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.
Of course, no one can predict with certainty that financial Armageddon will not visit us once again, despite the best efforts of the Dodd-Frank legislation and the new Financial Stability Oversight Council – just as it is possible that two disastrous 100-year hurricanes might occur within a few years of one another. But some reasonable perspective is required. Does it make sense to reengineer an entire industry – potentially destroying the utility of what has been an extremely safe, useful and efficient financial tool, and imposing significant costs, disruption and inconvenience on millions of investors – because of speculation about the remote possibility that such circumstances might recur?
Moreover, the SEC’s post-2008 amendments to its Regulation 2a-7 governing MMFs, which significantly increased liquidity and disclosure requirements, have shown that the threat of runs can be significantly ameliorated with measures far short of a complete overhaul of the industry. It is instructive that MMFs were able under the new rules to meet significant demands for redemptions during 2011 in the face of the Greek debt crisis and the downgrade of the United States’ credit rating. And with new robust disclosure requirements and significantly enhanced oversight and surveillance by the SEC, the regulatory environment for MMFs is materially different from what it was in 2008.
A similar exaggeration inheres in Volcker’s contention that MMFs should be subject to bank-like regulation, in order to avoid the need for government to "resort to highly unorthodox emergency funds to maintain the functioning of markets." Unlike the banking system, which he holds out as the desideratum and which has been the recipient of literally trillions of dollars of government support, not a single penny of public money has been spent on MMFs.
To be sure, during the liquidity crunch of 2008 the Treasury Department created a voluntary fee-based insurance program for MMFs and the Federal Reserve made nonrecourse credit available to member banks to purchase high-quality assets from money funds, which were used to collateralize the advances. Fed advances, made through 11 banking organizations to 105 MMFs, peaked at about $150 billion in the first ten days of the program and tapered off and became sporadic very rapidly after that – and all of the advances were repaid in full. The insurance offered by Treasury was never drawn upon. Both programs in fact generated substantial profits for the government.
While Volcker is obviously unhappy about these programs, one should put them in perspective as well.
The $150 billion in peak period Fed advances to fund the purchase of virtually riskless MMF assets (advances that substantially ran off in a very short period of time) was quite modest compared to the $700 billion in TARP funds pushed out to banks, the $1.2 trillion in Fed advances to banks outstanding in December 2008, or, as Bloomberg News has recently calculated, the $7.7 trillion shoveled out by the Fed as of March 2009 to support the banking system – support that earned some $13 billion for recipient banks. All told, the government pumped more than $30 trillion in liquidity into the markets during the crisis, of which the MMF program was a miniscule percentage.
As for the MMF programs being "highly unorthodox," one might recall that in the face of the Penn Central bankruptcy in mid-1970, at a time when it became clear that the government would not guarantee Penn Central’s debt and there was a concern that even “blue chip” issuers of commercial paper might have difficulty rolling over their outstanding debt, the Fed told member banks that it would provide them, at the normal discount rate, with the reserves necessary to provide credit to their customers to pay off maturing debt. Some $500 million flowed out through the discount window in response to provide liquidity in the commercial paper markets.
With Penn Central, as with the MMFs – however infrequent such events might be – the Fed was doing no more than using its statutory authority to provide liquidity in unusual and exigent circumstances.
Volcker’s insistence that the price of continued existence for MMFs should be their regulation as banks, subject to bank-like capital, reserve and insurance requirements, ignores the stark realities of such a far-reaching conversion of the industry, and does not take into account the costs that would be involved in transmuting $2.6 trillion in MMF investments into bank deposits. Over $100 billion in new leverage-ratio capital alone would be required to support such an enormous volume of new deposits – a practical impossibility at a time when banks are facing diminished loan demand and significant capital demands – not to mention the vast additional costs of paying a return on such funds, of risk-based capital requirements, deposit insurance, reserves and the panoply of bank compliance requirements.
