WASHINGTON — Securities and Exchange Commission Chairman Mary Schapiro may have lost the first round in her push to reform the $2.6 trillion money market mutual fund industry, but the fight has only just begun.
Although Schapiro was forced last week to abandon a planned SEC vote on her reform proposals, she continues to enjoy support from other federal regulators that may now act in her stead.
"We believe the door remains open to reforms that could put the money market mutual fund business model at risk," Jaret Seiberg, a senior policy analyst at Guggenheim Partners wrote in a recent analyst note.
Regulators remain concerned that money market mutual funds are vulnerable to runs, as seen during the financial crisis four years ago. In her statement announcing the SEC's delay on addressing the issue, Schapiro hinted that other agencies, including the Federal Reserve Board and Financial Stability Oversight Council, may now step in.
"Money market funds' susceptibility to runs needs to be addressed," Schapiro said. "Other policymakers now have clarity that the SEC will not act to issue a money market fund reform proposal and can take this into account in deciding what steps should be taken to address this issue."
Fed Gov. Daniel Tarullo has said the central bank could tighten rules on banks' borrowing from money market funds while Eric Rosengren, the president of the Federal Reserve Bank of Boston, has suggested officials could also require bank holding companies to hold capital to reflect the risk of supporting MMFs' par value.
Analysts suspect that the Fed may act on its own in a more limited way, using its authority under Dodd-Frank to impose capital standards for MMF-sponsorship activities as well as institute prudential requirements on bank holding companies.
"It's been reluctant to do on a stand-alone basis due to the adverse competitive impact bank holding companies fear," said Karen Shaw Petrou, a managing partner at Federal Financial Analytics Inc. "Now, however, it may advance specific proposals in this area to protect itself."
One intriguing possibility is that the Fed and Treasury Department could work together through FSOC to designate money market funds as systemically risky, a move that would essentially allow the central bank to seize oversight of such funds from the SEC.
But some observers said it would be risky for FSOC to designate an entire industry, rather than just particular firms.
"Dodd-Frank authorizes the FSOC to designate companies, and not industries," said Brian Gardner, a research analyst with Keefe, Bruyette & Woods Inc. "If the FSOC were to designate some of the larger MMF sponsors, then the FSOC would essentially create a two-tier regulatory system in which some funds would be subject to Fed supervision and some would not. We think this makes no sense and that the FSOC will move very slowly, if at all, because of this conundrum."
Any designation would also be vigorously opposed by the industry itself.
"MMFs will use every legal and political remedy at their disposal to fight designation and craft the FRB rules, surely using Congress to the greatest extent possible should the matters come to a head next year," said Petrou.
A source familiar with the matter said FSOC would carefully weigh through any possible action and ensure it had the authority to take it.
"Each step is taken carefully with thought to that," the source said. "The clear path to reform was the SEC, and it was expected that they'd move forward this week. Now that they are not, things change."
One thing is for sure: regulators are unlikely to let the issue go.
"This is an issue that will not go away and we think that investors should expect headlines about what alternative approaches may be floated now that the SEC proposal is off the table for the foreseeable future," said Brian Gardner, a research analyst with Keefe, Bruyette & Woods Inc. wrote in a recent note to clients.
Linus Wilson, an associate professor at the University of Louisiana Lafayette who obtained details on the crisis-era money market backstop through a Freedom of Information Act Request, agreed the issue will not recede. Despite a declaration of victory by the industry, he said regulators remain worried about the combination of a stable asset value and the funds' desire to maximize yield.
"There's ample evidence that money funds have been rewarded for increasing their risk levels post-crisis, that the ones that have sought higher yields have seen inflows of funds," Wilson says. "That seems to me classic moral hazard."
Schapiro called off her efforts to present a draft proposal to the SEC after losing a swing vote by Luis Aguilar, a Democrat and former mutual fund executive, who told media outlets he would not support the plan. His defection came a week before a highly-anticipated vote on the subject.
Aguilar said he felt that Schapiro's plan had too many unintended consequences and would wind up forcing investors into other unregulated markets.
In recent months, Schapiro has defended her calls to revamp the money mutual funds industry, arguing it remains a risk to the financial system. Both Fed and Treasury officials have joined Schapiro in calling for additional changes, despite safeguards that were introduced in 2010.
Those reforms were considered stop-gap measures until broader alterations could be made.
Late last month, Treasury Secretary Tim Geithner told the Senate Banking Committee the proposal by the SEC should be released to the public for comment as soon as possible, warning that such funds remain vulnerable to potential runs in the event of another financial crisis.
"My own judgment is that the SEC needs to go further, they can go further and that we should get on with the business of letting them expose to the world and to the markets a set of options that the world can comment on and help refine," said Geithner. "I think it's important that the SEC propose a range of options for how to go forward in this so that the market can assess those and comment on them and the SEC and others can reflect on what that means for trying to get this balanced right."
The SEC chairman has recommended two alternative reforms to address remaining structural vulnerabilities. For one, funds could be required to float their net asset values, an idea opposed by many in the mutual fund industry. Alternatively, funds could be required to hold a capital buffer in order to absorb losses, along with placing restrictions on how much investors can redeem shares at one time.
"There really is no mechanism to absorb sudden loss in the value of a portfolio security of a money market fund without threatening that stable one dollar net asset value," said Schapiro at last month's FSOC meeting. "And secondly, investors remain incentivized to redeem their money market fund holding at the very first sign of a problem."
A potential middle ground would be for Schapiro to repackage her proposal as an advance notice of proposed rulemaking and to broaden it to look at money market mutual funds and other cash investment options, analysts said.
"This could put pressure on Aguilar to support something more modest," said Seiberg. "At the same time, we believe Schapiro and the administration would prefer that the SEC ultimately decide MMF regulation."
The industry could also take the opportunity to come up with its own proposal, which could include "charging a fee to investors who want to immediately pull their cash," Seiberg said.