclaim that opting out is difficult becauseprivacy notices are complex, confus-ing, and hard to read.14 Food labelsare often cited, in contrast, as a sim-ple, well-understood notice system.Some financial institutions, however,are actively working toward simplerand clearer privacy notices.15 Appar-ently, they view that it is in their busi-ness interest to make their notices asagreeable to their customers as pos-sible. Many institutions sent privacynotices for the first time in 2001, andsome experimentation and learningseem to be taking place. Perhaps opt-out rates will rise as GLBA privacynotices are refined and consumerslearn about what they contain.

Nevertheless, the fact that so fewbank customers are currently taking therelatively easy step of opting out seemsto indicate that most consumers nowplace a negligible value on preventingfinancial institutions from sharing

12 Lee (2001).

13 America’s CommunityBankers (2001).

14 See transcripts and sup-porting documentation fromthe workshop on effectiveprivacy notices hosted by theFederal Trade Commissionand the federal financial reg-ulatory agencies (FederalTrade Commission 2001).

15 See the presentations byMarty Abrams, John Dugan,Patricia Faley, and David M.Klaus at the privacy noticesworkshop along with thepublic comments submittedby Walter Kitchenman, VanceGudmundsen, and SteveBartlett in connection with theevent (Federal Trade Commis-sion 2001).


nonpublic information about them withthird parties. A small fraction of con-sumers feel strongly enough to takeadvantage of the opt-out option. Thisgroup appears to place a significantvalue on guarding their financial priva-cy. But for a broad majority of Ameri-cans, the value they place on financialprivacy does not exceed the inconven-ience of exercising their right to opt out.16

This pattern — about 5 percent ofpeople willing to take action to protecttheir privacy — is consistent with otherevidence on consumers’ privacy pref-erences. The Direct Marketing Associ-ation, a marketing industry trade group,offers consumers the ability to opt outof telephone or mail marketing by theirmembers. The 4.2 million participantsin their telephone opt-out program rep-resent about 4.2 percent of U.S. house-holds with telephone service. The 4.0million participants in their mail opt-outprogram represent about 3.8 percentof total U.S. households.17

A very low opt-out rate is also con-sistent with other choices consumersmake with regard to privacy. Few con-sumers disable cookies when brows-ing the Internet. (Cookies are smallfiles that a Web site places on a user’scomputer to enable tracking the useron subsequent visits.) Few consumersread privacy notices. Many consumersreadily provide their credit card num-ber over the phone or to a waiter.18

The picture that emerges, then, is thata few consumers place significantvalue on preventing information shar-ing by their financial institutions, butthe broad majority of consumers arerelatively indifferent.

Opt-Out in Practice: FewBanks Pay

Financial institutions do notappear to be offeringinducements to customers toget them to refrain from opt-ing out. This suggests thatthe economic value of

sharing nonpublic customer informa-tion is relatively low. Otherwisefinancial institutions would find itworthwhile to compensate theircustomers for their cooperation. Infact, not all institutions are evenengaged in information sharing thatwould trigger the opt-out requirement.A survey of savings banks found thatfewer than one-third needed to sendout opt-out notices.19

Banks do not lack opportunitiesto share customer information. Thereis an active market for consumers’names, addresses, and other per-sonal information. Individual mer-chants rent their customer lists tomarketers, often through list brokers.Credit bureaus offer selections fromtheir databases based on age,income, occupation, family status,

16 One could argue that con-sumers are just lazy, but thisreasoning leads to the sameconclusion; the value theyplace on financial privacy isnot enough to motivate themto opt out.

17 The three main creditbureaus also offer a programthrough their trade groupthat allows consumers to optout of pre-approved creditoffers, but the credit bureausdo not release statistics onthe number of consumers opting out.

18 According to a recent sur-vey, 24 percent of consumersprotect their privacy by dis-abling cookies (Harris Interac-tive Inc. 2001). An AmericanBankers Association pollfound that 36 percent of con-sumers said they had readtheir bank’s privacy notice(American Bankers Associa-tion 2001).

19 America’s CommunityBankers (2001).

2001 Annual Report


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net worth, type of automobile, reli-gion, and so on. According to itsWeb site, Equifax even offers aselection based on a person’s carburetor type. American Expressoffers customer lists selected on thebasis of purchase patterns — shoebuyers that spend more than$1,000 annually, for example. Listsare available from magazines,membership organizations, bookclubs, and merchants.20

Apparently, the market for con-sumer information does not providebanks with sharing opportunities thatwould make it worthwhile to offermaterial rewards for consumer co-operation. A glance at the prices forsuch information suggests why —prices are relatively low. Rates for listsof merchandise buyers, for example,appear to be relatively consistent,ranging from 8 cents to 13 cents pername as of early 2001. Base pricesat one large credit bureau range from1.65 to 4 cents per name per mail-ing, depending on volume, with add-on charges for additional selectioncriteria ranging from .25 cents pername for length of residence, title,or gender to 2 cents per name for networth. Thus the value to a financialinstitution of sharing nonpublic cus-tomer information might not be largeenough to warrant offering a signifi-cant sum to customers.

Why Is Financial Privacy anIssue Now?

Applying economicsto financial privacyleads to the conclu-sion that financialmarkets can providean appropriate bal-

ance between consumers’ desires forprivacy and the economic value ofinformation sharing. If this is true, thenwhy do surveys show widespread consumer concern about privacy yetfew consumers taking action to opt outof information sharing? And why hasthere been such clamor for privacy legislation in the past few years, culminating in the financial privacyprovisions of the GLBA?

The dramatic changes in communi-cations and computing technologies inrecent years might help explain whyso many recent surveys report con-sumer concern about privacy. Financialinstitutions have always possesseddetailed information about their cus-tomers. Moreover, active markets forcustomer lists have been around fordecades.21 Only recently, however, hasthe collation and analysis of informa-tion from disparate sources becomehighly automated. This technologicaladvance allows more targeted mar-keting efforts; a company can solicithigh-income, gun-owning dog lovers,for example. The resulting improvement

20 For information on lists seeEquifax (2001), American ListCounsel (2002), and Worldata(2002).

21 I recall my father managingrentals of his company’s mail-ing list in the 1960s. The listwas kept on “addressographplates” — metal stripsembossed with names andaddresses. While these stripscould be linked together forautomated addressing ofmass mailings, any sorting orselection had to be handledmanually. The list was rentedout through mailing housesthat handled the actual print-ing and distribution. Allrentals had to be approved bylist owners. Decoys — falsenames and addresses — wereincluded in the list to providea means of verification by thelist owner.


in marketing success rates appears tohave led to an increase in the numberof mail and telephone solicitations.

