Form vs. Function: Regulating Money Market Funds

“If it looks like a duck, and quacks like a duck, we have at least to consider the possibility that we have a small aquatic bird of the family Anatidae on our hands.”

Douglas Adams, Dirk Gently’s Holistic Detective Agency

Following the collapse of Lehman in 2008, a run on U.S. prime money market mutual funds (MMMFs) was halted only when the U.S. Treasury provided a blanket guarantee. (Prime MMMFs typically invest in corporate debt, including the debt of intermediaries.) Shortly thereafter, the Federal Reserve added emergency machinery (the “Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility”) to encourage depositories to acquire illiquid assets from MMMFs.

Yet, more than five years later, we’re still waiting for the authorities to address the moral hazard and the potential for future financial disruption resulting from these crisis mitigation efforts.

The Securities and Exchange Commission (SEC) regulates investment companies, which include the managers of MMMFs. Following the Treasury guarantee, the SEC tightened rules on MMMF assets. However, few observers believe that these changes eliminate the risk of a run on prime (or possibly other) MMMFs. MMMFs are still allowed to offer fixed $1 value shares that investors can withdraw on demand. The SEC’s moves have also left unchecked the herd-like behavior of prime MMMF fund managers, whose portfolio shifts may have exaggerated the crisis of European banks in recent years – first, by piling in to these bank liabilities and then by rushing simultaneously for the exit in 2011 in what has come to be known as the “quiet run.”

Last summer, the SEC called for comments on a 698-page MMMF reform proposal that focuses on two alternatives. The first calls for moving away from fixed-value shares and reporting the daily floating net asset value (NAV) as other mutual funds do. The second would allow fund managers the option of imposing liquidity fees and permit temporary suspension of fund redemptions by investors (by raising fund “gates”).

In our view, neither option would prevent runs on MMMFs. As the Squam Lake Group of academics notes, money funds often hold illiquid assets. In a crisis, shareholders would still have the incentive to run on a floating-NAV fund. This incentive mirrors the trigger for a classic bank run: the absence of prices for illiquid instruments means that the reported NAV exceeds the true one. And recent research confirms that investors are more likely to exit from relatively illiquid mutual funds that experience bad performance than from liquid ones.

MMMF gates are no better, and possibly worse, than a floating NAV. If you suspect that a gate might rise to lock up your safest, most liquid savings, would you really hang around? And, in the same way that a run on a single bank can quickly lead to a market-wide panic, the raising of a gate by even one MMMF could spread and become a system-wide panic. The contagion associated with gates seems no less severe to us than that associated with “breaking the buck” under the current $1 fixed-share price commitment.

The fundamental problem facing U.S. regulators is that money market funds are banks in everything but their outward legal form. They perform liquidity and credit functions that are identical to those of chartered banks; in particular, they offer the equivalent of bank checking deposits, making them vulnerable to a run. Yet, MMMFs are subject to a completely different regulatory regime. And, despite the experience of 2008, they are still assumed to lack access to a government backstop or to the lender of last resort, so they do not pay premia, risk-based or otherwise, for deposit insurance.

Of course, just because an entity engages in some of the functions of a commercial bank does not mean that it should be regulated the same way: regulation should differentiate carefully across institutions in a way that is primarily aimed at discouraging systemic risk. MMMFs, for example, are far more constrained than commercial banks in the scale of their credit and maturity transformation activities. In addition, greater transparency regarding their portfolios – as the SEC proposes and as appears more feasible for MMMFs than for commercial banks – also would reduce the incentive for a panic in the face of a narrow run.

Nevertheless, is the optimal mechanism for securing the safety and soundness of MMMFs so different from that for commercial banks as either current practice or proposed reforms imply? We think not. Some of their functions are the same, and experience shows that under stress the government will intervene to stem a panic.

We argue elsewhere that a regime combining high capital and liquidity requirements with heightened transparency, deposit insurance, and a lender of last resort, can make a banking system sound. Giving the narrower scope for taking risk, the capital required to make this work for well-diversified MMMFs should be significantly smaller, but – as recent research indicates – it is almost surely not zero.

Since they look like banks and act like banks, money market funds should be regulated like banks.