How can community banks compete with industry giants for deposits? Here's what to know.

By Philip van Doorn

The Federal Home Loan Banks don't only provide emergency funding. They support mortgage lending and affordable housing -- without using taxpayer money.

If you want to understand how community banking works in the U.S., it is important to know something about the Federal Home Loan Bank system. The FHLBs have gotten more publicity than usual this year because of the roles two of them played in providing short-term financing to four troubled banks.

Those include Silvergate Bank of La Jolla, Calif., which is shutting down voluntarily; First Republic Bank of San Francisco, which was closed by state regulators on May 1; and Silicon Valley Bank of Santa Clara, which was shut down on March 10. All three banks had borrowed from the Federal Home Loan Bank of San Francisco to shore up liquidity during a period of rapid outflows of deposits.

The fourth institution, Signature Bank of New York, failed on March 12. It had also suffered a liquidity problem as depositors withdrew their money, and it had taken out short-term loans, known as advances, from the Federal Home Loan Bank of New York.

But the FHLBs -- there are 11 of them -- do much more than provide emergency financing. As wholesale banks that are cooperatively owned by their members, which are mainly community banks, the FHLBs provide a high level of service to their members, in close cooperation with their communities, to support mortgage lending and affordable housing.

So what exactly is the mission of the FHLBs, and how do they carry it out?

The wholesale banks work as "service-driven organizations," according to José R. González, the president and CEO of the Federal Home Loan Bank of New York. In an interview, he described a "seamless process" that allows the FHLBs to provide instant liquidity to their members.

(Editor's note: The author worked as a credit analyst at the FHLB of New York from May 1998 to July 2003.)

Before being appointed president and CEO of the FHLB of New York in April 2014, González had served as vice chair of the bank's board of directors for five years and as a director since 2004. González was also CEO of Santander BanCorp of Puerto Rico from 2002 until 2008 and served on that company's board until 2010. The New York FHLB's market territory includes New York, New Jersey, Puerto Rico and the Virgin Islands. Members of each FHLB vote to elect its directors.

The FHLB system

The FHLB system was created by Congress through the Federal Home Loan Bank Act, which was signed into law by President Herbert Hoover in 1932 as part of the government's effort to shore up the U.S. mortgage-lending market during the Great Depression by providing liquidity to savings banks and savings and loans.

The FHLBs were created "as a mirror image to Federal Reserve system, which only served commercial banks," González said.

The FHLBs aren't funded with taxpayer money. Rather, they are owned by their members, which include banks, credit unions and insurance companies, along with some Community Development Financial Institutions. Members own capital stock in the banks, upon which their voting rights are based.

An FHLB's share price is fixed at $100 and the shares aren't traded publicly. A member's capital stock holdings in its district FHLB are based on the member's total assets and a percentage of its borrowings from the FHLB, subject to a limit. The New York bank has a cap of $50 million on a member's capital stock, which is the highest membership cap in the FHLB system, according to Adam Goldstein, the bank's chief business officer.

Members are paid dividends on their capital stock. The dividend yields increased last year as interest rates went up: The fourth-quarter dividend rate for shares of FHLB of New York members was an annualized 6.75%, up from 4.4% a year earlier.

The FHLBs are regulated by the Federal Housing Finance Agency (FHFA), which also supervises Fannie Mae and Freddie Mac. Each bank in the system has its own market territory

After the bank failures -- or planned closure, in the case of Silvergate -- that came after large numbers of depositors moved their money from the regional banks to bigger banks, some commentators implied that it might have been a mistake for the FHLBs to lend to the flailing institutions. Those opinions overlook some important facts:

The FHLBs' mission has evolved over the decades. Under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, known as FIRREA, the banks dedicate at least 10% of their profits to affordable-housing programs. This money is allocated in close cooperation with members and with housing organizations in their communities.

González emphasized that supporting troubled institutions is part of the FHLBs' dual mission to provide "liquidity and support for housing." He also said that media reports about bank failures sometimes fail to note "the level of coordination between the FHLBs and prudential regulators during those situations."

