“The time has clearly come to harness money market funds in a manner that recognizes both their structural importance in diverting funds from regulated banks and their destabilizing potential… [T]hey should be treated as ordinary mutual funds, with redemption value reflecting day by day market fluctuations.” Paul Volcker, William Taylor Memorial Lecture, September 23, 2011
“Recent rule changes have had the unintended consequence of driving over $1 trillion from prime and municipal money market funds… Our bipartisan bill will reverse the damaging effects of this rule….” Congressman Keith Rothfus, Pennsylvania 12th District, May 4, 2017 press release
Shortly after Lehman failed in 2008, investors began to flee from money market mutual funds (MMMFs). To halt the run, the U.S. Treasury guaranteed all $3.8 trillion in outstanding MMMF liabilities. That rescue created enduring moral hazard: the expectation that a future crisis will lead to another bailout.
Aside from their legal form as mutual funds, MMMFs functioned much like banks engaged in the transformation of liquidity, credit and (to some extent) maturity. Similar to banks that redeem deposits at face value, they promised investors a fixed share value of $1 (a “buck”) on demand. Unlike depositories, however, MMMFs had no capital, no deposit insurance, and—at least officially—no access to the lender of last resort. So, when the Reserve Primary Fund “broke the buck” (by failing to redeem at the $1 par value) in September 2008, MMMF investors panicked.
Somewhat surprisingly, it took until 2014 for the Securities and Exchange Commission (SEC) to resolve political conflicts and introduce significant rule changes for MMMFs (see our earlier posts here and here). Following the suggestion of a number of observers, including former Federal Reserve Chair Volcker (cited above), the SEC now requires that institutional prime MMMFs—which (like Reserve Primary) frequently invest in short-term corporate liabilities—operate like other mutual funds with a floating net asset value (NAV). The same rule applies to institutional municipal MMMFs. Retail MMMFs, as well as those investing in federal government (and agency) securities, are exempt.
Then, 2017 ushered in a sea change in regulatory attitudes. The House passed the Financial CHOICE Act, which would eliminate the FSOC designation of systemic intermediaries and the FDIC authority to resolve them outside of court-administered bankruptcy (see here). The Treasury proposed to ease what they consider gold-plated capital requirements on systemic banks. And, in a remarkable turnaround, more than 60 representatives of both parties co-sponsored a bill (H.R. 2319) to reverse the SEC’s 2014 money fund rule and restore the authority of institutional funds to operate with a fixed share value. While much of this latest legislative effort is surely grandstanding, we see the trend as an indication that the U.S. government’s commitment to financial resilience is in jeopardy.
In light of the recent proposal to water it down, in this post we review the impact of the SEC’s 2014 reform. To highlight our conclusions: (1) it did not go far enough to reduce run risk; (2) aside from temporary dislocations, it has not raised nonfinancial sector funding costs by more than would be accounted for by reducing the implicit taxpayer guarantee for MMMFs; and (3) reversing the floating-NAV requirement would weaken the safety of the U.S. financial system.
Let’s start by explaining why we believe that the SEC reform is insufficient to ensure financial resilience. First, the focus of the rules is too narrow: as of end-2013, before they were announced, prime and tax-exempt institutional funds (excluding federal government and agency instruments) accounted for $1 trillion out of the total $2.7 trillion of MMMFs (ICI Factbook, Table 36). While the 2008 runs did not reach the prime and tax-exempt retail sector ($0.7 trillion), they might have—had the Treasury and Fed not already provided a blanket guarantee in response to the institutional fund panic.
Second, a shift to a floating NAV reduces, but does not eliminate, the first-mover advantage that leads to runs. So long as a mutual fund holds a significant volume of illiquid assets, those who withdraw early benefit from the fund manager’s ability to sell liquid assets first. Goldstein, Jiang and Ng documented this fragility in the case of corporate bond funds, while Chen, Goldstein, and Jiang did so with emerging market and equity funds. (See our earlier discussion of run risk in open-end mutual funds.)
Third, the SEC rules provide MMMF managers with the option to halt an incipient run by imposing a discretionary gate on redemptions in bad times. Yet, while closing a gate may help limit redemptions from a specific fund, it can spur a run on other similarly situated funds as investors seek to flee before the next gate closes. SEC Commissioner Kara Stein dissented from the SEC reform proposal precisely for this reason.
Finally, had the SEC wished to ensure the safety of MMMFs, it surely had alternatives. In 2012, acting ahead of the SEC, the FSOC proposed a number of reforms. These included various forms of risk-based capital requirements as well as non-discretionary redemption fees that would both limit first-mover advantage and compensate patient MMMF shareholders for the costs imposed by those who flee. (Hanson, Sunderam, and Stein discuss these proposals.)
