FED Notes Board of Governors of the Federal Reserve System October 18, 2017

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1 FED Notes Board of Governors of the Federal Reserve System October 18, 2017 The Increased Role of the Federal Home Loan Bank System in Funding Markets, Part 1: Background 1 Stefan Gissler and Borghan Narajabad Executive Summary The Federal Home Loan Bank (FHLB) system was founded in 1932 to support mortgage lending by thrifts and insurance companies. Over time, the system has grown into a provider of funding for a larger range of financial institutions, including commercial banks and insurance companies. During the early part of the last financial crisis, the FHLB system played an important stabilizing role as a "lender of next-to-last resort" by providing funding--collateralized by mortgages and mortgage related assets--to banks, thrifts, insurance companies, and credit unions. However, developments over the past few years have increased the tail risks that FHLBs pose to the financial system. Part 1 of this note provides an overview of the FHLB system. Part 2 highlights some of the recent developments in the FHLB system. And part 3 discusses the implications of these developments for financial stability. FHLBs have grown significantly over the past few years, and their total assets have surpassed precrisis levels. More recently, this growth coincided with two changes in government policies: The imposition of the Liquidity Coverage Ratio (LCR) in January 2015 for the largest U.S. banking organizations and the reform of U.S. money market funds in The preferential treatment in the LCR of medium-term borrowing from FHLBs has given large banking institutions an incentive to borrow more from FHLBs and less from private short-term money markets. As large banking institutions have increased term borrowing from FHLBs, the FHLBs have, in turn, increased their own reliance on short-term borrowing from money markets, thereby increasing the maturity transformation implicit in their financial activities. Although FHLB's use of short-term funding has been trending up for several years, it appears to have been supported more recently by the final implementation of the money fund reform. The reform caused about $1.2 trillion to shift from prime money funds--which provide direct funding to large banking institutions and other firms--to government money funds--which cannot fund banks directly but can fund the FHLBs that do. Indeed, government money funds currently hold more than half of all outstanding debt issued by FHLBs. The FHLBs have long been considered relatively safe intermediaries because their loans to private member institutions are over-collateralized, they can jump to the front of the line when a borrower defaults--the so-called "super lien" of their loans--and they benefit from an implicit government guarantee investors appear to associate with federal agencies. Moreover, changes to prudential regulations such as the revised risk-based capital requirements and stress tests have likely made the FHLBs more resilient. However, their increasing maturity transformation, combined with their high leverage, leave the FHLBs more vulnerable to shocks--an issue that has been highlighted recently by the regulatory authority of the FHLB system, the Federal Housing Finance Agency (FHFA). 2 Further, FHLBs' recent growth has increased the financial system's reliance on FHLB funding as well as the interconnectedness of the financial system, suggesting that distress among the FHLBs could be transmitted broadly to other firms and markets. Historical background and key institutional characteristics The Federal Home Loan Bank (FHLB) system was created by the FHLB Act of 1932 to help the mortgage market. The system began with 12 independent, regional wholesale banks and the national Office of Finance, which is the system's centralized debt issuance facility. 3 FHLBs, as government-sponsored entities, are perceived to have implicit backing from the government. In 1

2 addition, the U.S. Treasury is authorized to purchase up to $4 billion of FHLB System debt securities. Each FHLB is owned by its member institutions, which have equity stakes in the FHLB and must reside in the FHLB's district (Figure 1). 