Essays on Moral Hazard, Bank Size, Influence, and Risk at the Federal Home Loan Banks

Two chapters of research on the Federal Home Loan Bank advances, bank risk, and influence are presented. Federal Home Loan Bank (FHLB) advances are a growing source of debt financing for US banks. FHLB advances are not priced according to bank credit risk, creating potential for moral hazard. FHLB advances are positively related to contemporary bank risk, but the relation between prior advances and subsequent risk varies between large vs. small banks depending upon the risk measure used. The relation between FHLB advances and various measures of bank risk varies between pre-crisis (2005-07), crisis (2008-09), and post-crisis (2010-12) periods differently for large vs. small banks. Thus, FHLB advances are related to bank risk, but the nature of these relations is contingent on bank size and time period. When deciding to lend advances to risky banks and thrifts, the Federal Home Loan Banks (FHLBs) weigh moral hazard incentives against charter value preservation. FHLBs may be more likely to lend to risky large members than risky community banks because large members exert significant influence over the FHLBs through their outsized capital holdings and interest payments on advances, their presence on the Board of Directors, and their ability to obtain advances from multiple FHLB districts. Between 2005 and the financial crisis pinnacle in the third quarter of 2008, the share of advances to large banks surged, even though some of those banks were on the verge of failure. A positive relationship exists among large bank advances, influence metrics, and insolvency risk, consistent with the story that FHLB moral hazard incentives outweigh charter value preservation for their largest members. Regardless of their risk and influence, banks used the advances similarly, primarily as a funding source for new loans

CEO incentives and bank risk

We investigate the relationship between CEO compensation and bank default risk predictors to determine if short-term incentives can explain recent excesses in bank risk. We investigate early warning off-site surveillance parameters and expected default frequency (EDF) as well as crisis-related risky bank activities. We find only modest evidence that CEO compensation structures promote significant firm-specific heterogeneity in bank risk measures or risky activities. Compensation elements commonly thought to be the riskiest components, unvested options and bonuses, are either insignificant or negatively correlated with common risk variables, and only positively significant in predicting the level of trading assets and securitization income.CEO compensation Bank risk Bank regulation Bank failure Bank EDF