The Federal Home Loan Bank System (FHLBS) was chartered by Congress in 1932. It provides liquidity to member institutions that hold mortgages in their portfolios and facilitates the financing of home mortgages by making low-cost loans, called advances, to those members. From 1932 until 1989 the System was regulated by the Federal Home Loan Bank Board. The Financial Institution Reform Recovery and Enforcement Act of 1989 (FIRREA) created the Federal Housing Finance Board and gave it authority over the Bank system.
The FHLBS is designated as a Government Sponsored Enterprise (GSE) and raises the funds for advances primarily by issuing consolidated obligations (bonds) in the capital markets. Members of the System include savings associations and savings banks regulated by the OTS, and other institutions that meet the membership requirements.
The System is one of the largest debt issuers in the world and is the second largest GSE borrower. At year-end 2002 the FHLBS had about $668 billion in outstanding debt compared to Fannie Mae's $844 billion and Freddie Mac's $644 billion. They are the largest GSE issuer of long term debt, with $435 billion outstanding compared to $295 billion by Freddie Mac and $239 billion by Fannie Mae.
FHLB advances are available to members with a wide variety of terms to maturity, from overnight to long term. Qualifying collateral for advances includes residential mortgages, commercial mortgages, and (for small institutions) small business and agricultural loans. Advances facilitate asset liability management of depository institutions by providing medium- and long-term instruments not available elsewhere and by setting individualized terms to maturity. All advances are collateralized. The FHLBs require substantial levels of over collateralization and can usually demand additional collateral at will. Advances are designed to prevent any possible loss to the issuing bank. The FHLBs have a "super lien" when institutions fail. To protect their position they have a claim on any of the additional eligible collateral in the failed bank. In addition, the FDIC has a regulation that reaffirms the FHLBs priority and the FHLBs can demand prepayment of advances when institutions fail.
Over the last four years commercial banks have more than doubled the volume of advances on their books, from $106 billion in 1998 to $234 billion at the end of 2002. This increase has prompted the agency to examine advances from three different perspectives: supervision, resolution, and deposit insurance pricing.
Supervision
The supervisory review looked at the FDIC supervised banks that were the largest advance users in each FDIC region. These banks had advance to asset ratios between 14% and 51% with an average of 29% (industry average is 3.3%). The institutions were very healthy, all but two having CAMELS ratings of 1 or 2. No significant risks of using advances were identified, but activity would be examined on a case-by-case basis. Supervision has guidelines and policies that address the use of wholesale funding. These require the management to assess these products and their risk and assess their effect on the institution's liquidity, interest rate risk, earnings, and capital.
Resolutions
When an insured institution fails, creditors of the institution have a set priority of claims, similar to priority in bankruptcies. There are two classes of claimants, secured and unsecured. Secured claims are paid in full up to the value of the pledged collateral (principal and interest to date of closure) but no post-closing investment losses are paid. Unsecured claimants are paid in the following order: administrative claims, deposit liabilities, general creditors, subordinated obligations and finally, shareholders. In a typical failure the FDIC is appointed receiver of the bank and provides coverage for insured depositors. After paying or covering insured depositors, the FDIC as insurer is subrogated for the depositors' claims and receives dividends from the proceeds of the sale of assets along with uninsured depositors. Over the closing weekend the FDIC either sells the whole bank, parts of the bank or decides to pay off the insured depositors and liquidate the assets of the bank.
FHLB advances are secured by pledges of high-quality collateral, such as 1-4 family mortgages. If there are FHLB advances in the institution at failure the FDIC as receiver promptly pays off the principal and interest to date. The FHLB then demands a prepayment fee under regulation. The regulation allows prepayment fees not to "exceed the present value of the loss attributable to the difference between the contract rate… and the reinvestment rate…" The entire process of settling the claim can result in delay in reacquiring the pledged assets and completion of a resolution transaction. This is particularly true since the pledged assets are high-quality and usually included in the franchise sale.
The FDIC has identified five problems with the current resolution process involving FHLB advances. First, prepayment fees increase loss to uninsured depositors and the deposit insurance fund. There was a $906,000 pre-payment fee when the Bank of Alamo, Alamo, Tennessee ($74.4 million in assets) failed in 2002. Second, the process can create resolution delays. Third, the process gives FHLBs a preferred status that no other secured creditor receives, including the Federal Reserve Banks. Fourth, it is inconsistent with depositor preference priorities established in the Federal Deposit Insurance Corporation Improvement Act (FDICIA).1 Finally, it is not necessary to protect FHLBs from credit risk or any other investment risk as the FDIC repays advances with principal and interest almost immediately at failure.
Deposit Insurance Pricing
Advances and other secured borrowing can create pricing disparities under the current system. Insured institutions that use secured borrowings are subject to lower premiums than similar institutions that principally use insured deposits. This is demonstrated in the following example.
- Bank A and Bank B have the same asset composition and risk profile. Both banks are in deposit insurance assessment group 2B and are charged insurance premiums of 10 basis points per dollar of assessable deposits. Assume Bank A is funded only by insured deposits while Bank B derives 3% of its funding from FHLB advances (the average bank has 3% advances). Under these assumptions Bank A will pay approximately 3% more in insurance premiums than Bank B, even though the risk to the insurance fund is identical. Of course, the disparity in premiums would be greater if Bank B held a larger percentage of advances.
Conclusion
The Federal Home Loan Bank System is a valuable source of funding for both banks and thrifts. The large increase in the use of FHLBS advances has caused the FDIC to examine ways that these instruments may affect insured institutions and the FDIC. The FDIC has looked at possible supervisory issues, resolution issues and deposit insurance pricing issues. While no current supervisory issues have been identified, FHLB advances have implications for both failed-bank resolutions and deposit insurance pricing.
1
FDICIA established the priority for paying claims when an insured institution fails. First, secured claims are paid in full, with principal and interest paid to the date of closure. Next, unsecured claimants are paid in the following order: administrative claims, deposit liabilities, general creditor claims, subordinated obligations and finally, shareholders.
