On Nov. 7, the Federal Housing Finance Agency (FHFA) published a report outlining proposed reforms to the Federal Home Loan Bank (FHLB) System that would change how the FHLBs operate and may affect the banks and other entities that borrow from the System.

Despite the potential changes, we expect the FHLB System to remain a significant source of financing, particularly to banks, and maintain its important role in implementing U.S. government housing policy. Therefore, we do not expect any changes that follow the report to cause us to take ratings actions on the FHLB System or the 11 regional FHLBs that constitute it (see chart 1).

Chart 1

We also don't expect potential changes to the FHLB System to affect our ratings on commercial banks, as banks are likely to remain significant beneficiaries of FHLB funding. At the same time, the FHLBs may tie the structure, pricing, and availability of that funding more closely to housing and community development. Furthermore, the report--with its plan to ensure FHLBs do not serve as lenders of last resort--could alter how banks manage their contingent liquidity.

The FHLB System Was Established To Provide Liquidity To Members And Support Housing Finance And Community Development

Congress chartered the FHLB System in 1932 to provide members with liquidity in support of housing and community development. The 11 district FHLBs that make up the System extend long- and short-term advances to their member stockholders. There are roughly 6,800 members, made up of banks, credit unions, insurance companies, and certified community development financial institutions.

The System funds the advances it makes to its members by issuing debt through its Office of Finance. The regional FHLBs have joint and several liability for that debt. The FHLBs had $827 billion of outstanding advances extended to their members at Sept. 30, 2023, which was collateralized by residential mortages and other financial assets held on member balance sheets.

FHLB advances grew rapidly during the global financial crisis of 2007-2009 and peaked in March 2023 as banks demanded more liquidity due to deposit outflows (see chart 2). Advance balances have subsequently declined as banking sector volatility has lessened.

Chart 2

The Proposed Reforms Could Entail Meaningful Changes To The FHLBs And Their Members

The FHFA segmented the report into four themes: the mission of the System; being a stable and reliable source of liquidity; housing and community development; and the System's operational efficiency, structure, and governance (see Appendix).

The impact on FHLBs will become more apparent over time, but we do not anticipate the potential reforms will have ratings impact

According to the report, we believe the FHFA could over time modify how the FHLBs support and incentivize housing and community development; extend credit to their members; manage risk, funding, and liquidity; govern themselves; and compensate senior management. It could also lead to consolidation in the System.

Regardless of the materiality of those changes--which remains unclear--we expect the FHLBs to remain a significant source of financing to their members, playing an important role in implementing U.S. government housing policy. Therefore, we do not expect to change our ratings on them, assuming the banks maintain very strong loan asset quality and capitalization.

As discussed in the report, we expect the FHFA to update the System's mission statement and to develop additional metrics to assess the performance of each FHLB against the mission in its supervisory and evaluation process. Furthermore, the FHFA will evaluate how the FHLBs could provide financial incentives, such as discount advance rates or higher dividends, that would promote the System's mission.

We look favorably on the report's call for certain enhancements to risk management, such as a strengthening of capital management and stress testing. We believe risks could also be reduced if FHLBs collaborate with members' prudential regulators to ensure members have established protocols to meet emergency liquidity needs from the Federal Reserve's discount window. That could lessen the probability that an FHLB would provide liquidity to a large, troubled institution.

The report's recommendations for improving the FHLBs' own liquidity and funding management could also incrementally reduce risk. The FHFA is exploring options to enhance the System's liquidity, such as permitting FHLBs to maintain interest-bearing deposits with commercial banks. It also said it will take steps to limit large debt issuances (which can follow a large request from a member) that can materially raise debt clearing costs.

In addition, the FHFA will consider initiating or expanding various programs in support of housing finance. For example, it will consider requesting Congress to double the statutory minimum contribution for Affordable Housing Programs (most FHLBs have already voluntarily elected to increase their contribution to about 15% from the minimum 10%). A larger contribution could moderately diminish FHLBs' ability to build capital through earnings or to make distributions to their members.

The FHFA also aims to broaden the FHLBs' exposure to community development financial institutions or other mission-oriented organizations, as well as expand the scope of accepted collateral. We believe the odds of losses--which have been low for FHLBs because advances are overcollateralized with high-quality collateral--could rise if that were to occur depending on the changes. As of Sept. 30, 2023, the System had about 5% of advances to community development financial institutions, nonmembers, and housing associates (see chart 3). Still, we would not expect a material increase in risk taking.

Chart 3

The FHFA will also explore opportunities to improve the FHLB System's operational efficiencies, structure, and governance. However, we would not expect potential savings to materially benefit profitability. That's because for the first nine months of 2023, compensation, benefits, and other operating expenses amounted to an already low 15% of revenue (measured as net interest income plus noninterest income).

The report discussed the possibility of merging FHLBs for efficiency. However, we are uncertain whether that would occur, and varying cost structures based on membership, district size, and other factors may create challenges. The FHFA will also examine the board structure of FHLBs to ensure proper composition.

Lastly, the FHFA will seek to further align executive compensation with safety and soundness and mission activity, as well as ask for congressional approval to remove any restrictions that preclude the FHFA from prescribing compensation levels or ranges for executive officers of the FHLBs. Changes to boards and executive compensation could improve governance and mission alignment, but we don't envision any potential changes will cause us to change our ratings on the FHLBs.

We don't expect the FHFA's greater emphasis on housing and community development to materially change banks' advances from the FHLBs

The FHFA is planning to have FHLBs provide incentives, such as discounted advance rates or differential dividends on capital stock, to members that demonstrate strong support of the System's mission.