Before the technological develop-ments that lowered the cost of manip-ulating databases, assembling suchdetailed consumer profiles was not eco-nomically feasible. Consumers cameto view the limited nature of informa-tion sharing by financial institutions asan implicit part of their contractual rela-tionship, relying on the practical obscu-rity of what other firms knew aboutthem.22 Since widespread informationsharing was impractical then, few sur-veys asked how consumers felt aboutit. New technologies have dispersedthe fog of practical obscurity that for-merly surrounded many consumertransactions. The privacy concerns thatappear in consumer surveys could represent ex post regret at the lack ofcontractual constraints on informationsharing. This conflicts, however, withthe evidence cited earlier indicatingthat most consumers do not feel strong-ly about information sharing. Alterna-tively, perhaps consumer preferenceshaven’t changed, but consumers aremerely asked about them more oftentoday. Now that interfirm informationsharing is economically viable, we seesurveys on the subject.

Economists are often skeptical ofsurvey evidence on consumer prefer-ences, but it is not the sincerity of

consumers’ responses that is in doubt. Surveys rarely confront consumers withthe cost consequences of their choices.When asked whether they desiregreater privacy without reference tocost, they are likely to say “yes” —more of a good is generally preferredto less, after all. But when confrontedwith real-life choices, many consumersdecide that the benefits of greater privacy are outweighed by the costs. One recent study found adramatic disparity between consumers’stated privacy preferences and theiractual online behavior.23 Participantsanswered many “highly personal”questions, despite having stated thatprivacy was important to them. Thediscrepancy between widespread con-sumer “concern” and the willingnessof many consumers to readily com-promise their privacy could well reflectthe gap between the artificial choicesimplicit in survey questions and thereal choices consumers actually face.24

Conclusion

The economics of financialprivacy is based on thenotion that a financial institution’s privacy policyis a characteristic associ-ated with the products and

services the institution offers. In well-functioning markets, prices reflect prod-uct characteristics; consumers are

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22 Gramlich (1999).

23 Spiekermann, Grossklags,and Berendt (no date avail-able).

24 Harper and Singleton(2001).


2001 Annual Report

willing to pay more for characteristicsthey value, and producers charge morefor characteristics that are more costlyto supply. Consumers that value finan-cial privacy ought to be willing to payfor privacy policies that they prefer. Andif it is economically beneficial to shareinformation with other companies, finan-cial institutions ought to be willing tocompensate their customers for permis-sion to do so. The fact that few banksseem to be paying customers not to optout is strong evidence that the economicvalue of information sharing is relativelysmall. And the fact that so few con-sumers are opting out, despite the lowcost of doing so, is evidence that fewconsumers place a significant value onpreventing information sharing.

This line of reasoning also leads toa stark and surprising conclusion: thechoice between opt-out and opt-in standards is irrelevant. Under an opt-

out standard, banks could pay cus-tomers to refrain from opting out, whileunder an opt-in standard, banks couldpay customers to opt in. Either way,financial markets should deliver an effi-cient amount of information sharing.One puzzle remains, however: Whyis financial privacy such a controver-sial issue if few consumers care enoughabout preventing information sharingto take simple steps to prevent it? Nev-ertheless, the economics of the issue isclear —financial privacy laws like theGLBA accomplish less than either pri-vacy advocates or their critics presume.

This article benefited from the com-ments of my colleagues in the Bank’sResearch Department, especially JohnWeinberg, Marvin Goodfriend, LauraFortunato, Ned Prescott, Aaron Steel-man, and John Walter, and from theassistance of Elise Couper.


Feature Article

References

American Bankers Association. 2001.“ABA Survey Shows Nearly One Out ofThree Consumers Read Their Banks’ PrivacyNotices.” News Release (7 June).

American List Counsel. 2002.http://www.amlist.com [17 January].

America’s Community Bankers. 2001.“ACB Privacy Compliance Survey.” Manuscript (November).

Bauer, Paul. “Consumer’s Financial Privacyand the Gramm-Leach-Bliley Act.” FederalReserve Bank of Cleveland Economic Commentary (forthcoming).

Coase, Ronald H. 1960. “The Problem ofSocial Cost.” Journal of Law and Econom-ics 3 (October): 1-44.

____________. 1974. “The Lighthouse inEconomics.” Journal of Law and Economics17 (October): 357-76.

Equifax. 2001. TotalSourceXLTM. ConsumerDatabase (Fall).http://www.equifax.com/business_solu-tions/information_services/documents/Fall_2001_TotalSource_XL_Rate_Card.pdf [17 January 2002].

Federal Trade Commission. 2001. Intera-gency public workshop entitled GetNoticed: Effective Financial PrivacyNotices, 4 December, at The Ronald Reagan Building and International TradeCenter, Washington, D.C.http://www.ftc.gov/bcp/workshops/glb/index.html [17 January 2002].

____________. 2002. “Gramm-Leach-BlileyAct: Financial Privacy and Pretexting.”http://www.ftc.gov/privacy/glbact/index.html [17 January].

Friedman, David. 2000. “Privacy andTechnology.” Social Philosophy & Policy17 (Summer): 186-212.

Gramlich, Edward M. 1999. “Statement tothe U.S. House Subcommittee on FinancialInstitutions and Consumer Credit of theCommittee on Banking and Financial Ser-vices,” July 21, 1999. Federal ReserveBulletin 85 (September): 624-26.

Harper, Jim and Solveig Singleton. 2001.“With a Grain of Salt: What Consumer Privacy Surveys Don’t Tell Us.” Manuscript,Competitive Enterprise Institute (June).

Harris Interactive Inc. 2001. “A Survey ofConsumer Privacy Attitudes and Behav-iors.” Manuscript.

Kahn, Charles M., James McAndrews, andWilliam Roberds. 2000. “A Theory ofTransactions Privacy.” Working Paper2000-22. Federal Reserve Bank of Atlanta.

Kovacevich, Richard M. 2000. “Privacyand the Promise of Financial Moderniza-tion.” The Region 14 (March): 27-29.

Lee, W. A. 2001. “Opt-Out Notices Give NoOne a Thrill.” American Banker (10 July).

National Consumers League. 2000.“Online Americans More Concerned aboutPrivacy than Health Care, Crime, andTaxes, New Survey Reveals.” NewsRelease (4 October).

Paul, Pamela. 2001. “Mixed Signals.” American Demographics 23 (March): 45-49.

Spiekermann, Sarah, Jens Grossklags, andBettina Berendt. No date available. “Stat-ed Privacy Preferences versus ActualBehaviour in EC environments: a RealityCheck.” Manuscript, Humboldt University.

Worldata. 2002. Worldata & WebConnectOnline Datacard Library. Online database,http://www.worldata.com [17 January].

Financial Statements

MANAGEMENT ASSERTION

D E C E M B E R 3 1 , 2 0 0 1



To the Board of Directors:

The management of the Federal Reserve Bank of Richmond (FRB Richmond) is responsiblefor the preparation and fair presentation of the Statement of Financial Condition, Statementof Income, and Statement of Changes in Capital as of December 31, 2001 (the “FinancialStatements”). The Financial Statements have been prepared in conformity with the account-ing principles, policies, and practices established by the Board of Governors of the FederalReserve System and as set forth in the Financial Accounting Manual for the Federal ReserveBanks, and as such, include amounts, some of which are based on judgments and estimatesof management.