4 Members were initially limited to thrifts and insurance companies, which at the time had limited access to wholesale funding in private markets. Figure 1: Current geographical segmentation of the FHLB system Source: FHFA. Accessible version In response to the Savings and Loan crisis, the Financial Institutions Recovery, Reform, and Enforcement Act (FIRREA) of 1989 opened FHLB membership to all depository institutions holding more than 10 percent of their assets in residential mortgage-related assets. As a result, many commercial banks and credit unions joined the FHLB system. The Gramm-Leach-Bliley Act of 1999 attempted to make the system's capital structure more permanent, mainly by requiring a five-year redemption notice before a member can retrieve its equity stake in its FHLB. 5 Since 2008, the FHLB system has experienced two key structural changes. First, the Housing and Economic Reform Act of 2008 established the FHFA and put it in charge of regulating the FHLB system. Second, following the FHLB Seattle's losses on its securities investment, the bank was merged into FHLB Des Moines after several unsuccessful attempts to restore FHLB Seattle's capital. 6 Hence, the system currently comprises 11 FHLBs and the Office of Finance. FHLBs provide wholesale funding for their members' mortgages and mortgage-related investments by extending over-collateralized loans, known as advances upon request by members. These overcollateralized loans are available in various maturities with either fixed or variable interest rates and may include embedded options. Each FHLB independently chooses the interest rates of its advances and the haircuts on its members' collateral. But, all FHLB advances are subject to the statutory super-lien, which means that in the case of the borrower's insolvency, any security interest granted to an FHLB has priority over the claims and rights of any other party. 7 The super-lien on collateral has facilitated FHLBs' ability to lend to a variety of institutions, from subsidiaries of large insurance and bank holding companies to small saving banks and credit unions that might otherwise not have ready access to funding from investors who cannot secure such protection. FHLBs are highly leveraged financial institutions, with a capital level of about 5 percent of their assets. FHLBs' advances and other assets are funded by consolidated debt obligations. These consolidated obligations are joint and several liabilities, meaning that if an individual FHLB cannot repay it, then the other 10 FHLBs are liable to cover its debt. Also, investors cannot know which individual FHLB is receiving their money, because all debt is issued by a single entity, the Office of 2

3 Finance. Moreover, FHLBs' status as GSEs helps to ensure that funding costs for FHLBs are relatively low. The flow of funds from investors, such as money funds, to members of FHLBs is shown in Figure 2. Arrows denote the direction of lending. For example, money funds held $506 billion of FHLB-system debt at the end of last year, and FHLB Des Moines issued $63 billion of advances to Well Fargo. Figure 2: Schematic map of the flow of funding in the FHLB system *All amounts in billions of dollars, as of June 2017 Source: FHLB 10Q and 10K filings, SEC N-MFP filings, CALL reports. Part 2 in this series discusses recent trends in the FHLB system and potential drivers of those trends. 1. Authors: Stefan Gissler and Borghan Narajabad (R&S). We would like to thank Alice Moore and Erin Hart for their research assistance, and Celso Brunetti, Mark Carlson, Burcu Duygan-Bump, Joshua Gallin, Diana Hancock, Lyle Kumasaka, Andreas Lehnert, Laura Lipscomb, Patrick McCabe, Michael Palumbo, John Schindler, and Lane Teller for useful comments and insightful discussions. The views expressed in this paper are solely those of the authors and do not necessarily reflect the views of the Board of Governors of the Federal Reserve System or its staff. 2. See, for example, prepared remarks of Melvin L. Watt, Director of FHFA at 2017 Federal Home Loan Bank Directors' Conference (5/23/2017): FHFA-FHLBank-Directors-Conference.aspx 3. The FHLB Board originally oversaw the system, but was abolished by the Financial Institutions Recovery, Reform, and Enforcement Act of Note that the figure shows the current districts of the 11 remaining FHLBs, after FHLB Seattle's merger into FHLB Des Moines in Until 1999, most of members' capital investment in FHLBs was subject to a six month redemption notice. 6. The merger occurred in 2015, after the FHFA rejected FHLB Seattle's capital restoration plans in Super-lien gives FHLBs priority over the claims of depositors and almost all other creditors including the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve Banks (FRBs). Nevertheless, FRBs and FHLBs customarily work together to ensure that FRBs' retain their senior position with respect to collateral pledged to the FRBs by FHLB members. Please cite this note as: Gissler, Stefan, and Borghan Narajabad (2017). "The Increased Role of the Federal Home Loan Bank System in Funding Markets, Part 1: Background," FEDS Notes. Washington: Board of Governors of the Federal Reserve System, October 18, 2017, Disclaimer: FEDS Notes are articles in which Board economists offer their own views and present analysis on a range of topics in economics and finance. These articles are shorter and less technically oriented than FEDS Working Papers. 3

