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From Banking and Finance Law Daily, April 16, 2014

OIG reports that surge in FHLBank advances linked to new liquidity standards

By Colleen M. Svelnis, J.D.

The Federal Housing Finance Agency, Office of Inspector General, has issued a report examining a surge in advances to the four largest members of the Federal Home Loan (FHL) Banking System: JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo. From March 31, 2012, to Dec. 31, 2013, advances to these four banks surged by 158 percent to $135 billion, according to the report, “Recent Trends in Federal Home Loan Bank Advances to JPMorgan Chase and Other Large Banks.” The FHL Banking System makes these loans, known as advances, to their members primarily to promote housing finance.

The OIG report set out to identify potential causes for the surge in advances, identify the associated benefits and risks, and assess the FHFA’s oversight of this area. According to the report, the surge in advances to the four largest members is attributable, in large part, to the bank liquidity standards established by the international Basel Committee on Bank Supervision in December 2010. The standards require banks to increase their holdings of high quality liquid assets to improve their ability to withstand sudden financial and economic stress.

The report sought to answer the following questions:

  1. Will the surge in advances continue, and will it spread to other members, or has the trend already peaked?

  2. How effectively are the FHLBanks managing the advance concentration and other risks associated with such advances?

  3. What are the implications for the FHL Banking System’s ability to achieve its housing mission if member banks increasingly draw advances to help meet their liquidity requirements?

Bank liquidity standards. The report describes how officials from FHFA and an FHLBank reported that large members of the FHL Banking System recently drew FHLBank advances, in part, to purchase the investment securities necessary to meet the new liquidity standards. In response to inquiries by the OIG, two banks confirmed that the new liquidity standards contributed to their increased use of advances.

According to officials from FHFA’s Division of Federal Home Loan Bank Regulation (DBR) and an FHLBank as well as FHFA internal records, some large FHLBank members have increased their use of advances as part of an overall strategy to comply with regulatory requirements established by the international Basel Committee on Bank Supervision.

Oversight and assessment of risk management. Oversight of the surge in advances to large FHL Banking System members was a priority during the 2013 examination cycle and will remain so in 2014, says the OIG report. The OIG’s review of DBR’s 2013 planning materials for three FHLBanks confirmed that the examiners prioritized the surge in advances to large members. Additionally, the concentration and collateral management risks they created focused on assessing the FHLBanks’ risk management practices.

The DBR’s review revealed weaknesses in an FHL bank’s management of relatively risky collateral pledged by a large member to secure advances. Additionally, in two other examinations conducted in 2013, DBR assessed whether a large bank member of the System had double-pledged collateral to obtain advances from two FHLBanks. DBR concluded that the FHLBanks had controls in place to prevent such double pledging.

DBR officials said that they plan to study at least one of the largest members in the

System to evaluate the risks associated with the concentration of advances. Officials said that the study would likely assess such members’ advance activity, pricing, and the FHLBanks’ risk management procedures.

Benefits and risks. The potential benefits a bank and the FHL banking system could get from the rise in advances include the stabilizing effects the interest income generated. The report notes that increased interest income generated by advances would increase contributions to the Affordable Housing Programs (AHP), which receive 10 percent of each FHLBank’s net income each year. FHLBanks also may pay both dividends to their members based on quarterly or annual profits. However, the report discloses that overall interest income has declined over the past several years, even for the banks whose advance balances have grown significantly. However, a great risk is that an FHLBank could experience substantial losses if a large member defaulted on its advances.

OIG Recommendations. The report concludes that the FHFA can take steps to enhance transparency about recent trends in FHLBank advances and their potential implications. The upwards trend of advances could offer benefits, including higher interest income and an increased focus on regulatory-defined core housing mission assets. However, the surge in advances to the four largest members also presents safety and soundness risks, such as concentration risk, that must be mitigated.

OIG asserts that the FHFA should publicly report on FHLBank advances to members in 2014, emphasizing the consistency of such advances with the safety and soundness of the FHL Banking System, as well as its housing mission. The report states that the FHFA could enhance awareness and understanding of FHLBank advances across the government, financial industry, and the general public through its established reporting processes or the issuance of a special report. The FHFA generally agreed with the recommendations.

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