By Dan Brown
ABA DataBank
Local utilities post signs instructing contractors to call before they begin digging up the ground—lest they hit a gas line or water main and cause significant damage in their efforts to make repairs. Policymakers would do well to heed this advice as they review the various proposals to reform the Federal Home Loan Bank system.
Many discussions of the FHLBs among policy experts, especially academics, tend to focus on macroprudential or financial stability considerations. Unfortunately, these discussions ignore the FHLBs’ contributions to more foundational and business-as-usual considerations critical to the smooth functioning of the U.S. banking system as well as the statutory mandates underlying both the FHLBs and the discount window.
A 2022 paper by former Federal Reserve Governor Dan Tarullo and co-authors reflects these financial stability considerations. A more recent New York University white paper focuses on the FHLBs role in the bank failures during March 2023. The NYU paper referenced above also explored the concept of the FHLB system as the lender of next-to-last resort vis-a-vis the Federal Reserve in its role as the lender of last resort. This note looks to fill the gap in these discussions by highlighting important aspects of FHLB advances and their functional contribution to banks’ funding and risk management needs. FHLB advances are also particularly important for smaller institutions that lack access to capital markets and lack the scale to borrow at lower terms on their own. It also tangentially contrasts these advances with discount window borrowings from the Fed.
FHLB advance use
Figure 1 is illustrative of the aggregate view adopted in the ongoing discussions of the FHLB system in that it focuses on just the aggregate size of the advances from the system.
These aggregate numbers do not inform our understanding of these advances. In contrast to the discount window borrowing (which is typically overnight), the FHLB system has more options that allow banks to use advances for a wider range of purposes, even though eligible collateral for advances is narrower than for the discount window. For example, at the FHLBs, banks can choose from a variety of terms for advances that range from overnight to 30 years. Also, advances can have fixed rates or floating rates. This flexibility allows banks to target their borrowing from the FHLBs based on their funding and liquidity risk management needs or as a 
tool to manage interest rate risk. As a consequence, banks routinely use the FHLB system as a core source of day-to-day funding and liquidity risk management. Moreover, while Call Reports only disclose outstanding FHLB balances, Figure 2 shows the percentage of FHLB member banks that received an advance each year from 2016 to 2023. As the graph illustrates, a non-trivial percentage of FHLB member banks are taking out advances each year. This emphasizes the importance of the FHLB system for normal bank operations and does not indicate a large number of banks facing funding difficulties. The dip in 2021 is due to deposits in the banking system rising by more than 35 percent, and soft loan demand due to the unprecedented fiscal and monetary policy pandemic support. Unsurprisingly, there was a dip in overall advances during this time as well. Then in 2022, when stimulus ended and the Federal Reserve raised rates and started reducing the size of its balance sheet, the number of banks taking out advances also increased.
Customization is key
One often overlooked difference between the discount window and the FHLB system is that the latter provides a broader set of borrowing options to support varying funding needs of banks. The different term lengths for FHLB advances can help banks manage their interest rate risk and minimize their duration gap. The various borrowing options from the system also allow for different funding profiles based on macroeconomic and bank specific factors. Figure 3 displays quarterly FHLB advances from 2016 to 2023 by redemption term, along with the effective federal funds rate. The Figure suggests a correlation between term lengths and the interest rate cycle. For example, when Fed policy rates in 2020 fell to the effective lower bound, longer-term borrowing took up a relatively larger share of overall advances as borrowers could lock in low rates. The share of short-term borrowing (e.g., term of one year or less) grew as the Fed sharply increased rates starting in March of 2022. And as the pace of interest rate increases slowed in 2023, longer-term borrowing’s share increased slightly as expectations for rate cuts started to crystallize.
The option of floating or fixed rates for advances provides additional flexibility for banks. Especially for smaller banks that lack access to the derivatives markets, these borrowing options help banks manage their interest rate exposure. As Figure 4 illustrates, fixed vs floating preferences also appear to fluctuate based on the interest rate cycle, with a lower percent of floating rate advances when interest rates are at or near the bottom of the cycle. This optionality underscores not only the dynamic capabilities of the FHLBs but further explains the system’s popularity with member institutions.
Capital markets access for smaller banks
Another underappreciated aspect of the FHLBs is that they are a critical source of liquidity for smaller banks. Historically, banks could rely on interbank lending for everyday liquidity needs, but following the Great Recession, the Fed’s asset purchases and finalization of the liquidity coverage ratio rules led interbank lending to shrink dramatically. And while larger banks can issue debt via capital markets for needed liquidity, smaller institutions do not have the same direct access. The lack of alternatives is one of the main reasons why, on a proportional basis, smaller banks rely on FHLB advances more than larger institutions. While the largest banks borrow the most from the FHLBs in absolute dollar terms, Figure 5 illustrates that FHLB advances as a share of total liabilities is the lowest for the largest banks, further underscoring the importance of the system for smaller institutions. The volume of advances and FHLB debt generated by larger members allows smaller banks to access credit markets that would otherwise be unavailable to them. Therefore, any proposals that reduce the liquidity of FHLB debt would disproportionately affect smaller banks.
Affordable housing and community development initiatives
In addition to beneficial borrowing terms for smaller banks, the scale of the FHLBs also helps support the housing market and fund affordable housing and community development initiatives. As a previous ABA staff analysis highlighted, while there is an assumption that banks have retreated from the housing market, activities such as warehouse lines of credit to mortgage companies, mortgage-backed securities purchases, loans to homebuilders and other activities are additional ways that banks support the housing market. Yet proposals such as the mortgage asset threshold test do not take these other contributions into account and fail to account for the many ways banks support the housing market.
FHLB borrowing also helps contribute to the Home Loan Banks’ Affordable Housing Program and community development initiatives. According to the Council of Home Loan Banks, while the FHLBs were collectively required to contribute over $200 million in combined AHP subsidies in 2022, the FHLBs had contributed over $260 million in AHP subsidies that year. Any proposals to restrict FHLB members from taking advances could reduce these contributions.
Conclusion
Academic research and policy discussions regarding the FHLB system tend to ignore the varied nature of the advances taken by the banking system. Customization options make FHLB funding a popular choice with member institutions which, in turn, benefits consumers. FHLB borrowing options also promote financial stability during all phases of a business cycle, not just during periods of financial stress. Given the flexibility of terms for FHLB advances compared to the discount window, it should not be surprising that the two programs have evolved to serve different purposes. Zeroing in on what happens only during stressed market conditions is unhelpful as it ignores the design and operational differences between these two programs.
Furthermore, use of the FHLB system supports the overall housing market, as well as affordable housing and community development initiatives. In closing, it is instructive to note that some of the rating agencies have highlighted that if the FHLB system was to shrink (presumably due to regulatory action), this would cause a rating downgrade of FHLB debt. It is reasonable to expect that this will raise the cost of FHLB advances to banks of all sizes; this cost increase will therefore impact banks and their customers.
Dan Brown is a senior director and economist in ABA’s Office of the Chief Economist.
