What is the weakest link in America’s financial system today? That is not a question many have asked recently. After all, US banks look pretty healthy these days, at least relative to the horrors of eurozone banks. And the unfolding Libor saga has dominated much of the political debate and regulatory attention.
But while the markets are distracted by Libor, an intense fight is bubbling, largely ignored, about one weak link in the system - America’s vast money market funds. And while it may not be producing the same fireworks as Libor, investors should watch this battle, since it could have big implications for the wider financial world.
The issue is whether this $2.6 trillion money market fund sector is vulnerable to 'runs'. Before 2008, few observers ever asked that question, since the funds were considered extremely dull. After all, they are supposed only to invest in 'safe' assets (think highly rated bonds) and they pay low returns. Moreover, it was widely assumed that money market funds would never 'break the buck' (return less than 100 per cent of investors’ cash).
But 2008 shattered that assumption: when Lehman Brothers collapsed, one fund did break the buck. And that sparked a panic. For despite the dull-as-ditchwater reputation, the sector has an Achilles heel: unlike bank accounts, money market funds are not covered by any deposit insurance, and investors can redeem their money at will. That creates a 'cliff' problem, as a recent paper* from the New York Federal Reserve says: if investors fear a fund will break the buck, they have an incentive to run, as fast as they can.
The good news is that the initial crisis of 2008 did not spiral into a truly devastating money market run. That was largely because the US government stepped in to provide a backstop for the system. Since then the Securities Exchange Commission has introduced some small reforms: it has forced money market funds to purchase more short-term liquid assets and to offer better disclosure, in an effort to bolster confidence.
However, the bad news is that the US government is now banned from providing more backstops. And these modest changes have not resolved that "cliff” risk: the same incentives are in place for investors to run in a crisis. As a result, money market fund managers are a very skittish bunch. Last summer, for example, they dumped eurozone assets en masse in a distinctly destabilising way. That stampede could easily be repeated. One US government agency, for example, recently conducted a secretive analysis to assess what would happen if some corporate borrowers defaulted, or the eurozone woes got worse. They found that so many funds would break the buck that the conclusions were considered too alarming to publish.
Is there any solution? The SEC, for its part, is pushing two reform ideas: it wants the funds to hold cash reserves, to absorb losses, and to operate with floating net asset values, to educate investors that these investments cannot be treated like a bank account. Last week’s New York Fed paper proffered another idea: investors should be "gated” in a crisis, or forced to leave a small proportion in the fund to absorb losses; a mere 2-4 per cent could prevent runs, it says. To my mind, such ideas look very sensible; if implemented in co-ordination, they could probably reduce the systemic risks. But the SEC is now facing intense pressure from the financial industry to drop these ideas. In particular, fund managers argue that reforms would potentially load new costs on the funds – and thus reduce returns. This, they add, would make investors less willing to put money into these funds, given that yields are already being crushed by the low interest rate environment.
A recent survey from the Association of Finance Professionals, for example, suggests that many corporate treasurers will shift money from funds to banks if reforms go ahead. As a result, the debate - and the sector – is stuck. Nobody in Washington will publicly say that they want the money market funds to shrink, even if this creates a more stable system; after all, American companies and local governments raise huge amounts of finance from these funds. But nobody wants the government to backstop these funds; or for them to remain so vulnerable to runs. Little surprise, then, that it remains unclear when – or if – the SEC will summon the courage to implement those sensible reforms.
Until then, everyone had better hope nothing happens to create a new panic among money market fund managers or their investors; or we may all come to regret this shameful and dangerous $2.6 trillion policy fudge.
* The Minimum Balance at Risk; Federal Reserve Bank of New York staff report number 564, July 2012.
Copyright The Financial Times Limited 2012