a reliable supply of mortgages. As a result, the FHLB system was created to guarantee a stable source of funds for the mortgage market.
To take out an advance, a lender must first become a member of one of the system's 12 district banks. Membership is open to savings and loan associations, savings banks, credit unions, commercial banks, and insurance companies who have at least 10 percent of their portfolio in residential mortgages. Members have to purchase their district bank's stock, which is not traded, but which usually provides a dividend.
The traditional activity of the FHLBs, which is providing advances to member banks, has virtually no risk to the FHLBs. This is due to three factors: advances are overcollateralized with high quality assets; the FHLBs can tap their members' stock if the collateral proves insufficient; the FHLBs have a statutory lien priority over the borrowing members. This third factor means that FHLBs have the highest priority if a borrowing member goes bankrupt, giving the FHLB the choicest assets from the members' portfolio. In addition, advances carry little interest rate risk because the banks finance them with liabilities of similar duration.
To the federal government, the only potential cost of an advance is an indirect one. When members substitute an advance for a federally insured deposit, they pay less for deposit insurance. However, since advances are collateralized, the FHLBs do not bear any of the risk of the members' portfolios. Instead, the insurance funds take on the risk.
In this way, deposit insurance premiums are calculated in such a manner as to create inequities among depository institutions. Two lenders with identical risks can end up paying different amounts for deposit insurance. This, in turn, distorts the decisions of members about the most efficient ways to raise funds. If the Federal Deposit Insurance Corporation (FDIC) did not take steps to increase the pr...