If anything is calculated to cause despair about the prospects of making the financial system safer, it is the failure of the Securities and Exchange Commission to tame the $2.6 trillion US money market fund industry. Mary Schapiro, the SEC chairman, has tried her best but she was stymied last week.
The stakes are so high that reform now needs to be taken out of the hands of the SEC's commissioners, who have shown themselves to be fatally susceptible to industry lobbying, and led by the US Treasury and Federal Reserve. Failing that, international regulators should limit the dependence of banks on these shaky foundations.
What are the chances of the other US authorities succeeding where the SEC has failed? Sadly limited, given the poisonous climate in Washington, acrimony over the Dodd-Frank Act and the presidential election. These form dispiriting obstacles to reform of the shadow banking system, of which money market funds form one of the oldest parts.
Reform of money market funds ought to be an open-and-shut case, given the events of 2008. The first evidence of the distress triggered by the Lehman Brothers collapse was when the Reserve Primary fund "broke the buck” because it held $785 million of Lehman shares. That led to a rapid run on its deposits and official intervention to stop other funds toppling.
As Ms Schapiro observed in June, "we do not know what the full consequences of an unchecked run on money market funds would have been”, but it is safe to say: not good. The funds, established in the 1970s as competitors to banks, have become one of the primary short-term funding mechanisms of both US and European banks.
The rivals rely on each other in potentially unstable ways. The US Treasury estimates that 105 money market funds with total assets of $1 trillion could fail in the same way as Reserve Primary if any of their top 20 counterparties defaulted. The latter include many European banks – 30 per cent of the assets of money market prime funds are European bank debt.
In other words, the danger of another cascading crisis, with fragile banks being drained of funding, remains. The old-fashioned bank run, with depositors lining up outside banks to withdraw cash, has been updated to corporate treasurers wiring money from money market funds at any hint of trouble.
The structure of the funds makes them especially prone to a run. They are used by treasurers and investors to park their short-term cash, confident that their deposits will not lose value. Paul Tucker, a deputy governor of the Bank of England, has called them "narrow banks, in mutual-fund clothing”.
These funds started after regulators capped the interest rates banks could offer depositors. The mutual fund structure evaded these limits and offered investors higher returns at fairly low risk since funds were supposed only to invest in short-maturity and high-quality assets.
They grew rapidly, to a peak of $3.8 trillion in 2008, after the SEC decided in 1983 to let them fix their net asset values at $1 a share by dropping mark-to-market accounting. They could offer a bank-like guarantee to depositors that their cash would be repaid in full, with interest.
Defaults or downgrades of assets sometimes threatened to make funds "break the buck” – to be unable to maintain the $1 fixed value and have to go into runoff. But, except for one minor case, the investment companies that sponsored them stepped in to support them.
The 2008 failure exposed the key weakness. If a parent cannot, or will not support a troubled fund, its investors have an incentive to take their money out quickly, igniting a panic that can easily spread. "It is like a banking system without capital. I cannot see why [a run] will not happen again,” says Gary Gorton of Yale University.
Ms Schapiro wants to impose a safeguard by offering funds a choice. They could either become more like investment funds by allowing their net asset values to float, or more like banks by raising a buffer of capital. They might also limit redemptions of cash in times of panic.
Neither option seems unreasonable to me – neither would eliminate any possible problem, merely make it less likely – but the industry responded with overblown rhetoric about being persecuted. "All of these reforms are designed to eradicate money market funds as we know them,” complained Christopher Donahue, president of Federated Investors.
The funds, which were bailed out in the crisis by the Treasury guaranteeing their net asset values and financing banks to buy their commercial paper, claim – Goldman Sachs-like – not to have asked to be rescued. They were essentially the bystanders to a financial panic elsewhere, they insist.
This rewriting of history was enough to swing the votes of three SEC commissioners and block Ms Schapiro’s effort, with the excuse that more time has to be devoted to research. The only hope lies with the Financial Stability Oversight Council, the Treasury-chaired committee of regulators set up by Dodd-Frank to oversee systemic risks.
Several Fed governors have argued the case for money market fund reform, so we shall discover whether the FSOC is merely a distinguished talking shop or will override the SEC. If it does not act, Mr Tucker says supervisors should limit the amount of short-term funding that European and international banks can get from "flighty sources” such as money market funds.
After the Libor scandal, in which Mr Tucker played a role, it would be a fine way to inflame transatlantic financial tensions. Absent the right action in the US, however, it would also be a good idea.
Copyright The Financial Times Limited 2012.