LOLR

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….

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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). Not only did the FHLBs have a starring role in the recent banking turmoil, but they also played an important (albeit less publicized) part in the 2007-09 financial crisis by providing substantial funding to Washington Mutual, Countrywide, and Wachovia—all of which ultimately failed.

Put simply, in their current incarnation, the FHLBs make loans to illiquid intermediaries that are highly vulnerable to runs. However, 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” (just in case the overcollateralization is insufficient to satisfy the FHLB’s claim). Second, there is little timely disclosure about the identity of the borrowers or the amount that they borrow. All we have are quarterly filings in which the banks can disclose the amount they borrowed, while the FHLBs reveal their top 10 borrowers. Third, reflecting the super-lien, the overcollateralization of their advances, and the implicit federal guarantee of their liabilities, the FHLBs appear unconcerned about the viability of their borrowers: They are willing to provide speedy, low-cost funding to failing institutions—something we assume private lenders would not do. (For more on the distortions and incentive problems associated with the FHLBs, see Judge.)

It was not always so. Created by federal law in 1932, the FHLB System was designed to provide wholesale lending in support of residential mortgage finance and community investment. As of March 31, 2023, the system had 6,484 members. Like other GSEs, including Fannie Mae and Freddie Mac, investors view FHLB System debt as having the implicit support of the federal government. As a result, the FHLBs can borrow at rates that are only modestly above Treasury yields. Having evolved over time, the System today is a nationwide set of 11 wholesale cooperative banks that jointly raise funds in debt markets and use the proceeds to lend to members: including commercial banks, savings banks, credit unions, and insurance companies. (For more detail see Frame, and White and Frame.)

At the beginning of 2022, total FHLB System advances were $335 billion—well below the average of $555 billion during the previous decade. But during 2022 and over the first quarter of 2023, advances roughly tripled, reaching $1,044.6 billion by March 31, 2023. In the following chart, we plot FHLB System lending since 2003 (in red). For comparison, we also show Federal Reserve lending (in black). As Ashcraft, Bech, and Frame and Judge emphasize, and the chart highlights, the System’s members today primarily use its advances as a tool for liquidity management during periods of stress. Not only that, but the increases during stress periods are several times larger than the rise in Federal Reserve lending. This pattern suggests that borrowers strongly prefer advances from the FHLBs over discount loans from the central bank that usually are accompanied by greater supervisory scrutiny.

FHLB Advances to FHLB Members and Federal Reserve Lending to Banks, (Billions of U.S Dollars) Q1 2003–Q1 2023

Sources: Board of Governors, Financial Accounts of the United States, BOGZ1FL403069330Q and H.4.1.

The following table shows FHLB lending at the end of 2022 and during the first quarter of 2023 as reported in the system’s quarterly disclosures. For each of these dates, we report the 10 largest recipients of FHLB advances.

Top Ten Holding Company Recipients of FHLB Advances (Billions of U.S. Dollars), Year-end 2022 and March 31, 2023

*NY Community Bank owns Flagstar, which assumed substantially all deposits of Signature Bridge Bank.
Sources: Advances are from Federal Home Loan Banks (2023) Table 12 and Federal Home Loan Banks (2023) Table 7. For total assets, with the exception of First Republic and TD Bank, the information is for March 31, 2023, and comes from 10-Q filings. For First Republic, the information is from “FDIC’s Supervision of First Republic Bank,” September 8, 2023. For TD Bank, the information is from “TD Bank Group Reports First Quarter 2023 Results: Report to Shareholders,” and is for January 31, 2023 (converted from Canadian to U.S. dollars using that day’s exchange rate).

We draw four conclusions from this table. First, total advances for the top ten rise sharply from year-end 2022 to the end of the first quarter of 2023 (from $218.8 billion to $326.0 billion). Second, lending is quite concentrated and rising. The top ten borrowers accounted for 26.5% of advances at the end of 2022. And this rose to 31% three months later. Third, banks with assets in the range of $500 billion to $700 billion are quite prominent—especially at end of the first quarter of 2023, when they constituted the top four and account for 17.2% of total FHLB advances. Of the eight banks on the year-end 2022 list, seven were still there at the end of the first quarter of 2023 (SVB isn't!). (See our earlier post on the failure of SVB.)

