The Federal Home Loan Bank (FHLB) has come under fire recently for lending liquidity to banks in need. Four borrowing banks had either entered a conservatorship or self-liquidated since March, leading some to speculate about the role the FHLB played in their demise. Most of these criticisms fall short of proclaiming nobody should have extended liquidity to these struggling banks, simply that it was the Federal Reserve’s job to do so, not the FHLB’s. Critics don’t seem to grasp that doing this would only shift risky loans from the FHLB’s private investors to the taxpayer and consumer, turning personal liquidity into bailouts.
The FHLB’s 11 regional wholesale Government-Sponsored Entity (GSE) co-ops provide over-collateralized loans to financial institutions. The over-collateralization provides quick access to liquidity as loan repayments can be insured through collateralized bank assets. As a GSE, the FHLB has an implicit government guarantee on all debt obligations (which they have yet to use in 92 years of existence). The purpose of the FHLB is to provide liquidity to institutions that support the housing market. When the institution started, this was just savings and loan associations. Today it also includes retail banks, credit unions, insurance companies, and other institutions, as mortgage provision has expanded beyond savings and loan associations.
Recently the FHLB was put in the spotlight when four banks that received loans became insolvent. What is often missing from this story is that because FHLB loans are over-collateralized, and the GSE receives priority on repayment, there is little chance of these investments resulting in meaningful losses. Thus, the risk on these loans sits firmly on the shoulders of private investors.
Despite this, critics believe it was irresponsible for the FHLB to have extended liquidity to struggling banks and instead posit that such an action is the responsibility of the Federal Reserve. Without either institution, struggling banks would declare insolvency after their investments lost value and deposits began to withdraw. Though some may argue this would be a preferential system, it’s doubtful many in the government or the banking sector would agree, as proposals to terminate the Feds liquidity provision have not garnered traction.
Assuming that some institutional liquidity provider is necessary to protect vulnerable banks from transitory liquidity constraints, we are left with only two options, the FHLB or the Federal Reserve. If critics achieve their goals and the FHLB is restricted from extending liquidity, the Federal Reserve would take over as the sole provider. It’s doubtful this would have changed the outcome of the recent bank failures, but only who these banks would be indebted to.
Examining who bears the risk of these debt repayments, it becomes clear why the FHLB is a preferred lender in early crises, as a recent study by the American Consumer Institute demonstrates. The Federal Reserve extends “new money,” which affects money supply and inflation. The investment risk is on taxpayers and consumers. The FHLB, on the other hand, is funded through private investors in a free market (granted one that is tilted towards the FHLB through government benefits). Unless the FHLB breaks its 92-year record of never needing a federal bailout, all risk falls on the GSE’s investors. Taxpayers are spared the risk, and consumers are spared the devaluation of their dollars through the introduction of “new money.”
Studies on the FHLB’s liquidity provision showed it was the preferred provider during the first four months of the 2008 recession. Some believe this is due to the stigma of accessing the Federal Reserve’s emergency liquidity provision, while others believe the FHLB’s lower rates made it the obvious choice. Regardless, it’s clear that the FHLB can operate as a crisis liquidity provider before the Federal Reserve gets involved. Furthermore, emergency liquidity provision inherently involves extending loans to high-risk borrowers and will be performed by the Fed if not the FHLB.
If Congress did eliminate a free-market liquidity alternative to the Fed with a near-century-proven track record, it should be honest with taxpayers and consumers about what that means for them.
Isaac Schick is a policy analyst at the American Consumer Institute, a nonprofit education and research organization. For more information about the Institute, visit www.TheAmericanConsumer.Org or follow us on Twitter @ConsumerPal.