Why Paul Volcker Is Wrong About Money Market Funds

For more than 40 years, since the time he served as Chairman of the Board of Governors of the Federal Reserve System, Paul A. Volcker has made no secret of his view that money market funds should be forced back into the banking system, from whence they came. 

In his recent William Taylor Memorial Lecture to the Group of 30 he elaborated on his views. The essence of the Volcker attack is that MMFs are creatures of "regulatory arbitrage" that have cannibalized demand deposits from the banking system, that exist "truly hidden in the shadow of banking markets," and that "are demonstrably vulnerable in troubled times to disturbing runs."  He argues that if MMFs wish to continue to provide a service that "mimics commercial bank demand deposits," they should be subject to the same kind of regulation as banks, including "strong capital requirements, official insurance protection, and stronger official surveillance of investment practices."  This is necessary, he argues, to avoid the need for the government to "resort to highly unorthodox emergency funds to maintain the functioning of markets."  Alternatively, he believes MMFs "should be treated as ordinary mutual funds, with redemption value reflecting day by day market price fluctuations."

These comments present such a distorted picture of MMFs that they call out for a response.

While Chairman Volcker’s characterization of the exodus of demand deposits from banks as "regulatory arbitrage" seems intended as a disparagement of those who have foregone banks to obtain higher yields and greater convenience from MMFs, it should be remembered that the term "arbitrage" carries no moral implications. It is simply descriptive of conduct that occurs when price differences exist in different markets for identical or similar instruments, and is no more than a mechanism for insuring that prices do not deviate substantially from fair values, and that markets operate efficiently. 

Volcker’s somewhat evocative characterization that MMFs are "truly hidden in the shadow of banking markets" conjures up an image of fly-by-night firms operating surreptitiously in the darkness of back alleys.  But with 30 million investors and $2.6 trillion in assets, MMFs are hardly unseen, hidden or surreptitious.  Not only are they subject to significant control, examination and oversight by the Securities and Exchange Commission, with detailed prospectus requirements for the issuance of their shares, demanding reporting requirements, regular surveillance, and substantial requirements as to liquidity, asset quality and maturities, but they must publicly and frequently disclose the contents of their portfolios, on their websites and in regulatory filings – down to the individual security level.  And, of course, they must satisfy the standards and evaluations of the rating agencies, which in some respects are even more demanding. To suggest that MMFs exist in a hidden "shadow" world simply distorts reality. 

His comment that MMFs "are demonstrably vulnerable in troubled times to disturbing runs" is equally exaggerated, suggesting as it does a significant history of runs or an appreciable threat of future runs.  The fact is, of course, that there was a run on MMFs in September of 2008, primarily from institutional investors, after the Reserve Primary Fund broke the buck following the write-off of its unfortunate investment in Lehman Brothers debt.  But nothing remotely comparable had occurred in the money fund industry in the 38 years since then-Chairman Volcker, in an heroic fight against inflation, gave life to MMFs by driving market interest rates into the high teens. 

Moreover, the events of 2008 took place not merely in troubled times, but 20 months into a financial crisis of exceptional magnitude and in the context of truly extraordinary financial disasters involving failures or forced sales of some of the country’s largest financial institutions. The run that occurred – largely reflecting the uncertainty of institutional investors as to whether redemptions would be suspended or their funds would otherwise be inaccessible – has to be viewed in the context of that extreme turmoil.