The Little-Known Entity That’s Lent Over $1 Trillion To U.S. Banks (10x The Fed!) | Professor Kathryn Judge on The Federal Home Loan Bank (FHLB) System

Episode Summary

Executive Summary: Professor Catherine Judge argues that U.S. banking stress is concentrated in regional banks facing higher funding costs, unrealized losses, and commercial real estate exposure. She defends stronger regulation, criticizes the Federal Home Loan Bank system’s expansion and incentives, and supports ending LIBOR and tightening oversight of risk that banking rules miss, especially interest-rate and liquidity risks.

Main Topics: Health of the U.S. banking system and regional-bank stress: Judge describes the system as uneven: community banks and GSIBs are relatively resilient, while regional banks face rising funding costs, deposit outflows, and asset-quality pressure tied to higher rates and commercial real estate. The Federal Home Loan Bank (FHLB) system as lender of second-to-last resort: She explains the FHLB’s Depression-era purpose, how it differs from the Fed, and why banks increasingly use it before going to the discount window, especially during stress. How deregulation and 1989 reforms expanded and distorted the FHLB: Judge argues Congress preserved and enlarged the FHLB for balance-sheet reasons during the S&L cleanup, broadening access and collateral beyond the original housing-finance mission. Why FHLB borrowing can delay bank reckoning: She contends that distressed banks use FHLB advances, brokered deposits, and other sources to avoid confronting solvency problems, which can worsen eventual losses and obscure warning signs. Bank regulation after the regional-bank failures: Judge supports stronger oversight for large and mid-sized banks, better treatment of unrealized losses, and more robust tools to address systemic risk and non-bank migration. Middlemen, intermediation, and financial fragility: Drawing on her book, she links banking consolidation and longer intermediation chains to greater efficiency but also opacity, fragility, and information loss. LIBOR’s end and the move to SOFR: She welcomes the end of LIBOR as overdue because the underlying interbank market no longer supported it and the benchmark had become structurally vulnerable.

Key Arguments: Regional banks are under the most pressure because rising rates raise their funding costs, erode asset values, and intensify deposit outflows; community banks and GSIBs are holding up better. FHLB borrowing is often a pre-Fed source of liquidity and functions as a yellow flag for distress; troubled banks rely on it more heavily than healthy banks. The FHLB system originally existed to support thrift housing finance, but later reforms expanded its role beyond its intent and turned it into a large, profitable liquidity provider for banks. Congress used the FHLB system in the late 1980s as off-balance-sheet financing to clean up insolvent thrifts without fully recognizing the cost. FHLB advances can postpone necessary intervention and reduce assets available to the FDIC and uninsured depositors when a bank fails. A 2% cap on advances to any member would force earlier recognition of trouble and preserve the system for smaller banks that need it more. Risk-weighted capital rules focus too much on credit risk and not enough on interest-rate and duration risk, which contributed to SVB-style failures. Held-to-maturity accounting is appropriate for some small community banks, but large regional banks should be treated more like GSIBs and take losses into account more fully. The banking system is becoming more consolidated and middlemen-driven, which can increase efficiency but also creates longer, more fragile chains of financing and intermediation. LIBOR should have ended years ago because the underlying market became too thin to support a credible reference rate; SOFR is imperfect but more appropriate.

Data Points: Federal Reserve lending to banks: a little over $100 billion - Mentioned as the Fed’s discount window and Bank Term Funding Program lending compared with FHLB borrowing FHLB borrowings this year: $600 billion - Used to show the scale of regional-bank reliance on FHLB advances Outstanding FHLB note issuance: over $1 trillion - Illustrates the size of the FHLB funding base FHLB creation: 1932 - Year the Federal Home Loan Bank system was created Original regional banks in the FHLB system: 11 - Number of regional Federal Home Loan Banks established initially under the Federal Home Loan Bank Board 1989 cleanup mechanism: RefCorp bonds - Congress used these to fund the thrift cleanup off balance sheet Affordable-housing contribution: 10% of net earnings - Current requirement for FHLB earnings to go to affordable housing programs Collateral mix today: about 20% commercial real estate - Judge notes expansion of acceptable collateral beyond residential mortgages Mortgage market share of individual lenders in 1932: about 40% - Illustrates how fragmented mortgage finance was before institutionalization Typical down payment in early mortgage market: 50% - Shows how difficult home financing was before modern housing finance institutions Typical early mortgage term: less than 5 years - Historical context for why thrifts and housing finance support emerged FHLB collateral rule example: up to 60% of face value - For loans more than eight years and amortizing, under original rules SVB borrowing from FHLB San Francisco: $15 billion - Example used to show how heavily a troubled bank relied on FHLB funding Suggested cap on advances to one member: 2% of outstanding advances - Judge’s proposed reform to prevent outsized reliance by troubled banks March 2023 bank-failure response: systemic risk exception used for SVB and Signature - Cited as a necessary tool to contain losses and manage the crisis Largest FHLB borrowers at end-2021: JP Morgan and MetLife among top five - Shows the system was being used heavily by large institutions before regional-bank stress intensified Largest FHLB borrowers at end-2022: Wells Fargo and four regional banks - Presented as an early warning sign of regional-bank distress

Pivotal Quotes: "The federal home loan banks, which you see on financial documents and reports... really is the number one game in town when it comes to providing liquidity to banks." — Host: Framing the FHLB system as a major but underappreciated source of liquidity "I think about the Fed as being the very last resort... before they go to the Fed... they go to the Federal Home Loan Banks." — Catherine Judge: Explaining the FHLB’s role as lender of second-to-last resort "If we still care about having a vibrant community bank system... why don't we allow the benefits of the system to flow disproportionately to those smaller banks?" — Catherine Judge: Justifying a cap on FHLB advances to large member institutions

Implications: Expect tighter regional-bank regulation, more scrutiny of unrealized losses and funding patterns, and possible FHLB reform. The banking system may become more concentrated, while supervisors push more activity toward safer, better-monitored structures.