The management of the FRB Richmond is responsible for maintaining an effectiveprocess of internal controls over financial reporting including the safeguarding of assetsas they relate to the Financial Statements. Such internal controls are designed to providereasonable assurance to management and to the Board of Directors regarding the prepa-ration of reliable Financial Statements. This process of internal controls contains self-mon-itoring mechanisms, including, but not limited to, divisions of responsibility and a code ofconduct. Once identified, any material deficiencies in the process of internal controls arereported to management, and appropriate corrective measures are implemented.

Even an effective process of internal controls, no matter how well designed, has inher-ent limitations, including the possibility of human error, and therefore can provide onlyreasonable assurance with respect to the preparation of reliable financial statements.

The management of the FRB Richmond assessed its process of internal controls over finan-cial reporting including the safeguarding of assets reflected in the Financial Statements,based upon the criteria established in the “Internal Control — Integrated Framework” issuedby the Committee of Sponsoring Organizations of the Treadway Commission (COSO).Based on this assessment, the management of the FRB Richmond believes that the FRBRichmond maintained an effective process of internal controls over financial reporting includ-ing the safeguarding of assets as they relate to the Financial Statements.

Federal Reserve Bank of Richmond

J. Alfred Broaddus, Jr. Walter A. VarvelP R E S I D E N T F I R S T V I C E P R E S I D E N T

To the Board of Directors of the Federal Reserve Bank of Richmond:

We have examined management’s assertion that the Federal Reserve Bank ofRichmond (“FRB Richmond”) maintained effective internal control over financialreporting and the safeguarding of assets as they relate to the FinancialStatements as of December 31, 2001, included in the accompanyingManagement’s Assertion. The assertion is the responsibility of FRB Richmond’smanagement. Our responsibility is to express an opinion on the assertionsbased on our examination.

Our examination was made in accordance with standards established by theAmerican Institute of Certified Public Accountants, and accordingly, includedobtaining an understanding of the internal control over financial reporting, testing,and evaluating the design and operating effectiveness of the internal control,and such other procedures as we considered necessary in the circumstances.We believe that our examination provides a reasonable basis for our opinion.

Because of inherent limitations in any internal control, misstatements dueto error or fraud may occur and not be detected. Also, projections of anyevaluation of the internal control over financial reporting to future periods aresubject to the risk that the internal control may become inadequate becauseof changes in conditions, or that the degree of compliance with the policiesor procedures may deteriorate.

In our opinion, management’s assertion that the FRB Richmond maintainedeffective internal control over financial reporting and over the safeguardingof assets as they relate to the Financial Statements as of December 31, 2001,is fairly stated, in all material respects, based upon criteria described in “InternalControl — Integrated Framework” issued by the Committee of SponsoringOrganizations of the Treadway Commission.

March 4, 2002


REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Governors of the Federal Reserve System and the Board ofDirectors of the Federal Reserve Bank of Richmond:

We have audited the accompanying statements of condition of the FederalReserve Bank of Richmond (the “Bank”) as of December 31, 2001 and 2000,and the related statements of income and changes in capital for the yearsthen ended. These financial statements are the responsibility of the Bank’smanagement. Our responsibility is to express an opinion on the financialstatements based on our audits.

We conducted our audits in accordance with auditing standards gener-ally accepted in the United States of America. Those standards require thatwe plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement. An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements. An audit also includes assessing theaccounting principles used and significant estimates made by management,as well as evaluating the overall financial statement presentation. Webelieve that our audits provide a reasonable basis for our opinion.

As discussed in Note 3, the financial statements were prepared in con-formity with the accounting principles, policies, and practices established bythe Board of Governors of the Federal Reserve System. These principles,policies, and practices, which were designed to meet the specializedaccounting and reporting needs of the Federal Reserve System, are set forthin the “Financial Accounting Manual for Federal Reserve Banks” and con-stitute a comprehensive basis of accounting other than accounting principlesgenerally accepted in the United States of America.

In our opinion, the financial statements referred to above present fairly, in allmaterial respects, the financial position of the Bank as of December 31, 2001 and2000, and the results of its operations for the years then ended, on the basis ofaccounting described in Note 3.

March 4, 2002



REPORT OF INDEPENDENT ACCOUNTANTS


FEDERAL RESERVE BANK OF RICHMONDSTATEMENTS OF CONDITION

(IN MILLIONS)

As of December 31,ASSETS 2001 2000

Gold certificates $ 741 $ 750 Special drawing rights certificates 147 147 Coin 165 117 Items in process of collection 174 658 Loans to depository institutions 1 5 U.S. government and federal agency securities, net 33,556 30,437 Investments denominated in foreign currencies 3,544 4,121 Accrued interest receivable 341 355 Prepaid expense – interest on Federal Reserve notes to the U.S. Treasury 13 584 Interdistrict settlement account 13,211 2,402 Bank premises and equipment, net 232 202 Other assets 101 102

Total assets $52,226 $39,880

LIABILITIES AND CAPITAL

Liabilities:Federal Reserve notes outstanding, net 45,208 34,048 Deposits:

Depository institutions 3,191 1,641 Other deposits 76 47

Deferred credit items 109 683 Accrued benefit costs 83 76 Other liabilities 45 27

Total liabilities 48,712 36,522

Capital:Capital paid-in 1,757 1,679 Surplus 1,757 1,679

Total capital 3,514 3,358

Total liabilities and capital $52,226 $39,880

The accompanying notes are an integral part of these financial statements.

2001 Annual Report

FEDERAL RESERVE BANK OF RICHMONDSTATEMENTS OF INCOME

(IN MILLIONS)

For the years endedDecember 31,

2001 2000INTEREST INCOMEInterest on U.S. government and federal agency securities $1,756 $1,982 Interest on investments denominated in foreign currencies 80 71 Interest on loans to depository institutions 1 1

Total interest income 1,837 2,054

OTHER OPERATING INCOME (LOSS)Income from services 78 68 Reimbursable services to government agencies 34 34 Foreign currency losses, net (354) (371)U.S. government securities gains (losses), net 19 (5)Other income 6 4

Total other operating loss (217) (270)

OPERATING EXPENSESSalaries and other benefits 203 187 Occupancy expense 26 24 Equipment expense 76 69 Assessments by Board of Governors 92 75 Other credits (59) (34)

Total operating expenses 338 321

Net income prior to distribution $1,282 $1,463

DISTRIBUTION OF NET INCOMEDividends paid to member banks $ 103 $ 101 Transferred to surplus 78 974 Payments to U.S. Treasury as interest on Federal Reserve notes 1,101 388

Total distribution $1,282 $1,463





FEDERAL RESERVE BANK OF RICHMONDSTATEMENTS OF CHANGES IN CAPITAL

(IN MILLIONS)

For the years ended December 31, 2001 and December 31, 2000

Capital TotalPaid-in Surplus Capital

Balance at January 1, 2000 $1,691 $1,691 $3,382 (33.8 million shares)

Net income transferred to surplus — 974 974 Surplus transfer to the U.S. Treasury — (986) (986)Net change in capital stock redeemed (12) — (12)