Perhaps most disturbing is that the FHLBs seem content to lend large amounts to troubled banks. Had SVB, Signature, and First Republic instead been forced to face market discipline during 2022, their borrowing cost would have surely been far higher. Thus motivated to address their losses at an earlier stage, they might have survived—or at least could have been absorbed by other banks at lower public cost than what we saw. Yet, from the FHLB perspective, the combination of overcollateralization and the super-lien made these loans extremely safe—even though the borrowers faced an elevated risk of failure.

Clearly FHLB lending does not diminish the risk to the banking system as a whole. When some of the borrowers do eventually fail, other lenders must wait in line behind the FHLBs to get paid. Short of an unprecedented systemic calamity, it is impossible to imagine circumstances where the FHLBs are not repaid fully, but it is not difficult to imagine wider systemic stress and spillover costs. Indeed, this is one way to interpret the numerous bank failures of 2008-09: the FDIC imposed a special premium on surviving commercial banks to replenish its depleted Deposit Insurance Fund that in part went to repay the FHLBs.

It also is easy to understand why, when large unrealized losses eroded (or even wiped out) their net worth during 2022, SVB, Signature Bank, and First Republic Bank turned to the FHLBs to stay afloat. In addition to avoiding greater supervisory scrutiny, FHLB advances allowed these banks to delay asset sales that would have forced balance-sheet recognition of their losses and compelled them to increase their regulatory capital ratios (either by raising equity or shedding assets). Instead, the banks gambled for resurrection on the back of mispriced government-sponsored financing. In the end, the gamble failed. Indeed, SVB’s March 8, 2023, attempt to raise capital came so late that uninsured depositors ran, and the bank failed within two days. The panic then quickly spread to other mid-sized banks with similar vulnerabilities.

Furthermore, there are strong indications that the FHLB system facilitates regulatory arbitrage. As Anadu and Baklanova discuss, and we explained in an earlier post, FHLB liabilities are treated as high-quality liquid assets (HQLA) for banks in meeting their liquidity requirements and are eligible holdings for government-only money market funds (MMFs).

These special features of their liabilities mean that the FHLBs now serve as a conduit through which the MMFs can finance U.S. banks in normal times. But matters are worse during periods of stress because, as deposits move out of vulnerable banks into government MMFs, the FHLB System ends up recycling the funds: MMFs use the inflowing funds that had fled the banks to acquire the liabilities of the FHLBs; in turn, the FHLBs use the proceeds to lend to the vulnerable banks, filling their panic-driven funding gap.

This stress-driven version of regulatory arbitrage appears to have been especially important in March 2023. During that month, commercial bank deposits fell by $307 billion, while borrowing and other liabilities rose by $510 billion: Overall, the banking system balance sheet actually grew. In the same period, government MMF shares rose by $442 billion. While we do not have monthly data for the FHLB System, we know that during the first quarter of 2023, FHLB advances rose by $216 billion, while FHLB bond liabilities increased by $312 billion. Hence, significant increases in government MMF shares essentially funded FHLB advances which, in turn, made up for much of the lost bank deposits: The FHLB System used its government imprimatur to provide low-cost funding to the banks, displacing the Fed as LOLR.

This all leads us to conclude that in its current guise the FHLB System is counterproductive. To counter the most damaging aspects of the regulatory arbitrage, we should eliminate or sharply scale back the System’s ability to serve as a lender to stressed banks.

For the most part, banks and other intermediaries rely on market sources of liquidity that impose a healthy discipline on the borrowers, helping to limit the risks that they take. However, in periods of financial stress, the market supply of liquidity can become dangerously scarce, which justifies the existence of a central bank LOLR. Put simply, the LOLR addresses a well-known externality: that individual bank runs (or failures) can turn into systemwide panics and fire sales that threaten the payment system and/or the supply of credit to healthy borrowers. In contrast, we know of no such theoretical or practical foundation that can justify the creation of a GSE that effectively supplants the LOLR, substituting for market sources of liquidity when that supply is costly.

