The Federal Housing Finance Agency's (FHFA) inspector general also noted that some firms appear to be using funds from the program to meet liquidity standards designed to make banks more stable in a crisis.
The watchdog said in the report on Wednesday that loans to banks by government-sponsored entities that support mortgage and small-business lending jumped in 2013 after declining in the wake of the housing crisis.
That was largely because the four biggest members of the Federal Home Loan Banks system - JPMorgan Chase (>> JPMorgan Chase & Co.), Bank of America (>> Bank of America Corp), Citigroup (>> Citigroup Inc) and Wells Fargo (>> Wells Fargo & Co) - increased borrowing by 158 percent from March 2012 to December 2013, the report said.
That concentration could leave the system vulnerable if a big borrower defaulted, the watchdog said. It also said the government-sponsored lenders could unfairly prioritize big members over smaller ones.
The 12 home loan banks extend secured loans, known as advances, to banks to encourage them to lend. Advances dipped after the 2007-2009 financial crisis, when banks pulled back on mortgage lending.
Last year, the 12 lenders gave out nearly $500 billion in advances, still well below the 2008 peak of $1 trillion but a jump from $381 billion in March 2012, the report said.
Advances are seen as a core part of the home loan banks' mission to support housing finance. Boosting advances leads to higher interest income and could put the home loan banks on firmer footing, the report said.
But concentrated lending to bigger banks could pose safety risks or hurt public perception of the program because the firms used some of those funds to buy Treasury bonds and other securities to meet new liquidity rules.
The strategy is legal but could lead to questions about the home loan banks' "commitment to their housing mission," the report said.
The rules from an international group known as the Basel committee require big banks to hold assets they could sell quickly in a cash crunch. The goal is to make banks more stable during another economic meltdown.
The Federal Reserve last year proposed even tougher rules in the United States and projected U.S. banks would need about $200 billion more in liquid assets by 2017 to comply.
JPMorgan has disclosed in regulatory filings that it used federal home loan bank advances to buy liquid assets, the report said. Officials from two banks, which were not named in the report, confirmed that they stepped up use of advances to meet the rules.
An official from a third bank said the liquidity rules might influence its use of advances, and the fourth bank did not respond to requests for information from the FHFA inspector general, the report said.
Advances to smaller banks did rise by 9 percent from March 2012 to December 2013, the report said. That may have occurred after depositors withdrew funds to seek higher rates elsewhere, the watchdog said.
(Reporting by Emily Stephenson; editing by Andrew Hay)