Reforming the Federal Home Loan Bank System

We authored this post jointly with our friend and colleague, Lawrence J. White, Robert Kavesh Professor of Economics at the NYU Stern School of Business.

Some government financial institutions strengthen the system; others do not. In the United States, as the lender of last resort (LOLR), the Federal Reserve plays a critical role in stabilizing the financial system. Unfortunately, their LOLR job is made harder by the presence of the Federal Home Loan Bank (FHLB) system—a government-sponsored enterprise (GSE) that acts as a lender of next-to-last resort, keeping failing institutions alive and increasing the ultimate costs of their resolution.

We saw this dangerous pattern clearly over the past year when loans (“advances”) from Federal Home Loan Banks (FHLBs) helped postpone the inevitable regulatory reckoning for Silicon Valley Bank (SVB), Signature Bank, and First Republic Bank (see Cecchetti, Schoenholtz and White, Chapter 9 in Acharya et. al. SVB and Beyond: The Banking Stress of 2023).

From a public policy perspective, FHLB advances have extremely undesirable properties. First, in addition to being overcollateralized, these loans are senior to other claims on the borrowing banks—including those of the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve: If the borrower defaults, the FHLB lender has a “super-lien.” Second, there is little timely disclosure about the identity of the borrowers or the amount that they borrow. Third, they are willing to provide speedy, low-cost funding to failing institutions—something we assume private lenders would not do.

In this post, we make specific proposals to scale back the FHLB System’s ability to serve as a lender to stressed banks….

Libra's dramatic call to regulatory action

Facebook’s June 18 announcement that it has created a Geneva-based entity with plans to issue a currency called Libra is sending shock waves through the financial world. The stated objectives of creating Libra are to improve the efficiency of payments and to ease financial access. While these are laudable goals, it is essential that we achieve them without facilitating criminal exploitation of the payments system or reducing the ability of authorities to monitor and mitigate systemic risk. In addition, any broad-based financial innovation should ease the stabilization of consumption.

On all of these criteria, we see Libra as doing more harm than good. And, for the countries whose currencies are excluded from the Libra portfolio, it will diminish seignorage, while enabling capital outflows and, in periods of stress, accelerating capital flight.

Like Bank of England Governor Carney, we have an open mind, and believe that increased competition, coupled with the introduction of new technologies, will eventually lower stubbornly high transactions costs, improving the quality of financial services globally. But in this case, we urge a closed door….

Improving resilience: banks and non-bank intermediaries

Debt causes fragility. When banks lack equity funding, even a small adverse shock can put the financial system at risk. Fire sales can undermine the supply of credit to healthy firms, precipitating a decline in economic activity. The failure of key institutions can threaten the payments system. Authorities naturally respond by increasing required levels of equity finance, ensuring that intermediaries can weather severe conditions without damaging others.

Readers of this blog know that we are strong supporters of higher capital requirements: if forced to pick a number, we might choose a leverage ratio requirement in the range of 15% of total exposure (see here), roughly twice recent levels for the largest U.S. banks. But as socially desirable as high levels of equity finance might be, the fact is that they are privately costly. As a result, rather than limit threats to the financial system, higher capital requirements for banks have the potential to shift risky activities beyond the regulatory perimeter into non-bank intermediaries (see, for example here).

Has the increase of capital requirements since the financial crisis pushed risk-taking beyond the regulated banking system? So far, the answer is no. However, in some jurisdictions, especially the United States, the framework for containing systemic risk arising from non-bank financial institutions remains inadequate….

Banks and Money, Or Watch out What You Wish For

On 10 June 2008, a large majority of voters in Switzerland rejected a proposal that all commercial bank demand deposits be held at the central bank. This Vollgeld referendum was another incarnation of the justifiable public revulsion to financial crises and the bailouts that inevitably accompany them. Vollgeld proponents claimed that a system in which the central bank is the sole issuer of “money” will be more stable.

Serious people debated the wisdom of this proposal. One of Switzerland’s premier monetary economists, Philippe Bacchetta, wrote passionately in opposition. Martin Wolf, chief economics commentator at the Financial Times, argued in favor. And Swiss National Bank Chairman Thomas Jordan discussed the many dangers in detail.

It should come as no surprise that, had we had been among the Swiss voters, we would have voted “no.” In our view, the Vollgeld (sovereign money) initiative combined aspects of narrow banking with those of retail central bank digital currency. We see these as misguided, distorting the credit allocation mechanism and more likely to reduce than improve financial stability (see here and here). In the remainder of this post, we explain why….

Money Funds -- The Empire Strikes Back?

Shortly after Lehman failed in 2008, investors began to flee from money market mutual funds (MMMFs). To halt the run, the U.S. Treasury guaranteed all $3.8 trillion in outstanding MMMF liabilities. That rescue created enduring moral hazard: the expectation that a future crisis will lead to another bailout.

Aside from their legal form as mutual funds, MMMFs functioned much like banks engaged in the transformation of liquidity, credit and (to some extent) maturity. Similar to banks that redeem deposits at face value, they promised investors a fixed share value of $1 (a “buck”) on demand. Unlike depositories, however, MMMFs had no capital, no deposit insurance, and—at least officially—no access to the lender of last resort. So, when the Reserve Primary Fund “broke the buck” (by failing to redeem at the $1 par value) in September 2008, MMMF investors panicked.

Somewhat surprisingly, it took until 2014 for the Securities and Exchange Commission (SEC) to resolve political conflicts and introduce significant rule changes for MMMFs (see our earlier posts here and here). The SEC now requires that institutional prime MMMFs—which (like Reserve Primary) frequently invest in short-term corporate liabilities—operate like other mutual funds with a floating net asset value (NAV). The same rule applies to institutional municipal MMMFs. Retail MMMFs, as well as those investing in federal government (and agency) securities, are exempt.

In light of a recent legislative proposal to water it down, in this post we review the impact of the SEC’s 2014 reform. To highlight our conclusions: (1) it did not go far enough to reduce run risk; (2) aside from temporary dislocations, it has not raised nonfinancial sector funding costs by more than would be accounted for by reducing the implicit taxpayer guarantee for MMMFs; and (3) reversing the floating-NAV requirement would weaken the safety of the U.S. financial system....

Fintech, Central Banking and Digital Currency

How will financial innovation alter the role of central banks? As the structure of banking and finance changes, what will happen to the mechanisms and frameworks for setting monetary and financial policy? Over the past several decades, with the development of inflation targeting, central banks have delivered price stability. And, improved prudential policies are making the financial system more resilient. Will fintech—ranging from the use of electronic platforms to algorithm-driven transactions that supplant the traditional provision and implementation of financial services—change any of this?

This is a very broad topic, some of which we have written about in previous posts. This post considers an innovation suggested by Barrdear and Kumhof at the Bank of England: that central banks should offer universal, unlimited access to deposit accounts. What would this “central bank digital currency” mean for the financial system? Does it make sense for central banks to compete with commercial banks in providing deposit accounts?

We doubt it. It is not an accident that—at virtually every central bank—only commercial banks today have interest-bearing deposits. Changing this would pose a risk of destabilizing the financial system....

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Money, Banking, and Financial Markets