Rethinking Bretton Woods | Thu, Aug 23, 2012
Money market funds are a prime example of the "shadow banking" system. This article provides background on money market funds, what risks they pose in the financial system, regulatory actions taken in the US and how the financial industry lobby has forestalled talks of further reforms.
In between JP Morgan losses, the LIBOR rate-rigging and HSBC’s money laundering discoveries, banks have been suffering an unusually hot summer. A more quiet debate, but one with equally important consequences for financial stability, refers to the money markets mutual funds sector, and has engulfed the US Securities and Exchange Commission (SEC).
Money market mutual funds are one prime example of the vehicles that constitute “shadow banking” (or “credit intermediation involving entities and activities outside the regular banking system,” in the definition adopted by the Financial Stability Board). Shadow banking activities dwarf – according to recent estimates—the size of the banking sector. But it was only last year, and at the behest of the French Presidency of the G20, that the Financial Stability Board decided to cast the spotlight on them. In one of the first FSB papers scoping out the issues, money market funds were identified as an area of concern and are the subject of one of five workstreams on “shadow banking” identified by an FSB work program produced last year.
Money market funds or money market mutual funds are one type of mutual fund. Because the shareholders can redeem the money at any time and the funds pledge to preserve the principal, these funds operate, in the eye of retail or institutional investors seeking for a vehicle to park their money, as an alternative to a bank deposit. Money market funds have an estimated USD 4.7 trillion in assets under management as of the third quarter of 2011. 
They can be “constant” or “variable” Net Asset Value (NAV). The funds that motivate the greatest concern are those with Constant Net Asset Value, which are believed to represent 80 per cent of the total assets of money market funds. Throughout the rest of this article, unless otherwise stated, the expression “money market mutual funds” or MMMFs refers to this latter category. The constant value MMMFs aim to earn interest for shareholders while maintaining a net asset value of USD 1 per share. In order to backstop this pledge, MMMFs invest in high liquidity, low risk assets.
In the US, they are exempted from the normal requirements of valuation of mutual funds. Mutual funds would have to use the market value of their assets – the securities in which they invest-- in order to price their shares. In other words, the fluctuations in prices of the stocks, bonds, etc in which mutual funds invest would have to be reflected in the day-to-day price listed for their shares. But MMMFs are exempted from this requirement: they can use an “amortized cost” accounting convention, by which they round up the price of their shares, instead of using market value. For instance, if the value of the assets meant that their shares instead of 1 USD are worth, say, USD 0.997, they get to still list the price as 1 USD. Only if the market value of the assets falls by more than a half percentage point – that is, below a price per share of USD 0.995 – the MMMFs are required to reprice their shares downwards.
The benefit of this accounting convention was given to MMMFs understanding that the assets they invest on are highly liquid and low risk, and the regulation, thus, requires them to do so.
In practice, however, the value of the assets of MMMFs does fall at certain times below that threshold and what stands really behind the promise of the MMMFs have been their sponsors’ promise to buy back the assets so as to maintain the USD 1 per share value.
Concerns raised by money market funds
MMMFs in their current form have raised concerns for a number of reasons. First, unlike government-insured deposits, they are not supposed to enjoy explicit support from the government. However, the perception of systemic risks that can be triggered by a run on MMMFs might force the government to intervene. Sponsors guarantee the purchase of the shares at the stated price of 1 USD per share, but in the face of a widespread run the sponsors’ interventions might not be enough to stop a run. This is not a theoretical conjecture, but actually happened in 2008, when the Reserve Primary Fund, the oldest money market fund and holding then some USD 785 billion in debt of Lehman Brothers, faced an extraordinary number of redemptions, leading it to announce it would have to reprice its shares. Subsequently that led to investors in other MMMFs wanting to withdraw their funds, and it is estimated that the whole sector faced some USD 320 billion in redemption requests.
This immediately had repercussions on those getting funding from the MMMFs, as managers were unwilling to extend short-term credit or preferred to hold cash in order to face redemptions. In the last 2 weeks of September 2008, MMMFs reduced their holdings of highly-rated commercial paper by an astounding 29 per cent. More than 100 sponsors intervened to bail out their MMMFs but were unable to restore confidence in the market. Many more MMMFs would have had to reprice their shares, in spite of the extraordinary measures taken by sponsors, had the government not intervened.
The intervention came in the form of a US Treasury program, the Temporary Guarantee Program for Money Market Funds, which temporarily guaranteed certain investments in MMFs, and a Federal Reserve program, the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), which extended credit to U.S. banks and bank holding companies to finance their purchases of high-quality asset backed commercial paper from MMFs.
The susceptibility of MMMFs to a run is exacerbated by some of their particular features. The USD 1 per share pledge fosters an expectation of safety that is not really consistent with the fact that MMMFs face credit, interest rate and liquidity risks. While MMMFs enjoy the exemption from the market-based valuation requirement due to the low risk of its assets, in practice “low-risk” has come to be equated with Triple-A credit ratings. The crisis has provided well-illustrated examples of the pitfalls associated with the reliance on credit rating agencies’ judgment, and prompted a G20 commitment –of still uncertain implementation – to limit their role in legal and regulatory requirements for investment.
Also, investors have an incentive to redeem early as they sense trouble, concentrating greater losses on remaining investors and exacerbating liquidity constraints (in a dynamic completely similar to what happens when rumor that a bank is going under sends depositors in a rush to get back their deposits). This only worsens the problem as more investors try to do the same. Further, in order to return the money to requesting investors, MMMFs will have to sell their assets massively, depressing the prices and causing a cascade effect on other MMMFs that may hold the same assets.
