Reducing Systemic Risk: The Role of Money Market Mutual Funds as Substitutes for Federally Insured Bank Deposits
Jonathan R. Macey
Yale Law School
January 4, 2011
Yale Law & Economics Research Paper No. 422
In the wake of the events of September 2008, money market mutual funds have made significant changes to the way they invest. Those changes have been driven by business and investment needs as well as by substantial revisions to the regulatory framework in which funds operate. Yet, some policymakers and market participants are calling for additional regulatory or legislative action. This paper lays out the important role that money market mutual funds play in the short-term capital markets, traces the successful regulatory history of money market mutual funds and argues that more reforms could create, rather than reduce, systemic risk.
The first phase of these changes involved a number of amendments to Rule 2a-7, which governs the operation of mutual funds. The final rule changes released by the SEC in February 2010 included, among other things, tightened limits on portfolio maturity, greater disclosure obligations and heightened responsibilities for boards of money market funds.
When announcing the new rules in January 2010, SEC Chairman Schapiro indicated a possible second phase of reform that could include other “more fundamental” changes that the SEC would examine: a floating net asset value (or NAV), more frequent disclosure of mark-to-market NAVs, mandatory redemptions-in-kind for large redemptions, a private liquidity facility and a two-tiered system of money market funds in which the NAVs for some funds would float and the NAVs for others would not.
The Obama administration is also examining possible changes to money market funds. In June 2009, the administration instructed the President’s Working Group on Financial Markets to study whether fundamental changes are needed to reduce the susceptibility of money market funds to runs, including possibly prohibiting money market funds from relying on a stable NAV.
These reforms are being considered at a time when others, such as former Federal Reserve Board Chairman Paul Volcker, have called for money market funds to be regulated like banks.
Missing from the debate so far has been an acknowledgment of the enormous benefits that money market funds have provided over the last 40 years, both to investors and to the financial system as a whole. For both individual and institutional investors, money market mutual funds provide a commercially attractive alternative to bank deposits. Money market funds offer greater investment diversification, are less susceptible to collapse than banks and offer investors greater disclosure on the nature of their investments and the underlying assets than traditional bank deposits. For the financial system generally, money market mutual funds reduce pressure on the FDIC, reduce systemic risk and provide essential liquidity to capital markets because of the funds’ investments in commercial paper, municipal securities and repurchase agreements.
Despite these benefits, the changes under consideration, particularly a floating NAV, likely would curtail significantly, or potentially eliminate altogether, the money market fund industry as we know it. In this paper, I explore the advantages that funds have offered and the risks to the financial system from destabilizing the money market fund industry through these so-called reforms.
After a brief introduction explaining the operations of money market funds and a summary of the history of the industry, I describe the experiences of money market funds during the financial crisis. While much attention rightfully has been paid to the problems of the Reserve Primary Fund, the money market fund industry as a whole weathered the crisis quite well. Except for remaining shareholders in the Reserve Primary Fund, who in the end received more than 98 cents on each dollar invested, no money market fund investor suffered a loss of principal during the financial crisis. That said, money market funds did come under pressure and the federal government responded with its Temporary Guarantee Program. Prior to that program, some general purpose institutional money market funds experienced significant redemptions as investors looked to other investments such as Treasury bills and government money market funds.
In section IV of the paper, I describe in detail some of the advantages of money market funds, which I believed have been overlooked in the current policy debate. In particular, I discuss the following: •Money market funds reduce pressure on the FDIC: Banks suffer from a fundamental mismatch between their liabilities (which are deposits that can be withdrawn at any time) and their assets (which normally are in the form of much longer-term and illiquid commitments such as mortgages or commercial loans). Because of this mismatch, banks are susceptible to runs in the absence of deposit insurance. The FDIC has served as a back stop to protect depositors and, thus, has decreased the propensity for runs on banks. Still, the less pressure that is placed on the FDIC’s limited resources the better, particularly in light of the alarming rate at which banks continue to fail. Money market funds provide an alternative to bank deposits without the need for FDIC insurance. The $2.9 trillion that investors have placed in money market mutual funds would likely be deposited at banks if money market mutual funds did not exist. A stable $1.00 NAV and features such as check writing and no limits on the number of withdrawals make money market funds an attractive investment for short-term cash management. At the same time, money market funds do not suffer from the same structural mismatch between their assets and liabilities because of the liquidity and maturity requirements of Rule 2a-7. •Money market funds reduce systemic regulatory risk: Having all short-term savings subject to one regulatory regime creates systemic risk. The different regulation of banks and money market funds serves as an important method to diversify the regulatory risks involved in protecting short-term savings. Some have called for money market funds to be regulated like banks, citing functional similarities such as check-writing services. Doing so would be a mistake. Imposing the bank regulatory scheme on money market funds would increase, rather than decrease, systemic risk. Homogenous regulatory practices create the possibility that the oversight practices miss the next potential financial crisis. •Money market funds provide valuable liquidity by investing in commercial paper, municipal securities and repurchase agreements: Money market funds are significant participants in the commercial paper, municipal securities and repurchase agreement (or repo) markets. Money market funds hold almost 40% of all outstanding commercial paper, which is now the primary source for short-term funding for corporations, who issue commercial paper as a lower-cost alternative to short-term bank loans. The repo market is an important means by which the Federal Reserve conducts monetary policy and provides daily liquidity to global financial institutions.
In light of the many benefits that money markets funds provide, policymakers should be careful not to disrupt the operations of the money market industry by making more fundamental changes. These “reforms” are being discussed in the context of a regulatory structure that is already robust. In sections V and VI of the paper, I explain a number of the requirements in Rule 2a-7 and caution against making additional fundamental changes. The strength of Rule 2a-7 is underscored by the success and reliability of money market funds to investors over the last 40 years.
Like all regulatory regimes, policymakers should evaluate periodically whether improvements can be made. In the case of money market funds, those improvements should come within the context of Rule 2a-7, should not alter the basic structure of the funds and should not seek to impose arbitrarily a regulatory regime designed for a fundamentally different type of entity.
The proponents of more fundamental changes claim that they would reduce systemic risk. However, changes such as abandoning the stable $1.00 NAV could end the money market fund industry by causing a massive inflow of money to banks, which would increase the overall risk of the financial system.
Number of Pages in PDF File: 63
Keywords: banks, financial institutions, mutual funds, money market mutual funds, net asset value, regulation, securities, Securities and Exchange Commission, Rule 2a-7
JEL Classification: G18, G20, G21, G23, G28, G30, K00
Date posted: January 5, 2011 ; Last revised: January 23, 2011