Subscriber note: Crane Data published its latest Money Fund Portfolio Holdings Wednesday with data as of Sept. 30, 2012 yesterday. Visit our Content center to download files or visit our Money Fund Portfolio Laboratory to access our "transparency" module.... On Wednesday, Federal Reserve Board Governor Daniel K. Tarullo gave a lecture at the University of Pennsylvania Law School in Philadelphia on "Financial Stability Regulation" which included a section on shadow banking and money market mutual funds. Tarullo says after extensive comments on other Dodd-Frank issues, "Having just a few months ago devoted an entire speech to the shadow banking system, I wanted to spend more time today on the interpretive issues just discussed. However, to give a sense of the complementary regulatory challenges in dealing with the shadow banking system, let me describe one specific, current issue and just briefly mention a much broader concern. The specific issue is that of money market funds."
He explains, "As many of us in the government have pointed out, money market funds remain a major part of the shadow banking system and a key potential systemic risk even in the post-crisis financial environment. In fact, the industry's survival in its present form is likely due in no small part to the unprecedented interventions by the Treasury and the Federal Reserve in providing insurance and liquidity support, respectively, to the industry in response to the run prompted by the failure of the Reserve Primary Fund in 2008."
Tarullo continues, "The interesting point here is that a regulatory agency, the Securities Exchange Commission (SEC), has ample regulatory authority to address the systemic risk problem. Indeed, the legality of money market funds continuing to publish a fixed net asset value (NAV) of one dollar per share, even as the actual value of the underlying assets varies within a modest range, is itself the consequence of the SEC's Rule 2a-7, which exempts money market mutual funds from the requirement of a floating NAV generally applicable to open-end mutual funds. In amending its rules in 2010, the SEC took some good first steps to improve the resilience of money market funds, but many--including Chairman Schapiro--do not believe these are sufficient to mitigate the run potential in money market funds."
He says, "Unfortunately, a majority of the current SEC commissioners has to this point been opposed to moving forward with the reform measures Chairman Schapiro has proposed. The FSOC, meanwhile, has endorsed further reform along these general lines. The question, then, is how the FSOC and its other member agencies should proceed given that the SEC has declined to act. I should note here that, during the debates preceding Dodd-Frank, some versions of proposals for what eventually became the FSOC would have empowered the FSOC to override agency action or inaction within its sphere of authority. Others, including many who favored strong reforms, opposed this power, which would have created a kind of super-agency with veto authority over all the regulators. Instead, the FSOC has the more limited authority to present an agency with recommendations for action and the right to receive an explanation should the agency not accept those recommendations."
Tarullo tells UPenn, "As you may have seen, two weeks ago Treasury Secretary Geithner sent a letter to the members of the FSOC in his capacity as its chair, in which he urged the Council to use its authority under Section 120 of Dodd-Frank, and to consider alternative actions to reduce the structural vulnerabilities associate with money market funds "in the event the SEC is unwilling to act in a timely manner." These alternatives could include FSOC designation of money market funds as systemically important and thus subject to the prudential requirements promulgated under Dodd-Frank. They could also include action by FSOC member agencies, such as the bank regulatory agencies imposing restrictions on regulated financial institutions' ability to sponsor, borrow from, invest in, or provide credit to money market funds that do not have structural protections. From my perspective, at least, each of the options open to the FSOC and the rest of its constituent agencies is decidedly a second-best alternative as compared to a change in SEC rules to remove the fixed net asset value exception, to require a capital buffer that would staunch or buffer runs, or measures of similar effect. And, when I say second-best here, I mean to include the funds themselves. The protective tools available to the rest of us do not fit the problem precisely and thus will not regulate at the least cost to the funds while still mitigating financial risk. But that is the legal situation we all confront. My hope, of course, is that recent indications that other SEC commissioners are now willing to move forward with reforms will lead to the SEC adopting first-best measures in the near-term."
Finally, he adds, "The money market fund example is a noteworthy case study in substantial part because of the interesting institutional issues it raises. More generally, though, the capacity of private financial market actors to create what are, at least in normal times, considered cash equivalents raises broader financial stability questions. Specifically, there may be a need for new macroprudential instruments, such as comprehensive authority to impose margins on all cash-like instruments, regardless of whether a firm creating those instruments is a regulated entity such as a bank holding company. Such possibilities obviously carry significant consequences, not just for the liquidity available to the financial system, but also for values such as the concentration of governmental authority. This is a topic on which much further thought is needed."