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Home Community Banking

The outlook for FHLB advances

October 6, 2023
Reading Time: 4 mins read
The Federal Home Loan Bank of Atlanta. Photo by Tyler Lahti

The Federal Home Loan Bank of Atlanta. Photo by Tyler Lahti

By Jeff Huther
ABA Data Bank

Banks looking for additional funds these days are caught between the Fed’s ongoing quantitative tightening, which is reducing the supply of funding available to banks, and a regulatory structure that penalizes unsecured, short-term borrowing from most sources. One cushion that remains available to banks is borrowing (known as advances) from the Federal Home Loan Banks, which receives favorable regulatory treatment. Given the need for additional funds and the lack of attractive alternatives, bank use of FHLB advances is very likely to grow and should not necessarily be interpreted as a sign of banking stress.

The effects of quantitative tightening

Figure 1. (Click to enlarge and share.)

Quantitative easing led to sharp declines in the amount of borrowing that banks have needed. As shown in figure 1 nearby, borrowing (that is, from sources other than deposits) as a share of total liabilities generally declined for both small and large banks during the Fed’s balance sheet expansions (based on data from the Fed’s weekly H.8 report). In the absence of a change in the Fed’s balance sheet reduction plans, we expect that quantitative tightening will reduce deposits, leading to increased borrowing by banks.

When the Fed engages in quantitative easing, it exchanges securities held by individuals and institutions for bank deposits. The sellers who receive the deposits may leave them with the bank or, more likely, invest in other products that recirculate to banks (towards the end of the last round of quantitative easing, many of those funds were lent back to the Fed through its Overnight Reverse Repurchase facility which, for the sake of simplicity, we will ignore in this note). The process, while not symmetrical, largely works in reverse in quantitative tightening. When the Fed allows Treasury securities to mature, the U.S. Treasury must issue more debt to the public. By switching from lending to businesses to lending to the U.S. Treasury, investors deplete bank deposits.

Alternative lenders

Prior to the global financial crisis, banks borrowed in a robust short-term funding market from other banks and from short term institutional investors such as money market mutual funds. Activity in this market has been severely reduced by a combination of factors. The Fed’s quantitative easing, described above, reduced banks need to borrow from other sources. Regulations have discouraged participation in the market for both borrowers and lenders: the liquidity coverage ratio reduces the attractiveness of short-term borrowing, MMMF reform led to a contraction in lending to banks, and bank stress testing made unsecured lending costly. While these regulations have made banks less susceptible to funding shocks, they have also reduced banks’ ability to manage the normal short-term cash volatility that is inherent in the maturity transformation that lies at the heart of the banking system.

Figure 2. (Click to enlarge and share.)

Figures 2 and 3 show how dramatically bank borrowing has changed since the 2008-09 global financial crisis. As shown in figure 2, interbank loans dropped precipitously during the global financial crisis and, since the finalization of LCR rules announced in early 2013, have remained close to zero according to the Federal Reserve. Money market fund reforms in 2016, which discouraged investment in prime MMMFs (funds that are allowed to lend to banks) led to a reduction in prime MMMF assets by two-thirds, shown in Chart 3. The remaining prime MMMF lending is reportedly now almost entirely to foreign banks and nonbank institutions that need dollar funding.

With the banking system reserves still high from prior rounds of quantitative easing, the lack of private sector sources of short-term funding has not been a concern. As the Fed normalizes its balance sheet however, banks increasingly need a flexible source of funding even if the normalization process stops when reserves are, from a monetary policy perspective, still “ample.”

Figure 3. (Click to enlarge and share.)

Liquidity regulations that encourage banks to step back from unsecured interbank borrowing leave open one avenue for short-term borrowing that does not incur prohibitive capital costs: FHLB advances. Bank borrowing from FHLBs is securitized and considered a stable source of funding; and so requires less capital to be held against those balances. While a portion of bank demand for FHLB advances is invariant to the economic environment (that is, it is part of banks’ routine efforts to maintain diversified funding sources), aggregate bank demand for FHLB advances has been inversely correlated with changes in the size of the Fed’s balance sheet. Chart 4 shows the relationship between changes in the Fed’s balance sheet (that is, deposit creation and destruction) and FHLB advances. When the Fed creates deposits, banks need to borrow less from other sources and when the Fed reduces the supply of deposits, banks turn to the FHLBs to maintain stable balance sheets. The correlation coefficient for the two series since 2005 is -0.5.

Figure 4. (Click to enlarge and share.)

The negative correlation between Fed’s quantitative policies and FHLB lending could be construed as detrimental to the implementation of monetary policy. Instead, FHLB advances should be viewed as aiding policy implementation by allowing the Fed to change its balance sheet policies without disrupting banks’ long-term financing of economic activity. Since 2009, the Fed’s balance sheet has been used to reinforce or reset expectations of interest rate policies. FHLB advances ensure that banks can consistently provide long-term loans, helping to ensure stable long-term economic growth.

Conclusion

Given the Fed’s still-large balance sheet and benign economic conditions, quantitative tightening is likely to continue for quite a while. The contraction in the Fed’s balance sheet will increase banks’ need for borrowing from sources other than depositors. Given the regulatory attractiveness of FHLB advances, banks are very likely to increase their demand. It’s worth keeping these drivers in mind given periodic commentary suggesting that bank use of FHLBs is a sign of weakness or that FHLB demand is the result of the perception that the FHLB funding is guaranteed by the U.S. government. The reality is that the Fed has crowded out other lenders, and that regulators broadly have discouraged bank borrowing from non-FHLB sources.

Jeff Huther is VP for banking and economic policy research at ABA.

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Tags: ABA Data BankBalance sheet managementFHLBsLiquidity
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Author

Jeff Huther

Jeff Huther

Jeff Huther is VP for banking and economic policy at the American Bankers Association. Before joining ABA, he spent ten years at the Federal Reserve Board providing advice to the FOMC on money markets, including the transition from Libor to SOFR. Huther went to the Board from the Federal Reserve Bank of New York, where he helped guide policy on the Fed’s balance sheet. Prior to his work at the New York Fed, he spent three years at Freddie Mac, initially developing debt management strategies before managing the financial engineering team. He also spent six years at the U.S. Treasury in the debt management office. Huther began his post-graduate work at the New Zealand Treasury, where he worked on portfolio management issues for the New Zealand government.

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