Second, MMMFs are interconnected with the banking sector. Many banks are on the borrowing side of the intermediation provided by MMMFs. This was recently in evidence as the unwillingness of MMMFs to renew funding for European banks shed light on the degree of dependence of the sector on US-based MMMFs for, especially, dollar-denominated operations. In 2011 U.S. MMFs exposure to European banks represented around 52 per cent of total U.S. MMMF assets. This exposure was often in the form of short term loans to European Banks. But banks can also be investors in MMMFs, in this case contributing, sometimes, to the rapid withdrawal of large amounts that can weaken the ability of MMMFs to maintain a stable value.
The importance of the SEC reforms for the money market fund industry
Ninety per cent of the MMMFs (by volume) are in the US and Europe, but 64 per cent of those in the US alone.  Because of the high concentration of MMMFs in the US, the regulatory measures the Securities and Exchange Commission is willing to undertake are crucial to set the tone. In 2010 the SEC introduced a series of reforms. They were designed to reduce the risks of money market funds’ portfolios by reducing the average maturities of assets they held, improving credit standards –including limitations to the reliance on credit rating agencies-- and mandating liquidity requirements so that money market funds could better meet redemption demands. The new reforms also required money market funds to report the “shadow net asset value” -- the market-based value of the fund – to the SEC and the public.
The reforms were not, however, sufficient to address the concerns mentioned above. The Head of the SEC recognized as much, saying that the 2010 reforms do not: “(1) change the incentives of shareholders to redeem if they fear that the fund will experience losses; (2) fundamentally change the dynamics of a run, which, once started, will quickly burn through the additional fund liquidity; (3) prevent early redeeming, often institutional investors from shifting losses to remaining, often retail investors or (4) enable money market funds to withstand a “credit event” or the loss in value of a security held by a money market fund, precisely what triggered the run on the Reserve Primary Fund.”
So the SEC has been discussing in the last few months options to enhance the regulation of the sector. One of these is the move to floating value. This proposal would require money market funds to buy and sell their shares based on the market value of the funds’ assets.
A second idea is the introduction of capital buffers. MMMFs would be required to maintain a capital buffer to support stable values. This would not necessarily imply a buffer of enough size to absorb losses, but a buffer of enough size to purchase shares in the amount necessary to absorb the mark-to-market losses that take place on a day-to-day basis. Since sponsors already frequently intervene to support the stable value, this provision would just make the sponsor’s support explicit.
A third idea is the possibility of limits in the form of restrictions or fees on redemptions. This measure would force investors to bear the costs of early redemptions, thus shifting the incentives to an early rush for the exit that they currently have. A recently-released paper published by the Federal Reserve Board of New York proposes a “minimum balance at risk” of some 5 per cent of each shareholder’s recent balances. In case of a redemption, the MMMF could withhold this minimum balance at risk for a period of 30 days. This would ensure that redeeming investors have to bear part of the potential portfolio losses. But the authors also propose, as a further disincentive, that balances left by early redeemers are used as a cushion for losses before those of investors that have not redeemed.
The industry has lobbied hard against these reforms, generally wielding as a main argument that, if implemented, the proposals would reduce the attractiveness of the vehicle, and will lead to investors not wanting to use it.
This might well be the consequence if the vehicle’s only benefit was its capacity to hide true risks. But, then, would their disappearance or shrinking size be such a bad thing?
Like in the case of other shadow banking vehicles, the case has been made that money market mutual funds help diversify funding sources. To quote the FSB “the shadow banking system may provide market participants and corporations with an alternative source of funding and liquidity.”
But this diversification effect is not as genuine as it seems. Some experts even deem the liquidity created by MMMFs “fictitious liquidity.” Indeed, borrowers from a MMMF actually expect to receive currency or, as a substitute, a deposit in an insured banking institution. So an MMMF, in order to lend, will first have to obtain such currency or deposit from investors that buy its shares. This means that MMMF’s liabilities could not exist independently from insured banking institutions.
Against this backdrop, one could say that the proposals advanced by the SEC leadership were rather modest. Yet, there are good reasons to believe these modest proposals will not see the light of day. In the 5-member SEC the measures cannot pass without at least 3 commissioners in favor, and the industry has succeeded in swaying the views of 3 commissioners against. Those same three commissioners issued a statement last Spring questioning the consultation paper issued by IOSCO –which largely reflects the 2010 reforms but also the newly-proposed ones.
A vote on a proposed rule was scheduled for end of August. But, after several attempts to bridge the differences, on August 22 the chair of the SEC, Ms Mary Schapiro announced that as she had been informed by three commissioners that they intended to vote against, there was no point in calling for such formal vote. An important point she made was that having a proposed rule –notwithstanding differences among commissioners-- would have, at least, given the chance for the public to weigh in the debate.
With the current composition of Congress, there is no hope that Congressional action can remedy the gaps that the US financial reform legislation had on this field (Dodd-Frank was particularly mild with regards to shadow banking). If regulatory action by the SEC is ruled out, it seems additional reforms on money market funds cannot be expected in the near future (probably not before the next financial crisis strikes…).
 McCabe, Patrick E., Marco Cipriani, Michael Holscher and Antoine Martin 2012. The Minimum Balance at Risk: A Proposal to Mitigate the Systemic Risks Posed by Money Market Funds. Federal Reserve Bank of New York Staff Reports, No. 564. July.