Those prudential regulators are the Federal Deposit Insurance Corp. and the Federal Reserve Banks, as well as state banking departments and the Office of the Comptroller of the Currency, which charters and supervises national banks.

Collateral relationships

One thing that sets the FHLBs apart from other wholesale lenders to banks is their collateral relationship with their members.

The role of Fannie Mae and Freddie Mac as purchasers of the majority of newly originated fixed-rate one- to four-unit residential loans is well known. These government-sponsored enterprises provide underwriting guidelines to lenders. Newly originated mortgage loans that meet the guidelines can be sold quickly to Fannie and Freddie, which lowers banks' interest-rate risk. One problem that eventually led to the failure of First Republic early in May was that the bank was saddled with a large portfolio of fixed-rate jumbo-mortgage loans that had very low interest rates and couldn't be sold to Fannie or Freddie.

So banks will be eager to sell fixed-rate mortgage loans if they can, but some loans cannot be sold. Other loans with adjustable rates are retained because rate changes protect the lenders from interest-rate risk. The advantage of FHLB membership is that mortgage loans, including multifamily and commercial real-estate loans, can be listed as collateral by the members, along with securities holdings, to secure advances.

All of that collateral can be turned into liquidity instantly through the FHLBs. This isn't to say collateral cannot be pledged to other borrowers. It can. But the FHLBs' "seamless" process allows for instant action. "We know the collateral; we know the members," González said. "That makes this a much easier process, especially in a time like mid-March."

Accepting mortgage loans as collateral, rather than only accepting securities, is a "fundamental essence of the system," he said.

He emphasized that the FHLBs aren't lenders of last resort. Instead, members incorporate FHLB borrowing into their business strategies, he said.

One reason that FHLB members include insurance companies is that a strong secondary market for mortgage-backed securities helps improve liquidity available to mortgage borrowers. The insurers' ability to pledge their mortgage-backed securities as collateral for FHLB advances supports the system's mission.

And advances aren't only for short-term funding or for emergencies. Members of the FHLBs can take advantage of lower interest rates at the longer end of the yield curve right now, Goldstein said. "Additionally, for those members that choose to retain long-term mortgage production in this higher-rate environment, longer-term advances allow them to extend their liabilities and mitigate funding mismatches while locking in advantageous spreads."

The macro case for FHLBs

González referred to the FHLB system as "a utility" that plays "an important role in the financial stability of the U.S. banking industry." By supporting a group of about 6,800 financial institutions, the system makes it easier for the smaller banks to survive. And that diversity of lenders means stronger local knowledge of economic conditions.

"We are an industry-capitalized, industry-funded support system for liquidity before you hit the central bank," González said. "We prevent many cases from getting to the last resort," which would be borrowing from the Federal Reserve -- or failing.

"Banking is a risky businesses," he added. "There are always failures that come in waves. But we are essentially a risk mitigant to those waves."

The FHLBs raise money to fund advances as a group through the FHLBanks Office of Finance. Operating as a group gives the system an advantage -- high investment-grade ratings from Moody's and Standard & Poor's. "The 11 banks are jointly and severally liable for the debt we issue," González said. "It is the second-largest fixed-income debt franchise in the world after the U.S. Treasury -- a strong well-recognized debt franchise with global investors who recognize it as one of the premier issuers in the world."

During the first quarter, FHLB advances to members increased 27% to a record $1.04 trillion, according to Freddie Strickland, vice president of equity research at Janney Montgomery Scott.

In a note to clients on May 18, Strickland wrote: "Despite a higher level of advances, the primary capital measurement used by the FHLBs' regulator reflects better capital levels systemwide compared to [the fourth quarter of 2019] (pre-pandemic) on a median basis (and for 6 of the 11 FHLBs individually)." That group of six FHLBs includes the New York bank, according to Janney's data.

Strickland added that "every single FHLB is in a better capital position today versus the previous ... peak in FHLB advances" in the third quarter of 2008.

Partnerships with members

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