4 The Increased Role of the Federal Home Loan Bank System in Funding Markets, Part 2: Recent Trends and Potential Drivers 1 Stefan Gissler and Borghan Narajabad The FHLB system's balance sheet: 2000 to the present Figure 1 shows the evolution of the combined FHLB system's assets; the left panel shows dollar amounts and the right panel shows percentage shares. About two thirds of FHLBs' assets are advances to members, shown in dark purple. In addition to advances, FHLBs' assets include securities, shown in light purple, which are mainly mortgage-related and, on average, make up about one-fifth of their assets. 1 They also hold some liquid assets, including about 7.5 percent of their assets in federal funds, to meet regulatory required contingent liquidity buffer. The left panel shows that during the first part of the last financial crisis, the FHLB system acted as a lender of next-to-last resort by providing significant funding to FHLB members at a time of severe market stress. FHLBs' advances increased by 50 percent between 2007 and fall 2008, as FHLB members encountered severe difficulties accessing other sources of wholesale funding upon which they had become heavily reliant. FHLB system assets started to contract in the fall of 2008 as members started to use funding provided by the Treasury and the Federal Reserve System. Advances have grown fairly steadily since about 2012 and recently surpassed their pre-crisis level. Figure 1: Evolution of assets Source: FHLB 10Q and 10K filings. Figure 2 shows the composition of member firms' borrowing from FHLBs between 2000 and In 2000, thrifts were the main borrowers of FHLBs, but since then commercial banks and insurance companies have become predominant. In January 2017, borrowing by commercial banks comprised over 65 percent of total advances outstanding. Furthermore, most of these advances were extended to large commercial banks, shown in dark purple. This is a marked shift from the past: Whereas commercial banks with assets over $50 billion accounted for less than 2 percent of overall advances in 2000, their share climbed to around 50 percent by the end of last year. Figure 2: Evolution of advances to members by type 4

5 Note: CDFI and Housing Assoc. receive negligible advances. Breakdown of commercial banks is based on CALL report data. Source: FHLB 10Q and 10K filings. Potential drivers of the recent trends in the FHLB system's balance sheet The main motivation for the more recent rise in FHLB borrowing by large banks seems to be their incentive to engage in a "collateral upgrade" to help satisfy the requirements of the Liquidity Coverage Ratio (LCR) that banks are now subject to as part of the Basel III. Banks can post lessliquid assets such as whole mortgage loans to FHLBs as collateral against advances and use the proceeds to buy high quality liquid assets (HQLA). As long as FHLB advances have a remaining maturity of longer than 30 days, this strategy will improve the borrowing banks' LCRs. Also, the favorable treatment of FHLB advances in the LCR helps borrowing banks even with advances due within 30 days. 2 Anecdotal evidence suggests that large banks are indeed motivated to borrow from the FHLBs for this reason. 3 Figure 3 compares the maturity structure of FHLBs advances (left panel) with the maturity structure of their debt (right panel). While FHLBs do not seem to have significantly altered the maturity structure of their advances (the dark blue area on the left has been fairly steady), the maturity of their debt has shortened (the dark and orange areas on the right have expanded). In 2006 advances were financed with a mix of short-term discount notes and medium-to-long-term bonds. FHLBs tapped short-term funding markets to meet their members' urgent funding needs during the crisis-- the hump-shaped red and orange portions of the right panel--but let that short-term debt run off as pressures eased in 2009 and early However, FHLB's reliance on short-term funding began to increase later in 2010, and by the end of 2016 almost 80 percent of liabilities had a residual maturity of less than 1 year. The share of short-term debt has already exceeded the peak it reached during the crisis. Given the relative stability of the maturity structure of FHLB's assets, this implies a significant increase in FHLBs' maturity transformation -that is, a much larger gap between the maturity of FHLB assets and liabilities. Figure 3: Maturity structure of assets and liabilities Source: FHLB 10Q and 10K filings. Although the shift toward FHLB's