The Federal Reserve Bank’s use of home loan advances to offset crypto deposit losses has raised questions about banks’ reliance on a quasi-governmental funding mechanism for liquidity.
La Jolla, California-based Silvergate Bank and New York-based Signature Bank, arguably the two traditional banks with the most exposure to the digital asset industry, both took advantage of Home Loan Bank advances following the collapse of cryptocurrency exchange FTX.
Of the two, Silvergate, which has focused most of its operations on digital assets over the past decade, has been more significantly affected by the volatility following the FTX collapse. The bank received 4.3 billion dollars in advances from Federal Home Loan Bank of San Francisco in the fourth quarter of 2022 for compensation 8.1 billion dollars of withdrawn deposits. Advances now account for more than 60 percent of Silvergate’s wholesale financing.
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This episode puts the spotlight on the oversight of crypto activity in the banking sector and the use of advances to support institutions that do little to support housing finance.
“The fact that this bank, which was exposed to large crypto losses, was involved with the Federal Home Loan Bank is the first suggestion that the real financial system and crypto may be somehow interconnected,” David Zaring, professor of legal studies at the University of Pennsylvania’s Wharton School of Business, he said. “That it’s interlinked with … quite a hidden way in which banks can cover their liquidity needs is, in my view, a bit worrying.”
At the heart of the debate is whether the Federal Home Loan Bank of San Francisco, in making advances to Silvergate, was merely adhering to its mandate to provide liquidity to a member bank or was giving de facto assistance to a company engaged in a risky and unproven business.
Advances are intended to be a source of Tier 1 capital for member banks, said Ryan Donovan, president and CEO of the Council of Federal Home Loan Banks, an organization that serves as the voice for the entire Federal Home Loan Bank System. As long as the company can provide adequate assets as collateral, home loan banks are obligated to provide liquidity, Donovan said.
“Home loan banks are not a source of liquidity in an emergency. There is a perception that if an institution has a need for liquidity, it is somehow in trouble, but liquidity problems can arise for a number of reasons in the normal course of business,” He said. “We were created by Congress to meet the needs of banks in these situations.”
Indeed, advances are often the first place many banks will turn for liquidity in a time of distress. In the latest Fed senior financial officer surveywhose results were released last week, more than three-quarters of Home Loan Bank members said they would be “very likely” to use advances if their reserves fall below the desired level. Bank advances for housing loans were by far the most preferred source of liquidity included in the questionnaire.
There are several reasons why banks prefer advances, Zaring said, including their cost relative to other funding sources and the lack of stigma from industry analysts, investors and peers about their use. Meanwhile, turning to other facilities, such as the Fed’s discount window, tends to be viewed more negatively, he said.
Julie Hill, a University of Alabama law professor who specializes in financial regulation, said regulators are aware of this predilection for advances and should sign off on their inclusion in banks’ liquidity plans. She said this was most likely the case between Silvergate and its primary regulator, the Fed.
“The Federal Reserve absolutely knew before FTX that cryptocurrencies presented unique liquidity risks, Silvergate absolutely knew that too, which is part of the reason their balance sheet looked so different from a traditional community bank of a similar size,” Hill said. “You know Silvergate had a liquidity plan, you know securities were part of that plan, and I would be very surprised if borrowing money from a place like the Federal Home Loan Bank of San Francisco wasn’t part of that liquidity plan.”
Silvergate and the Fed’s Board of Governors declined to comment for this article.
Hill said there’s an argument that regulators did the right thing by allowing Silvergate to go back on Home Loan Bank advances because it allowed the bank to weather the run and avoid failure. On the other hand, she sees concerns that using advances to stop the run unnecessarily creates more risk for the Federal Deposit Insurance Corp.
The 11 federal home loan banks were created as government-sponsored corporations by act of Congress, but are privately capitalized by member banks, credit unions, savings associations and other financial institutions. They enjoy certain advantages, such as preferential tax treatment and fundraising costs. They are also given first lien priority, which means they are paid off first in cases of bank bankruptcy. That means the FDIC could be on the hook for a potential future bankruptcy.
