Remarks as Prepared for Delivery

Melvin L. Watt, Director

Federal Housing Finance Agency

2017 Federal Home Loan Bank Directors' Conference

Washington, D.C.

May 23, 2017

Good afternoon and thank you for inviting me to speak again this year at the Federal Home Loan Bank Annual Directors' Conference.  It's always a pleasure to join you and share my thoughts on the work FHFA and the FHLBanks are doing to create a stronger FHLBank System.  

Status of the Federal Home Loan Bank System

Let me start, as I always like to do, with some facts (generally good news) about FHLBank performance. 

Building on the financial strength of the System in 2015, the FHLBank System had its most profitable year in history last year, with net earnings of $3.4 billion.  This level of profitability benefited from some FHLBanks' private-label securities litigation settlements, which contributed $952 million of the total.  Earnings, while still strong, would have been more in line with recent annual System earnings, without this non-recurring settlement income. 

The FHLBanks' 2016 net income generated $392 million in Affordable Housing Program (AHP) funding, pushing the average contribution for the last five years to over $300 million per year. 

Consistent profitability of the System has also allowed the FHLBanks to add almost $7.8 billion to their accumulated retained earnings over the last five years.  Although not distributed evenly across the FHLBanks, these retained earnings should make your members very comfortable about the financial strength of the System.  System-wide retained earnings now constitute more than 1.5 percent of aggregate FHLBank assets and more than 30 percent of regulatory capital, up from 16 percent five years ago. 

2016 also saw advances grow by $71.2 billion to $705.2 billion at year-end.  The increase in advances pushed System assets past the $1 trillion mark for the first time since 2010.  Advances to smaller borrowers increased System-wide, despite the fact that the ten largest borrowers accounted for 80 percent of the increase.  The concentration of advances to large members remains a focus of FHFA's supervisory and examination work.

Advance growth, of course, helps the FHLBanks focus on their core mission.  System-wide, the primary core mission asset to consolidated obligations ratio rose from 73.6 at year-end 2015 to 75.9 percent at year-end 2016.  Only two FHLBanks have not yet met the preferred ratio of 70 percent, and both of them have been moving in the right direction.

FHLBank Supervisory Priorities

Despite general positive trends, a number of regulatory issues remain that we should all be focused on.  Many of these issues relate to four critical and interrelated areas of FHFA's supervision of the FHLBanks:  funding, liquidity, capital, and large member concentrations. 

A concern that we have focused more attention on in the last couple years is the heavy reliance of the FHLBanks on short-term funding of longer-term assets.  Overreliance on short-term funding can strain the System's capacity to issue short-term debt at attractive spreads.  Currently, market demand appears to be large enough to accommodate ample amounts of FHLBank short-term debt, but that may not always be the case.  Entering a future downturn with extensive short-funded, long-asset positions would be imprudent as it would pressure the FHLBanks to exacerbate that funding mismatch.  Additionally, rolling short-term debt is more challenging when interest rates are rising as they appear to be doing now.  These risks raise the question of whether the FHLBanks are over-relying on short-term funding for longer-term assets and creating maturity mismatches.

I raised this concern at last year's conference.  I talked about FHFA's letter encouraging the FHLBanks to continue pursuing measures to limit reliance on short-term funding and to better match the maturities of your assets and liabilities.  As I previewed then, FHFA undertook a survey of the debt markets, which helped us understand the market forces driving the attraction of short-term funding to the FHLBanks.  Changes in the rules governing money market funds have been the main driver of an increase in demand for FHLBank short-term debt.  And that increase in demand was a significant factor behind the attractive terms the FHLBanks received when financing their short-term debt during 2016. 

A year later, we have seen some progress on this front.  While the FHLBank System as a whole is reducing maturity mismatches, some FHLBanks are doing better than others.  The general improvement comes from issuing longer-term debt, and this is taking place in several ways.  The level of discount notes with durations of 3 months or less has declined as the FHLBanks have increased floating rate note issuances with longer maturities of up to 18 months.  Another factor has been regular debt issuances through your Global Debt Program.  Issuing these bonds with 2-, 3-, and 5-year maturities provides stable funding for the FHLBanks and reduces the pressure to rollover 3-month and other short-term obligations. 

We encourage the FHLBanks to continue these debt offerings and to do so on a regular schedule so investors can anticipate these ongoing offerings.  In making all of these adjustments, the FHLBanks are being aided by more favorable bond rates for longer-term debt, making these issuances less expensive.

FHFA is continuing to evaluate ways to formalize FHFA's supervisory expectations regarding the appropriate amount of short-term funding of longer-term assets.

