A senior Federal Reserve Board official would require money market funds to have a meaningful capital-like buffer that exceeds their single-issuer concentration exposure limit, perhaps on the order of 2 to 3 percent, that, if violated, would automatically lead to a fund’s conversion to a floating net asset value. Boston Fed President Eric Rosengren said that examples of how to structure such a buffer include having the sponsor of the money market fund directly fund the creation of the buffer, or creating a separate class of loss-absorbing shares that could be marketed to investors willing to bear some risk in exchange for a higher return than that provided by the stable value shares. If in some appropriate period of time a satisfactory plan for such a capital buffer is not produced and accepted, then those prime funds would be required to float their net asset value.
In remarks at a seminar on the capital markets in Stockholm, the Fed official said that, given the systemic importance of the money market fund industry, it is critical that one way or another regulators make the industry less susceptible to credit shocks and liquidity runs. While many in the industry have been reducing their exposure to troubled financial institutions, some continue to take what some observers might consider outsized credit risks. The experience of 2008 showed the potential for a money market fund's problems to precipitate redemptions that are ultimately destabilizing to short-term credit markets, and contribute to economic difficulties.
Like other mutual funds of which they are a subset, money market funds are not required to hold any capital as protection against adverse movements in the value of the assets they hold. This absence of capital, noted the Fed senior officer, together with the stable net asset value, results in a structure that despite its appeal in other ways is prone to shareholder “runs” during times of financial stresses.
The Boston Fed President urges a more pro-active regulatory approach with regard to money market funds. Currently, money market funds are required to provide a monthly report of holdings and, while monthly reporting has been helpful, noted the Fed official, given the very short maturity of many of the assets the reporting should be more frequent to avoid the possibility of “window dressing” at the end of the month. Also, reducing a fund’s maximum permissible exposure to any one firm could reduce the potential loss that would occur from a credit event involving only one counterparty. Consideration might also be given to whether the assets of riskier firms (for example those with very high market credit default swaps prices are appropriate investments for money market funds, which are expected to maintain a low risk profile.
Money market funds have purchased a large amount of foreign-bank securities, he observed, but most funds have been reducing their exposure to European banks posing more significant credit risks. Some of the reductions have been quite dramatic, and money funds are no longer holding short-term credit instruments issued by institutions headquartered in the most financially strained countries. They have greatly reduced the size of their overall exposure, and have also significantly reduced the maturity they are willing to hold. But the Fed official cautioned, just as in the fall of 2008, a very few aggressive money market funds could encounter trouble that ends up ratcheting up redemption requests across the industry.
Money market funds have also substantially increased their liquidity over the last year, noted the Fed official. In part this reflects a tightening of liquidity requirements by the SEC, but it also reflects the realization among fund managers that during times of significant liquidity risk, they need to maintain a more defensive posture.