Zaring said this was a concern because the home loan banks’ incentive to support their members could conflict with broader considerations of financial stability.
“The Fed is staying [the Financial Security Oversight Council]mortgage banks don’t, so the Fed has a kind of financial stability mandate that’s important when you think about contagion and bailing out banks in providing liquidity,” he said. “It’s just not clear that the Federal Home Loan Bank Committee has that systemic view of what what’s happening in the financial ecosystem.”
Donovan said that in the case of Silvergate, as with all developments, a member bank’s regulators — in this case the Fed and the FDIC — could block the liquidity insurance if they felt the bank posed a threat to financial stability.
“In the case of Silvergate and others, the FDIC, the Fed and state bank regulators are in constant contact with the mortgage banks,” he said. “If they were concerned about the safety and soundness of the bank, they could have requested that the advance not be paid.”
Hill said the episode shows how regulators themselves have used a trial-and-error approach to managing the counterparty risks posed by crypto companies.
“It’s not like regulators are allowing all banks or thousands and thousands of them to do this,” Hill said. “Regulators have allowed a few banks to experiment in this space and now they may be reconsidering what kind of experimentation they will allow.”
Alison Hashmall, a banking and regulatory attorney at law firm Debevoise & Plimpton, said she expects the Fed to take a tougher approach toward banks that want to do business with emerging crypto companies. She pointed to a joint letter from the Fed, the FDIC and the Comptroller of the Currency issued earlier this month, in which regulators committed to a cautious approach to overseeing exposure to digital assets.
“[Regulators are] advising banks that, in order to follow safe and sound practices, you need to be aware of and consider how much of your deposit base comes from these types of [crypto] companies,” she said. “Examiners will be looking at that and want the banks to make sure they’re not overexposed. I don’t think they would like to see that [type of run] repeat.”
Founded in 1988 as an industrial lending company, Silvergate began as a commercial real estate specialist before transitioning into a single-family mortgage lender and then a multifamily lender. In 2013, she started building her digital asset business. Today, the bulk of the bank’s business is focused on providing payment, lending and financing services to crypto companies. Much of this is done through the Silvergate Exchange Network platform.
Meanwhile, Silvergate’s presence in the mortgage industry has dwindled. It exited its mortgage warehouse loan product late last year, citing rising interest rates and falling mortgage volumes.
The fact that the Bank’s mortgage funds are being used to prop up banks that do little in the area of home financing has frustrated some housing advocates. As the Federal Housing Finance Agency, which oversees home loan banks, conducts a sweeping review of the system, some are calling for tougher regulations that will force banks to focus on their core mandate.
Caroline Nagy, senior adviser on housing policy, corporate power and climate justice at Americans for Financial Reform, said that if mortgage banks are going to provide subsidized funding for banks, the government should ensure that the activity leads to more housing.
“If we think that promoting liquidity for the nation’s largest banks and insurers is a valid use of public resources, and I’m talking specifically about the preferred lien status and the tax-free status of the system, we really have to see it for the public good,” Nagy said. “Frankly, we have a huge need for the kind of investment that this banking system could produce. We desperately need affordable housing, we’re in an affordable housing crisis.”
The FHFA declined to comment for this story.
While Silvergate’s advances are seen by some as an abuse of the Home Loan Bank system, Signature’s use of funding sources is more typical.
One of New York’s largest multifamily lenders, Signature frequently requests advances from Home Loan Bank of New York to support this activity. And while it launched a similar network to process digital payments, its falling deposits — which stood at $88.6 billion on Dec. 31, from $106.1 billion a year earlier — are the result of a conscious effort to withdraw from the digital property space.
“We really are the quintessential example of what the Federal Home Loan Bank was created to do because all of the loans we have from the FHLB support our loans in the multifamily sector,” Eric R. Howell, Signature’s chief operating officer, said American Banker. “It’s really just part of our overall funding equation. We use those advances to fund our businesses.”