Nor do we see any externality that rationalizes the existence of such a lender. As it currently operates, the FHLB System delays and undermines market discipline. It expands the supply of low-cost, federally subsidized credit to severely troubled, and potentially insolvent, banks. It also undermines supervisory discipline—especially that of the LOLR. For example, an effective LOLR must commit not to lend to insolvent banks: In addition to subordinating other lenders, such lending would make other recipients of LOLR loans—institutions that are solvent, but temporarily illiquid—suspect of insolvency. Moreover, lending to insolvent banks would not put an end to financial fragility. More likely, it delays and raises the costs of resolution.

Unless someone produces a good justification, policymakers should eliminate the FHLB’s role as U.S. lender of second-to-last resort. We also see little justification for yet another GSE or Federal agency to support residential housing, on top of the Federal Housing Administration (FHA), Fannie Mae, Freddie Mac, Ginnie Mae, and the Veterans’ Administration. However, it is likely too much to ask that the entire FHLB System be shut down.

Instead, we offer three concrete proposals for reform:

  1. Eliminate the super-lien. As it stands, the FHLBs are tempted to lend to zombie banks in the form of a stealth, but temporary, bailout. This delays resolution, increasing public costs. 

  2. Require that Federal Reserve supervisors approve their banks’ borrowings (advances) from the FHLBs beyond a normal level: The conditions for advances should be at least as stringent as those for discount loans.

  3. Require immediate public disclosure by each FHLB of its advances (or, at least of advances beyond some size threshold) and of the lending conditions (including the collateralization). In that way, other creditors would learn quickly about the strains that advance recipients may face, helping to focus counterparty and regulatory scrutiny where it belongs. Because this information is materially relevant for bank investors, policymakers also should require the borrowing banks themselves to make this disclosure in their quarterly filings, rather than just in their annual reports.

Some of these proposals—certainly the first—would require legislative action, but we hope that the FHLBs and bank supervisors would quickly implement what is feasible on a voluntary basis.

As it stands, the FHLB System is a destabilizing force in the U.S. financial system. By providing subsidized loans during period of stress, it undermines the LOLR. Fixing this would improve financial resilience by creating greater incentives for banks to manage risk.

This post is a revised version of Chapter 9 in SVB and Beyond: The Banking Stress of 2023.

Acknowledgement: Without implicating her, we are grateful to Professor Kathryn Judge (Columbia Law School) for her guidance regarding the legal aspects of FHLB reform.

Erratum 2023-12-06: In the bottom panel of the table, we have made modest corrections to several entries under “Total Assets" and “Advances as a Pct. of Assets.”  These corrections have no impact on our analysis.

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Understanding How Central Banks Use Their Balance Sheets: A Critical Categorization

This comment is jointly authored by Stephen G. Cecchetti and Sir Paul M.W. Tucker.

Central banks have been reinvented over the past decade, first in response to the financial crisis, and then as a consequence of Covid-19. While trying to maintain monetary stability and promote economic recovery, their balance sheets have ballooned. In 2007, the central banks in the United States, euro area, United Kingdom, and Japan had total assets from 6% to 20% of nominal GDP. By the end of 2020, the Fed’s balance sheet was 34% of GDP, the ECB’s 59%, the Bank of England’s 40%, and the Bank of Japan’s 127%.

Before it is possible to consider how well this worked, it is necessary to be clear about what policymakers’ various operations were trying to achieve. Headline declarations of aiming at “price stability” or “financial stability” are unsatisfactory as they jump to end goals without attending to the motivations for specific operations and facilities. The case of the Fed is illustrative. Among other things, they bought U.S. Treasury bonds, offered to purchase commercial paper, corporate and municipal bonds, and set up facilities to lend directly to real-economy businesses as well as to securities dealers. These cannot be assessed solely on whether, alone or together, each materially improved the outlook for economic activity and inflation.

Without a sense of the intended purpose of each central bank action, it is difficult for political overseers or interested members of the public to hold central banks accountable. Precisely because central banks are independent (rightly in our view), that accountability takes the form of public scrutiny and debate. But we argue that it is also hard for central bankers themselves to do their jobs unless they distinguish carefully—in internal deliberations, and external communication—the rationale for different interventions….

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Fix Money Funds Now

On September 19, 2008, at the height of the financial crisis, the U.S. Treasury announced that it would guarantee the liabilities of money market mutual funds (MMMFs). And, the Federal Reserve created an emergency facility (“Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility”) to finance commercial banks’ purchases of illiquid MMMF assets. These policy actions halted the panic.

