The crisis in the euro area is a reminder that threats to financial stability are never far away. While progress has been made on financial reform over the past two years, more must be done to ensure that the financial system is robust enough to absorb shocks and still provide the credit needed for economic growth and job creation.
A glaring vulnerability exists with money-market mutual funds. I believe changes along the lines proposed by Mary Schapiro, the chairman of the U.S. Securities and Exchange Commission, are essential. In particular, money funds should have capital buffers and modest limits on investor withdrawals. Such reforms are necessary to protect the economy from financial instability in the future.
Let me explain why. In our modern financial system, most of the credit to consumers, businesses and governments is supplied through the capital markets. This supply of credit depends on activities that are financed with short-term IOUs issued to money funds and other institutional investors.
For example, the ability of a car buyer to obtain an auto loan on good terms rests on the ability of the dealer’s financing arm to issue commercial paper to fund its inventory of loans. Likewise, corporations and the government can issue debt at a reasonable price because of the willingness of securities dealers to make markets in notes and bonds, and the dealers in turn rely on their ability to issue short-term debt to finance their holdings.
Money-market mutual funds are the biggest source of this type of finance, which economists call short-term wholesale funding. Money funds finance about 40 percent of the $480 billion financial-sector commercial paper market and about one-third of the $1.8 trillion tri-party repo market, in which financial firms borrow against their inventories of securities.
But we discovered in 2007 and 2008 that this type of funding is highly unreliable in a crisis. We saw that, when there is stress, money funds and other providers of short-term wholesale funds are prone to “run,” or to pull back on financing.
When this happens, credit to the economy suddenly contracts and financial firms must sell assets at fire-sale prices. These sales push them toward bankruptcy and generate mark-to-market losses for other firms holding similar assets. This contagion further amplifies the contraction of credit, which radiates broadly through the economy, causing widespread business failures and job losses.
Runs in the wholesale funding markets, analyzed in the work of economists such as Gary Gorton and Andrew Metrick, both finance professors at the Yale School of Management, and Darrell Duffie, a finance professor at Stanford’s Graduate School of Business, are the contemporary equivalent of the depositor runs that plagued the U.S. banking system 80 years ago. As with old-fashioned depositor runs, wholesale funding runs can have devastating consequences for the real economy.
Making our financial system more robust and less vulnerable to funding runs requires a number of steps, including forcing banks to rely less on cheap, short-term borrowing and strengthening the infrastructure of the markets in which wholesale funding takes place. But money-fund reform has to be part of the mix.
Money funds are particularly prone to run at times of stress because the funds themselves are highly exposed to runs from their own investors. This is due to shortcomings both in design and regulation. They are marketed as offering stable net-asset values. Investors who put a dollar in believe they can always take a dollar out. But this hasn’t always been true, and it won’t necessarily always be true in the future. Money funds take risks, and sometimes these risks turn sour.
When money-fund investors perceive any danger that a fund could “break the buck,” meaning that it doesn’t have enough money left to repay investors in full, they have a tremendous incentive to head for the exit. After all, if they are first in line, they can get out while the fund can still pay out dollar-for-dollar, leaving other investors to suffer all the losses. Large sophisticated investors tend to run first, leaving small investors behind.
It is true that fund sponsors have in the past often stepped up to cover such losses. The frequency with which this has been necessary is hardly reassuring. Most important, sponsor support may not always be available on a sufficient scale in a financial crisis.
Consider the experience of 2008. When Lehman Brothers Holdings Inc. went bankrupt, many money funds suffered significant losses. Sponsors supported all but one fund, and that single money fund -- the Reserve Primary Fund -- broke the buck. This triggered a stampede of withdrawals across the sector that threatened severe consequences for the economy and for millions of investors. The stampede was halted only when the U.S. Treasury stepped in to guarantee the value of the money funds, at taxpayer risk, and the Federal Reserve put in place additional emergency programs to backstop credit markets.
Congress has prevented Treasury from putting a money fund guarantee of that sort in place again. The 2010 Dodd Frank financial-reform law also narrowed the scope for future Fed interventions. This makes it even more essential to fix the underlying problem.
Contrary to what some in the industry suggest, run risk didn’t end when the SEC sensibly tightened rules on money-fund holdings in 2010. Analysis by the U.S. Treasury’s Office of Financial Research showed that, as of April this year, no fewer than 105 money-market funds with more than $1 trillion in assets were at risk of breaking the buck if any one of their top 20 borrowers were to default.
The SEC’s Schapiro would address run risk by requiring money funds to move to floating net-asset values (like most other mutual funds) or to adopt capital buffers, possibly along with redemption restrictions.
Floating net-asset values would be a significant improvement over stable net-asset values. It would reduce the incentive for shareholders to get out early in times of stress. But it wouldn’t eliminate the incentive to run altogether. Fund managers faced with large redemption requests typically sell their most liquid assets first, leaving the remaining investors with a riskier, less-liquid portfolio and a greater risk of loss.
As explained in a recent paper by Federal Reserve economists, combining small capital buffers with a requirement that investors who withdraw funds must maintain a small balance for a short period to absorb near-term losses would make the system safer by creating a disincentive to run. The modest withdrawal restrictions, which create a “minimum balance at risk,” might be set at 5 cents on the dollar, based on the high-water mark of recent holdings.
Crucially, the minimum balance retained by those who had pulled money out would be put in the first-loss position for about 30 days. This would protect those who remain in the fund from losses caused by others’ redemptions. Exemptions for small investors, who are least likely to run, could be considered. For instance, the first $50,000 of an investor’s redemptions could be exempt from first loss. Small investors would share proportionately in any fund losses instead.
A minimum balance would increase market discipline. Corporations and other sophisticated investors would have an incentive to monitor risk taking more carefully, rather than rely on their ability to get out first when trouble materializes.
Even with such reforms, investors would have instant access to 95 percent of their money at a fixed-asset value. They would be able to get the remaining 5 percent 30 days later. This seems to be a small price to pay for greater financial stability.
I seriously doubt that the reforms I propose would lead to the demise or even the radical restructuring of the money-market-fund industry. The funds would still offer a very high level of liquidity and convenience, but without implicit public subsidies or features that put the U.S. economy at risk.
(William C. Dudley is president of the Federal Reserve Bank of New York. The opinions expressed are his own.)
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