As the stock market celebrates the bad news delivered by the most recent batch of US economic data and is being viewed as a sign of the Fed nearing the end of its interest rate hikes. The US regulators are continuing to beef up its policies and processes through the continuance of Basel III implementation and the FDIC proposing that banks with over $100 Billion in assets to issue long-term debt that could absorb bank losses before the depositors and FDIC’s fund gets involved. The latter of which will also require banks to update their recovery and resolution plans to give the FDIC more options when failed banks go into receivership. As regulators are looking towards recovery, it would seem they are looking to involve the private side more as it is starting to make moves in improving liquidity conditions as US officials are reportedly considering widening the membership base of the Federal Home Loans Banking (FHL Banks) system.
Doing so would not be an easy task as this would require the US Congress to get involved to vote on any amendments to the FHL Banking charter. The last time this was done was in 1989 when the US opened membership to FHL Banks to include commercial banks and credit unions, previously membership was only limited to institutions that provided mortgages (hence the name Federal HOME Loans). The way that FHL Bank works is that its members are granted access to the liquidity that FHL Bank can provide during times of liquidity crunches or any distress that would impact solvency. To simplify, the FHL Banks raise funding by selling bonds then proceed to lend that money to its members at lower rates compared to other sources of funding. Effectively placing a “super lien” on the collateral or assets of the borrowing member, which is a legal mechanism that would allow FHL Banks to get in before anyone else and settle all obligations before other creditors or shareholders can get access.
However, this super lien that gives the FHL Banks dibs has proven to be a double-edged sword as it was designed to give FHL Bank protection from not getting paid at the cost of FHL Bank more willing to lend money to its riskier members. Like, Silicon Valley Bank. Silicon Valley Bank before its failure in March has had $15 Billion in outstanding loans to FHL Bank of San Francisco as FHL Bank helped its members and has recently been estimated by Bloomberg to be a $1.5 Trillion backstop being used to prop up banks instead of homebuyers that it was originally designed to service.
Clearly apart from updating the qualified members, FHL Banks should also investigate the internal scoring mechanisms that it has and update them to include risk measurement with respect to its diversifying risk profile. Not necessarily to restrict access to its members but for FHL Banks to properly adjust the pricing of the loans given to members especially if US Congress votes to expand its potential membership base to include Non-Bank Mortgage Lenders, which are known to accept riskier clients compared to banks.
Another benefit (or curse?) is should this expansion of FHL Banks happen and ultimately gain newer members would also have to agree to additional government oversight to meet the requirements to be a member and avail of FHL Bank’s liquidity lines as the US government seeks to improve FHL Banks capabilities to be the preferred final stop for cash before banks turning to the Fed.