By Steven K. Beckner
STONE MOUNTAIN, Ga. (MNI) – Boston Federal Reserve Bank President
Eric Rosengren issued stern warnings Wednesday about the risks to
financial stability posed by money market funds and called for increased
regulation and/or changes in the way they do business.
Calling the status quo regarding the money market fund industry
“unacceptable,” Rosengren blamed those non-bank intermediaries for
intensifying the financial crisis in 2008 and said their excessive
risk-taking threatened to worsen spillover effects from the more recent
European debt crisis.
Money market funds continue to pose a risk as a “transmission
channel” for European problems because of their investments in European
debt instruments, he alleged in prepared remarks at the Atlanta Fed
annual financial markets conference.
Rosengren called for some combination of increased capital,
increased supervision and/or a change in money market funds’ historic
practice of promising investors a fixed net asset value (NAV).
Rosengren, who is not a voting member of the Fed’s policymaking
Federal Open Market Committee this year and who did not talk about the
economy or monetary policy, acknowledged the importance of money market
funds.
They “serve as important intermediaries between investors who want
low-risk, highly liquid investments, and banks and corporations that
have short-term borrowing needs,” he said. “Money market funds are a key
buyer of the short-term debt instruments issued by banks and
corporations — commercial paper, bank certificates of deposit, and
repurchase agreements.”
But precisely because of their size and importance, Rosengren said
they must be brought to heel because “any disruptions to those credit
markets represent a potential financial stability issue of both domestic
and global significance.”
He was speaking particularly of so-called prime money market funds,
which hold a mix of short-term debt instruments including commercial
paper and large certificates of deposit, as well as Treasury and agency
securities.
“Prime funds played a critical role in the amplification of
financial problems in recent years,” he said. He cited the large number
of Lehman Brothers securities held by the Reserve Primary Fund, when
that investment bank went bankrupt in October 2008, causing the fund to
“break the buck” (redeem shares for less than $1) and sparking a run by
investors that led the Fed to create back-up liquidity facilities.
More recently, he cited the funds’ large holdings of European debt
and their disruptive flight from European money markets.
Rosengren made four main contentions:
1. “Some prime funds have taken on significant credit risk — at
times incurring losses that necessitated the support of the parent or
sponsor of the fund, and in one case substantial government support.”
2. “The assumption of significant credit risk is not appropriate
for intermediaries that have no capital and implicitly promise a fixed
net asset value (NAV).”
3. “Without additional reforms, this structural problem could
trigger or amplify future financial stability problems.”
4. “Fragilities related to money market funds could be
significantly mitigated by proposed SEC reforms and, potentially, by
monitoring and reducing the credit risk taken by prime funds.”
Rosengren said “issues of potential financial instability were not
fully resolved by the 2010 reforms” and that “the credit risk taken by
some money market funds is still significant, even after the financial
problems experienced from 2007 to 2010 and the recent SEC reforms.”
Regarding European debt problems, he charged that “money market
funds remain an important potential transmission channel to the United
States.” He pointed out that over 60 money market funds had exposure to
Dexia, a bank that required the support of the French and Belgian
governments in the fall of 2011.
The money market fund industry has not learned its lesson, he
suggested.
“Despite the experience of the Reserve Primary Fund during 2008, a
number of money market funds held securities that posed significant
credit risk during the 2011 period of European problems,” he said.
“While there were significant outflows, no losses or runs occurred —
but in my view this should provide us little solace.”
“We should care not only about the realized losses, but also about
the potential losses associated with risk exposures,” he continued.
“From a public policy perspective, we should in short care that
significant risks were taken even though the potential bad outcome did
not occur.”
“The willingness of multiple money market funds to take excessive
credit risk even after the 2010 reforms suggests that money market
funds, absent some changes, still pose some risks to financial
stability,” he went on. “Simply put, my view is that taking large credit
risks is incompatible with being an intermediary that has no capital and
implicitly promises a fixed net asset value.”
Rosengren suggested a number of ways of reducing money market fund
risks.
“One possible way to mitigate the risks is to no longer transact at
a fixed net asset value,” but allow money market shares to float in
value, he said.
He acknowledged two “potential drawbacks” to a floating rate NAV.
“First, it transforms the product from a near-substitute for bank
deposits into an asset with a fluctuating price. Those fluctuations in
price, and the taxable gains or losses that result, would make money
market funds less attractive as a transaction account for many
investors.”
“Second, it only partially prevents runs, because as soon as
investors become concerned about credit losses, there is a strong
incentive to get out of the fund early,” he said.
But he said “a move to a floating NAV would more accurately reflect
the fundamental nature of the product actually offered, rather than
making implicit promises to investors that cannot always be kept during
stressful times.”
Another alternative he suggested would be “to require money market
funds to hold capital, and to impose a cost on redemptions.”
Rosengren conceded those proposed remedies would also “raise
potential concerns and have costs.”
“Raising capital in a low interest rate environment would be
challenging and, depending on how it is raised, would impact returns to
sponsors or investors,” he said, and “a change in redemption practices
would pose a potential risk to investors that would make the money
market fund less attractive relative to other products.”
Nevertheless, he said “appropriately calibrated capital and
redemption policies would reduce the risk that investors would not be
able to get full value on their redemptions or that runs would occur.”
Beyond those proposals, Rosengren said “there may be opportunities
for SEC policymaking and monitoring to inhibit funds from taking on
excessive credit risk.”
He said these alternatives are not mutually exclusive and “could be
adopted in some combination.”
“The bottom line … is that the status quo is not acceptable,” he
said, adding that even after Lehman, “a significant number of money
market funds continued to take substantial credit risk during the recent
European financial problems.”
“So, I must conclude that reforms enacted to date do not seem to
sufficiently limit money market funds’ ability to assume excessive
credit risks,” he said.
“The risks to the stability of the financial system that underpins
the economy are too great not to take the actions that will make the
industry, and our financial system, more stable,” he declared.
** MNI **
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