The Federal Reserve Bank of Kansas City recently published a working paper entitled, "Explaining the Life Cycle of Bank-Sponsored Money Market Funds: An Application of the Regulatory Dialectic." Its "Abstract" states, "In this paper, we present empirical evidence of the regulatory dialectic in the prime institutional money market fund (PI-MMF) industry. The 'regulatory dialectic', developed by Kane (1977, 1981), describes how banks and regulators react to each other. For decades, a cap on commercial deposit interest rates fueled dramatic growth in bank-sponsored PI-MMFs as a form of shadow banking. During the growth period, banks with more commercial deposits were more likely to enter the PI-MMF industry in an effort to keep their commercial customers in affiliated subsidiaries. However, the 2008 crisis and subsequent regulatory changes halted the rapid growth of PI-MMFs. In the post-crisis regulatory regime, bank-sponsored funds were more likely to exit the industry than nonbank-sponsored funds. Simultaneously, the industry shifted from PI-MMFs to government institutional MMFs as substitute products. We conjecture that the collapse of the PI-MMF can lead further to the emergence of substitute products, such as stablecoins as part of the continuing dialectical process."
The paper's Introduction says, "Bank-sponsored prime institutional money market funds (PI-MMFs) grew dramatically in the 1990s, followed by a precipitous decline in the 2010s. In August 1987, bank-sponsored PI-MMFs accounted for only 0.7 percent of the market share in the PI-MMFs industry. Over the next decade, however, bank-sponsored PI-MMFs reached a 50 percent market share, peaking in 2009 with more than $600 billion aggregate total net assets (TNA). In the first quarter of 2009, 25 bank holding companies (BHCs) sponsored 153 share classes of PI-MMFs. By the fourth quarter of 2016, however, only 14 BHCs, sponsoring just 59 share classes with a TNA of $51 billion, remained in the industry."
It explains, "In this paper, we show how the rise and the decline of the bank-sponsored PI-MMF industry provide the first empirical evidence of the regulatory dialectic framework proposed by Kane (1977) and developed by Kane (1981). Kane (1981, p. 355) describes the interplay between banks and their regulators as a balance between the 'political processes of regulation and the economic process of regulatee avoidance [that], like riders on a seesaw, adapt continually to each other.' He argues that if banks are prohibited from performing a profitable activity, they have a strong incentive to circumvent the prohibition by developing a less regulated substitute product or service that closely mimics the regulated activity. After recognizing this behavior, regulators re-regulate the novel ways of performing the activity. Banks then seek to avoid the new regulation, and the process starts once again (see Eisenbeis [2023] for a retrospective)."
The paper tells us, "The evolution of the bank-sponsored PI-MMF industry between 1988 and 2016 exemplifies how banks and regulators react to one another. We show that the growth of bank-sponsored PI-MMFs can be traced to the regulatory restrictions that prevented banks from paying interest on demand deposits. Banks faced disintermediation by commercial depositors who kept their funds in noninterest-bearing demand deposits. Because these deposits offered only implicit returns in the form of account services, commercial depositors had an incentive to move funds to accounts offering higher net (implicit and explicit) returns at money market funds. Bank sponsorship of PI-MMFs emerged as an alternative to keep bank commercial customers under a bank's corporate umbrella, countering the threat of disintermediation. In this way, the bank-sponsored MMF could pay interest on a product similar to commercial deposit, while keeping the revenue generated within the corporate parent, thus increasing the size of the so-called 'shadow banking system.'"
It continues, "In aggregate, between 1986 and 2001, the banking industry experienced a massive reduction in noninterest-bearing deposits (our proxy for commercial deposits), while bank-sponsored PI-MMFs showed rapid growth. Fund-level analysis shows that BHCs that relied relatively more on commercial deposits and were thus more exposed to the threat of disintermediation posed by interest-bearing MMFs, were more likely to start and sponsor a PI-MMF."
