THE IMPACT OF FHLB ADVANCES ON BANK HOLDING COMPANY LENDING OVER THE CREDIT CYCLE

• DOI: http://doi.org/10.1111/jfir.12162
• Date: 01 December 2018
• Published date: 01 December 2018

THE IMPACT OF FHLB ADVANCES ON BANK HOLDING COMPANY

LENDING OVER THE CREDIT CYCLE

Elijah Brewer III

DePaul University and Federal Reserve Bank of Chicago

William E. Jackson III

University of Alabama

Thomas S. Mondschean

DePaul University

Abstract

We examine the sensitivity of bank holding company loan growth to the growth in

funding obtained through the Federal Home Loan Bank (FHLB) advances program.

FHLB advances are a low-cost funding source that banking organizations may substitute

for funds drawn out of the financial system during periods of tight monetary policy or

financial stress. This may be especially relevant for community banking organizations

that have relatively less access to wholesale funding sources. Our findings show that

FHLB advances provide banking organizations with some liquidity protection that

reduces the impact of financial market distress and tight monetary policy on loan growth.

JEL Classification: G2, G21, G28, E52

I. Introduction

Banking organizations,

1

as conceptualized in the literature (e.g., Allen and Santomero

1998), add economic value by acquiring short-term, liquid funds from a variety of

sources and using those funds to provide loans that are often longer term and less liquid.

Moreover, because of their size and expertise, banking organizations can offer financial

services to firms and households in ways that overcome the challenges of adverse

selection and moral hazard at a lower transactions cost than other types of institutions

can. As a result, banking organizations improve the efficiency of financial intermediation

by being more effective in allocating scarce financial resources than other methods of

Research support from DePaul University’s Driehaus College of Business is gratefully acknowledged. The

authors thank seminar participants at DePaul University for their insightful comments, and Noah Deck, Sarah

Guminski, Joshua Hernandez, and Preethi Prakash for excellent research assistance. We thank an anonymous

referee and Scott Hein, one of the editors, for helpful comments and suggestions that significantly improved the

manuscript. We also thank Kathy Moran for editing assistance. The views expressed here are those of the authors

and do not represent the Board of Governors of the Federal Reserve System or the Federal Reserve Bank of

Chicago.

1

We use the terms banking organizations and bank holding companies interchangeably throughout this

article.

The Journal of Financial Research Vol. XLI, No. 4 Pages 415–443 Winter 2018

DOI: 10.1111/jfir.12162

415

© 2018 The Southern Finance Association and the Southwestern Finance Association

channeling funds from savers to borrowers. This outcome, however, depends on stable

sources of low-cost liquid funds such as core deposits or other money market

instruments. Core deposits are mostly federally insured liabilities that tend to have little

external finance premia embedded within their costs and are less interest rate sensitive

than other sources of funds. Changes in the availability of noncore deposit sources of

funds due to negative economic shocks, for example, can adversely affect a banking

organization’s ability to provide the optimal level of financial intermediation. Moreover,

bank lending might be constrained because of informational frictions in the market for

uninsured wholesale funding (see, e.g., Jayaratne and Morgan 2000).

An alternative source of funding whose rates also embed a minimal external

finance premium became available to commercial banks with the passage of the

Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA).

FIRREA opened the Federal Home Loan Bank (FHLB) system membership to

commercial banks, allowing them to use loans provided by the 11 FHLBs.

2

These loans,

known as advances, provide banking organizations with another stable funding source

besides core deposits and, thus, mitigate the constraints of financial intermediation

mentioned earlier. FHLB advances and core deposits can improve a banking

organization’s ability to weather negative credit market shocks that could raise funding

costs, resulting in less disruption to its intermediation activity. Thus, access to FHLB

advances can insulate a banking organization’s costs of funds from exogenous credit

shocks and mitigate the impact on its borrowers because the cost of FHLB advances

tends to be insensitive to changes in aggregate credit risk.

3

This insight leads us to the central question of this article: Does access to FHLB

advances allow banking organizations to grow their book of loans in terms of magnitude

and composition in ways that are similar to core deposits? Like core deposits, FHLB

advances have little or no external finance premium embedded within their cost structure.

We analyze this research question by developing a version of the investment–cash flow

model used by Jayaratne and Morgan (2000) and testing it empirically using a panel of

commercial banks.

Our tests for evidence that the growth in FHLB advances (controlling for the

growth in core deposits and other variables) influences the growth in loans is related to

questions about how changes in external risk premia on uninsured wholesale funding

sources could get transmitted into changes in a banking organization’s balance sheet and

whether this is affected by the degree of capital adequacy or bank size. The approach in

this article is similar to what has been done in the investment–cash flow literature that

tests for capital market frictions faced by nonfinancial firms by seeing whether

investment by such firms depends on cash flows. That literature interprets a positive

correlation between cash flows and investment (after controlling for investment

2

The Federal Home Loan Bank of Seattle merged with the Federal Home Loan Bank of Des Moines on June 1,

2015.

3

There is an unintended negative consequence of the advance program. The existence and easy availability of

large pools of liquidity through the advance program could enable financially distressed commercial banks to

continue to engage in excessively risky activities that might expose the Federal Deposit Insurance Corporation

(FDIC) to larger losses (see Ashley, Brewer, and Vincent 1998).

416 The Journal of Financial Research