Cost of debt and federal home loan bank funding at U.S. bank and thrift holding companies

We investigate the relationship between the cost of debt issued by bank holding companies (BHCs) and thrift holding companies (THCs) and their use of Federal Home Loan Bank (FHLB) advances. Cost of debt is used as a measure of bank riskiness for the first time in a FHLB study. A two-equation model of FHLB advances and cost of debt is estimated. Three main results are obtained. First, greater reliance on advances by BHCs and THCs is associated with lower cost of debt in the pre-crisis period, and more strongly so during the crisis, because granting of advances sends a positive signal to the market about FHLB’s support. Second, greater holding company (HC) cost of debt, as an explanatory variable, is associated with smaller advances as FHLBs restrict advances to riskier HCs. Third, we find no separate effect on the cost of debt from FHLB membership. Our results are robust to 3SLS estimation, used to address endogeneity, and to alternative model specifications. The negative association between cost of debt and advances suggests that BHCs and THCs do not use advances to make riskier loans and that FHLB policies and services have some risk-reducing effects which more than offset the effect of potential moral hazards.