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Financial modernization, the FHLB and agricultural banks

October 1, 2000


Ron J. Feldman Assistant Vice President
Jason Schmidt Senior Financial Economist
Financial modernization, the FHLB and agricultural banks

Recently passed legislation increased the powers available to banks, but many of these new activities appear geared to larger institutions. In contrast, policymakers aimed a series of the reforms in the legislation directly toward smaller, agriculturally focused banks. Specifically, the Gramm-Leach-Bliley (GLB) Act increased the access that such banks have to lower-cost funds from a government-sponsored entity (GSE) called the Federal Home Loan Bank (FHLB) system. Although these changes could be important to a particular bank, initial estimates suggest that the overall effect of the reforms could be small.

FHLB membership pre-GLB

As a GSE, the FHLB makes loans, called advances, to its member financial institutions. GSEs are privately owned, federally chartered corporations with specialized lending powers. GSEs are supposed to correct deficiencies in the functioning of financial markets, such as the mortgage market. To help carry out this public purpose, the charters of GSEs give them special benefits, such as exemption from registering their securities with the Securities and Exchange Commission or exemption from state and local taxation. More importantly, these special powers suggest to those who own debt issued by GSEs that the federal government will protect them for loss if the GSE cannot pay them back. This implicit credit support of the federal government allows the GSE to borrow at rates slightly above those available to the U.S. Treasury. Thus a GSE like the FHLB can provide funds to its borrowers at relatively low cost.

FHLB membership was originally restricted to savings and loans. Commercial banks were first allowed to join the FHLB with passage of the Financial Institutions Reform, Recovery and Enforcement Act in 1989. To join the FHLB, banks had to be in sound financial condition (usually a regulatory safety and soundness rating of 1 or 2) and have at least 10 percent of their assets in residential mortgage loans. To receive an advance, a member has to purchase FHLB stock and pledge high-quality assets as collateral. Acceptable collateral includes first mortgages and other real estate-related assets, Treasury and GSE securities, and deposits held at the FHLB.

GLB makes membership and borrowing easier

For a number of years, rural, agriculturally focused banks (those with a ratio of agricultural loans to total loans of greater than 25 percent) have been seeking new low-cost sources of funds. While core deposits remain the primary source of funds for agricultural banks, their share of total liabilities has fallen steadily from 90 percent to 81 percent over the last 10 years (see graph).

Chart: Liabilities at Agricultural Banks

Agricultural banks have been replacing these core deposits with other sources of funds, such as large certificates of deposits. Some agricultural banks have begun borrowing from the FHLB system. But the requirement that banks hold a certain percent of their assets in mortgage-related assets to join the system and the limited types of collateral they could pledge were viewed as a barrier to full access to this source of low-cost funding.

These concerns were addressed in the financial modernization legislation that passed in 1999. (The legislation is discussed in more detail in "Is financial modernization anything new?" in the April 2000 fedgazette.

GLB took steps to increase the number of commercial banks that can join the FHLB and the types of assets these banks can offer as collateral. (GLB made other changes to the FHLB and the financial system that we do not explore.) Eligibility is increased under GLB by allowing a bank with assets under $500 million to join the FHLB "without regard to the percent of its total assets that is represented by residential mortgage loans." GLB also allowed commercial banks with assets under $500 million to offer small business and farm loans as collateral for FHLB advances. As a result, virtually all of the nation's nearly 2,300 agricultural banks are eligible for FHLB membership.

GLB may have small effect

We have made rough estimates as to the number of agricultural banks that will be able to join the FHLB system after GLB and the number that were eligible to join the system prior to GLB but did not (in addition to current members). We find that as of the end of 1999 when GLB passed, roughly 50 percent of agricultural banks were already members, and roughly 30 percent of agricultural banks could have joined but had not. Newly eligible agricultural banks under GLB approximate 20 percent. This distribution is roughly the same in the Ninth District where about 30 percent of agricultural banks will become newly eligible to join the system. (The methodology is available from the authors by request.)

Moreover, we find that some important characteristics of the newly eligible banks for membership are similar to those that were previously eligible but did not join. For example, both the newly and currently eligible agricultural banks have asset growth rates of around 5 percent, in contrast to the nearly 9 percent growth rate for agricultural banks that are members. Likewise, the newly and currently eligible agricultural banks used core deposits at roughly the same rate, which was higher than agricultural banks that had joined the system (86 percent of liabilities vs. 81 percent of liabilities). This type of data suggests that the newly eligible agricultural banks may decide, like the currently eligible banks that they resemble, not to join the FHLB system.

We estimate that the total amount of collateral that agricultural banks can pledge for FHLB advances could increase by roughly 50 percent under the GLB rules. We find that under existing rules, eligible collateral for agricultural banks equaled $36.4 billion. Using the new GLB collateral and eligibility rules, agricultural banks will have eligible collateral equaling $55.2 billion. However, the total amount of advances made against the new collateral could very well be smaller. The FHLB of Des Moines has suggested that advances made against newly pledged farm loans will likely be much less than the typical 80 cents on the dollar for mortgages.

Additionally, the need to pledge the new collateral and increase FHLB borrowings is unlikely to be the same for all current and potential FHLB members that are agricultural banks. We measure the potential propensity to borrow by examining the ratio of deposits to loans at individual banks. Higher ratios could indicate that a bank has not fully deployed its deposits to fund loan growth. As might be expected, agricultural banks that are actively borrowing from the FHLB have the lowest deposit-to-loan ratios, indicating more full deployment of deposits and the potential need to find other sources. The newly eligible agricultural banks have significantly higher median ratios, implying a lower need to borrow from the FHLB. This could limit the growth in advances, since roughly 38 percent of the $18 billion projected increase in eligible collateral results from the newly eligible agricultural banks.

Agricultural Bank Group Deposit-Loan Ratio
Newly eligible
Eligible nonmember
Nonborrowing member
Borrowing member


Agricultural banks naturally want access to as many low-cost sources of funds as they can find. GLB includes reforms that were designed to add a new source, the FHLB system. However, the bill may not have a significant effect. In part, this reflects the success the FHLB already has in signing up agricultural bank members. In part, it reflects the fact that not all banks see it as advantageous to join the system currently.