In what's touted as the first study to examine the impact of Federal Home Loan Bank membership and funding on commercial bank risk, a University of Arkansas researcher and colleagues at two Federal Reserve banks found evidence to suggest that FHLB member banks have somewhat higher risk profiles than non-member banks.

"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 if bank leverage ratios revert to historical norms," says Tim Yeager, associate professor of finance in the Sam M. Walton College of Business at the University of Arkansas. The term "moral hazard" means the possibility of loss to an insurance company deriving from the character or circumstances of the insured.

Yeager says increasing reliance on FHLB 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 Vaughan at the Federal Reserve Bank of Richmond, Va., wanted to know if FHLB membership and advances could lead to greater risk-taking.

Congress established the FHLB system in 1932 to advance funds against mortgage collateral. As such, the system predates Fannie Mae and Freddie Mac as the first government-sponsored enterprise for housing. FHLB banks have provided a source of long-term stable funding for home mortgages.

Initially, membership was limited to thrifts, or savings and loan associations, which focused on taking deposits and originating home mortgages. But recent passage of federal laws, including the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 and the Federal Home Loan Bank Modernization Act of 1999, have opened the system to commercial banks and credit unions.

Since the early 1990s, commercial banks have turned to FHLB advances to plug the gap between loans and deposits. The controversial issue, as Yeager mentioned, is that this practice could lead to safety and soundness problems by relaxing constraints on risk-taking in the same way that brokered deposits helped savings-and-loan institutions ramp up risk in the 1980s. Yeager says that brokered deposits are those obtained through the use of a broker at any point in the transaction.

The researchers found that liquidity risk and leverage risk rose modestly for FHLB members compared with nonmembers. Liquidity risk represents threats to a financial institution's ability to convert assets into cash or to cover current financial liabilities quickly with current assets. Leverage risk rises as institutions take on more debt for a given amount of equity because large financial losses could leave a bank insolvent.

The study showed that interest-rate risk—a drop in bank earnings or equity due to the variability of interest rates—declined for banks that accepted advances as a benefit of FHLB membership. Credit risk—the risk of loss due to a debtor's nonpayment of a loan or other line of credit—and of overall bank failure largely were unaffected by FHLB membership.

"Although the evidence fails to produce a 'smoking gun,' the worrisome incentives embedded in the FHLB advances should give policymakers pause," Yeager asserts. "We argue that bank supervisors should remain 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."

The researchers suggest that legislators and banking regulators consider imposing usage restrictions on advances similar to those used on brokered deposits, which would curtail access to advances as bank risk increases and capital ratios decline. Secondly, the FDIC and other regulators may attempt to remedy the situation by imposing a capital charge on banks with large amounts of collateralized obligations. The FDIC recently announced that it will take FHLB advances into account when setting deposit-insurance premiums in 2009.

Overall, Yeager says, the researchers' findings on FHLB activity and risk should help bank managers and supervisors distinguish between prudent and imprudent use of advances.

The study was published in the Journal of Banking and Finance. Prior to his appointment in the Walton College, Yeager was an economist at the Federal Reserve Bank of St. Louis.