(0.2 million shares)

Balance at December 31, 2000 1,679 1,679 3,358 (33.6 million shares)

Net income transferred to surplus 78 78 Net change in capital stock issued 78 — 78

(1.5 million shares)

Balance at December 31, 2001 $1,757 $1,757 $3,514 (35.1 million shares)


2001 Annual Report

NOTES TO FINANCIAL STATEMENTS


1. OrganizationThe Federal Reserve Bank of Richmond (“Bank”) is part ofthe Federal Reserve System (“System”) created by Congressunder the Federal Reserve Act of 1913 (“Federal ReserveAct”) which established the central bank of the United States.The System consists of the Board of Governors of the Fed-eral Reserve System (“Board of Governors”) and twelve Fed-eral Reserve Banks (“Reserve Banks”). The Reserve Banksare chartered by the federal government and possess aunique set of governmental, corporate, and central bankcharacteristics. Other major elements of the System are theFederal Open Market Committee (“FOMC”) and the Feder-al Advisory Council. The FOMC is composed of membersof the Board of Governors, the president of the FederalReserve Bank of New York (“FRBNY”) and, on a rotatingbasis, four other Reserve Bank presidents.

StructureThe Bank in Richmond, Virginia, and its branches in Baltimore,Maryland, and Charlotte, North Carolina, serve the Fifth Fed-eral Reserve District, which includes Maryland, North Caroli-na, South Carolina, Virginia, the District of Columbia, and aportion of West Virginia. In accordance with the FederalReserve Act, supervision and control of the Bank are exercisedby a Board of Directors. Banks that are members of the Sys-tem include all national banks and any state chartered bankthat applies and is approved for membership in the System.

Board of DirectorsThe Federal Reserve Act specifies the composition of theBoard of Directors for each of the Reserve Banks. Each boardis composed of nine members serving three-year terms: threedirectors, including those designated as Chairman andDeputy Chairman, are appointed by the Board of Gover-nors, and six directors are elected by member banks. Of thesix elected by member banks, three represent the public and

three represent member banks. Member banks are dividedinto three classes according to size. Member banks in eachclass elect one director representing member banks and onerepresenting the public. In any election of directors, eachmember bank receives one vote, regardless of the numberof shares of Reserve Bank stock it holds.

2. Operations and ServicesThe System performs a variety of services and operations.Functions include: formulating and conducting monetary pol-icy; participating actively in the payments mechanism, includ-ing large-dollar transfers of funds, automated clearinghouse(“ACH”) operations and check processing; distributing coinand currency; performing fiscal agency functions for theU.S. Treasury and certain federal agencies; serving as thefederal government’s bank; providing short-term loans todepository institutions; serving the consumer and the com-munity by providing educational materials and informationregarding consumer laws; supervising bank holding com-panies and state member banks; and administering otherregulations of the Board of Governors. The Board of Gov-ernors’ operating costs are funded through assessments onthe Reserve Banks.

The FOMC establishes policy regarding open market oper-ations, oversees these operations, and issues authorizationsand directives to the FRBNY for its execution of transactions.Authorized transaction types include direct purchase and saleof securities, matched sale-purchase transactions, the purchaseof securities under agreements to resell, and the lending ofU.S. government securities. The FRBNY is also authorized bythe FOMC to hold balances of and to execute spot and for-ward foreign exchange and securities contracts in nine for-eign currencies, maintain reciprocal currency arrangements(“F/X swaps”) with various central banks, and “warehouse”foreign currencies for the U.S. Treasury and Exchange Sta-bilization Fund (“ESF”) through the Reserve Banks.



3. Significant Accounting PoliciesAccounting principles for entities with the unique powers andresponsibilities of the nation’s central bank have not beenformulated by the Financial Accounting Standards Board.The Board of Governors has developed specialized account-ing principles and practices that it believes are appropriatefor the significantly different nature and function of a centralbank as compared to the private sector. These accountingprinciples and practices are documented in the FinancialAccounting Manual for Federal Reserve Banks (“FinancialAccounting Manual”), which is issued by the Board of Gov-ernors. All Reserve Banks are required to adopt and applyaccounting policies and practices that are consistent with theFinancial Accounting Manual.

The financial statements have been prepared in accor-dance with the Financial Accounting Manual. Differencesexist between the accounting principles and practices of theSystem and accounting principles generally accepted in theUnited States of America (“GAAP”). The primary differencesare the presentation of all security holdings at amortizedcost, rather than at the fair value presentation requirementsof GAAP, and the accounting for matched sale-purchasetransactions as separate sales and purchases, rather thansecured borrowings with pledged collateral, as is general-ly required by GAAP. In addition, the Bank has elected notto present a Statement of Cash Flows. The Statement of CashFlows has not been included as the liquidity and cash posi-tion of the Bank are not of primary concern to the users ofthese financial statements. Other information regarding theBank’s activities is provided in, or may be derived from, theStatements of Condition, Income, and Changes in Capital.Therefore, a Statement of Cash Flows would not provideany additional useful information. There are no other sig-nificant differences between the policies outlined in the Finan-cial Accounting Manual and GAAP.

Effective January 2001, the System implemented proce-

dures to eliminate the sharing of costs by Reserve Banks forcertain services a Reserve Bank may provide on behalf ofthe System. Data for 2001 reflects the adoption of this pol-icy. Major services provided for the System by this bank,for which the costs will not be redistributed to the otherReserve Banks, include Standard Cash Automation and theCurrency Technology Office.

The preparation of the financial statements in conformitywith the Financial Accounting Manual requires managementto make certain estimates and assumptions that affect thereported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financialstatements and the reported amounts of income and expens-es during the reporting period. Actual results could differfrom those estimates. Certain amounts relating to the prioryear have been reclassified to conform to the current-yearpresentation. Unique accounts and significant accountingpolicies are explained below.

a. Gold CertificatesThe Secretary of the Treasury is authorized to issue goldcertificates to the Reserve Banks to monetize gold held bythe U.S. Treasury. Payment for the gold certificates by theReserve Banks is made by crediting equivalent amounts indollars into the account established for the U.S. Treasury.These gold certificates held by the Reserve Banks arerequired to be backed by the gold of the U.S. Treasury.The U.S. Treasury may reacquire the gold certificates at anytime and the Reserve Banks must deliver them to the U.S.Treasury. At such time, the U.S. Treasury’s account is chargedand the Reserve Banks’ gold certificate accounts are low-ered. The value of gold for purposes of backing the goldcertificates is set by law at $42 2/9 a fine troy ounce. TheBoard of Governors allocates the gold certificates amongReserve Banks once a year based upon average FederalReserve notes outstanding in each District.

