Regulating money: How did shadow banks respond to a $1 trillion shock

Abstract

During financial crises, investors demand large amounts of government-backed
assets. What constitutes an orderly flight-to-liquidity? Studying how suppliers
of government-backed safe assets respond to heightened demand during a crisis is
challenging due to a multitude of confounding factors. In contrast, the 2014 money
fund reform prompted a flight-to-liquidity in otherwise calm market conditions,
with $1 trillion flowing from prime to government funds. Using this regulatory
change together with fund-level and security-level data, we show the vital role of a
flexible provider of safe assets. The Federal Home
Loan Banks (FHLBs) supplied government funds with large quantities of safe assets
when the supply of Treasuries was sluggish to respond. Moreover, the flexible mix
of FHLBs’ supply of safe assets was crucial for government funds’ risk management.
FHLB debt was not only a substitute for Treasuries but also a complement.

Keywords: money markets, safe assets, shadow banks, interest rate risk

JEL Classification: G23, G28, E41