Thursday, July 19, 2012

NY Fed Report Places Minimum Balance at Risk Approach at Center of Money Market Fund Reform

A NY Federal Reserve Bank staff report proposes introducing a minimum balance at risk as part of reforming money market fund regulation in order to make the financial system safer and reduce systemic risk. The proposal would mitigate the vulnerability of money market funds to runs by introducing a minimum balance at risk that that would provide a disincentive to withdraw funds from a troubled money fund by bridging the worlds of capital and redemption restrictions.

The Fed staff envisions that the minimum balance at risk would be a small fraction of each shareholder’s recent balances that would be set aside in the event that they withdrew from the fund. Most regular transactions in the fund would continue as before, said the staff report, but redemptions of the minimum balance at risk would be delayed for thirty days to ensure that redeeming investors remain partially invested in the fund long enough to share in any imminent portfolio losses or costs arising from their redemptions.  Small investors could be exempted from the requirement to maintain a minimum balance as they were less prone to withdraw their money at the first sign of trouble.

Moreover, the NY Fed believes that a minimum balance at risk requirement could strengthen market incentives for early market discipline for money market funds by clarifying that investors cannot quickly redeem all shares from a fund during a crisis.  Investors would have strong incentives to identify potential problems well before any losses are realized. Furthermore, by discouraging investors from redeeming shares in a troubled fund, the minimum balance at risk would help the fund avoid the need for fire sales of assets to raise cash, thereby reducing contagion risk throughout the system.

Noting that SEC Chair Mary Schapiro has suggested money market fund reforms  requiring either a floating NAV or a capital buffer, the NY Fed staff said that capital buffers have drawbacks. A small buffer on its own would do little to mitigate systemic risks, noted the NY Fed, adding that investors would likely flee from money market funds in any crisis out of fear  losses would exceed the size of the buffer.

The Fed noted that capital might blunt money market fund portfolio managers’ incentives for prudent risk management and investors’ incentives to monitor risks in their funds, since capital could absorb losses associated with small mistakes. Of course, continued the staff report, a very large buffer could diminish these concerns, but raising sufficient capital to absorb the losses that might be associated with systemic events would be challenging, particularly in light of the very low yields that money market funds earn when short‐term rates are low.

Conceptually, reasoned the NY Fed, the minimum balance at risk straddles the two primary approaches to shoring up a stable‐NAV money market fund: capital and redemption restrictions. By identifying a minimum portion of each investor’s balance that would be at risk for absorbing losses,  the minimum balance at risk essentially serves a function similar to capital. As a form of redemption restriction, it avoids the conditionality problem that limits the usefulness of most such restrictions for reducing systemic risk. That is, a minimum balance at risk rule would always be in place, so investors would not be able to redeem preemptively to avoid the restriction. Yet, the minimum balance at risk would have no effect on most transactions in a fund, particularly during normal times. Only when a money market fund appears to be at risk of losses would the minimum balance at risk materially affect investors’ incentives to redeem shares.