That episode drove home what we all knew: MMMFs are vulnerable to runs. Everyone also knew that the Treasury and Fed bailout created enormous moral hazard. Yet, the subsequent regulatory efforts to make MMMFs more resilient and less bank-like have proven to be half-hearted and, in some cases, counterproductive. So, to halt another run in March 2020, the Fed revived its 2008 emergency liquidity facilities.

We hope the second time’s the charm, and that U.S. policymakers will now act decisively to prevent yet another panic that would force yet another MMMF bailout.

In this post, we briefly review key regulatory changes affecting MMMFs over the past decade and their impact during the March 2020 crisis. We then discuss the options for MMMF reform that the President’s Working Group on Financial Markets identifies in their recent report. Our conclusion is that only two or three of the report’s 10 options would materially add to MMMF resilience. The fact that everyone has known about these for years highlights the political challenge of enacting credible reforms.

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The Fed Goes to War: Part 2

In this note, we update our earlier comment on the first set of Fed actions that appeared on March 23 just as a slew of new ones arrived.

While most of the changes represent simple extensions of previous tools, the Fed also has introduced facilities that are going to involve it deeply in the allocation of credit to private nonfinancial firms. Choices of whom to fund are inherently political, and hence destined to be controversial. Engaging in such decisions will make it far more difficult for the Fed eventually to return to the standard of central bank independence that it has guarded for decades. We urge the Fed to limit its involvement in the allocation of credit to the private nonfinancial sector. And, should Congress deem it necessary, we encourage them to provide explicit authorization to the Treasury (along with the resources) to take on this crisis role.

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The Fed Goes to War: Part 1

Over the past two weeks, the Federal Reserve has resurrected many of the policy tools that took many months to develop during the Great Financial Crisis of 2007-09 and several years to refine during the post-crisis recovery. The Fed was then learning through trial and error how to serve as an effective lender of last resort (see Tucker) and how to deploy the “new monetary policy tools” that are now part of central banks’ standard weaponry.

The good news is that the Fed’s crisis management muscles remain strong. The bad news is that the challenges of the Corona War are unprecedented. Success will require extraordinary creativity and flexibility from every part of the government. As in any war, the central bank needs to find additional ways to support the government’s efforts to steady the economy. A key challenge is to do so in a manner that allows for a smooth return to “peacetime” policy practices when the war is past.

In this post, we review the rationale for reintroducing the resurrected policy tools, distinguishing between those intended to restore market function or substitute for private intermediation, and those meant to alter financial conditions to support aggregate demand….

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Bank Runs and Panics: A Primer

A bank promises its clients immediate access to cash. Depositors can redeem their funds on demand at face value—first come, first served. Other short-term creditors can do the same, albeit at varying speeds, by not rolling over their loans. And, households and firms that pay a fee for a credit commitment can take down their loans at will.

For banks that hold illiquid assets, these promises of liquidity on demand are the key source of vulnerability. The same applies to other financial institutions (de facto or shadow banks) that perform bank-like services, using their balance sheets to transform illiquid, longer-maturity, risky assets into liquid, short-maturity, low-risk liabilities.

A bank run occurs when depositors wish to make a large volume of withdrawals all at once. A bank that cannot meet this sudden demand fails. Even solvent banks—those whose assets exceed the value of their liabilities—fail if they cannot convert their assets into cash rapidly enough (and with minimal loss) to satisfy their clients’ demands. A banking panic is the plural of a bank run: when clients run on multiple banks. We call the spread of runs from one bank to others contagion—the same term used to describe the spread of a biological pathogen.

In this primer, we characterize the sources of bank runs and panics, as well as the tools we use to prevent or mitigate them….

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Some Unpleasant Gold Bug Arithmetic

Most people care far more about the prices of things they purchase—food, housing, health care, and the like—than the price of gold. Not coincidentally, professional economists display a remarkably explicit consensus against forcing the central bank to adopt a policy that fixes the price of gold.

Yet, there are still powerful people who think that the United States would benefit if the central bank’s sole purpose were to restore a gold standard. With the nomination of gold standard advocate Judy Shelton to be a Governor of the Federal Reserve, we feel compelled to take these views seriously. So, here goes.

