(Bloomberg) -- A push by US regulators to rein in the Federal Home Loan Banks risks casting broad ripples through the US financial system, increasing costs to banks by pulling a major force from the nation’s funding markets. 

That’s a key takeaway from Wall Street strategists after the Federal Housing Finance Agency released a report this week that called for limiting access to loans from the banks.

The so-called FHLBs, created in the 1930s to help finance Americans’ home purchases, in recent decades have steadily expanded their scope, morphing into a linchpin of the loan markets where banks turn to borrow short-term cash. That role has drawn heightened scrutiny after they lent heavily to Silicon Valley Bank, Signature Bank and First Republic Bank as they careened toward collapse, underscoring how the system is encroaching on the Federal Reserve’s role as a lender of last resort.

The housing agency is now looking to ensure that banks turn to the Fed during times of stress instead of the FHLBs, which extended massive amounts to banks earlier this year as fearful depositors yanked out cash on fears of an escalating crisis.

Gennadiy Goldberg, head of US interest rates strategy at TD Securities, said limiting the scope of the FHLBs may cause banks to stockpile cash during times of crisis, given the market stigma associated with turning to the Fed for emergency loans. 

“The change could lead to banks hoarding additional liquidity during times of stress,” he said. “This could serve to increase banks’ liquidity needs and could exacerbate market volatility during times of stress as banks will be reluctant to tap Fed facilities quickly.” 

The regulator hasn’t yet revealed any specific steps nor a timeline for implementing them, so any concrete impacts won’t emerge for some time. The release, instead, was more of a blueprint for a potential multi-year effort that would require rulemaking and potential Congressional action.

“A lot remains to be seen on an actual plan,” said Blake Gwinn, head of US interest rates strategy at RBC Capital Markets. “So it’s still possible this is a big nothing burger.” 

Analysts said the vision the agency has sketched out could result in higher funding costs as banks are forced to turn to more expensive markets, like the ones for commercial paper or time deposits, instead of drawing on short-term loans, also known as advances, from the FHLBs. Financial institutions are already facing higher funding costs as they attempt to safeguard liquidity after depositors moved trillions of dollars to higher-yielding alternatives. 

But the FHFA proposal could also shift the way in which FHLBs manage their excess liquidity, expanding the ability of the FHLBs to deposit funds directly into commercial bank accounts instead of into the federal funds market, a place where banks can lend dollars to each other overnight. 

Right now, FHLBs are the biggest lenders in the fed funds market because that’s the primary place they park their excess cash. That means their pullback could cause trading volumes in the roughly $100 billion space to dwindle, complicating the Fed’s ability to implement monetary policy, since it currently does that by targeting the effective fed funds rate.

“A reduction in volumes would place upward pressure on the fed funds rate and call into question the appropriateness of utilizing fed funds as a policy target for the Fed,” according to Mark Cabana, head of US interest-rates strategy at Bank of America Corp. 

Ultimately, the overhaul is about moving the FHLB system away from its role as a source of last-resort liquidity. It’s part of a broader push aimed at encouraging banks to become more comfortable using the central bank’s emergency lending facilities, which some are hesitant to do because it can be seen as a sign of distress.

Fed policy makers for years have tried to remove that stigma, even eliminating the penalty rate, and its greater use could offset the impacts of any pullback by the FHLBs. Just last month the central bank and Federal Deposit Insurance Corp. issued a statement imploring depository institutions to use the discount window to meet liquidity demands. 

But if there’s still hesitancy, banks may wind up amassing more liquidity than they actually need, driving funding costs even higher by reducing the supply to those who need it.

“You can bring a horse to water but you can’t make it drink,” Barclays Plc’s Joseph Abate said in a note. “While banks’ ability to use the FHLB as a lender of last resort will be more limited in the future, it is not clear that banks will be any more willing to borrow at the discount window.”

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