greater reliance on short-term funding began several years ago, more recently this shift seems to have been given extra support by the effects of the SEC's reform of prime money market funds. In response to the reforms, money market fund managers and investors shifted $1.2 trillion from prime money funds to government money funds, which are restricted to holding essentially only Treasury and agency securities--including those issued by FHLBs--and Treasury- and agency-backed repurchase agreements. As shown in the left panel of Figure 4, at the end of February 2017, almost one-fifth of the money fund industry's three trillion dollar portfolio was invested in FHLB debt. 4 Moreover, the share of FHLB debt held by money funds--shown in the middle panel of the figure--has increased sharply, and as of February 2017 stood at more than half of all outstanding FHLB debt. 5 And, as shown by the red line in the right panel of the figure, money funds have shortened the weighted average maturity (WAM) of their FHLB debt-holding. 6 5

6 Figure 4: Money funds and FHLB debt Source: SEC N-MFP filings, FHLB filings. The money fund reform seems to have given FHLBs a further advantage in their funding costs relative to financial institutions that relied on funding from prime money funds. As shown by the red line in Figure 5, the weighted average rate on FHLB debt held by money funds as of the end of February 2017 was about 10 basis points below that of prime money funds, denoted by the dashed black line. 7 As a result, for financial institutions it might have become cheaper to receive funding intermediated by FHLBs than funding from money funds. Figure 5: Weighted average yield on instruments held by money funds Source: SEC N-MFP filings. The increased borrowing by large members also seems to have altered the nature of competition among FHLBs. Historically, FHLBs did not compete for business among themselves because members only operated in one district and therefore each had access to only one FHLB. However, many large banks and insurance holding companies now have subsidiaries that are members of multiple FHLBs. Holding companies can and do appear to exercise a degree of market power by switching their borrowing to FHLBs that offer better terms, thereby managing to lower the interest rate spread of their advances over FHLBs' funding costs. Given the sizable amount of maturity transformation by FHLBs, the small margin between interest rate of advances and FHLBs' funding cost could be puzzling. This small margin might be partly due to the fact that most of advances are received by large members with access to low short-term rates. Therefore, at least on the margin, FHLBs may not be able to charge their large members a spread higher than the spread between government and prime money fund yields. In this part we highlighted some of the recent developments in the FHLB system. Part 3 discusses the implications of these developments for financial stability 6

7 1. Authors: Stefan Gissler and Borghan Narajabad (R&S). We would like to thank Alice Moore and Erin Hart for their research assistance, and Celso Brunetti, Mark Carlson, Burcu Duygan-Bump, Joshua Gallin, Diana Hancock, Lyle Kumasaka, Andreas Lehnert, Laura Lipscomb, Patrick McCabe, Michael Palumbo, John Schindler, and Lane Teller for useful comments and insightful discussions. The views expressed in this paper are solely those of the authors and do not necessarily reflect the views of the Board of Governors of the Federal Reserve System or its staff. 2. The composition of the balance sheet differs across FHLBs and therefore the share of the securities portfolio may be rather small (such as for FHLB New York) or more than one third of the balance sheet (such as for FHLB Chicago). 3. Borrowing money from an FHLB will increase the bank's net cash outflow by a negligible amount because of the favorable run-off rates applied to FHLB advances due within 30 days. FHLB advances secured by Treasury securities do not count toward outflows. For advances backed by Agency securities, 15 percent of the amount is treated as a cash outflow. The assumed run-off rate for other advances is 25 percent. It is worth noting that the LCR assumptions might be at odds with FHFA's liquidity assumptions. FHFA requires FHLBs to maintain sufficient liquidity to meet the following scenarios: (i) an inability to access debt markets for five days, with all maturing advances renewed except those for very large, highly rated members; and (ii) inability to access debt markets for 15 days, with no maturing advances renewed. (See FHLB 10K filings under "Liquidity Requirement.") However, the LCR gives favorable treatment to the net cash outflow of FHLB advances. That is, the LCR assumes