Several years ago, we emphasized that a gold standard is incredibly unstable. In this post, we address the mechanics of how the U.S. central bank would run the system. In our view, it is incumbent on any gold standard advocate to answer a series of practical questions: What gold price are they proposing? How much gold would the Federal Reserve have to acquire and hold to make the scheme credible? Will the Fed be able to lend to banks and operate as a lender of last resort?

Our answers highlight the operational challenges. Since the Fed initially would commit to holding a particular dollar value (that is, the product of price and quantity) of gold, we need to consider price and quantity together. With the smallest balance sheet we can imagine, our best guess is that the Fed initially would have to triple its gold holdings, driving the price of gold up by two thirds (to about $2,600 per ounce). Then, to maintain the gold standard, the Fed would still need to purchase one-third of world gold production each year. Without gold holdings over and above this minimum, the Fed would not be able to lend at all, much less without limit as it can under a pure fiat money standard….

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The Federal Home Loan Banks: Two Lessons in Regulatory Arbitrage

There is an important U.S. government-sponsored banking system that most people know nothing about. Created by an act of Congress in 1932, the Federal Home Loan Banks (FHLBs) issue bonds that investors perceive as having government backing, and then use the proceeds to make loans to their members: namely, 6,800 commercial banks, credit unions, insurance companies and savings associations. As the name suggests, the mission of the (currently 11) regional, cooperatively owned FHLBs is “to support mortgage lending and related community investment.” But, since the system was founded, its role as an intermediary has changed dramatically.

With assets of roughly $1 trillion, it turns out that the FHLBs—which operate mostly out of the public eye—have been an important source of regulatory arbitrage twice over the past decade. In the first episode—the 2007-09 financial crisis—they partly supplanted the role of the Federal Reserve as the lender of last resort. In the second, the FHLBs became intermediaries between a class of lenders (money market mutual funds) and borrowers (banks), following regulatory changes designed in part to alter the original relationship between these lenders and borrowers. The FHLBs’ new role creates an implicit federal guarantee that increases taxpayers’ risk of loss.

In this post, we highlight these episodes of regulatory arbitrage as unforeseen consequences of a complex financial system and regulatory framework, in combination with the malleability and opaqueness of the FHLB system.…

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FEMA for Finance

Modern financial systems are inherently vulnerable. The conversion of savings into investment—a basic function of finance—involves substantial risk. Creditors often demand liquid, short-term, low-risk assets; and borrowers typically wish to finance projects that take time to generate their uncertain returns. Intermediaries that bridge this gap—transforming liquidity, maturity and credit between their assets and liabilities—are subject to runs should risk-averse savers come to doubt the market value of their assets.

The modern financial system is vulnerable in a myriad of other ways as well. For example, if hackers were to suddenly render a key identification technology untrustworthy, it could disable the payments system, bringing a broad swath of economic activity to an abrupt halt. Similarly, the financial infrastructure that implements most transactions—ranging from retail payments to the clearing and settlement of securities and derivatives trades—typically relies on a few enormous hubs that are irreplaceable in the short run. Economies of scale and scope mean that such financial market utilities (FMUs) make transactions cheap, but they also concentrate risk: even their temporary disruption could be catastrophic. (One of our worst nightmares is a cyber-attack that disables the computer and power grid on which our financial system and economy are built.)

With these concerns in mind, we welcome our friend Kathryn Judge’s innovative proposal for a financial “Guarantor of Last Resort”—or emergency guarantee authority (EGA)—as a mechanism for containing financial crises. In this post, we discuss the promise and the pitfalls of Judge’s proposal. Our conclusion is that an EGA would be an excellent tool for managing the fallout from dire threats originating outside the financial system—cyber-terrorism or outright war come to mind. In such circumstances, we see an EGA as a complement to existing conventional efforts at enhancing financial system resilience.

However, the potential for the industry to game an EGA, as well as the very real possibility that politicians will see it as a substitute for rigorous capital and liquidity requirements, make us cautious about its broader applicability. At least initially, this leads us to conclude that the bar for invoking an EGA should be set very high—higher than Judge suggests….

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