The US banking safety net has proved its value

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The writer is on the finance faculty of Boston University Questrom School of Business and is a former Federal Reserve bank examiner

Most federally insured US financial institutions, including more than 80 per cent of banks covered by the Federal Deposit Insurance Corporation, rely on their regional Federal Home Loan Bank and hasty reforms could produce many unintended consequences for the country’s financial system.

For over 90 years, FHLBs have supported residential housing finance and community development, including providing reliable, on-demand liquidity that is useful in good economic times, but vital to financial system resiliency in times of crisis. Stretching from Boston to San Francisco, the 11 FHLBs are privately owned by their members, self-capitalised, independently operated and regulated by the Federal Housing Finance Agency. They are also risk averse in their operations.

FHLBs are not well-known, but boom or bust they work behind the scenes to meet changing member borrowing needs by expanding and contracting their balance sheets. Funds are raised in the capital markets by issuing consolidated debt through the Office of Finance. While the federal government doesn’t directly guarantee this debt and FHLBs receive no federal funding, they can raise funds at favourable rates and pass the savings on to members. That small members borrow at the same rates as the biggest serves as a great equaliser.

Investors find FHLB debt attractive due to strict collateralisation polices, implied guarantee status and the “super lien” position allowing for a priority claim should the FDIC become the receiver of a FHLB member.

Over the past decade, FHLB advances have averaged about $610bn a year but in times of market crisis lending can spike. During the 2008 Great Recession advances topped $1tn, in the pandemic they hit $800bn in 2020 and this March reached $1.1tn. At these times the FHLBs’ high collateral requirements have safeguarded taxpayers from loss.

Yet despite FHLBs’ success as liquidity provider, a misguided movement is afoot. Recently, some have claimed the March bank failures are proof that the system needs to be curtailed or even abolished. That is a dangerous view.

Should the FHLBs’ role as on-demand liquidity provider be curtailed, the banking system would become more brittle and less liquid. The cost of member funding would increase, lending would decline and higher rates would be borne by consumers and businesses nationwide. The Fed would be forced to step in.

It was well documented that Silvergate Capital, Silicon Valley Bank, Signature Bank and First Republic all borrowed from their local FHLB before failing earlier this year. However, these troubled institutions represented less than one-tenth of 1 per cent of FHLB membership. During this period, lending surged. But many healthy member banks, out of caution, also increased borrowing to bolster their liquidity. That helped to inoculate them.

The recent bank runs tested the FHLBs and proved the system carried out its stabiliser role as designed. The 2023 bank failures weren’t caused by FHLB lending but by a lack of strong regulatory oversight and poor risk management. If FHLBs had not provided on-demand liquidity, the entire burden would have fallen to the Fed, which is not positioned to make loans at the same speed and as discretely. Healthy members could have been discouraged from prudent borrowing, potentially fuelling a deeper deposit run.

The role FHLBs play as an all-season liquidity provider and crisis shock absorber remains essential. To simply disband or fundamentally change the system would be the equivalent of removing a storm barrier that for 90 years has successfully protected a fragile coastline. Policymakers and regulators need to tread cautiously as they reassess the role of the FHLBs.