William Dudley of the Federal Reserve Bank of New York spoke yesterday in Tokyo on "Regulatory Reform of the Global Financial System". Dudley says, "The interconnectedness of the financial system also caused shocks to spread quickly. For example, the failure of Lehman Brothers led to losses at the Reserve Fund, which precipitated a widespread money market mutual fund panic. It also led to actions by U.K. bankruptcy authorities that had the effect of freezing the assets owned by hedge fund and other clients of the firm and this encouraged such investors to pull assets from other institutions perceived to be weak. These and other propagation channels in turn, led to virtual stoppage of lending and borrowing activity in the money markets and, ultimately, a credit crunch that reverberated throughout the global financial system.... But the focus will not just be on large financial firms. Activities and practices that occur outside of the core institutions are also important. For example, the activities of money market mutual funds is one area receiving close scrutiny. As you know, a run on the money market funds developed in the fall of 2008 when the Reserve Fund broke the buck when Lehman Brothers failed. This underscored a critical structural weakness of money market mutual funds created by the convention that the net stable asset value could be fixed at par. When a money market mutual fund incurs losses that cause it to "break the buck," this encourages investors to rush to withdraw their funds from other funds before they break the buck. The result can be a run on money market mutual fund assets. In the United States, the Securities Exchange Commission has already tightened the rules with respect to liquidity, quality and the average maturity of so-called 2a-7 fund assets, but there is still more to be done to address the remaining vulnerabilities."