We are uncertain how significant such incentives would be and how materially they would change banks' behavior. Further, we would not expect the incentives by themselves to necessarily cause banks to use significantly more advances. We believe banks' overall funding needs, determined in large part by changes in loans and deposits, will remain the greatest driver of their use of FHLB advances.

We also wouldn't expect a potential change in the definition of "long-term" advances to substantially affect banks. FHLB members must hold residential housing finance assets equal to at least the amount of their long-term advances. (Since the funds garnered from borrowings are fungible, members in effect sometimes use those funds to finance assets unrelated to residential housing finance).

The FHFA indicated it is considering changing the long-term definition by shortening its current five year threshold, perhaps to one year. That would mean the minimum amount of residential housing finance assets that borrowers would have to hold would be higher.

The FHFA said, since 2020, 10%-30% of outstanding advances had an original maturity greater than five years and 40%-70% had an original maturity greater than one year. That said, we believe most banks currently hold residential housing finance assets in excess of their advances with maturities greater than a year. The minority of banks that do not would potentially have to either reduce their borrowings or increase their residential housing finance assets.

We also do not expect a major impact because FHLB borrowings tend to be a small part of most banks' funding. FDIC-insured banks reported a peak of $804 billion of FHLB advances at the end of the first quarter of 2023, following the failure of Silicon Valley Bank (SVB). Still, that compared to almost $19 trillion in deposits and accounted for less than 5% of their overall funding.

How Banks Manage Contingent Liquidity Could Change, Particularly In The Wake Of The Bank Failures This Year

While the FHLBs are set up to provide liquidity to their members, the FHFA does not believe they can serve as lenders of last resort, especially for large, troubled members.

In particular, the failure of SVB in March 2023 supports that belief and could result in some changes in how banks manage their contingent liquidity needs, in our view. The report says FHLBs should coordinate with their members' primary regulator and the regional Federal Reserve Banks to make sure members' access can be met even when they do not meet the FHLBs' criteria.

Banks look to the FHLBs not only as important sources of ongoing liquidity, but also as providers of contingent liquidity. However, there are limitations to how quickly the FHLBs can advance large amounts of funds to banks, as was evidenced when SVB failed. The lines FHLBs extend to banks are also uncommitted and can be canceled or scaled back for a variety of reasons, including financial deterioration at the bank borrower.

Shortly before its failure, SVB reported $65 billion in available borrowing capacity based on pledged collateral with the FHLB of San Francisco, up from about $26 billion at year-end 2022. We don't believe an FHLB can typically advance that much in a short time--the Office of Finance would first likely have to issue debt to obtain the funds needed. When SVB had a rapid and outsize deposit outflow of more than $40 billion in a single day, it could not access the liquidity to meet that outflow quickly enough, either from the FHLB of San Francisco or the repurchase market.

According to a Federal Reserve report on the bank's failure, SVB was unable to move collateral it had pledged at the FHLB of San Francisco to the Fed's discount window. In addition, the bank expected another $100 billion in deposit outflows the next day, which likely would have caused its failure even it had been able to meet the first day's outflows.

In our view, the SVB failure underscored the importance of robust contingent liquidity planning for banks and the risk of over-relying on contingent access to the FHLBs as essentially a lender of last resort. It is conceivable that banks will alter their contingency liquidity plans to rely more on the Fed through its discount window than the FHLBs. That could mean over time they will pledge more collateral to the Fed that they could draw against, moving some of that collateral away from the FHLBs. Doing so would facilitate their ability to rapidly draw contingent liquidity if needed.

Also, bank regulators may update liquidity-related rules and guidance at least for large banks (those with at least $100 billion in assets). Such changes could effectively cause those banks to rely less on the FHLB System as a source of emergency liquidity. (See "Regulatory Capital Requirements For Large U.S. Banks Look Likely To Increase," July 18, 2023).

The Changes Will Likely Take Several Years To Implement, And Some Requiring Congressional Action Might Never Occur

The FHFA makes clear in the report that the actions described in the report will be a longer-term undertaking. We also expect any changes to occur incrementally. The probability and timing on some recommended changes--such as eliminating restrictions on setting executive pay at the FHLBs--are especially uncertain given they require congressional action.

Congress would also have to take action if it would like to expand FHLB membership to nonbank mortgage companies and REITs. Such entities have become large players in residential housing finance, with some stakeholders arguing they should be allowed to become FHLB members. The FHFA does not argue for or against that in the report, but says that all members should be subject to similar safety and soundness and mission-related eligibility requirements. We are uncertain whether Congress will ever expand eligibility to nonbank mortgage companies and REITs. Doing so would likely require a major undertaking by the FHLBs to have the capacity and ability to add those new members and manage the associated operations and risks. Their ability to manage the additional risk could affect our ratings on the FHLBs, if that were to occur.

Appendix: Key Themes From The FHFA Report

Related Research

• Federal Home Loan Bank of Boston, Aug. 4, 2023
• Federal Home Loan Bank of Cincinnati, Aug. 3, 2023
• Federal Home Loan Bank of Des Moines, Aug. 1, 2023
• Federal Home Loan Bank of San Francisco, Aug. 1, 2023
• Federal Home Loan Bank of Dallas, Aug. 1, 2023
• Federal Home Loan Bank of Topeka, July 31, 2023
• Federal Home Loan Bank of Chicago, July 31, 2023
• Federal Home Loan Bank of Pittsburgh, July 31, 2023
• Federal Home Loan Bank of New York, July 31, 2023
• Federal Home Loan Bank of Indianapolis, July 31, 2023
• Federal Home Loan Banks, July 31, 2023
• Federal Home Loan Bank of Atlanta, July 28, 2023