Friday, October 22, 2010

President’s Working Group Proposed Reform of Money Market Fund Regulation Would Require SEC Rulemaking and Legislation

A report by the President’s Working Group on Financial Markets detailing reforms for money market funds will be considered by the Financial Stability Oversight Council, with the assistance of the SEC. The Commission, which would lay an integral role in implementing the reforms, will soon solicit public comment on the proposed reforms. Some of the proposed reforms could be adopted by the SEC under its existing authorities, while others would require legislation. The reform options address the vulnerabilities of money market funds that contributed to the financial crisis in 2008. Following the crisis, the Treasury Department directed the PWG to report on options for mitigating the systemic risk associated with money market funds and reducing their susceptibility to runs.

Several key events during the financial crisis underscored the vulnerability of the financial system to systemic risk. One such event was the September 2008 run on money market funds, which began after the failure of Lehman Brothers Holdings, Inc. caused significant capital losses at a large money market fund. Amid broad concerns about the safety of money market funds and other financial institutions, investors rapidly redeemed fund shares, and the cash needs of the funds exacerbated strains in short-term funding markets. These strains, in turn, threatened the broader economy, as firms and institutions dependent upon those markets for short-term financing found credit increasingly difficult to obtain. Thus, reducing the susceptibility of money market funds to runs and mitigating the effects of possible runs are important components of the overall policy goals of decreasing and containing systemic risks.

One reform proposed by the PWG would be to move from the current stable NAV, which has been a key element of the appeal of money funds investors but has also heightened their vulnerability to runs, to a floating NAV. The Working Group conceded that the elimination of the stable NAV for money market funds would be a dramatic change for a nearly $3 trillion asset-management sector that has been built around the stable share price. Such a change may have several unintended consequences, including the reductions in money funds’ capacity to provide short-term credit due to lower investor demand.

Another proposed reform is to provide emergency liquidity facilities for money market funds since their liquidity risk contributes to their vulnerability to runs. The PWG believes that an external liquidity backstop augmenting the SEC’s new liquidity requirements for money market funds would help mitigate this risk by buttressing their ability to withstand outflows, internalizing much of the liquidity protection costs for the industry, offering efficiency gains from risk pooling, and reducing contagion effects. A liquidity facility would also preserve fund advisers’ incentives for not taking excessive risks because it would not protect funds from capital losses.

When investors make large redemptions they may impose liquidity costs on other shareholders in the fund by forcing the fund to sell assets in an untimely manner. The PWG would require money market funds to distribute large redemptions in kind, rather than in cash, thereby forcing these redeeming shareholders to bear their own liquidity costs and thus reducing the incentive to redeem. But the PWG acknowledged that mandating redemptions in kind could present policy challenges to the SEC, which would have to make key judgments regarding when a fund must redeem in kind and how funds would fairly distribute portfolio securities. Funds should not, for example, be able to distribute only their most liquid assets to redeeming shareholders, since doing so would undermine the purpose of an in-kind redemptions requirement.

More broadly, the PWG proposed a two-tier system of money market funds with enhanced protection for stable NAV funds. The susceptibility of money market funds may be effectively reduced if investors are permitted to select the types of funds that best balance their appetite for risk and their preference for yield. Policymakers could allow two types of money market funds, said the PWG, stable NAV funds, which would be subject to enhanced regulatory protections, and floating NAV funds, which would have to comply with certain, but not all, Rule 2a-7 restrictions and which would presumably offer higher yields.

Because this two-tier system would permit stable NAV funds to continue to be available, reasoned the PWG, it would reduce the likelihood of a substantial decline in demand for money market funds and large-scale shifts of assets toward unregulated vehicles. At the same time, the forms of protection encompassed by such a system would mitigate the risks associated with stable NAV funds. It would also avoid problems that might be encountered in transitioning the entire MMF industry to a floating NAV. Moreover, during a crisis, a two-tier system might prevent large shifts of assets out of money market funds, and a reduction in credit supplied by the funds, if investors simply shift assets from riskier floating NAV funds toward safer stable NAV funds.

Another approach to the two-tier system would distinguish funds by investor type: Stable NAV money market funds could be made available only to retail investors, who could choose between stable NAV and floating NAV funds. This approach would require the SEC to define who would qualify as retail and institutional investors.

Finally, another policy option laid on the table by the PWG would be to regulate stable NAV money market funds as special purpose banks based on the many functional similarities between money market fund shares and bank deposits. While the conceptual basis for this option is fairly straightforward, noted the PWG, its implementation might take a broad range of forms and would probably require legislation together with interagency coordination.

One important hurdle for successful conversion of a money market fund to a special purpose bank may be the very large amounts of equity necessary to capitalize the new banks. In addition, to the extent that deposits in the new special purpose banks would be insured, the potential government liabilities through deposit insurance would be increased substantially, and the development of an appropriate pricing scheme for such insurance would be challenging.