2001 Annual Report



b. Special Drawing Rights Certificates

Special drawing rights (“SDRs”) are issued by the Inter-national Monetary Fund (“Fund”) to its members in pro-portion to each member’s quota in the Fund at the time ofissuance. SDRs serve as a supplement to international mon-etary reserves and may be transferred from one nationalmonetary authority to another. Under the law providingfor United States participation in the SDR system, the Sec-retary of the U.S. Treasury is authorized to issue SDR cer-tificates, somewhat like gold certificates, to the ReserveBanks. At such time, equivalent amounts in dollars arecredited to the account established for the U.S. Treasury,and the Reserve Banks’ SDR certificate accounts areincreased. The Reserve Banks are required to purchaseSDRs, at the direction of the U.S. Treasury, for the purposeof financing SDR certificate acquisitions or for financingexchange stabilization operations. At the time SDR trans-actions occur, the Board of Governors allocates amountsamong Reserve Banks based upon Federal Reserve notesoutstanding in each District at the end of the precedingyear. There were no SDR transactions in 2001.

c. Loans to Depository InstitutionsThe Depository Institutions Deregulation and Monetary Con-trol Act of 1980 provides that all depository institutions thatmaintain reservable transaction accounts or nonpersonal timedeposits, as defined in Regulation D issued by the Board ofGovernors, have borrowing privileges at the discretion of theReserve Banks. Borrowers execute certain lending agreementsand deposit sufficient collateral before credit is extended. Loansare evaluated for collectibility, and currently all are consideredcollectible and fully collateralized. If any loans were deemedto be uncollectible, an appropriate reserve would be estab-lished. Interest is accrued using the applicable discount rateestablished at least every fourteen days by the Board of Direc-tors of the Reserve Banks, subject to review by the Board of

Governors. Reserve Banks retain the option to impose a sur-charge above the basic rate in certain circumstances.

d. U.S. Government and Federal Agency Securities and Investments Denominated in Foreign Currencies

The FOMC has designated the FRBNY to execute open mar-ket transactions on its behalf and to hold the resulting secu-rities in the portfolio known as the System Open MarketAccount (“SOMA”). In addition to authorizing and direct-ing operations in the domestic securities market, the FOMCauthorizes and directs the FRBNY to execute operations inforeign markets for major currencies in order to counter dis-orderly conditions in exchange markets or to meet otherneeds specified by the FOMC in carrying out the System’scentral bank responsibilities. Such authorizations are reviewedand approved annually by the FOMC.

Matched sale-purchase transactions are accounted for asseparate sale and purchase transactions. Matched sale-pur-chase transactions are transactions in which the FRBNY sellsa security and buys it back at the rate specified at the com-mencement of the transaction.

The FRBNY has sole authorization by the FOMC to lendU.S. government securities held in the SOMA to U.S. gov-ernment securities dealers and to banks participating in U.S.government securities clearing arrangements on behalf ofthe System, in order to facilitate the effective functioning ofthe domestic securities market. These securities-lending trans-actions are fully collateralized by other U.S. government secu-rities. FOMC policy requires FRBNY to take possession ofcollateral in excess of the market values of the securitiesloaned. The market values of the collateral and the securi-ties loaned are monitored by FRBNY on a daily basis, withadditional collateral obtained as necessary. The securitiesloaned continue to be accounted for in the SOMA.

Foreign exchange (“F/X”) contracts are contractual agree-ments between two parties to exchange specified currencies,


2001 Annual Report

at a specified price, on a specified date. Spot foreign con-tracts normally settle two days after the trade date, where-as the settlement date on forward contracts is negotiatedbetween the contracting parties, but will extend beyond twodays from the trade date. The FRBNY generally enters intospot contracts, with any forward contracts generally limitedto the second leg of a swap/warehousing transaction.

The FRBNY, on behalf of the Reserve Banks, maintains renew-able, short-term F/X swap arrangements with two authorizedforeign central banks. The parties agree to exchange their cur-rencies up to a pre-arranged maximum amount and for anagreed upon period of time (up to twelve months), at an agreedupon interest rate. These arrangements give the FOMC tem-porary access to foreign currencies that it may need for inter-vention operations to support the dollar and give the partnerforeign central bank temporary access to dollars it may needto support its own currency. Drawings under the F/X swaparrangements can be initiated by either the FRBNY or the part-ner foreign central bank, and must be agreed to by the drawee.The F/X swaps are structured so that the party initiating thetransaction (the drawer) bears the exchange rate risk uponmaturity. The FRBNY will generally invest the foreign currencyreceived under an F/X swap in interest-bearing instruments.

Warehousing is an arrangement under which the FOMCagrees to exchange, at the request of the Treasury, U.S. dol-lars for foreign currencies held by the Treasury or ESF overa limited period of time. The purpose of the warehousingfacility is to supplement the U.S. dollar resources of the Trea-sury and ESF for financing purchases of foreign currenciesand related international operations.

In connection with its foreign currency activities, the FRBNY,on behalf of the Reserve Banks, may enter into contracts whichcontain varying degrees of off-balance sheet market risk,because they represent contractual commitments involving futuresettlement and counter-party credit risk. The FRBNY controlscredit risk by obtaining credit approvals, establishing trans-action limits, and performing daily monitoring procedures.

While the application of current market prices to the securi-ties currently held in the SOMA portfolio and investments denom-inated in foreign currencies may result in values substantiallyabove or below their carrying values, these unrealized changesin value would have no direct effect on the quantity of reservesavailable to the banking system or on the prospects for futureReserve Bank earnings or capital. Both the domestic and for-eign components of the SOMA portfolio from time to time involvetransactions that can result in gains or losses when holdings aresold prior to maturity. However, decisions regarding the secu-rities and foreign currencies transactions, including their pur-chase and sale, are motivated by monetary policy objectivesrather than profit. Accordingly, earnings and any gains orlosses resulting from the sale of such currencies and securitiesare incidental to the open market operations and do not moti-vate its activities or policy decisions.

U.S. government and federal agency securities and invest-ments denominated in foreign currencies comprising theSOMA are recorded at cost, on a settlement-date basis,and adjusted for amortization of premiums or accretion ofdiscounts on a straight-line basis. Interest income is accruedon a straight-line basis and is reported as “Interest on U.S.government and federal agency securities” or “Interest oninvestments denominated in foreign currencies,” as appro-priate. Income earned on securities lending transactions isreported as a component of “Other income.” Gains andlosses resulting from sales of securities are determined byspecific issues based on average cost. Gains and losseson the sales of U.S. government and federal agency secu-rities are reported as “U.S. Government securities gains(losses), net.” Foreign-currency-denominated assets are reval-ued daily at current market exchange rates in order toreport these assets in U.S. dollars. Realized and unrealizedgains and losses on investments denominated in foreigncurrencies are reported as “Foreign currency losses, net”.Foreign currencies held through F/X swaps, when initiat-ed by the counter-party, and warehousing arrangements


are revalued daily, with the unrealized gain or loss report-ed by the FRBNY as a component of “Other assets” or“Other liabilities,” as appropriate.

