Banks tap the liquidity spigot

Surging interest rates coupled with an increased share of fixed-rate securities over the past year have made many banks vulnerable to evaporating deposits and duration risk.

Smaller banks are having the most difficulty, but all banks are responding to reduced liquidity by restraining their lending, selling off liquid securities, and—critically— borrowing from backstops offered by the Federal Home Loan Banks and the Federal Reserve secured by their less liquid assets.

The FHLB system is a collective of 11 governmentchartered cooperatives with nearly $1 trillion in assets that provides a reliable source of liquidity to the banking system. These cooperatives make secured short- and long-term loans, called advances, to more than 6,500 members, collateralised by their mortgage securities and other assets to help the members meet their depositors’ withdrawal demands and other liquidity needs.

Moreover, the FHLB system is often viewed as the “lender of next to last resort” in that it provides liquidity to banks as credit conditions tighten, which may help to prevent avoidable failure of many small-to-medium institutions by effectively diversifying their funding risks.

Perfect storm

In early 2022, banks were still flush with deposits. However, banks quickly found themselves inside a perfect storm. The Fed started to hike rates in February 2022—and aggressively picked up the pace in the summer—while also unwinding its balance sheet.

At the same time, both businesses and consumers accelerated their borrowing through the second quarter of 2022 to capitalise on lower interest rates.

Meanwhile, bank balance sheets had an increased share in fixed-income securities, including Treasury bonds and mortgage-backed securities, since many financial institutions sought to benefit from the higher yields available, having been provided with extra cash from government fiscal and monetary support during the pandemic.

Banks do not necessarily have to realise such losses— unless they urgently need cash. But, as interest rates began to rise and depositors withdrew funds, banks, particularly midsize institutions, came under pressure to raise cash and to realise some of these losses.

To cover deposits while customers withdraw, banks sought out FHLB advances, which rose 40% from the first to the second quarter of 2022 and finished the year 140% higher than in 2021. The increase in advances over the last year, to meet the liquidity demands of banks, mirrors the rise in the 2008 financial crisis.