that the big banks will be able to renew most of their FHLB advances even as FHFA seems to assume they might decide not to. 4. This type of lending by FHLBs is different from the original intended role of FHLBs as credit enhancers for their members. While FHLBs continue to provide critical funding for their smaller members, it is a relatively volatile business. In contrast, lending to LCR members appears to generate more stable interest income. This results in more stable dividends for all FHLBs' members. For this reason even (non-borrowing) small members of FHLBs are interested in increasing advances to large LCR members. Note that FHLB charters provide each member with a single vote, independent of their equity share. Thus, the incentives of small members are essential for understanding FHLBs' decisions. 5. Almost all of the FHLB debt held by money funds belong to government money funds. About 30 percent of government money funds' two trillion dollar portfolios is invested in FHLB debt. 6. The share of FHLB discount notes held by money funds is not much higher than its historical levels. However, the share of FHLB bonds held by money funds has more than doubled in the past two years. 7. Money funds must keep the WAM of their entire portfolio, the black line in the right panel of Figure 6, below the SEC's regulatory limit of 60 days. When money funds held smaller amount of FHLB debt, their FHLB debt holding had a long WAM. As the share of FHLB debt in money funds' portfolio has risen, money funds have shortened the WAM of their FHLB debt holding, to keep the WAM of their entire portfolio low. 8. As a reference, the black line shows the weighted average yield of government money funds. Please cite this note as: Gissler, Stefan, and Borghan Narajabad (2017). "The Increased Role of the Federal Home Loan Bank System in Funding Markets, Part 2: Recent Trends and Potential Drivers," FEDS Notes. Washington: Board of Governors of the Federal Reserve System, October 18, 2017, Disclaimer: FEDS Notes are articles in which Board economists offer their own views and present analysis on a range of topics in economics and finance. These articles are shorter and less technically oriented than FEDS Working Papers. The Increased Role of the Federal Home Loan Bank System in Funding Markets, Part 3: Implications for Financial Stability 1 Stefan Gissler and Borghan Narajabad Potential shocks and vulnerabilities to the FHLB system As highly leveraged financial institutions with fairly small capital buffers, FHLBs cannot support large losses without implementing a capital restoration plan. During the last financial crisis, the values of FHLB Seattle's and FHLB Chicago's security portfolios declined, and their capital levels dropped from 5 percent to 1 and 1.5 percent of assets, respectively. FHLB Chicago was able to recover from its capital loss by retaining earnings over the next several years. Owing to the additional pressures it faced after the withdrawal of a large member, Washington Mutual, and the disappearance of its attendant business, FHLB Seattle was not able to retain sufficient earnings to quickly rebuild its 7

8 capital position. In 2015, after five years of unsuccessful efforts to recapitalize the institution, FHLB Seattle was merged into FHLB Des Moines. Given the significant growth in advances and the increased concentration of borrowing by large financial institutions, one potential source of risk for FHLBs could be the distress of one or more members. While such an event would not likely pose direct credit losses to FHLBs given their superliens, it could significantly lower the FHLB's interest income and could imperil an FHLB's long-term viability, as was the case with FHLB Seattle a few years ago. In addition, increased lending to large members has also increased the interconnectedness of FHLBs since the last crisis because large holding companies may borrow from multiple FHLBs. Increased interconnectedness may have raised the system's vulnerability to a single counterparty failure. FHLBs face significant rollover risk given the maturity transformation inherent in their business model, which suggests that the greatest source of vulnerability may be the possibility that investors lose confidence in an FHLB's implicit government back-stop. 2 The loss of investor confidence could destabilize the FHLB system and short-term funding markets more broadly. In fact, investors lost confidence in GSEs in 2008 due to the substantial troubles facing Fannie Mae and Freddie Mac. The FHLB system found itself "guilty by association" and experienced considerable pressures on its funding. 3 A spike in funding costs reduced the FHLB system's ability to act as a lender of next-to-last resort and FHLBs' advances and interest income dropped significantly. 