Balances of U.S. government and federal agency secu-rities bought outright, securities loaned, investments denom-inated in foreign currency, interest income, securities lend-ing fee income, amortization of premiums and discountson securities bought outright, gains and losses on sales ofsecurities, and realized and unrealized gains and losseson investments denominated in foreign currencies, exclud-ing those held under an F/X swap arrangement, are allo-cated to each Reserve Bank. Income from securities lend-ing transactions undertaken by the FRBNY are also allo-cated to each Reserve Bank. Securities purchased underagreements to resell and unrealized gains and losses onthe revaluation of foreign currency holdings under F/Xswaps and warehousing arrangements are allocated to theFRBNY and not to other Reserve Banks.

Statement of Financial Accounting Standards No. 133, asamended and interpreted, became effective on January 1, 2001.For the periods presented, the Reserve Banks had no derivativeinstruments required to be accounted for under the standard.

e. Bank Premises and EquipmentBank premises and equipment are stated at cost less accu-mulated depreciation. Depreciation is calculated on a straight-line basis over estimated useful lives of assets ranging from2 to 50 years. New assets, major alterations, renovationsand improvements are capitalized at cost as additions to theasset accounts. Maintenance, repairs and minor replace-ments are charged to operations in the year incurred. Inter-nally developed software is capitalized based on the costof direct materials and services and those indirect costs asso-ciated with developing, implementing, or testing software.

f. Interdistrict Settlement AccountAt the close of business each day, all Reserve Banks and branch-

es assemble the payments due to or from other Reserve Banksand branches as a result of transactions involving accounts resid-ing in other Districts that occurred during the day’s operations.Such transactions may include funds settlement, check clearingand ACH operations, and allocations of shared expenses. Thecumulative net amount due to or from other Reserve Banks isreported as the “Interdistrict settlement account.”

g. Federal Reserve NotesFederal Reserve notes are the circulating currency of the Unit-ed States. These notes are issued through the various FederalReserve agents to the Reserve Banks upon deposit with suchAgents of certain classes of collateral security, typically U.S.government securities. These notes are identified as issued toa specific Reserve Bank. The Federal Reserve Act provides thatthe collateral security tendered by the Reserve Bank to the Fed-eral Reserve Agent must be equal to the sum of the notes appliedfor by such Reserve Bank. In accordance with the FederalReserve Act, gold certificates, special drawing rights certificates,U.S. government and federal agency securities, triparty agree-ments, loans to depository institutions, and investments denom-inated in foreign currencies are pledged as collateral for netFederal Reserve notes outstanding. The collateral value is equalto the book value of the collateral tendered, with the exceptionof securities, whose collateral value is equal to the par valueof the securities tendered. The Board of Governors may, atany time, call upon a Reserve Bank for additional security toadequately collateralize the Federal Reserve notes. The ReserveBanks have entered into an agreement which provides for cer-tain assets of the Reserve Banks to be jointly pledged as col-lateral for the Federal Reserve notes of all Reserve Banks inorder to satisfy their obligation of providing sufficient collater-al for outstanding Federal Reserve notes. In the event that thiscollateral is insufficient, the Federal Reserve Act provides thatFederal Reserve notes become a first and paramount lien onall the assets of the Reserve Banks. Finally, as obligations ofthe United States, Federal Reserve notes are backed by the full


faith and credit of the United States government.The “Federal Reserve notes outstanding, net” account rep-

resents Federal Reserve notes reduced by currency held inthe vaults of the Bank of $10,230 million, and $16,797 million at December 31, 2001 and 2000, respectively.

h. Capital Paid-inThe Federal Reserve Act requires that each member banksubscribe to the capital stock of the Reserve Bank in anamount equal to 6 percent of the capital and surplus of themember bank. As a member bank’s capital and surpluschanges, its holdings of the Reserve Bank’s stock must beadjusted. Member banks are those state-chartered banks thatapply and are approved for membership in the System andall national banks. Currently, only one-half of the subscrip-tion is paid-in and the remainder is subject to call. Theseshares are nonvoting with a par value of $100. They maynot be transferred or hypothecated. By law, each memberbank is entitled to receive an annual dividend of 6 percenton the paid-in capital stock. This cumulative dividend is paidsemiannually. A member bank is liable for Reserve Bank liabilities up to twice the par value of stock subscribed by it.

i. SurplusThe Board of Governors requires Reserve Banks to maintain asurplus equal to the amount of capital paid-in as of December31. This amount is intended to provide additional capital andreduce the possibility that the Reserve Banks would be requiredto call on member banks for additional capital. Reserve Banksare required by the Board of Governors to transfer to the U.S.Treasury excess earnings, after providing for the costs of oper-ations, payment of dividends, and reservation of an amountnecessary to equate surplus with capital paid-in.

The Consolidated Appropriations Act of 2000 (Public Law106-113, Section 302) directed the Reserve Banks to trans-fer to the U.S. Treasury additional surplus funds of $3,752million during the Federal Government’s 2000 fiscal year.

Federal Reserve Bank of Richmond transferred $987 millionto the U.S. Treasury. Reserve Banks were not permitted toreplenish surplus for these amounts during fiscal year 2000which ended September 30, 2000; however, the surpluswas replenished by December 31, 2000.

In the event of losses or a substantial increase in capital,payments to the U.S. Treasury are suspended until such loss-es or increases in capital are recovered through subsequentearnings. A portion of the payments made to the U.S. Trea-sury earlier in the year are classified as “Prepaid expense-interest on Federal Reserve notes to the U.S. Treasury.” Weekly payments to the U.S. Treasury may vary significantly.

j. Income and Costs related to Treasury ServicesThe Bank is required by the Federal Reserve Act to serveas fiscal agent and depository of the United States. Bystatute, the Department of the Treasury is permitted, but notrequired, to pay for these services. The costs of providingfiscal agency and depository services to the TreasuryDepartment that have been billed but will not be paid areimmaterial and included in “Other credits.”

k. TaxesThe Reserve Banks are exempt from federal, state, and localtaxes, except for taxes on real property, which are reportedas a component of “Occupancy expense.”

4. U.S. Government and Federal Agency SecuritiesSecurities bought outright are held in the SOMA at theFRBNY. An undivided interest in SOMA activity, with theexception of securities held under agreements to resell andthe related premiums, discounts and income, is allocatedto each Reserve Bank on a percentage basis derived froman annual settlement of interdistrict clearings. The settlement,performed in April of each year, equalizes Reserve Bankgold certificate holdings to Federal Reserve notes out-standing. The Bank’s allocated share of SOMA balances


2001 Annual Report

was 5.974 percent and 5.870 percent at December 31,2001 and 2000, respectively.

The Bank’s allocated share of securities held in theSOMA at December 31, that were bought outright, wereas follows (in millions):

Total SOMA securities bought outright were $561,701 mil-lion and $518,501 million at December 31, 2001 and2000, respectively.

The maturity distribution of U.S. government and federalagency securities bought outright, which were allocated to theBank at December 31, 2001, were as follows (in millions):

At December 31, 2001 and 2000, matched sale-purchasetransactions involving U.S. government securities with parvalues of $23,188 million and $21,112 million, respectively,were outstanding, of which $1,385 million and $1,239 mil-lion were allocated to the Bank. Matched sale-purchase trans-actions are generally overnight arrangements.

