The SEC has finally acted. On July 23, the SEC issued 859 pages of new rules for the operation of some money market funds. (You can find a mercifully short description here.) To summarize our reaction: we are underwhelmed! It is hard to see how the new rules will reduce systemic risk in any meaningful way.
We first wrote about money market funds in May. The original post is here. But we are getting ahead of ourselves. Let’s start by summarizing the new final regulation. It has three parts:
1) It applies to institutional prime money funds only.
2) These funds are required to have floating net asset values (NAV).
3) Fund boards will have the option to impose liquidity fees and redemption gates if the funds “weekly liquid assets” fall below a threshold.
This new framework simply will not stop runs. Discretionary liquidity fees and redemption gates increase the risks of a run, not decrease them. Think about it. If you are worried that a fund you own is about to impose a 1% or 2% fee for withdrawals, would you wait around until they did it? What if you became concerned that the fund would suspend redemptions for the next two weeks? Rational, prudent, informed institutional investors will do exactly what we all expect: withdraw ASAP!
The instability associated with gates comes as no surprise to the SEC (or anyone else). The Squam Lake Group of academicians highlighted it in their comment letter regarding the SEC’s proposals, as did the Presidents of the 12 regional Federal Reserve Banks in theirs. In fact, in her July 23 statement regarding the final rule, SEC Commissioner Kara Stein put it as well as anyone could:
“…after careful study, I am concerned that gates are the wrong tool to address this risk. As the chance that a gate will be imposed increases, investors will have a strong incentive to rush to redeem ahead of others to avoid the uncertainty of losing access to their capital. More importantly, a run in one fund could incite a system-wide run because investors in other funds likely will fear that they also will impose gates. I share the concerns of many commenters and economists that while a gate may be good for one fund because it stops a run in that fund, it could be very damaging to the financial system as a whole.”
What about a floating NAV? Here, the jury is less one-sided. This was the first alternative suggested by the Financial Stability Oversight Council (FSOC) in its 2012 reform proposals, and it was endorsed by the Reserve Bank Presidents. Compared to a fixed share price, a floating NAV should reduce the first-mover advantage of those who run. However, it would not fully eliminate that advantage. To quote ourselves: “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.”
To be fair, the floating NAV could do two things that might improve financial stability. First, it could drive the more risk-averse investors into fixed-NAV bank accounts, reducing the size of the money market fund sector. And second, related to the first, a floating NAV would likely reduce the risk aversion of the investor pool that still prefers MMMFs to bank accounts. These effects could make things better. But we would have to be convinced before believing that they were large, or that they were sufficient to offset the behavior of others who might wish to take even more risk in return for accepting floating NAVs.
Finally, there is the first part of the new rule: it only applies to a subset of funds. According to data from the Investment Company Institute, coverage is slightly more than one-third of the total $2.56 trillion currently held in money market funds. To be sure, the money fund run in 2008 focused on the prime funds that the new rule covers. But the subsequent federal government guarantee for money funds covered all varieties. Had the government not stepped in, might the instability have spread beyond prime funds to the retail varieties? We can’t know, but it is inappropriate to simply assume that the answer is no, as the new framework appears to do.
What would we have done? The answer is simple. We would require capital buffers for all fixed-NAV money market funds, retail and institutional, that would reflect the riskiness of their assets. [A close alternative that would work is the “minimum balance at risk” (MBR) proposed by FRBNY researchers. The MBR functions as a kind of subordinated capital.] Because MMMF assets are usually of shorter maturity and less risky than those in bank portfolios, the resulting capital requirements would be significantly smaller than those for banks, but – unlike today – they would not be zero. We also would require a contribution to the FDIC’s deposit insurance scheme. After all, if you offer liquid deposit liabilities, then you are a bank. For floating-NAV funds, there need be no deposit insurance, and the capital requirement would be smaller (reflecting the reduced first-mover advantage), but it still would be greater than zero. In neither case (fixed NAV or floating NAV) would we permit redemption gates. [An attractive approach would be a universal liquidity fee that imposes a cost on speedy redemption across all funds at all times without discretion. Such a fee would not induce an incentive to run.]
So, nearly six years after the U.S. Treasury was forced to offer a blanket guarantee to all retail and institutional funds, the SEC has spoken. And the result is a whisper, not a shout. We hope that this is not the final word on the subject of MMMF regulation. Perhaps the Financial Stability Oversight Council (FSOC) will again see fit to prod the SEC, as it did in 2012 when it addressed MMMF reform. The FSOC should act in line with its obligation to protect the financial system. Doing so also will protect U.S. taxpayers against future MMMF bailouts.