By Dan Brown, Jeff Huther and Joe Pigg
As the Federal Home Loan Bank system reached its ninth decade, the normally low-profile system has earned more attention in recent weeks—due largely to the active role FHLBs are playing in helping banks boost their liquidity right now and because of the comprehensive review of the FHLB system launched by its regulator, the Federal Housing Finance Agency, in late 2022. If the purpose of that review is to question the need for the FHLBs, the last two months should provide a compelling affirmative answer.
FHLB membership has expanded over the decades by Congress to include institutions such as credit unions and commercial banks, but its broad liquidity mission has remained. While Congress did expand the FHLBs’ mission to include a specific housing finance mission with the creation of the Affordable Housing Program mandate in 1989, the core mandate of the system has always been to provide advances, backed by eligible collateral—including but not limited to mortgage loans. Recent events have shown that mission to provide liquidity to members—in all market conditions—remains just as important as ever.
The recent run on Silicon Valley Bank and Signature Bank highlights the crucial role the FHLBs play in providing liquidity to well-capitalized banks. The FHLBs maintain large holdings of cash and cash-like instruments to meet members’ funding needs. While real-time numbers on the amount of liquidity provided to banks by the FHLBs are not yet publicly available, we can piece together an idea of the magnitude of the support they have provided member banks by examining how their participation in related markets changed in response to bank demand for precautionary funds.
Normal FHLB operations
The FHLBs collectively keep over $100 billion in cash available to meet members’ immediate needs. On the face of it, $100 billion in cash may seem like a large number; however, relative to economic activity in the U.S., the FHLB backstop balances are lean. For comparison, just the ACH volumes processed by the Federal Reserve average $155 billion per day. FHLB cash, if not called on by members, is typically invested overnight through fed funds, repurchase agreements (repos) and deposits at banks.
In addition to holding precautionary balances, the FHLBs maintain active debt issuance programs that can provide additional funding on short notice. The strengths of the FHLB borrowing program include a collective guarantee of repayment, a large and diverse set of investors supported by an extensive dealer network, and issuance scale that ensures liquidity of outstanding securities. These strengths create a low-cost source of funding for FHLB member banks.
For immediate needs, the FHLBs (through their collective borrowing arm) issue same day discount notes into a market that is accustomed to large changes in supply (many of the dealers and investors are also active participants in the $3 trillion Treasury bill market). The FHLBs also regularly participate in the larger long-term debt market; participation that ensures a ready conduit to a diverse and deep pool of investors. These longer-term debt issuances allow the FHLBs to match the maturity structures of their advances with their debt maturities.
Banks borrow from the FHLBs to take advantage of low borrowing costs and to diversify their funding sources. Roughly a quarter of all banks have constant or increasing FHLB advance levels on an annual basis, which shows they use the system for routine liquidity management.
While the FHLB system is used by many members for routine liquidity needs, the largest sums of advances have been borrowed during periods of monetary tightening. As shown by Figure 1, demand has fallen when the Fed has aggressively added reserves to the banking system and risen when the Fed has stabilized or withdrawn reserves. For example, FHLB advances increased considerably leading up to the great financial crisis in the third quarter of 2008 and the onset of the coronavirus pandemic in the first quarter of 2020. Conversely, Fed accommodation and fiscal stimulus later in 2020 made liquidity less of a concern, and advance levels fell by more than 50 percent from the first quarter of 2020 to the third quarter of 2021. From the third quarter of 2021 to the end of 2022, advance levels increased 133% as the massive deposit influx in 2020 and 2021 leveled off, loan demand increased, and bank reserve levels flattened.
FHLB activity in March 2023
In response to the SVB and Signature Bank failures, FHLB members significantly increased their demand for advances to prepare for any potential volatility. One of the clear signs of this precautionary behavior comes from the federal funds market. FHLBs are large, daily lenders in the fed funds market, a market that allows borrowers and lenders to adjust their needs on a same-day basis. The market is attractive to the FHLBs because participation ensures that they stand ready to meet unexpected funding needs of their member banks. On a typical day, the FHLBs lend about $80 billion to fed funds borrowers. In response to bank demand for precautionary balances as SVB deteriorated, the FHLBs diverted money normally lent in the fed funds market to member advances (see Figure 2).
