Steven Senne/AP Photo
A person removes a notice from a glass door at the Silicon Valley Bank branch location in Wellesley, Massachusetts, March 27, 2023.
This story is part of a Big Ideas series that brings together experts to offer steps that the government can take to protect the financial system, after the collapse of Silicon Valley Bank showed its inherent fragility. You can read all of the stories in this series here.
Part of what makes the failure of Silicon Valley Bank, Signature Bank, and Silvergate Bank so striking is the banality of their path to demise. These banks may have been serving high-tech companies and crypto firms, but the seeds of their undoing were all too familiar, from rapid growth to excessive risk and overly concentrated exposures. Also familiar to banking experts is the lifeline these banks clung to in order to stay afloat, even as market-based sources of funding ran dry: the Federal Home Loan Banks.
The Federal Home Loan Bank (FHLBank) system was created in 1932 to promote homeownership. Over the last 90 years, it has grown massively, while also morphing to serve the interests of giant financial institutions far more than homeowners. Even more troubling, the FHLBank system is now an entrenched lender of, well, second-to-last resort, yet one that is even less accountable and public-minded than the Federal Reserve, which Congress created to serve as the lender of last resort during periods of stress. Reforming the Federal Home Loan Bank system so it serves the public rather than banks should be a top priority in the years ahead.
Understanding the original design of the FHLBank system is key to understanding where it went wrong and how to right its course. For much of the 20th century, banking was highly segmented. Investment banks made money underwriting and trading securities. Commercial banks focused on serving businesses. Thrifts, like the Bailey Brothers Building & Loan run by Jimmy Stewart’s character in It’s a Wonderful Life, specialized in serving the masses. They helped ordinary people build savings, and they provided the mortgages that all but the very rich need to buy a home.
Against this backdrop, the FHLBanks could promote homeownership by allowing only thrifts, not commercial banks, to become members. The FHLBanks could further encourage member thrifts to extend mortgages by agreeing to accept mortgages as collateral when a thrift sought to borrow money (known as advances) from a regional FHLBank.
Access to those loans was, and remains, valuable. Just like Fannie Mae and Freddie Mac, the FHLBanks are a government-sponsored enterprise, with an implicit government backstop. This provides the FHLBanks access to cheap funding, and attractive terms on advances are one way this subsidy is passed along to member banks. Access to FHLBank advances also helps member banks manage the challenges that arise from the mismatch we saw at work with Silicon Valley Bank, between the short-term nature of the deposits and other liabilities banks rely on for funding and the long-term and illiquid loans they hold as assets. This was a particular challenge for thrifts, because they had no access to the Federal Reserve’s standing lending facility until 1980.
Yet even in its earliest iterations, this setup was also conducive to abuse. Alongside access to cheap funding, the FHLBanks enjoy a statutory super-lien. When a member bank fails, any outstanding FHLBank advance gets paid back in full before depositors or any insurance fund sees a dime. This helps explain why the FHLBanks have often been eager to extend advances to troubled institutions, since they take on very little risk to do so.
Over the last 90 years, the FHLBank system has grown massively, while also morphing to serve the interests of giant financial institutions far more than homeowners.
When interest rates spiked in the 1970s, depressing the value of long-term mortgages sitting on thrift balance sheets, many thrifts faced the prospect of insolvency. Yet troubled institutions were often able to limp along, increasing the cost of the eventual government bailout, in part by borrowing additional funds from the FHLBanks. Researchers at the Federal Reserve Bank of Chicago found that failed thrifts were far more likely to have relied on FHLBank advances than their healthy counterparts, and borrowed far more relative to their total assets.
Alongside the tendency of FHLBanks to extend loans to unhealthy thrifts, other developments in the 1980s disrupted system design features that had made it possible to use advances to promote homeownership. Congress expanded the range of assets and activities available to thrifts, in the hopes that diversification might allow weak thrifts to earn their way to health. At the same time, commercial banks became increasingly involved in making home loans. And then Congress allowed commercial banks to become FHLBank members, so long as they engaged in sufficient housing-related activities when they first joined.
The primary rationale for this was to make the FHLBank system bigger and more profitable, so it could pay off bonds that Congress authorized to fund the cleanup of all of the troubled thrifts “off-balance sheet.” It was a classic accounting shenanigan to maintain the appearance Congress was abiding by targets to reduce the deficit without actually doing so.
As a result of these decisions, the FHLBank system has grown massively even as most of its operations have become increasingly attenuated to promoting homeownership. The FHLBanks have also continued to lend to troubled institutions. In 2022, SVB borrowed $15 billion from the Federal Home Loan Bank of San Francisco before its messy demise. Back in 2008, Washington Mutual, Wachovia, IndyMac, and other banks all tapped their regional Federal Home Loan Bank for new loans en route to their own messy failures. And just in the last two weeks, the FHLBanks have borrowed over $300 billion, as member banks continue to turn to the FHLBank system in droves.
It’s time to put an end to these abuses. Capping the advances that any FHLBank can extend to any member institution to 2 percent of outstanding advances would go a long way toward preventing large, troubled banks from using FHLBank advances to delay a needed reckoning. It would also help reorient the system to benefit community banks and smaller members more than their giant counterparts.
Longer term, Congress should reconsider the aims and design of the FHLBank system. The other GSEs have done a lot to ease access to housing finance; today, it is often the high cost and limited availability of housing that impede homeownership, not the inability to obtain a mortgage. Yet meaningful challenges continue to impede other types of credit creation. Small businesses, for example, often have a hard time accessing the credit they need to survive and thrive.
Moreover, there remains a tighter nexus between small-business lending and community banks than exists in housing today. This could enable a redesign that uses the FHLBank architecture to support community banks and encourage them to do even more small-business lending and grow the economy.
This is just one of many designs possible. More important than the precise end point is the need to start on the path to reform. The FHLBanks provide some benefits for small banks and provide some financial support for affordable-housing initiatives, but those do not justify allowing this giant to continue to trudge along in its current form.
