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ANGEL: Walk, don’t run, toward money-market fund reform
Some tinkering creates more problems than fixes
Several regulators have called recently for drastic changes in the money-market mutual-fund industry. Proposed “reforms” include abolishing the industry by getting rid of the stable $1 net asset value that is the essence of the product and requiring costly “capital buffers” that would tax investors far beyond any realistic estimates of risk. Their expressed motivation is to prevent destabilizing “runs” in money-market funds that could exacerbate the next financial crisis.
In 2008, regulators were spooked by the difficulty large corporations faced in issuing commercial paper during the week when Lehman Brothers and AIG failed. One money-market fund holding Lehman paper had broken the buck, meaning its investment income didn’t cover operating expenses or investment losses, and there was fear that redemptions would force funds to sell assets into disorderly markets.
Unfortunately, the proponents of such proposals fundamentally misunderstand the cause of the systemic risk they are seeking to prevent. When there is a crisis in financial markets, there is a flight to quality. This is inevitable in times of uncertainty. In such times, prudent investors rationally will shun all but the safest short-term investments and seek to park their funds in the safest possible places until the uncertainty is resolved.
During a week when once seemingly invulnerable institutions such as AIG and Lehman Brothers suddenly failed, one cannot blame anyone for seeking the safest haven possible. If a Lehman or AIG can fail, so can anyone. In such a crisis, commercial paper issuers will have trouble issuing commercial paper. Banks overreliant on repurchase financing will have trouble rolling over their repurchases. This is inevitable during a crisis.
The crisis in 2008 did not begin in the money-market funds. It is more accurate to say money-market funds were hit by the crisis. An isolated mistake at a single money-market fund will not set off a panicky run. When a small money-market fund in 1994 broke the buck, it did not set off a wave of redemptions that toppled the economy.
Even if money-market funds as we know them did not exist (the likely effect of the proposals) the short-term funding markets still would be under extreme pressure in a future crisis. The proper policy response is not to abolish money-market funds but to find ways of stabilizing the entire short-term funding markets when the next crisis hits. The Federal Reserve still has ample powers to do this. Banks overreliant on repurchasing can borrow directly from the Fed. The Fed also can purchase or lend against high-quality, short-term assets such as commercial paper at no cost to the taxpayer.
Regulators also need to distinguish between a destabilizing run and an orderly walk. In a run, a wave of redemptions could force a money-market fund to sell assets into a disorderly market, further destabilizing the markets. For this reason, the Securities and Exchange Commission passed reforms in 2010 that require money-market funds to have 10 percent of their assets mature daily and 30 percent within a week. This drastically reduces the chance that there will be a forced liquidation of assets. When the next crisis hits the financial markets, money-market fund investors will have the option to walk safely to their perceived havens without destabilizing the markets. Indeed, such orderly walking has been evident as concerns over the European debt crisis have mounted.
These proposed “reforms” are not about consumer protection. The worst thing that happened to money-market fund investors in 2008, amid all the financial carnage, was that investors in one fund received just 99 cents on the dollar. In other words, they lost just a few months of interest on their funds. As a result of the 2010 reforms, money-market funds are safer than ever, and the risk of a disorderly run has been reduced to that of an orderly walk.
The proposed reforms will not reduce systemic risk. If the industry is eliminated or vastly shrunk, some of the assets will flow into banks, making too-big-to-fail institutions larger and thus systemically riskier. Large investors such as corporate cash managers, not covered by the limited Federal Deposit Insurance Corp. insurance, will run from those banks even faster than they would from money-market funds. Other assets will flow into riskier alternatives or even offshore, increasing risks to consumers and the financial system.
Our underresourced regulators are overburdened already with hundreds of Dodd-Frank Act-required rule-makings. In some cases, they are missing the legal deadlines by more than a year. Mangling money-market mutual funds is not one of the required rule-makings. Our regulators don’t have the bandwidth to do a proper job with their required rule-makings and address money-market funds at the same time. Now is not the time to experiment with destroying a vital part of the economy in the theoretical but incorrect hope of preventing a run when the next 100-year flood hits the markets.
James J. Angel is an associate professor of finance at the McDonough School of Business at Georgetown University.
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