The FHLBs also participate in the overnight repo market, placing funds not needed by members on any given day. By any measure, the overnight repo market is huge with over $1 trillion between private sector participants and another $2 trillion between the private sector and the Federal Reserve. While we do not have numbers on FHLB participation in the repo market, they must be relatively small participants. Volumes of repo with the Federal Reserve (through its Overnight Reverse Repurchase Agreements program) declined by roughly $200 billion (10 percent) from Thursday, March 9, to Tuesday, March 14, and then subsequently recovered the following week. This decline also suggests FHLBs diverted funds normally invested in the repo market to fund advances.
The FHLBs supplemented funds that would have otherwise gone into the fed funds and repo markets with additional borrowing. The regular participation of FHLBs in the discount note market ensures that they have a conduit open, through dealers and credit arrangements, to investors seeking short-term, low-risk and liquid securities. As demand for precautionary balances grew in March 2023, the FHLBs were able to turn to regular investors for additional funds. Investors are comfortable lending to the FHLBs during times of heightened uncertainty because advances are backed by good collateral, constrained by individual institution borrowing limits and, if ever needed, guarantee of repayment by all FHLB members.
The FHLBs were able to increase issuance in both the long-term bond and shorter-term discount note debt markets. As Figure 3 shows, on Monday, March 13, the FHLB Office of Finance issued almost $90 billion in bonds, which was the highest one-day total in the system’s 90-year history. Figure 4 tracks the daily changes in discount note issuance, and the almost $50 billion dollar increase on March 13, coupled with the small decline in issuance on March 14, suggests particularly elevated issuance on the 13th and 14th,, followed by a return to relatively normal levels after that.
In theory, banks can turn to the Fed’s discount window for precautionary balances. In practice, discount window usage is stigmatized as a sign that a borrower has no alternative source of funding and must be in a distressed situation. In March 2023, the Federal Reserve actually had two lending facilities that were available to banks, the Federal Reserve Discount Window and the newly established Bank Term Funding Program, which was operational on March 13.
For the week of March 13, banks borrowed $165 billion from Federal Reserve facilities, which was about half of the $304 billion that the FHLB system issued in debt that same week. It should also be noted that this preference toward FHLB borrowing over Federal Reserve facilities occurred despite the fact that the premium of the primary credit discount window rate over the top end of the federal funds target rate is zero (it was reduced from 50 basis points to zero in 2020). The preference for FHLB borrowing may be in large part due to FHLB advances being viewed as a normal funding source so an increase in bank usage does not have the negative implications that discount window borrowing has. Because most banks have an existing and active relationship with their FHLB, it is viewed as faster and more seamless to borrow from the FHLB.
While concerns about bank liquidity have not fully subsided as of the end of the first quarter of 2023, there are indications that precautionary demand for cash has stabilized. Fed funds volumes have returned to pre-March levels, overnight discount note volumes have been much lower than mid-March highs and flight-to-safety concerns, reflected in low interest rates on Treasury securities, have somewhat recovered.
The events of March 2023 clearly illustrate the importance of the FHLB system not only to provide liquidity to member institutions, but they also demonstrate their significant role in overall market functioning. The FHLBs were able to quickly go to the capital markets to raise the funds needed to satisfy the liquidity demands of members, and they were also able to ramp down debt issuance once those liquidity needs were met.
As FHFA conducts its comprehensive review, these events should serve as a reminder to the FHFA about the important role the FHLBs provide for banks in all market conditions and especially during periods of volatility. The events should also caution FHFA to ensure that reforms do not interfere with the FHLBs’ ability to provide liquidity to members, so the system can continue to contribute to orderly market functioning for the next 90 years and beyond.
Dan Brown is an economist and senior director on ABA’s economic research team. Jeff Huther is a VP for banking and economic research at ABA. Joe Pigg is SVP and senior counsel for ESG and mortgage finance at ABA.