In addition to our work on the maturity mismatch issue, a second priority has been examining FHFA's existing FHLBank liquidity requirements to determine what standards should be put in place going forward.  The challenge the FHLBanks faced in issuing debt in 2008-2009 highlights the importance of setting the right overall liquidity standards.  Although the FHLBanks were able to issue short-term debt at attractive rates during that time, they were not able to issue longer-term debt at attractive rates.  Of course, the challenge is always deciding what liquidity standard is prudent for both normal times and times of economic stress.

Our primary goal here is to ensure that the FHLBanks can continue their operations even if market demand for FHLBank debt is disrupted.  We have had numerous discussions with FHLBank representatives, and we understand that the liquidity and funding challenges facing the FHLBanks differ from those facing depository institutions.  While we are still working on the details, we intend to issue a proposed liquidity rule by the end of this year to replace the 2009 liquidity letter that currently sets our expectations in this area.

The third FHFA responsibility I want to discuss is ensuring that the FHLBanks have adequate capital.  FHFA is reviewing and working to revise the current risk-based capital regulation.  We believe there is an opportunity to take advantage of new data and modeling improvements that have become available since 2001 when the Finance Board issued the current rule.  Revising the Rule will also allow us to get into compliance with the Dodd-Frank Act's requirement to remove references to, and prohibit any FHLBank from relying solely on, ratings from Nationally Recognized Statistical Rating Organizations. 

The new Rule will not prohibit the FHLBanks from using these ratings as part of their own methods to assess the credit risk of assets.  Again, our obligation is to ensure that the FHLBanks hold sufficient capital to operate safely and soundly through good times and bad.

Finally, FHFA continues to monitor the concentration of advances for the System as a whole, and for some FHLBanks in particular, to a few large members.  In our examinations we will be looking at each FHLBank's policies and practices regarding large member borrowing. 

We want to ensure that each FHLBank is pricing their advances to large members appropriately and that the FHLBank has appropriate contingency plans if a large member decreases demand for advances or is unable to repay its advances. 

We will be looking especially closely at the increasing use of long-term, floating-rate advances that reprice quarterly and how these advances are funded.  These advances can create rollover risk when a FHLBank funds them primarily with 3-month discount notes, rolling them over until the advance expires. 

We want to be sure that the FHLBanks are funding and pricing long-term advances to large members appropriately to reflect and charge members for the rollover risk that the FHLBanks incur in providing these advances.   

FHFA is continuing to consider ways to address concerns regarding funding, liquidity, capital, and large member concentrations, as well as other issues, to ensure the stability of the FHLBank System.  As always, we will carry out this work in a transparent manner, and we look forward to working with you to do so.  Fred Graham will be prepared to address some of these issues more specifically in his discussions with you later today.    

Diversity and Inclusion Oversight and Examinations

Let me conclude by making a few comments about diversity and inclusion.   

After several years of preparation, in January of this year we started including FHLBank performance on diversity and inclusion as an integral component of our regular examinations.  Our objective here is to have each FHLBank view diversity and inclusion as an essential part of your efforts to meet your mission, not as an isolated endeavor.  Just as safety and soundness are business imperatives, so too are diversity and inclusion. 

So we want you to think of this not just as a compliance exercise or an effort to fulfill a statutory obligation, but as part and parcel of ensuring a successful operation.  Each FHLBank board should be providing leadership on diversity and inclusion and each FHLBank should be providing leadership for the housing finance industry as a whole.  

FHFA continues to assess how we can help you meet those objectives.  We believe that one important step each FHLBank must take is to have a well-governed diversity and inclusion program accompanied by defined, measurable goals as you do in all other areas of your business.  This requires each FHLBank to ensure program governance that aligns the FHLBank's activities with program goals. 

Our diversity and inclusion examiners, all of whom are experienced financial institution examiners with specialized training, have completed their first round of examinations of three FHLBanks and are now in the process of wrapping up examinations of the next three FHLBanks.  The diversity and inclusion examinations focus on assessing seven components of each entity's program:  Board Oversight, Strategic Planning, Organizational Framework, Supplier Diversity and Inclusion, Workforce Diversity and Inclusion, Reporting, and Compliance/Audit.  

So far, our examinations have identified both the significant efforts that you have been making in your respective programs and common themes and challenges across the System.  These results will help FHFA provide better and more specific guidance.  Our goal is to help you understand FHFA's expectations related to your diversity and inclusion obligations.  We are encouraged by the progress we have seen so far.

Conclusion

Thank you again for inviting me to be here with you today and to discuss my thoughts on FHFA's supervision of the Federal Home Loan Bank System.  I look forward to continuing to work with you to promote both safety and soundness and diversity and inclusion throughout your institutions and, ultimately, to create a stronger FHLBank System.  I look forward to answering your questions about our work on these and other priorities.