Over-Regulation Versus Smart Regulation: The Cast of Money Market Funds
While many are starting to recover from the financial crisis that gripped the United States in 2007 and 2008, who should be held responsible has yet to be settled. One view blames greedy financial titans for manipulating the financial system while their influence in Washington permitted them to take advantage of homeowners and mortgage investors alike, crashing the financial system, while enjoying huge personal gains.
Another view, outlined in the dissenting opinion of the Financial Crisis Inquiry Commission (FCIC)- a congressionally appointed commission tasked with understanding the crisis – lists ten causes, none of which include greedy titans.
The powerful appeal of the blame-Wall Street narrative led policy makers to determine that if there had been more restrictive financial regulations there would have been no calamity. And it tempts some to conclude that more regulation is always better, a policy error that could have substantial consequences for the United States.
Consider money market funds (MMFs). Implementation of the massive Dodd-Frank legislation is slowly wending its way through the regulatory bureaucracy, but the Securities and Exchange Commission (SEC) has already moved to strengthen the rules governing MMFs. In 2010 it increased the credit standards for investments, shortened the average maturity of investments made by MMFs, and imposed more stringent requirements for liquidity and transparency.
In the eyes of many, these were sensible responses to lessons learned during the crisis. But the regulatory push did not stop there. Recently, the chair of the SEC, Mary Schapiro, suggested further regulations that would substantially diminish the popularity and usefulness of MMFs to investors, and perhaps even threaten their existence. Specifically, the proposals under consideration would force companies offering MMFs to move from a fixed to a floating net asset value (NAV) and/or force funds to hold a capital buffer combined with redemption restrictions.
Such draconian regulation suggests that a product is inherently dangerous, which is precisely the argument being made about MMFs – namely that they pose a systemic risk to financial markets that regulation to date failed to eliminate. This conclusion is based on the notion that money market funds were a principal catalyst for the 2008 financial crisis. Accordingly, this line of reasoning continues, it is appropriate to enact regulations that would significantly diminish or even end a $2.5 trillion dollar financial market.
Where is the evidence that MMFs in their current form represent a grave and systemic threat to the health of the country’s financial markets? A review of the facts reveals that no such evidence exists. The so-called “breaking of the buck” by the Reserve Fund in 2008 was not a cause of the financial crisis or a catalyst for the financial meltdown of that period but rather the consequence of the unprecedented financial panic.
Moreover, there is little evidence that the diminution of the MMF market—an inevitable consequence of the SEC’s proposed reforms—would improve the overall safety of U.S. financial markets. In fact, it might leave financial markets even more susceptible to financial panics. In short, Chairman Schapiro’s proposals fall in the category of over-regulation; not the smart regulation that the U.S. requires to maintain safety, soundness, and global competitiveness.
Money market funds are a central aspect of U.S. financial markets. Companies depend on MMFs for their cash-management needs. Accordingly, one of the core services provided by MMFs is liquidity; as cash flows fluctuate businesses can raise or lower their balances quickly and reliably using their MMF accounts.
At the heart of the liquidity services provided by MMFs is the stable NAV, which permits easy investment in MMFs and redemption of shares. MMFs investment portfolios are professionally managed, relieving each business of having this expertise in-house.
Through their investment activities, MMFs are a major source of funding for the U.S. commercial paper market and for U.S. state and local governments. As of May 2012, U.S. money market funds held $365 billion in commercial paper – 36 percent of all commercial paper outstanding – according to iMoneyNet. As a funding source, MMFs offer these entities rates much lower than conventional bank borrowing. As of March 2012, MMFs held $407.6 billion of outstanding short-term municipal debt and accounted for an estimated 82 percent of the market.
In short, unwise regulation of MMFs risks the loss of important liquidity services, and reliable and cheap funding sources for U.S. governments and firms.
MMFs and the Financial Crisis
The breaking of the buck by the Reserve Primary Fund in September 2008 is often cited as one of the seminal events of the entire financial crisis. There is no denying the fact that it occurred in a watershed moment of that chaotic period. However, to conclude that it precipitated further capital flight and exacerbated the crisis is at odds both with the record of that period, and the detailed, objective analysis of the congressionally-chartered FCIC. It is worthwhile to examine each in turn.
The Financial Crisis Timeline.
The Reserve Fund failure took place amidst unprecedented financial market turmoil. In September, the government put Fannie Mae and Freddie Mac into conservatorship, an act that then-Secretary Hank Paulson had previously described as a “bazooka” that he would never have to use. The government also brokered a deal in which Bank of America bought Merrill Lynch, and set out to find a buyer for Lehman Brothers. However, in short order Lehman went bankrupt, and the Federal Reserve lent AIG $85 billion, essentially taking over the company. A panic ensued.
Thus, while it is true that on September 15th there was an outflow of $50 billion from MMFs and that the Reserve Fund broke the buck a day later, these events occurred on precisely the same days as the Lehman bankruptcy and AIG bailout. It is far more likely that MMFs were victims, not catalysts, of a panic that encompassed stocks, bonds, commodities, and every other financial asset (except Treasury securities).
This line of reasoning also fits the events prior to September 2008. Financial pressures began to emerge in 2007. In June 2007, two Bear Stearns hedge funds suspended redemptions because of losses on investments in securities backed by subprime mortgages. As the year progressed, the damage from low-quality, subprime mortgages spread through unregistered “enhanced cash” funds and reached BNP Paribas, France’s largest bank, which froze several funds that were unable to sell mortgage-related assets to meet redemptions.
Finally, the toll from real estate-related investments became too severe. In late 2007 and early 2008, there was a wave of failures, including American Home Mortgage Corp., HomeBanc Corp., the Financial Guaranty Insurance Company, and Countrywide. Some others, like Citigroup, Ambac Financial Group, and MBIA needed help to survive. Finally, during this period the auction rate securities market froze entirely.
During this period, the money market showed considerable evidence of stress as the spreads between 1-month asset-backed paper and Treasury bills reached as much as 400 basis points. But there was no run, and the financial crisis did not start.
The Findings of the FCIC. The FCIC was a 10-member commission created by the Fraud Enforcement and Recovery Act of 2009 “to examine the causes, domestic and global, of the current financial and economic crisis in the United States.” After nearly 20 months of study, in January 2011 the Financial Crisis Inquiry Commission released its final report. The FCIC was unable to agree upon a single report, issuing instead a majority report and two dissenting minority reports that discussed the series of events, policy choices, and regulatory environment that led to the crisis and its aftermath. The reports are viewed by the media and policy experts as the most comprehensive assessments of the origins of the financial malaise.
The three reports contained three different narratives. The narrative of the majority report blames Wall Street and its influence in Washington as discussed above. One dissenting report argues that the primary cause was government intervention, principally through Fannie Mae and Freddie Mac, that led to a housing bubble that triggered the crisis. The second dissention emphasizes both global economic forces and failures in U.S. policy and supervision.
Importantly, none of the reports assigns a significant role for the creation of the financial crisis to MMFs. MMFs are an important part of the events of 2008, but largely because they are a significant aspect of the U.S. financial market. Thus, it is difficult to imagine them insulated entirely from such a systemic panic. But in normal financial market conditions, MMFs display no systemic risk.
The future regulation of U.S. financial market is an important policy issue. Appropriate regulation can ensure safety, soundness, and internationally competitive financial markets. Unfortunately, as exemplified by the recent SEC suggestions for further regulation of MMFs, some regulatory initiatives appear to impose costs far in excess of their benefit.