4 The FHLB system's access to funding markets was only restored when the Federal government signaled support for GSEs. Potential consequences of a distressed FHLB system Should the FHLB system experience distress, the effects on investors would depend on the severity of the shock and their access to alternative short-term investments, such as T-bills and the Federal Reserve's Overnight Reverse Repo facility. For example, should government money market funds shift toward alternative investments, then FHLBs may need to quickly shrink their balance sheets significantly. 5 Given their maturity mismatch, some could end up draining their contingent liquidity buffer and decide not to extend outstanding advances to their borrowers when those come due, possibly resulting in an abrupt loss of funding for firms reliant on FHLBs. Thus, the ultimate effects on FHLB members depend on their ability to access other funding sources once the terms of the members' FHLB advances expire. If investor confidence in the financial system remains intact, large members should be able to substitute FHLB advances with alternatives such as repo or commercial paper. Funding costs to satisfy the LCR requirement may increase. 6 Yet for members without access to wholesale funding, advances are an important source of funding and liquidity. 7 Losing access to FHLB advances could potentially lead to a decrease in mortgage and small-business lending, especially by small thrifts and commercial banks. However, in case of a larger systemic distress, losing access to FHLB advances may put even large members at risk and result in significant pressure for government support, as occurred during the last financial crisis. Furthermore, while banks may be able to satisfy their liquidity needs (in the short-run) using the discount window, non-banks do not have this option. Finally, the FHLBs currently play a crucial role in the federal funds market, which represents a key source of liquidity for eligible depository institutions. FHLBs maintain a stable share of their portfolios in federal funds, mainly as their contingent liquidity buffer. 8 As a result, their presence in the federal funds market has been stable. But the decline of the overall size of the federal funds market has increased the relative importance of the FHLBs in this market. On some days, FHLBs account for almost the entire supply of federal funds. Should an FHLB experience difficulty in rolling over its short-term debt, the FHLB would likely withdraw from the federal funds market, which has the potential to disrupt trading activity. Assuming most FHLBs would withdraw, the Federal Reserve Bank of New York might need to rely on contingency options for the publication of the fed funds effective rate. 9 Such contingencies could be necessary given that the federal funds rate is used as the benchmark rate for a very large volume of financial products. Although the contingency options to handle the calculation of the federal funds rate are public, a hasty transition to an alternative reference rate could disrupt the functioning of money markets and complicate the communication of monetary policy. 8

9 Conclusion Although FHLBs have long been considered a relatively robust part of the mortgage finance system, there have been times in the past, such as during the Savings and Loan crisis and near the time that Fannie Mae and Freddie Mac were put into conservatorship, when the capacity of the FHLB system to provide sufficient liquidity to their members has been in doubt. The FHLB system's recent increased size, reliance on large members, and dependence on shorter-term liabilities funded by government money funds could make it more, not less likely, that the FHLB system may not be able to fill its roles, both as a liquidity back-stop and as an integral provider of funding in credit markets, in the next financial crisis. One might view the current large size of FHLBs advances to the largest bank holding companies as benign because these companies have built up significant liquidity buffers that can be run down in a liquidity crunch. Moreover, so long as FHLBs can access the debt markets, the maturity transformation they provide can be helpful for their members. An alternative view focuses on the potential roll-over risk associated with short-term funding for the FHLBs and the consequences for their members. Although large banks' liquidity buffers are built on the assumption that there is a maximum 25 percent run-off rate for FHLB advances in 30 days, the FHLBs are only required to maintain sufficient liquidity to renew advances for small members, not to renew advances for their very large highly-rated members in a stress