Changes under way in the $2.7 trillion money market fund industry are expected to further tighten yields that have already squeezed banks' funding and investment returns for years.
Fidelity Investments, one of the largest managers in the industry, is moving ahead of a 2016 compliance deadline by reallocating asset purchases for three funds including its largest, Fidelity Cash Reserves, with $115 billion in assets into government securities.
The conversions, which other managers such as Federated Investors may soon follow, will increase their purchases of Treasury bills and agency mortgage securities. Those securities yield less than the nongovernment notes that prime money market funds traditionally purchased, lowering returns for banks and other fund investors.
The reallocations also mean those funds will step away from buying unsecured bank notes, which are a source of short-term funding for banks.
Federated's chief investment officer, Deborah Cunningham, sought to reassure banks that its products could be tailored to address their needs and risk profiles.
"Our intention is to have buckets to catch all raindrops coming out of this," she said in a phone interview.
Cunningham is reaching out to the 4,000 banking institutions that have relationships with Federated. The firm is the most "entrenched" mutual fund engaged with the banking sector, she said.
Securities regulators last year adopted reforms to the money fund industry that they said would promote economic stability in times of stress. Banking overseers are at the same time poking at banks' reliance on wholesale short-term funding, which some argue can be obtained below true economic costs.
The biggest impact of these changes may be to non-U.S. institutions, because those firms lack access to retail-deposit substitutes. Global and foreign banks are among the largest nongovernment issuers in prime money funds, according to data pooled by Harvard Business School professors Samuel Hanson, David Scharfstein and Adi Sunderam.
The largest include Barclays Bank, Deutsche Bank, Mitsubishi UFJ Financial Group andBank of Nova Scotia. Eight firms in the top 50 are large U.S. banks. They have said re-allocation of funds will raise the cost of unsecured funding.
Banks selling commercial paper, repurchase agreements and certificates of deposit face headwinds, as prime money market funds, previously big buyers, may step back in a significant way. Fidelity's three funds hold about $100 billion in bank unsecured paper and other nongovernment securities, which equals 75% of those three funds' total assets.Over the next few months, managers of those funds will let that commercial paper and those CDs term out, according to Barclays rates analyst Joseph Abate.
About 60% of the $1.4 trillion in balances in prime funds industrywide are invested in bank commercial paper and certificates of deposit.
"The wholesale conversion of prime funds into government-only funds would shift between $540 billion and $840 billion worth of unsecured bank debt into government paper and repo. We suspect that this would be massively disruptive pushing government debt and repo rates sharply lower as [the London interbank offered rate] and rates on bank [commercial paper] and CDs surge," Abate told clients in a note.
The same banks will be further constrained as they come to terms with the liquidity coverage ratio and net stable funding ratio in new regulatory requirements, which will make it challenging to issue anything with terms shorter than six months.
Fidelity's president of fixed income, Nancy Prior, described the challenges to banks' short-term wholesale financing as an issue that was a long time coming. "Banks have increased their deposits, they have cash on hand, they have termed out their debt to move away from this kind of funding, mostly because regulators don't like it," she said in a phone interview.
"If you think about the overall money market for domestic [commercial paper] and the universe for prime money market securities, that total market is $2.5 trillion; assets we propose to convert from prime to government funds, that's less than 4% of that overall market size," she said.
Federated's Cunningham likewise said that it is very possible that private funds, which Federated and Fidelity also offer, will replace prime funds as buyers of commercial paper and CDs. "It could be a one-for-one switch," Cunningham said. "We just don't know."
Institutional lenders such as UMB Financial, a $14 billion-asset banking company based in Kansas City, Mo., offer business checking and deposit services that sweep cash into investments, sometimes into money funds. Some small banks take their depositors' money and push it into a sweep account where it earns around 5 to 10 basis points. The small banks argue that this form of funding will diminish because the fee shares they gather from money funds will decline as the funds convert to the lower-yielding, but safer, government-securities portfolios.
The greatest impact on financial institutions may be indirect, in the form of higher market volatility, as is often the case. Government securities will benefit from stronger demand, but yields are expected to bend on supply. Government money funds have added $50 billion over the past two years, but the stock of Treasury bills outstanding has dropped by $200 billion over the same time, and less will be issued this year. Those dynamics have created a gap between supply and demand.
"If budget deficits stabilize in line with the latest [Congressional Budget Office] estimates, rather than rising, Treasury will have less capacity to ramp up bill issuance next year, and may need to take alternate steps to maintain liquidity in the bill market," said Alex Roever, rates head at J.P. Morgan Securities.