At December 31, 2001 and 2000, U.S. government secu-rities with par values of $7,345 million and $2,086 mil-lion, respectively, were loaned from the SOMA, of which$439 million and $122 million were allocated to the Bank.

5. Investments Denominated in Foreign CurrenciesThe FRBNY, on behalf of the Reserve Banks, holds foreigncurrency deposits with foreign central banks and the Bankfor International Settlements and invests in foreign gov-ernment debt instruments. Foreign government debt instru-ments held include both securities bought outright andsecurities held under agreements to resell. These invest-ments are guaranteed as to principal and interest by theforeign governments.

Each Reserve Bank is allocated a share of foreign-cur-rency-denominated assets, the related interest income, andrealized and unrealized foreign currency gains and loss-es, with the exception of unrealized gains and losses onF/X swaps and warehousing transactions. This allocationis based on the ratio of each Reserve Bank’s capital andsurplus to aggregate capital and surplus at the precedingDecember 31. The Bank’s allocated share of investmentsdenominated in foreign currencies was approximately24.344 percent and 26.301 percent at December 31,2001 and 2000, respectively.



2001 2000Par value:

Federal agency $ 1 $ 8 U.S. government:

Bills 10,877 10,492 Notes 15,887 14,099 Bonds 6,193 5,447

Total par value 32,958 30,046

Unamortized premiums 675 571 Unaccreted discounts (77) (180)

Total allocated to Bank $33,556 $30,437

Par ValueU.S. Federal

Maturities of Government AgencySecurities Held Securities Obligations Total

Within 15 days $ 638 $ — $ 638 16 days to 90 days 7,440 — 7,440 91 days to 1 year 7,804 — 7,804Over 1 year to 5 years 9,150 1 9,151Over 5 years to 10 years 3,186 — 3,186Over 10 years 4,739 — 4,739

Total $32,957 $ 1 $32,958

The Bank’s allocated share of investments denominatedin foreign currencies, valued at current exchange rates atDecember 31, were as follows (in millions):

Total investments denominated in foreign currencies were$14,559 million and $15,670 million at December 31,2001 and 2000, respectively.

The maturity distribution of investments denominated in for-eign currencies which were allocated to the Bank at Decem-ber 31, 2001, was as follows (in millions):

At December 31, 2001 and 2000, there were no openforeign exchange contracts or outstanding F/X swaps.

At December 31, 2001 and 2000, the warehousing facil-ity was $5 billion, with zero outstanding.

6. Bank Premises and EquipmentA summary of bank premises and equipment at December31 is as follows (in millions):

Depreciation expense was $31 million and $30 million for theyears ended December 31, 2001 and 2000, respectively.

Bank premises and equipment at December 31 include the fol-lowing amounts for leases that have been capitalized (in millions):

The Bank leases unused space to outside tenants. Those leas-es have terms ranging from 1 to 5 years. Rental income fromsuch leases was $1.3 million for each of the years endedDecember 31, 2001 and 2000. Future minimum lease pay-ments under noncancellable agreements in existence atDecember 31, 2001, were (in millions):


2001 Annual Report

Maturities of Investments Denominated in Foreign Currencies

Within 1 year $3,339

Over 1 year to 5 years 98

Over 5 years to 10 years 107

Over 10 years —

Total $3,544

2001 2000

European Union Euro:Foreign currency deposits $ 1,118 $ 1,218Government debt instruments 656 714

including Agreements to resell

Japanese Yen:Foreign currency deposits 460 724Government debt instruments 1,294 1,446

including agreements to resell

Accrued interest 16 19

Total $3,544 $4,121

2001 2000

Bank premises and equipment:Land $ 19.7 $ 16.2Buildings 122.6 117.9 Building machinery and equipment 44.1 35.1Construction in process 0.3 8.5Furniture and equipment 292.8 253.4

479.5 431.1Accumulated depreciation (247.5) (229.1)

Bank premises and equipment, net $232.0 $202.0

2001 2000

Bank premises and equipment $20 $33 Accumulated depreciation (13) (22)

Capitalized leases, net $ 7 $11

2002 $1.12003 1.22004 1.22005 1.2 2006 1.2

Thereafter 0.0

$5.9


7. Commitments and ContingenciesAt December 31, 2000, the Bank was obligated under non-cancelable leases for premises and equipment with termsranging from 1 to approximately 4 years. These leases pro-vide for increased rentals based upon increases in real estatetaxes, operating costs or selected price indices.

Rental expense under operating leases for certain oper-ating facilities, warehouses, and data processing and officeequipment (including taxes, insurance and maintenance whenincluded in rent), net of sublease rentals, was $40 millionand $37 million for the years ended December 31, 2001and 2000, respectively. Certain of the Bank’s leases haveoptions to renew.

Future minimum rental payments under noncancelable oper-ating leases and capital leases, net of sublease rentals, withterms of one year or more, at December 31, 2001, were(in millions):

At December 31, 2001, there were no other commitmentsand long-term obligations in excess of one year.

Under the Insurance Agreement of the Federal ReserveBanks dated as of March 2, 1999, each of the Reserve Bankshas agreed to bear, on a per incident basis, a pro rata shareof losses in excess of 1 percent of the capital paid-in of theclaiming Reserve Bank, up to 50 percent of the total capitalpaid-in of all Reserve Banks. Losses are borne in the ratio that

a Reserve Bank’s capital paid-in bears to the total capitalpaid-in of all Reserve Banks at the beginning of the calendaryear in which the loss is shared. No claims were outstand-ing under such agreement at December 31, 2001 or 2000.

The Bank is involved in certain legal actions and claimsarising in the ordinary course of business. Although it is dif-ficult to predict the ultimate outcome of these actions, in man-agement’s opinion, based on discussions with counsel, theaforementioned litigation and claims will be resolved with-out material adverse effect on the financial position or resultsof operations of the Bank.

8. Retirement and Thrift Plans

Retirement PlansThe Bank currently offers two defined benefit retirement plansto its employees, based on length of service and level ofcompensation. Substantially all of the Bank’s employees par-ticipate in the Retirement Plan for Employees of the FederalReserve System (“System Plan”) and the Benefit EqualizationRetirement Plan (“BEP”). The System Plan is a multi-employ-er plan with contributions fully funded by participatingemployers. No separate accounting is maintained of assetscontributed by the participating employers. The Bank’s pro-jected benefit obligation and net pension costs for the BEPat December 31, 2001 and 2000, and for the years thenended, are not material.

Thrift PlanEmployees of the Bank may also participate in the definedcontribution Thrift Plan for Employees of the Federal ReserveSystem (“Thrift Plan”). The Bank’s Thrift Plan contributionstotaled $6 million for each of the years ended December31, 2001 and 2000, and are reported as a component of“Salaries and other benefits.”


Operating Capital

2002 $1.4 $1.42003 1.2 0.92004 1.0 0.82005 0.4 0.1Thereafter 0.0 0.0

$4.0 3.2Amount representing interest (0.2)

Present value of net minimum $3.0lease payment


2001 Annual Report

9. Postretirement Benefits Other Than Pensions and Postemployment Benefits

Postretirement benefits other than pensionsIn addition to the Bank’s retirement plans, employees whohave met certain age and length of service requirements areeligible for both medical benefits and life insurance cover-age during retirement.