scenario. This inconsistency in assumptions has allowed for a situation in which there is a greater risk that large banks will not be able to rely on FHLBs for liquidity as planned in a stressed environment. Large banks could then be forced to turn to alternative sources of liquidity at the worst of times when wholesale funding markets may already be tight. Moreover, should FHLBs need to tap their own contingent liquidity buffers, the federal funds market could be disrupted. Given the short tenors of FHLB debt and the fact that the debt is primarily held by a wide range of cash investors, mainly government money market funds, the lynchpin for the more benign scenario seems to be continued confidence among money market participants in the implicit government guarantee for FHLB debt. References Ashcraft, Adam, Morten L. Bech, and W. Scott Frame (2010). "The Federal Home Loan Bank System: The Lender of Next to Last Resort?" Journal of Money, Credit and Banking 42.4: Authors: Stefan Gissler and Borghan Narajabad (R&S). We would like to thank Alice Moore and Erin Hart for their research assistance, and Celso Brunetti, Mark Carlson, Burcu Duygan-Bump, Joshua Gallin, Diana Hancock, Lyle Kumasaka, Andreas Lehnert, Laura Lipscomb, Patrick McCabe, Michael Palumbo, John Schindler, and Lane Teller for useful comments and insightful discussions. The views expressed in this paper are solely those of the authors and do not necessarily reflect the views of the Board of Governors of the Federal Reserve System or its staff. 2. This business model also suggests they may be exposed to interest-rate risk, and especially to changes in the slope of the yield curve. However, FHLBs have increased the share of their floating rate advances, thus, reducing their exposure to interest-rate risk. 3. At that time, most of the money funds used to report all of their FHLB debt under "agency debentures," making it impossible for outside analysts to distinguish between their exposure to FHLBs and other GSEs. 4. Ashcraft et al. (2010) note that "even after the Federal Reserve surpassed the FHLB System in terms of total liquidity provided, the FHLB System continued to be the largest lender to U.S. depository institutions, as much of the Federal Reserve's liquidity operations benefited nondepository or foreign financial institutions." 5. About 80 percent of FHLB debt has maturity of less than one year. Money funds hold about 50 percent of FHLB debt, so it is fair to assume that short-term debt of FHLBs are widely held, even outside the money funds. 6. During a systemic distress, the LCR requirement may be relaxed. 7. On average, the ratio of advances over assets is 5 percent for borrowing members with assets below $2 billion, with some members funding over 25 percent of their assets by advances. 8. An additional driver behind FHLBs' participation in the fed funds market is to meet their intraday debt service funding needs. Cash invested in fed funds is typically returned early the next day, as opposed to triparty repo which is often returned later in the day. The early return of cash helps the FHLBs meet the mid-day timing requirements of the Office of Finance's debt payment wires. 9

10 9. On its public website, the FRBNY describes contingency options for the publication of the fed funds effective rate if reported transactions are insufficient to publish a rate. These include publishing the prior day's rate in the absence of adequate data. The increasing dependence of the Federal Reserve on a limited set of transactions to support the calculation of the federal funds effective rate was recognized in the years following the financial crisis, and several steps have been taken to improve its calculation, specifically through a new data collection. The FR2420 collection was used to improve the federal funds rate calculation and to provide insight into a broader range of bank funding market activity through the publication of a new rate: the overnight bank funding rate (OBFR), which combines federal funds transactions with similar transactions booked offshore. In a prolonged event that precluded the publication of the fed funds effective, this OBFR or another rate could be determined to be the successor rate. Please cite this note as: Gissler, Stefan, and Borghan Narajabad (2017). "The Increased Role of the Federal Home Loan Bank System in Funding Markets, Part 3: Implications for Financial Stability," FEDS Notes. Washington: Board of Governors of the Federal Reserve System, October 18, 2017, Disclaimer: FEDS Notes are articles in which Board economists offer their own views and present analysis on a range of topics in economics and finance. These articles are shorter and less technically oriented than FEDS Working Papers. 10