Surge in Federal Home Loan Bank Borrowing by 4 Biggest Banks

Use of secured loans or advances from the 12 Federal Home Loan Banks (FHLBanks) by their four largest members has surged over the last two years.  The primary mission of the FHLBanks is to support housing finance and they do so by providing advances to their 7,500 member institutions which include banks, thrifts, credit unions, and insurance companies.  By law the members can use these advances to originate mortgages or for other purposes.  

Use of these advances had declined by about 62 percent from a 2008 peak of about $1 trillion to $381 billion in March 2012.  Then advances began to increase, reaching $500 billion by December 2013.  The growth was driven primarily by a 158 percent increase in advances to JP Morgan Chase, Bank of America, Citigroup, and Wells Fargo to a group total of $135.11 billion.

According to the Federal Housing Finance Agency (FHFA) which regulates the FHLBanks, the increase in advances to these four members is largely attributable to bank liquidity standards established in December 2010 by the International Basel Committee on Bank Supervision.  These so-called Basil III standards require that banks increase their holdings of high quality liquid assets such as U.S. Treasury securities, to improve their ability to withstand sudden financial and economic stress.  FHFA said that large numbers of system members have recently taken advances, in part to purchase the securities necessary under these rules.

FHFA OIG has concluded an audit of these advances to determine whether the surge in advances will continue, will spread to other member institutions, or if it has peaked.  OIG also looked at how effectively the FHLBanks are managing the concentration of advances and the associated risks, and what the implications might be for the System's housing mission if its members increasingly use advances to meet liquidity requirements.   Specifically OIG looked at the following issues:

• How bank holding company subsidiaries may be members of multiple FHL Banks and thus borrow from more than one Bank.
• The growth in advances to the four largest System members since early 2012.
• The role played by recently adopted liquidity standards in this growth.
• The benefits and risks associated with this growth.
• The effectiveness of FHFA oversight of the management of risks associated with these advances.

That four large banks have dramatically increased their use of FHLBank advances is magnified by the structure of the System.  An eligible institution may become a member of only one of the 12 banks, but bank and thrift holding companies may own subsidiaries situated in several FHLBank districts and each may join the bank in the district in which it is situated.  FHFA confirms that 49 institutions currently operate through subsidiaries in two or more System districts.  Thus the four large institutions not only are the largest members of the system in terms of total advances but each holds advances from multiple banks.

As of December 31, 2013 JP Morgan Chase held $61. 83 billion in advances from five FHLBanks, with 67.4 percent of the total lent by Cincinnati.  Bank of America held $28.94 billion from four banks, 60 percent of which was borrowed from the Atlanta Bank while Citigroup's, $25.20 billion and Wells Fargo's 19.14 billion were almost totally from the New York and Des Moines banks respectively.  While the individual numbers were not large, the four institutions had all received advances from the San Francisco FHLBank totaling over $17 billion in the aggregate.

While each of the four banks have increased their borrowing significantly, Chase and Wells Fargo grew at triple digit rates while Bank of America and Citigroup doubled their rate of advances.  Further, Chase's increase in advances of $48 billion accounted for 59 percent of the total of $84 billion in advances to all four during the period.

The increases in advances to the four banks contrasts sharply with the relatively stable rate at which advances were made to other System members during the period.  While the four increased their use of advances by 158 percent other systems members posted an average increase of 9 percent.  Further, the 9 percent occurred entirely in the last three months of the period; from March 31 2012 to September 30, 2013 other member advances declined by 1 percent.  As the four big banks increased their total advances they also increased their relative share of all System advances, accounting for 27 percent of advances at the end of the period compared to 14 percent on March 31, 2012. 

The most significant concentration of advances was from the Cincinnati bank to JP Morgan Chase.  At the end of the second quarter $4 billion in advances to Chase represented 11.6 percent of that bank's total; by years end Chase held 64 percent of all of the Cincinnati's banks advances to its members.