The Bank funds benefits payable under the medical andlife insurance plans as due and, accordingly, has no planassets. Net postretirement benefit costs are actuarially deter-mined using a January 1 measurement date.

Following is a reconciliation of beginning and ending bal-ances of the benefit obligation (in millions):

Following is a reconciliation of beginning and ending balancesof the plan assets, the unfunded postretirement benefit obliga-tion, and the accrued postretirement benefit costs (in millions):

Accrued postretirement benefit costs are reported as a com-ponent of “Accrued benefit costs.”

At December 31, 2001 and 2000, the weighted averagediscount rate assumptions used in developing the benefit obli-gation were 7.0 percent and 7.5 percent, respectively.

For measurement purposes, a 10.00 percent annual rateof increase in the cost of covered health care benefits wasassumed for 2002. Ultimately, the health care cost trend rateis expected to decrease gradually to 5.00 percent by 2008,and remain at that level thereafter.

2001 2000Accumulated postretirement benefit obligation at January 1 $71.0 $63.8 Service cost-benefits earned during the period 2.3 1.9 Interest cost of accumulated benefit obligation 5.6 4.7 Actuarial loss 12.5 3.0 Contributions by plan participants 0.4 0.3 Benefits paid (3.4) (2.7)Plan amendment/settlement (11.0) —

Accumulated postretirement benefit $77.4 $71.0 obligation at December 31

2001 2000

Fair value of plan assets at January 1 $ — $ — Actual return on plan assets — —Contributions by the employer 3.0 2.4 Contributions by plan participants 0.4 0.3 Benefits paid (3.4) (2.7)

Fair value of plan assets at December 31 $ — $ —

Unfunded postretirement benefit obligation $77.4 $71.0 Unrecognized prior service cost 11.6 0.7 Unrecognized net actuarial loss (20.1) (7.9)

Accrued postretirement benefit costs $68.9 $63.8


Assumed health care cost trend rates have a significanteffect on the amounts reported for health care plans. A onepercentage point change in assumed health care cost trendrates would have the following effects for the year endedDecember 31, 2001 (in millions):

The following is a summary of the components of net peri-odic postretirement benefit costs for the years ended Decem-ber 31 (in millions):

Net periodic postretirement benefit costs are reported as acomponent of “Salaries and other benefits.”

Postemployment benefits The Bank offers benefits to former or inactive employees.Postemployment benefit costs are actuarially determined andinclude the cost of medical and dental insurance, survivorincome, and disability benefits. Costs were projected usingthe same discount rate and health care trend rates as wereused for projecting postretirement costs. The accrued postem-ployment benefit costs recognized by the Bank at December31, 2001 and 2000, were $13.6 million and $11.8 mil-lion, respectively. This cost is included as a component of“Accrued benefit costs.” Net periodic postemployment ben-efit costs included in 2001 and 2000 operating expenseswere $2.6 million and $2.4 million, respectively.


2001 2000

Service cost benefits earned during the period $2.3 $1.9Interest cost of accumulated benefit obligation 5.6 4.7Amortization of prior service cost (0.1) (0.1)Recognized net actuarial loss 0.3 0.1

Net periodic postretirement benefit costs $8.1 $6.6

1 Percentage 1 PercentagePoint Point

Increase DecreaseEffect on aggregate of service and interest $1.7 $(1.3)cost components of net periodic postretirement benefit costs

Effect on accumulated postretirement benefit obligation 5.6 (7.7)


2001 Annual Report

FEDERAL RESERVE BANK OF RICHMONDSUMMARY OF OPERATIONS

(UNAUDITED)

Year-to-Date December

Dollar Amount Volume

2001 2000 2001 2000CASH

Currency received and counted 48.1 Billion 47.6 Billion 3.2 Billion 3.0 BillionCurrency destroyed 6.7 Billion 8.7 Billion 719.0 Million 1,168.9 MillionCoin bags received and counted 60.1 Million 68.8 Million 131.5 Thousand 110.9 Thousand

NONCASH PAYMENTS

Commercial checks processed 1.4 Trillion 1.3 Trillion 1.7 Billion 1.7 BillionCommercial checks, packaged 720.2 Billion 706.3 Billion 784.9 Million 814.5 Million

items handledU.S. government checks processed 43.5 Billion 40.8 Billion 37.7 Million 28.8 MillionAutomated Clearing House transactions:

Commercial1 602.0 Billion 856.4 Billion 208.0 Million 264.7 MillionGovernment1 276.6 Billion 387.1 Billion 2.2 Million 3.2 Million

Fedwire funds transfers 21.6 Trillion 19.6 Trillion 11.9 Million 10.8 Million

LOANS TO DEPOSITORY INSTITUTIONS

Discount window loans made 14.7 Billion 2.5 Billion 66 160

SECURITIES SERVICES

Safekeeping balance of book-entry 246.9 Billion 226.7 Billion N/A N/Asecurities as of December 31

Fedwire securities transfers 11.7 Trillion 11.1 Trillion 699.7 Thousand 655.8 Thousand

SERVICES TO U.S. TREASURY AND GOVERNMENT AGENCIES

Issues, redemptions, and exchanges 1,736.5 Million 1,022.3 Million 6.2 Million 5.9 Millionof U.S. savings bonds

Food stamps redeemed 412.0 Million 330.1 Million 81.9 Million 66.7 Million

N/A = not applicable

1 ACH operations were consolidated in September 2001, and the statistics are now reported from the consolidation site at the Federal Reserve Bank of Atlanta.

Editor: Elaine Mandaleris

Managing Editor: Alice Felmlee

Design Firm: AURAS Design, Inc.Stuart Greenwell, Designer Robert Sugar, Creative Director

Illustrator: Richard Tuschman

Photographers: Larry Cain and Geep Schurman

Printer: Federal Reserve Bank of Richmond

Circulation: Joyce Eberly and Scottie Woody

Special thanks to Laura Fortunato, Lisa Oliva, and Martha Schneider for editorial comments, and Rebecca Martin for fact-checking assistance.

This Annual Report is also available on the Federal Reserve Bank of Richmond’s Web siteat www.rich.frb.org. For additional print copies,contact the Public Affairs division, Federal ReserveBank of Richmond, P.O. Box 27622, Richmond, VA 23261.

Fifth Federal Reserve District Offices

RICHMOND

701 East Byrd Street

Richmond, Virginia 23219

(804) 697-8000

BALTIMORE

502 South Sharp Street

Baltimore, Maryland 21201

(410) 576-3300

CHARLOTTE

530 East Trade Street

Charlotte, North Carolina 28202

(704) 358-2100

CHARLESTON

1200 Airport Road

Charleston, West Virginia 25311

(304) 353-6100

COLUMBIA

1624 Browning Road

Columbia, South Carolina 29210

(803) 772-1940

www.rich.frb.org

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