Felix Salmon

Last week, I bemoaned the end of the interbank market — a market which looks like it might never come back, and which certainly hasn’t been done any favors by today’s news that Barclays is paying $453 million to settle allegations that it manipulated the key interbank interest rate.

Now Steven Davidoff has an interesting take on a broader phenomenon — that of money-market funds. There are many big differences between commercial paper, on the one hand, and interbank lending, on the other — but those differences are narrowing, and the commercial paper market has to a first approximation become an entirely financial market, a place for banks and shadow banks to do their short-term borrowing while the interbank market remains closed.

According to David S. Scharfstein of Harvard Business School, who also testified last week, of the 50 largest issuers of debt to money market funds today, only two are nonfinancial firms; the rest are banks and other financial companies, many of them foreign.

Once upon a time, before the financial crisis, money-market funds were a mechanism whereby individual investors could make safe, short-term loans to big corporates, disintermediating the banks. But all that has changed now. For one thing, says Davidoff, “about two-thirds of money market users are sophisticated finance investors”. For another, the corporates have evaporated away, to be replaced by financials. In the corporate world, it seems, the price mechanism isn’t working any more: either you’re a big and safe corporate and don’t want to run the refinancing risk of money-market funds suddenly drying up, or else you’re small enough and risky enough that the money market funds don’t want to lend to you at any price. At this point, money-market funds control just $2.6 trillion, down a whopping $1.7 trillion from the $4.3 trillion they had before the crisis.

This is very similar to what is quite familiar in the interbank market: instead of a market where supply and demand are matched at a certain price, we have a market which simply isn’t clearing — where no deals get done at all. The corporates are out entirely, as are a huge swathe of the retail investors; what’s left is financial investors lending to financial borrowers, taking advantage of the fact that the shadow banking system doesn’t have the same kind of capital adequacy rules that the real banking system has.

All the more reason, then, to regulate these animals with a heavy hand. The industry is screaming blue murder, but the louder they shout, the less compelling they sound. As Davidoff says, the money-market industry’s argument basically comes down to saying that it’s important to make retail investors believe their money is secure, even when it isn’t. And that’s not the kind of argument that any regulator should have any time for.

Bloomberg has got its hands on new data from the Fed, and it’s looking a bit desperate in its attempt to squeeze news out of that data. Its latest scoop, under the headline “Fed Made State Street Profitable as Middleman”, starts like this:

State Street Corp. (STT) and JPMorgan Chase & Co. (JPM) profited during the financial crisis by borrowing $200 billion almost risk-free from the Federal Reserve under a program intended to rescue money-market mutual funds.

What on earth does it mean to borrow money “almost risk-free”? There’s risk involved in lending money, of course. But I have no idea what risk-free borrowing might be. On top of that, the profits here seem incredibly modest. The Fed lent State Street $89 billion; State Street then took that money and bought various securities from money-market funds. It held those securities to maturity, and ended up making a profit of $75.6 million.

That’s a return of 0.08%.

It’s hard to get too worked up about this: the Fed needed to do something about money-market funds; it was legally incapable of conducting this operation itself; and therefore it got State Street and JP Morgan to help set up the program, paying them a modest 8bp fee for doing so. Bloomberg tries to find an expert of some description to get outraged about this, but the best they can do is to find a finance professor who thinks the fee was “appropriate”:

“The program was enacted without any bidding process and awarded on the basis of whoever was there at the moment,” said Joseph R. Mason, a finance professor at Louisiana State University in Baton Rouge. While the banks’ return may have been appropriate, the lack of competitive bids is troubling, Mason said. He noted that for State Street, JPMorgan and other participants, “there was virtually no risk.”

That’s true — but you can be sure that if there was risk involved, State Street and JP Morgan would have charged much more than 0.08%. It’s also worth noting that the Fed itself made much greater profits on the program than the banks did: some $543 million in total.

State Street didn’t get its $75 million for nothing. For one thing, it helped to design and set up the program. And it also took the risk that it could end up buying debt which wasn’t indemnified by the Fed and which might end up defaulting. There’s operational risk in all of these schemes, especially when they’re set up in a hurry and have to get implemented in the middle of a financial crisis.

And the Bloomberg headline is I think a bit misleading: the way I read it, at least, it’s saying that the Fed program was responsible for making State Street profitable. That’s not true. In fact, it’s just saying that State Street’s role as a middleman was profitable. Which is true, but hardly news: if a bank can’t make money by acting as a middleman, then it won’t act as a middleman.

The big picture, here, is not that the State Street program made money, but that the program to rescue money-market funds worked. Many of these funds faced enormous redemption requests in the days after the Reserve fund broke the buck; thanks to this program, all of them managed to meet those requests. Ultimately what happened was that hundreds of millions of dollars which would normally have gone to depositors in money market funds went instead to the Fed, with State Street and a few other banks taking a small slice. The funds were saved, the Fed made a handy profit, and the system didn’t collapse. Sounds like a big success to me, rather than any kind of scandal.

There’s a new flurry of commentary today on money-market funds: the Independent Directors Council has responded to the government’s report on the subject, as has Blackrock.

The problem which needs to be solved here is that money-market funds are in the business of maturity transformation: the funds are instantly available to investors in the funds, but they’re lent out for non-negligible periods of time. As David Merkel says, “financing illiquid assets with liquid liabilities is unstable, and begs for bankruptcy at the first significant loss of confidence.”

Merkel’s solution to the problem — requiring that liabilities match assets — is a simple one, and I like it a lot. If money-market funds promise investors their money back on demand, then they should only lend out money overnight.

How much downside would be associated with eradicating maturity transformation in this way? Not much, says Ashwin Parameswaran, who argues that “structural changes in the economy have drastically reduced and even possibly eliminated the need for society to promote and subsidise maturity transformation”.

I’m inclined to agree with him, since the downside of eliminating maturity transformation is higher interest rates, and a move towards equity and away from debt. Which would be very welcome, and make the economy as a whole much more robust.

This doesn’t mean, of course, that deposit insurance should be abolished. Deposit insurance does indeed act as means to promote maturity transformation, but it also acts to safeguard the savings of people with very little money, and encourage them to move their money out of the mattress and into the banking system.

But when people put their money in uninsured vehicles like money-market funds, they’re effectively trying to get interest rates associated with longer-term investments, on the order of a few weeks, while refusing to lock up their money for any time at all. If they want to make those longer-term investments, they should do so, rather than having their cake and eating it as they do right now.

Maturity transformation has, historically, been a helpful thing in terms of providing credit to grow the economy. But its time might have come and gone. At this point, there’s too much debt, not too little. And requiring assets to match liabilities would help move us back to a healthier state.