US banks will need to find other ways to access liquidity if the Federal Housing Finance Agency follows through with its goal to limit depository institutions from borrowing from Federal Home Loan Banks.

According to a recently released report, the Federal Housing Finance Agency (FHFA) plans to propose rules that would curtail US banks' borrowings from the Federal Home Loan Banks (FHLBs) to ensure they are not used as a "lender of last resort." The announcement comes after the liquidity crunch in March spurred several banks to tap into the FHLB system, sending FHLB advances to a three-year high in the first quarter. During that quarter, when two large regional banks failed, FHLB advances totaled $804.39 billion, comprising 3.7% of banks' total liabilities.

While totals have fallen since then, sitting at $602.62 billion, or 2.8% of total liabilities, in the third quarter, the FHFA is still seeking to impose limitations. Should the agency enact the new rules, banks' liquidity options would be hindered. The FHFA wants Federal Reserve facilities to be used instead, but banks are reluctant to tap those because of the stigma attached to those sources, industry experts said.

"It is fair to argue that some banks have come to rely on FHLB funding as a crutch, and the ramp in lending to struggling banks during the mini-crisis in March is an area of continued debate," Isaac Boltansky and Isabel Bandoroff of BTIG LLC wrote in a Nov. 11 note. "With that being said, there is still a clear stigma associated with tapping the Fed's Discount Window and other facilities, which should be part of the conversation if the FHLB support will eventually be curtailed."

Among the various rules the FHFA plans to propose is requiring that certain members have at least 10% of their assets in residential mortgage loans or equivalent mission assets, including assets that qualify as Community Financial Institution collateral, on an ongoing basis in order to stay eligible for FHLB financing.

Such a change could "prevent many members from being borrowers," said Scott Coleman, a partner at Ballard Spahr LLP who represents banks and bank holding companies.

"Even larger community and regional banks, some of them may not hold mortgages period and may sell them all on the secondary market, and a requirement that at least 10% of their assets be in residential mortgage loans might have some effects and, of course, send them to other liquidity sources," Coleman said in an interview.

Seek liquidity elsewhere

Limiting banks' FHLB borrowing abilities will require them to search out liquidity elsewhere, pushing them toward more costly options.

"It will force them to look at more costly, less preferential forms of liquidity," Max Bonici, counsel advising on bank regulation at Venable LLP, said in an interview.

More costly funding options would weigh on banks' lending appetite.

"Being able to have the liquidity necessary to be able to put new loans on is critical, and part of that sourcing is the Federal Home Loan Bank," Craig Mueller, a managing director and co-head of the financial institutions group at Oak Ridge Financial Inc., said in an interview. "As they put on more restrictions, it's going to theoretically shut down credit availability."

Stripping away stigma

The FHFA hopes banks will tap Fed facilities, such as the discount window, more because those are "set up to provide emergency financing for troubled financial institutions confronted with immediate liquidity challenges," the FHFA report said.

If the FHFA is successful in limiting banks' FHLB borrowing abilities, lenders will still be hesitant to use the discount window because of its stigma of potentially signaling problems, which is "more of a psychological phenomenon," Bonici said.

The stigma is one reason the Fed's Bank Term Funding Program (BTFP) has not received as much action as FHLB advances did in the quarters since it was created in March when the two bank failures raised liquidity concerns. The program is intended to ease potential concerns by providing additional liquidity against banks' securities so they do not have to sell those quickly in times of stress.

Total BTFP borrowings were $103.08 billion at June 28, near the end of the second quarter, compared to $658.62 billion in borrowings from the FHLB at June 30.

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The topic of the stigma associated with Fed facilities came up during a Nov. 14 Senate hearing with leadership from the federal bank and credit union regulators.

"Should we go beyond this encouragement of using the discount window and actually require some level of mandating?" Sen. Mark Warner (D-Va.) asked regulators. "I don't have any sympathy for banks who then say, 'Well, that would put us under the stigma from the market.' Well, you can't complain about regulations and then not use the tools that are already in existence."

Federal Deposit Insurance Corp. Chairman Martin Gruenberg responded that the agency is trying to "address any stigma" attached to borrowing from Fed facilities.

"We're looking broadly at our liquidity rules to see whether we might make improvements," Fed Vice Chair for Supervision Michael Barr added. "We are looking at the kinds of issues you raised with respect to making sure that banks are prepared to use the discount window, they have good contingency funding plans, they test those plans, and they use the discount window."