The KC Fed writes, "The 2008 crisis had a profound impact on the PI-MMF industry, as government actions corroborated implicit safety-net coverage for 'shadow banks' such as MMFs. For example, bank-sponsored shadow banks had no reserve or capital requirements and paid no fees to the FDIC for the risks their MMF affiliates created for the sponsoring banks (Acharya, Schnabl, and Suarez, 2013; Jacewitz, Unal, and Wu, 2022). Consequently, federal regulation was then extended to control the expansion of systemic risk inherent in these 'loophole' deposit substitutes -- again consistent with the regulatory dialectic hypothesis."
They explain, "Regulatory changes during the crisis and post-crisis reforms made sponsorship of PI-MMFs less attractive to banks. Basel III required BHCs to hold additional liquidity against lines of credit to sponsored nonbank entities. In addition, the Dodd-Frank Act of 2010 repealed the statutory prohibition of interest rate payments on demand deposits and banks were allowed to pay market rates to their commercial depositors in 2011, decreasing the attractiveness of MMFs to investors. In addition, the Temporary Liquidity Guarantee Program (TLGP) also fundamentally changed MMF's competitive environment and hampered the attractiveness of MMFs by extending unlimited deposit insurance coverage from October 2008 through 2010 to transaction accounts, a close MMF substitute, among other changes. Following TLGP, noninterest bearing transaction accounts remained temporarily covered under a provision of the Dodd-Frank Act starting in 2010 until the end of 2012."
The paper also says, "The regulatory changes made the bank-sponsorship of MMFs less lucrative and opened avenues for substitute products. Consistent with the regulatory dialectic, our empirical tests show that, from 2010 to 2013, when the regulations took form, bank sponsors were more likely to close their PI-MMF affiliates than nonbank sponsors. Importantly, institutional investors did not switch from bank-sponsored to nonbank-sponsored funds; we do not observe any increase in the number or asset size of nonbank-sponsored funds. Instead, as further evidence of the regulatory dialectic, our analysis on asset flows suggests that bank sponsors resorted to substitute products such as government institutional MMFs (GI-MMFs) in response to regulatory changes."
It adds, "In addition to these regulatory reforms affecting bank-sponsorship, the Securities and Exchange Commission (SEC) brought 'structural and operational reforms' in 2014, and new mechanisms that could restrict investors' access to non-government funds. However, in contrast to the earlier bank regulatory changes, these SEC reforms affected primarily the MMF investors and not the bank sponsors of MMFs. The new rules discouraged investor redemptions, while granting fund sponsors new tools, like liquidity fees and redemption gates that allowed them to limit their run exposure. Taken together, these measures shifted the run risk from the sponsor, who may have needed to cover asset losses, to the investor. Having much more restrictive portfolios, GI-MMFs were exempt from the regulatory changes that applied to PI-MMFs. Therefore, while the SEC reforms may have contributed to the decline in PI-MMFs, we would not expect any differential response between bank and nonbank sponsors. Consistent with this expectation, we observe no differences in the exit decisions between bank and nonbank sponsors from 2014 to 2016."
The paper comments, "While the evolution of the PI-MMF market provides an illustrative historical example of the regulatory dialectic in action, Kane's logic around the interplay between the financial industry and financial regulators continues to hold. Demand for less regulated, but close substitute, financial products remains in the economy. For example, many have noted that there are close structural similarities between the established MMF investment product and a relatively new creation: stablecoins (for instance, see Fed Chair Powell, 2021; Gorton and Zhang, 2022; and Anadu, et. al, 2023). Both products provide a money-like investment opportunity, designed to maintain a steady nominal value, while performing liquidity transformation (see Anadu, et. al, 2023). Both PI-MMFs and stablecoins are also demonstrably susceptible to runs (for instance, the runs on IRON in 2021, terraUSD in 2022, and USDC in 2023).... Of course, given the paucity of data, we make no conclusions, other than to state that these observations are consistent with a modern, active regulatory dialectic."
Finally, they state, "We organize the paper as follows. In Section 2, we present the data used in the analysis. In Section 3, we examine the rise of the bank-sponsored PI-MMFs. Section 4 discusses the regulatory changes that contributed to the decline of these funds. Section 5 empirically examines the eventual decline of bank-sponsored PI-MMFs and asset flows into substitute products. Section 6 concludes."
