The battle over money funds
Both Securities and Exchange Commission Chairman Mary Schapiro and Federal Reserve Chairman Ben Bernanke have warned in recent days that money market funds remain vulnerable to runs. That is unquestionably true, and if a run occurs, U.S. taxpayers will bear the costs of bailing them out. Should taxpayers continue to subsidize the money market mutual fund (MMMF) industry?
The run on U.S. MMMFs in September 2008 was a critical moment in the financial crisis. It underscored the extent to which these funds, an important part of the shadow banking system, created systemic risk that indirectly threatened the financing of even the healthiest U.S. firms. To end the run, the U.S. Government guaranteed MMMF liabilities, sustaining the funds’ promise to pay $1 for every share.
That guarantee stopped the run, but it also created enormous moral hazard. Were a similar threat to arise today, we can safely assume that taxpayers would remain on the hook to rescue the MMMFs. This uncompensated, rainy-day backstop constitutes a subsidy to the MMMF industry — and to its investors and borrowers.
No wonder, then, that representatives of these groups loudly oppose regulatory efforts to counter the systemic threat that still emanates from the MMMF business model. The SEC (which is the industry’s regulator) reportedly is considering the introduction of capital requirements, constraints on fund convertibility and — most important — replacement of the $1-per-share valuation commitment with a floating net asset value (NAV).
From the point of view of taxpayers, policy action to address the systemic threat is long overdue. Aside from the government-sponsored enterprises, the most glaring omission in the Dodd-Frank financial reform was the failure to address critical short-term markets such as those for money funds and repurchase agreements.
There is no shortage of evidence for an enduring systemic threat. As recently as May 2011, according to Fitch, more than half the assets of the largest prime MMMFs were invested in European banks as the funds searched for yield to attract investors. When these funds (and their regulator) finally woke to the crisis in the euro area, it triggered a run. The scramble by the funds to exit put pressure on European banks to sell their dollar assets rapidly. A fire sale of dollar assets could have quickly undermined U.S. credit conditions. To avoid this outcome, the Federal Reserve reactivated its dollar-swap agreements with foreign central banks, allowing the European Central Bank to meet the dollar funding needs of euro-area banks from which MMMFs were running.
So why do we regulate MMMFs so differently from banks? To be sure, their assets are short term and of relatively high quality, making them less risky. Yet MMMFs are the prototypical “shadow” banks — providing liquidity services that are virtually identical to those of banks, with the advantages of much less regulation and an uncompensated insurance policy from taxpayers. It is an extraordinary and enduring regulatory arbitrage for an industry that still holds $2.5 trillion in assets.
The simplest solution — one that former Fed Chairman Paul Volcker has advocated — is to require a floating NAV. The promise to repay investors sequentially at face value creates the risk of a run on MMMFs. That promise means that when a shock lowers the value of MMMF assets, the first investors to withdraw can do so at a price above market value! Whoever fails to get in line may get nothing. A switch to a floating NAV would fundamentally alter this incentive to run. No one could exit at a price above market value. That is why we usually don’t see runs on mutual funds when they lose value. Aside from MMMFs, mutual funds have floating NAVs.
The incentives created by the fixed share price are the same ones that make banks fragile. Deposit insurance and a lender of last resort mean that bank depositors don’t have to worry about getting in line. But having created these crisis-prevention devices, we regulate banks to limit their potential burden on taxpayers, and (at least in principle, if not in fact) we charge them for the deposit insurance provided.
Ultimately, the SEC and Congress will decide. Will policymakers back an effort by MMMF regulators and others to protect taxpayers and limit systemic risk, or will they be swept away by the chorus of complaints about the burdens of financial regulation? If safeguarding taxpayers is the top priority, reforming MMMF rules will not be a partisan issue.