According to the FHFA's Division of Federal Home Bank Regulation (DBR) and internal records the large member banks have increased their use of advances as part of an overall strategy to meet the Basel III liquidity requirements.  DBR stressed that this use is consistent with the FHLBanks collateral requirements, lending limits, and other statutory, regulatory and internal standards and that" there are no restrictions on the uses to which members may put the advances other than those that already exist in law and regulation." 

OIG spoke with representatives of the Securities and Exchange Commission and with officials of three of the large banks about the use of advances for meeting Basel III requirements and the SEC and two of the banks verified this theory.  Chase identified the advances as one source available for funding a reported 53 percent increase in its high quality asset holdings.  Officials from two other banks confirmed that the Basel III requirements contributed to their increased use of advances with one identifying it as the primary driver.  The fourth bank did not respond to OIG's requests.

DBR officials speculated that a deposit run-off at member institutions may have contributed to the increases in advances to the remaining FHLBank members in the fourth quarter of 2013 as depositors may have withdrawn money from low interest savings accounts seeking higher returns in the stock market.

OIG said there were both risks and benefits associated with the surge in advances to large members.  The advances could help stabilize the finances of the 12 banks and potentially the system as a whole, increasing the dividends available to large and small member banks and allowing larger contributions to the Affordable Housing Programs which receives 10 percent of each FHLBank's net income each year.  However, OIG notes that these growing advances have not yet translated into materially higher interest income.  As overall interest rates have declined the rates paid by large members have fallen even as their advance balances have grown.  Further, many of the advances to larger members were floating rate advances at very low initial rates.  However, the advances may serve to offset some of the System's non-core mission assets such as PLMBS which have been criticized in earlier OIG reports.

Risks inherent in the growth of advances are largely those of concentration.  An FHLBank could experience substantial losses if a large member defaulted on its advances and if the lender had not ensured and monitored its collateral.  OIG said that both FHFA and System officials claimed that collateral management is a high priority and that FHFA evaluates the System's risk management controls at every annual examination.

There is also the possibility that the System's banks could become overly dependent on the interest income from the large banks and could face financial challenges if a large member reduced its advances or withdrew its membership.  DBR said that some of the Banks are better able to "scale" their advance activity than others and mitigate such risks.

There is also a potential that FHLBanks could favor large members over smaller ones to gain business; lowering advance rates or easing capital or collateral requirements or that a company that belonged to more than one FHLBank could redirect funding to cause price competition within the system. 

Lastly, FHFA officials said there may be an increased "image risk" associated with the pattern of advances.  Concerns about the housing mission focus could be raised by the Basel III purpose of the advances.  FHFA, however, classifies all advances to be core housing mission assets and only those with maturities longer than five years are designated specifically for housing purposes.

OIG found that oversight of the surge in advances was a priority of DBR in its 2013 examination cycle and will remain so in 2014.  Examiners have focused on the System's risk management practices such as collateral management and have maintained regular communications with officials about the growth of advances to the four largest members.   Weaknesses found by examiners at three FLHBanks are currently being corrected.

DHR exams found no indication of favorable treatment to large member banks; it appeared lending was transparent and consistent with established policies and no pricing discrepancies were identified.  The regulator also said it had plans to study at least on large member to evaluate the risks association with the concentration of advances.  The study would likely assess the members' advance activity, pricing, and the FHLBanks' risk management procedures.

OIG concluded that the rapid growth of advances from March 2012 through December 2013 was primarily due to a surge in advances by the System's four largest members which was likely driven by the need to meet Basil III liquidity requirements.  The advance trend, if it continues, offers potential benefits to the System including higher interest rate income and an increased focus on core housing mission assets.  The surge however presents safety and soundness risks that must be mitigated and increasing use of advances for liquidity needs could raise public concerns about the System's commitment to housing. 

OIG said it believes that FHFA can take steps to enhance transparency about the advances and recommends that the agency collect and analyze information on FHLBank advances in 2014 and report publicly on this as an advance trend, the reasons for such advances, the effectiveness of System risk management practices, and the consistency of such advances with the System's housing mission.