What impact did the 2014 SEC reform actually have on capital markets? Institutional investors voted with their feet, exiting prime and tax-free funds with a floating NAV in favor of government funds with a fixed share value and without gates (see chart). Between end-June 2014, just prior to the SEC announcement, and October 2016, when the rules took effect, overall MMMF assets were unchanged at $2.9 trillion, but the mix of fund types changed drastically: government funds more than doubled from $0.9 trillion to $2.2 trillion, while prime and tax-free institutional funds shriveled.
MMMF Assets by Fund Type (Billions of U.S. Dollars), 2014-November 2017
Critics of the rule, like the sponsors and supporters of H.R. 2319, argue that this shift has deprived U.S. businesses and municipalities of access to key capital market funding. However, despite the trillion-dollar decline of institutional MMMFs cited by Congressman Rothfus (see above), a range of evidence strongly suggests otherwise.
First, in mid-2014, prime MMMFs had very large foreign holdings: including supranational debt, these totaled over $1 trillion, or more than 60 percent of all prime money fund assets. Because our interest is in understanding the domestic impact of the rule, we need to focus on their U.S. assets. Fortunately, the Office of Financial Research’s Money Market Fund Monitor allows us to do this. From June 2014 to October 2016, prime funds’ domestic assets fell from $660 billion to $212 billion. But over 90 percent of this decline was accounted for by the plunge in holdings of federal government securities (from $360 billion to $97 billion) and financial sector liabilities (from $224 billion to $69 billion). The combined drop in holdings of the debt of domestic nonfinancial corporations and municipalities was just $30 billion, or less than 7 percent of the total.
U.S. Domestic Investments of Prime MMMFs (Billions of U.S. Dollars), 2014-November 2017
Second, the notable rise in nonfinancial sector debt in recent years is clearly inconsistent with the view that the SEC MMMF rule imposed any meaningful financing constraint on business expansion. According to the Financial Accounts of the United States (Table L.3), these liabilities are up by 22.3% since just before the announcement of the new rule in mid-2014. For comparison, nominal GDP rose by less than 13% over this period.
Third, gross yields on various MMMFs have evolved largely in line with other short-term benchmarks (see chart). As of end-November 2017, the spreads over the 4-week Treasury bill secondary market yield for prime, government, and tax-exempt funds were 20, 2, and minus 12 basis points, respectively. These are barely changed from two years earlier (17, 5, and minus 3 basis points), when the SEC began publishing the data. While there was a period in 2016 when tax-exempt fund yields rose disproportionately (as investors shifted toward funds that would have fixed values under the new rule, rather than variable NAVs), broader competition in the supply of credit from bank and other nonbank lenders quickly filled the gap. (The same pattern of temporary dislocation is evident from the evolution of the SIFMA Municipal Swap Index, which reflects short-term, tax-exempt interest rates.)
Gross Yields on MMMFs by Fund Type and the 4-week Treasury Bill Yield, November 2015-November 2017
More to the point, isn’t it entirely appropriate that the relative cost of MMMF-provided short-term funding rise? To the extent that funding of the private nonfinancial sector shifts from MMMFs to banks that must pay for deposit insurance and finance themselves in part with equity, observed funding costs will rise. But this adjustment merely reflects the reduction of the subsidy that taxpayers provide to de facto banks like MMMFs.
Despite its imperfections, in our view, undoing the SEC’s 2014 reform would make the financial system more fragile. One reason is that the new rules have driven risk-averse investors—those who wish to hold fixed-value shares—into safer, more liquid instruments: the liabilities of the federal government and its agencies. Similarly, those investors who remained in prime and tax-free money funds are presumably less risk averse and more patient. Conversely, to the extent that short-term financing of corporates and municipalities has shifted to banks, it is now cushioned by their equity buffers and protected in a crisis by the combination of deposit insurance and access to the lender of last resort. Putting the funding of the private nonfinancial sector on a more secure footing lowers the risk of a credit crunch when the system comes under stress.
That brings us back to the Congressional effort to undo the 2014 SEC rule. As we have noted before, the scandal in finance is what’s legal—or, at least, what our legislators allow to be legal. It would indeed be scandalous if, to satisfy powerful special interests, Congress were again to enable a financial empire of institutional MMMFs and their privileged borrowers to exploit taxpayers through an implicit subsidy that becomes evident only in the next crisis. As we have argued before, there is no credible way for the government to promise not to bailout MMMFs in a crisis. The only time-consistent policy—on which the government has no incentive to renege—is to ensure that uncollateralized credit to the nonfinancial sector is held either by those who are prepared to bear the risk of market fluctuations or by well-capitalized, insured depositories with access to the lender of last resort.
That means treating MMMFs in one of two ways: either make them into conventional open-end mutual funds with a floating NAV (and, ideally, a risk-commensurate capital buffer or a non-discretionary redemption fee), or convert them into a bank.