Regulators’ worries about FHLB risk are outsize

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In good times, it can be hard to find anything that keeps regulators up at night — right now, the Federal Home Loan banks might just be it.

Since 2012, FHLBs have taken on a larger role in funding commercial banks. In the process, the government-sponsored banks have transitioned to issuing shorter-term obligations. The worry is that the increasing maturity mismatch between their assets and liabilities makes FHLBs vulnerable to a liquidity shock and that they now represent a stress point in the financial system.

However, the increase in collateralized loans to banks contrasts sharply with the red flag represented by surges in this activity in the past.

In past episodes — namely, the periods leading up to the savings and loan crisis and the global financial crisis — banks and thrifts ramped up their leverage and ran into trouble when private sources of funding turned away. This time around, the surge in FHLB funding is not a signal of riskier banks at all — in fact, it’s quite the opposite. The FHLBs may have taken on risk, but this is merely a side effect of regulatory reforms that have made banks and money market funds safer.

Brought into being by Congress to support mortgage lending, FHLBs have evolved into an important provider of funding for banks. In fact, FHLB advances to banks total more than $450 billion, according to the latest numbers. These advances now make up a quarter of commercial banks’ total nondeposit liabilities, compared to less than 13 percent in 2012. In addition to advances, FHLBs have become the largest lender in the fed funds market (roughly $75 billion) and they provide $48 billion in the form of repurchase agreements.

Yet the lack of apparent, ready substitutes for the niche role of FHLBs in the new regulatory environment has created concern that they will become a stress point in the financial system.

Last year, former Federal Reserve Vice Chairman Stanley Fischer highlighted the “vulnerability [of FHLBs] should they encounter liquidity pressure.” And just a few months ago, the Fed’s board of governors showcased a three-piece series on FHLBs’ significant growth, and risks, since 2012. However, as we have shown in our research the story is more about the way banks found new sources of funding than it is about FHLBs. In effect, the recent increase in FHLB advances is a byproduct of regulatory reforms designed to reduce banks’ reliance on short-term funding.

The increase in FHLB advances over the last five years can be explained mostly by rising demand from the largest banks: institutions with assets over $250 billion. As a group, these banks quadrupled their borrowing between 2012 and 2017 — from $53 billion to $211 billion. First, the adjustment was driven by stringent new liquidity requirements. But, after slowing in 2015, the surge resumed in 2016—this time spurred by the regulatory shake-up of the money market fund industry.

Essentially, FHLBs increasingly stepped in as regulatory constraints limited access to traditional sources of private funding, such as money market funds and broker-dealers. As a result, FHLBs took over as a key provider of nondeposit funding to banks even as banks dramatically reduced their reliance on nondeposit sources of funding overall.

Markets don’t eliminate risk; they transform it. The reduction in systemic risk in the banking system came at a price. Banks are now even more interconnected with government-sponsored entities like FHLBs, and more dependent on their public guarantees, than before the crisis.

How much rollover risk is borne by the home loan banks — and ultimately by the taxpayers who backstop them — as a result of the increased maturity mismatch on their balance sheets is unclear at this stage. The odds that the FHLBs will face a liquidity shock are quite low. It would require a loss of confidence among the investors who buy their obligations, and this is unlikely except in the extreme case that calls FHLBs' implicit public guarantee called into question.

It’s a safe bet that regulators will give FHLBs heightened scrutiny. Although this is justified, the FHLBs should not become a top priority for regulatory agencies. Despite their newfound importance, the FHLBs still are just one potential stress point among many in the financial system.

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Federal Home Loan Banks Commercial banking