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The Federal Home Loan Bank (FHLB) system was established in 1932 to fill the need for a stable funding source for residential mortgages created by the undermining of the American banking system during the Great Depression. Today, the 12 Federal Home Loan Banks and their members are the largest source of residential mortgage financing in the country. Yet until this year, no one had taken a hard look at how membership in the FHLB system affected commercial bank risk.
“Although our findings suggest that the cumulative impact of FHLB membership and advances on bank risk is modest, we caution that our sample period was one of robust economic growth, and that serious moral-hazard problems could arise in bank leverage ratios revert to historical norms,” explains Tim Yeager, associate professor of finance at the university of Arkansas’ Sam M. Walton College of Business and co-author of the study which was published in the Journal of Banking and Finance. “The increasing reliance on these advances is a potential safety and soundness concern because access to them can undermine market discipline, and the FDIC [Federal Deposit Insurance Corp.] cannot raise premiums sufficiently to deter risk-taking.”
Yeager and his colleagues, Dusan Stojanovic at the Federal Reserve Bank of Chicago and Mark Vaughn at the Federal Reserve Bank of Richmond, VA, found that liquidity and leverage risk were modestly higher for FLB members than for non-members. Credit risk and overall risk of bank failure were unaffected byFHLB membership. FHLB members were exposed to less interest rate risk, which measures the effect of variable interest rates on bank earnings or equity, than non-members.
“Although the evidence fails to produce a ’smoking gun’ the worrisome incentives embedded in FHLB advances should give policymakers pause,” Yeager said. “We argue that bank supervisors should remian vigilant, and only careful monitoring by state and federal supervisors can prevent distressed banks from responding to the moral-hazard incentives associated with FHLB funding and underpriced deposit insurance.”
Commercial banks have turned to FHLB advances to help close the gap between loans and deposits since the early 1990’s when legislation opened the system, previously restricted to thrifts whose focus was on accepting deposits and orginating home mortgages, to commercial banks and credit unions. Researchers suggest future legislation or regulation may impose usage restrictions on advances similar to those used on brokered deposits on a capital charge on institutions having large amounts of collateralized obligations. The FDIC recently announced that it will be FHLB advances into account when setting deposit insurance premiums in 2009.
The issue of bank risk, whether associated with FHLB membership or not, should not greatly worry insured depositors. Uninsured depositors and those wishing to ascertain the health of their bank should monitor the risk levels of their financial institutions. Detailed information on specific banks can be found on the FDIC web site at fdic.gov. According to Yeager, if a bank’s core capital is below 5 percent and has been falling over time, the bank’s solvency may be an issue.
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