Furthermore, it does not take into account the hazards of making existing banking behemoths even larger, and therefore more systemically important. Today the 10 largest U.S. banks account for 65% of banking assets. If as little as two-thirds of MMF investments moved into the banking system and 75% of that flowed to the 10 largest banks, the concentration in those banks would increase by $1.3 trillion to 74% of total deposits.
Nor does it consider the pressures that would be created for riskier lending by banks seeking to earn returns on the vast and costly volume of new deposits, or the truly monumental additional exposure to the FDIC insurance fund. Based on the current ratio of insured deposits to total domestic deposits (approximately 65%, excluding non-interest bearing deposits temporarily insured until the end of 2012 under Dodd-Frank), an inflow of $2.6 trillion to the banking system would add about $1.7 trillion in new “permanently” insured deposits, against which the FDIC would be required to hold additional reserves (at the statutory designated reserve ratio of 1.35%) of about $23 billion (or $52 billion to meet the FDIC’s internally targeted reserve ratio of 2%). As of Sept. 30, the deposit insurance fund, only recently having emerged from seven successive quarters of deficit, stood at $7.8 billion. Simply to meet the Dodd-Frank 1.35% minimum reserve target for the current amount of permanently insured deposits by the statutory deadline of Sept. 30, 2020, the fund would need an additional $68 billion.
Even more important, the view that MMFs should be folded back into the banking system ignores the impact of such a transmutation on issuers of commercial paper, for whom MMFs have been an extremely important supplier of credit – a market in which banks have not been a significant player.
Finally, Volcker argues that if nothing else is done and MMFs continue business as they have been doing, they should be treated "as ordinary mutual funds," with redemptions at a net asset value that reflects "day by day market price fluctuations." His assumption reflects the folklore that a floating NAV would deter or dampen "runs." But that folklore ignores the fact that 30 million investors have put their liquid funds in MMFs precisely because of funds’ long history of dollar-in-dollar-out treatment. Systems established for the management of millions of brokerage, trust and other accounts, as well as innumerable cash management programs, have been constructed and calibrated on the assumption of a stable NAV, and both investors and money managers have recognized that, notwithstanding the Reserve Primary Fund experience, MMF credit risk is not a significant concern. Even in that watershed case investors lost less than one cent per share following the Lehman write-off.
Investors also appreciate, I believe, that while short-term interest rate fluctuations might potentially affect the value of their shares, funds have been very successfully managed to minimize the impact of these fluctuations. What attracts investors to MMFs, in addition to their record of being far safer than uninsured bank deposits, is the convenience and predictability of the stable NAV for liquidity and cash management uses. Those who believe the myth that a floating NAV would do away with runs should ponder what the average fund shareholder would be likely to do either when such a change was announced, when their fund first broke the buck with a downward adjustment, or when a downward adjustment might be anticipated. Indeed, the experience of 2008 itself demonstrates that it was the mere anticipation of a breaking of the buck that caused institutional investors to flee.
Quite apart from the misguided notion that a floating NAV would dampen runs, it would clearly do nothing to ameliorate the kind of liquidity crunch that occurred in 2008. If at some future time, in an environment of financial Armageddon, a money fund were to experience a credit-based default comparable to that experienced by the Reserve Primary Fund, even shareholders in variable NAV funds might be inclined to scramble to higher ground unless there were adequate assurances of fund liquidity. Indeed, a recent study by HSBC Global Asset Management found no evidence to support the argument that constant NAV funds are more susceptible to run risk that variable NAV funds.
This simply underscores the conclusion that those who busy themselves with inventing new ways to reengineer the industry would do better to focus on means for assuring the availability of abundant liquidity in times of extreme stress.
John D. Hawke, Jr., a partner in Arnold & Porter LLP in Washington, formerly served as Under Secretary of the Treasury for Domestic Finance, Comptroller of the Currency and General Counsel to the Federal Reserve Board. He represents Federated Investors, Inc., a sponsor of money market mutual funds. This article is adapted from a paper prepared for Federated.