Regulation of money market funds is an area receiving a lot of attention in current discussions over financial restructuring.
These products are regulated by the Securities and Exchange Commission under the Investment Company Act of 1940. Under SEC Rule 2a-7, they are required to invest only in short-term, investment-quality debt instruments.
Money funds have been offered to investors since 1970. As of April 1, there were 784 such funds in the United States with about $3.9 trillion in assets. About a third of money market fund shares are owned by retail investors directly; institutional investors own the balance. Money funds hold about a quarter of all taxable money market debt instruments nationally.
In the history of money market funds, only two have ever "broken the buck," or failed to maintain a net asset value of $1 a share — the U.S. Government Securities Money Market Fund in September 1994 and the Reserve Primary Fund in September of last year. Investors in the 1994 fund liquidation received back 96% of their investments.
Proposals for more regulation of money market funds have come from several sources. Both the Federal Reserve Board and the Treasury Department have stressed the importance of measured enhancements to regulation while recognizing the role the funds play.
Last month Fed Chairman Ben Bernanke said such funds are critically important both in providing secured short-term financing to bond dealers in the government securities repurchase agreement market, and in serving as an investor in commercial paper. To address a "potential fragility," Bernanke suggested "tighter restrictions on the instruments in which money market funds can invest, potentially requiring shorter maturities and increased liquidity." A "second approach" would be a limited system of insurance for such funds.
Treasury Secretary Timothy Geithner, recognizing the funds are subject to strict SEC regulation, called them "one of the most stable and least risky investment vehicles." Nevertheless, acknowledging the liquidity stress put on money funds in the fall, he urged the SEC to further strengthen regulation to reduce the credit and liquidity risk profile and to make them less susceptible to runs.
SEC Chairman Mary Schapiro testified that her agency plans to "strengthen the regulation of money market funds by considering ways to improve the credit quality, maturity and liquidity standards applicable to these funds," with a focus on mitigating the risk of "breaking the buck."
The Investment Company Institute, the fund industry's trade association, published a paper recommending ways to refine Rule 2a-7 to reduce the risks associated with these funds. The ICI would impose stronger liquidity requirements, mandate stress-testing, shorten maximum weighted average portfolio maturities, strengthen credit review requirements, enhance risk disclosures and provide a better liquidation protocol.
The SEC and ICI approaches would strengthen the money fund industry while preserving the utility and desirability of these funds. But a very bad idea has been presented by the Group of 30, a private organization of academics, industry executives and retired central bank officials from around the world.
In January it issued a report that suggested money market funds be forced either to give up their stable net asset value and transactional and withdrawal features — in essence, to become fluctuating-value short-term bond funds — or to become special-purpose banks, subject to regulation and supervision by banking regulators, with capital and reserve requirements and access to loans from the central bank. This proposal would bring about the end of money market funds as we know them.
The current leaders of the Fed, the Treasury and the SEC have been cool to this proposal, and with good reason — it would needlessly deprive investors, the credit markets and the banking system of an extremely useful and minimally risky product.
Proposals for radical change to the current system of regulating such funds — including banklike reserve requirements, a shadow class of additional equity reserves withheld from current earnings to "smooth" future returns in down periods and a permanent program of federal insurance — go well beyond what is called for.
Money market funds have been the cash management vehicle of choice for individuals and large and small businesses alike for years. Many have chosen the funds because they are seen as more convenient and a better investment than other options.
Moving the funds into the regulated banking system would present major problems. Bank balance sheets, already under severe capital pressure, do not have the capacity to take on an additional $3.9 trillion of deposits, inflating their liabilities by about 25%. With a 6% leverage ratio requirement, banks would need nearly $200 billion more of equity capital to take over all of the balances held in money funds. Raising capital to accommodate such an inflow of deposits would be virtually impossible.
In addition, removing these products as providers of funding in the credit markets would deprive both business and governmental borrowers of an extremely important source of short-term credit and an important source of liquidity in the repo market.
Money funds have become a ready source of short-term credit to major borrowers. If these funds were removed as a source of credit and liquidity, the shock to our financial system and our economy would be grave. This is not the time for such a draconian change.
Forcing money funds into the banking system would be anomalous for another reason. The track record of these funds in avoiding financial calamities is extraordinary; the track record of banks in avoiding failure is not. In 39 years only two money market funds have lost money for investors, and no taxpayer bailouts were involved. In the same period 3,123 federally insured banks and savings institutions failed.
Banks as a whole, despite FDIC insurance, are not safer than money market funds — they are far riskier. The SEC has provided much more protection for money market fund shareholders than banking regulation has provided for bank depositors and shareholders.
Last fall's experience and the ongoing financial crisis certainly give credence to the view that some attention needs to be paid to money market funds. Refining SEC rules to build on the lessons of this experience and pursuing ICI's suggestions would be well worthwhile. A "death sentence" is fundamentally a bad idea.