The Federal Housing Finance Agency is engaging in its “System at 100” review of the Federal Home Loan Bank System. In the course of this review, the agency, it seems, is being forced to come to terms with some of the conflicts that other banking regulators have had to navigate with their regulated institutions for some time. Of course, navigating these conflicts poorly brings the threat of litigation and failing institutions — the same sorts of issues other banking regulators have had to manage for decades — but hey, no pressure.
Traditionally, the FHFA has regulated safety and soundness; and it has looked to see that the Federal Home Loan banks properly implemented their affordable housing, community development and liquidity missions. Much of this activity was formulaic. For example, were the Home Loan banks setting aside at least 10% of net income for affordable housing?
More recently, the FHFA appears to have adopted a more subjective standard by focusing on whether the banks are “doing enough” to support affordable housing. As a result, the regulation of mission is potentially in conflict with safety and soundness, which runs the risk of imperiling both. The irony is, requiring more for affordable housing can increase costs that make the Federal Home Loan banks’ products more expensive than market alternatives. That means less business gets done, safety in the form of retained earnings is diminished, and there is less income generated, which is what funds the affordable housing programs. You thus have the conflict that requiring more to be done for affordable housing may produce less for affordable housing. At the extremes, the whole system could become uncompetitive.
The fundamental problem is built into the nature of the regulated entities. The Federal Home Loan banks have more than one regulator, though this may come as a surprise to the FHFA. They also have other stakeholders in the form of members/shareholders and other counterparties and beneficiaries. Ultimately, the Home Loan banks are running businesses that have to offer products and services that customers want at a price they will pay with sufficient volume and profitability to pay for things such as rent and salaries and the like — and enough of a return to shareholders to motivate them to continue investing their capital in the enterprise.
Any retail banker who survived the Great Recession has likely seen firsthand the conflict between stakeholders, be they regulators, shareholders or customers. The Federal Deposit Insurance Corp. has a duty to protect the insurance fund, not the bank shareholders. The bank has a duty to preserve value in the institution for its owners — which includes preventing it from failing. The Federal Reserve has a duty to protect the banking system, but that includes peoples’ perceptions of it — and thus a bank failure means the Fed has fewer banks on its list of troubled banks. This may make the banking system look better, and not worse in the public eye, and thus the failure may be acceptable. State regulators have their own concerns. In some cases, these interests overlap; in some cases, they don’t. But generally speaking, one set of stakeholders generally had little or no understanding of, or care for, the concerns of other stakeholders.
This is a modern-day issue as well. I would posit that a chief cause of failure for Silicon Valley Bank (SVB) in March was not just bad asset/liability management, but rather interregulatory mismatches. Specifically, the banking regulator ordered SVB to sell bonds at a loss, which negatively affected SVB’s capital. So SVB decided to also raise capital to replace that which it was just ordered to flush. Because SVB was publicly traded, and the loss was a materially disclosable event, the bank had to promptly file an 8-K with the Securities and Exchange Commission — which was then publicly available. The disclosure amounted to announcing: “We’re raising capital (because we just lost a bunch of it)” and made the problem look particularly bad, which then triggered the run that led to the bank’s collapse.
The next week, the Federal Home Loan banks issued over $300 billion in short-term debt that stabilized the jittery financial markets — the emergency liquidity system worked as intended, and at a scale and speed that is truly sobering. Had SVB not been publicly traded, it might not have failed. Neither regulator was able to, or perhaps interested in, considering the other stakeholders’ needs.
So how does this fit in with the FHFA and its review of the Federal Home Loan Bank System? The Home Loan banks’ primary regulator is the FHFA. However, the FHFA has two regulatory goals, which are somewhat in conflict. The agency regulates the banks’ safety and soundness, but it also regulates their mission performance in providing liquidity, fostering affordable housing and financing livable communities. Just as is the case with retail banks and their need to balance safety with Community Reinvestment Act requirements, so too should the FHFA balance these similar goals as part of its review. However, the FHFA does not have the same experience in managing these conflicts as do many other banking regulators, as most of its experience has been overseeing a set-aside formula rather than defining “enough.” The current structure has produced a form of equilibrium that has made the Home Loan banks the largest private long-term funder of affordable housing in the U.S. Changing that equilibrium and rebalancing attendant conflicts involves new regulatory skills and requires understanding changes to the business environment. It is unclear that there is sufficient understanding of these issues.
For example, income from the banks could be retained to make them safer, or it could be used to support their housing and economic development mission, or it could be returned to the shareholders that contributed that capital and own the Federal Home Loan banks themselves. There are also potential conflicts between the FHFA and the SEC. Securities laws require the Federal Home Loan banks to pay attention to their owners’ rights, too, as they define the rights to own and run a company.
For the FHFA to become more aggressive in, say, addressing “efficiencies,” short of serious safety-and-soundness concerns, there is a potential conflict with securities laws that allow a company’s management to run its own business. Congress can change the rights of the Federal Home Loan banks’ owners, including how much of their capital must be dedicated to support affordable housing, but direct change or coercive encouragement by the agency may well fall outside of its authority. And importantly, if the FHFA implements changes to the banks’ business in ways that affect the pricing of the Federal Home Loan banks products, it is a fundamental concern as to whether the FHFA truly understands the competitive environment that the Federal Home Loan banks operate within — particularly because the FHFA supervises the operation of the Federal Home Loan banks’ largest competitors in the mortgage industry through the agency’s conservatorship over Fannie Mae and Freddie Mac.
The failures of SVB and Signature Bank and their aftermath show the vital function the Federal Home Loan banks provide in stabilizing markets in times of stress, and the need for them to remain viable. But it is the Federal Home Loan banks’ daily operations that drive their income, and thus their ability to remain a vital funder of affordable housing in the U.S.
I sincerely hope the FHFA is taking time as part of its systemwide review to deeply understand both the complete regulatory environment and the competitive business environment in which the Federal Home Loan banks operate. No one wants the legacy of the agency’s valuable review process to be summarized as “oops!” if itsreforms make the banks uncompetitive and thus unable to generate the income to power their statutory mission or remain viable.