Do Federal Home Loan Bank Membership and Advances Lead to Bank Risk-Taking?

During the 1990s, commercial banks turned to advances from the Federal Home Loan Bank to help plug the gap between loan growth and core deposit growth. Between 1992 and 1999, annual loan growth at U.S. commercial banks averaged 7.9 percent, while core deposits grew at an average annual rate of only 3.1 percent. In contrast, between 1984 and 1990, annual loan growth averaged 5.4 percent, while annual core deposit growth averaged 6.5 percent.

The pickup in loan growth during the 1990s—which showed up at banks of all sizes—reflected the length and strength of the economic expansion. The slowdown in core deposit growth reflected heightened consumer interest in non-deposit investment alternatives. For example, stock and bond funds grew at an annual rate of 10.7 percent per year between 1992 and 1999—even after adjusting for the run-up in the stock market. Over the same interval, money market mutual funds grew at a 15.2 percent annual clip.

The importance of the Federal Home Loan Bank System's growth to the banking sector can be seen in the increase in its System membership and advances outstanding. Between 1992 and 1999, the number of Home Loan Bank members more than doubled, fueled by the opening of membership to commercial banks. Similarly, throughout the same period, advances outstanding to System members nearly quintupled. For community financial institutions—defined by the Financial Modernization Act of 1999 (Gramm-Leach-Bliley) as banks with less than $500 million in assets—the increases were even more impressive: Membership increased by a factor of four, and advances outstanding increased by a factor of 16.

Along with broadening the range of permissible activities for banking organizations, Gramm-Leach-Bliley relaxed Home Loan Bank membership and collateral requirements for community financial institutions. Once these provisions are in place, nearly all of the nation's thrifts and commercial banks will be eligible for System membership, and total outstanding advances to commercial bank members could top $250 billion.

These trends raise the question: Do Home Loan Bank membership and advances lead to risk-taking? This question is important because Home Loan Bank funding could allow member institutions to increase risk without paying a price. Similar incentives played a role in the savings and loan troubles of the 1980s.

As a senior secured creditor, the Home Loan Bank faces minimal credit risk and, therefore, has little incentive to adjust the terms on advances as the risk of a member rises. At the same time, because member institutions can easily substitute advances for other wholesale funding, market discipline from unsecured, uninsured creditors may not keep risk in check. Finally, because the Federal Deposit Insurance Corp. cannot assess a premium above 27 cents per $100 of deposits, the cost of deposit insurance may not dissuade member institutions from increasing risk. In short, absent heightened supervisory scrutiny, access to Home Loan Bank advances could lead to an increase in risk-taking at member institutions and an increase in expected losses to the deposit insurance fund.

In a paper presented at the Federal Reserve Bank of Chicago's 2001 Bank Structure Conference, three economists from the St. Louis Fed—Dusan Stojanovic, Mark Vaughan and Tim Yeager—investigated the relationship between access to Home Loan Bank funding and risk-taking among community financial institutions during the 1990s. Specifically, the authors compared the risk profiles of Home Loan Bank members and nonmembers. They also examined the relationship between dependence on advances and risk-taking among member banks.

Their evidence suggests that banks increase risk-taking after joining the Home Loan Bank System, and that risk-taking increases with dependence on advances. These differences, while statistically significant, were not large during the 1990s. The authors argue that high capital ratios kept member bank risk-taking in check. Nonetheless, they feel that bank supervisors should remain vigilant to ensure that risk-taking does not increase should capital ratios weaken.