A new research paper, "The Quiet Run of 2011: Money Market Funds and the European Debt Crisis," written by Sergey Chernenko of The Ohio State University, Fisher College of Business and Adi Sunderam of Harvard Business School, describes money fund outflows due to European concerns and financing difficulties faced during the summer of 2011. The Abstract says, "We show that money market funds transmitted distress across firms during the European sovereign debt crisis. Using a novel data set of US money market fund holdings, we show that funds with large exposures to Eurozone banks suffered significant outflows between June and August 2011. These outflows have significant short-run spillover effects on other firms: non-Eurobank issuers that typically rely on these funds raise less financing in this period. The results are not driven by issuer riskiness or direct exposure to Europe: for the same issuer, money market funds with greater exposure to Eurozone banks decrease their holdings more than other funds. Our results illustrate that instabilities associated with money market funds persist despite recent changes to the regulations governing them."
Chernenko and Sunderam write, "In the aftermath of the financial crisis, risk taking by financial intermediaries has been heavily scrutinized by academics, regulators, practitioners, and the general public. One important reason for this scrutiny is that financial firms may be subject to runs if the concerns develop about the quality of their assets (Gorton and Metrick, 2011; Gorton, 2010). And as pointed out by Bernanke (1983), runs can result in a contraction of the supply of credit to firms and consumers with potentially serious consequences for the macroeconomy."
They explain, "Despite its importance, there is little empirical evidence directly demonstrating how risk taking by financial intermediaries can set the stage for runs and therefore lead to eventual reductions in the supply of credit to creditworthy firms. In this paper, we provide such evidence, studying the role US money market mutual funds play as intermediaries in short-term credit markets. Using a novel data set of the security-level holdings of money market funds, we document the interaction of risk taking, runs, and credit supply in the context of the European sovereign debt crisis. Specifically, we show that risk taking by money market funds, in the form of investments in risky Eurozone banks, drives large investor redemptions in Summer 2011, significantly reducing the ability of other firms to raise short-term financing."
The paper's Introduction continues, "This paper empirically identifies a novel channel through which runs on financial intermediaries may have consequences for the real economy. We demonstrate how runs can create collateral damage: they can result in a sudden and indiscriminate loss of funding for a large number of firms. Due to institutional and market frictions, issuers maintain relationships with specific money market funds and cannot always seamlessly substitute between different funds as suppliers of financing. Thus, concerns about the creditworthiness of one firm or a set of firms can lead investors in a particular money market fund to run, resulting in short-term funding difficulties for the other firms financed by that fund."
It adds, "Our analysis proceeds in three steps. We first show that prior to June 2011 money market funds had strong incentives to take on risk in order to increase their offered yields. Facing a at yield curve and regulatory constraints on portfolio maturity, funds took on risk primarily by holding large positions in Eurozone banks -- in May 2011, more than a quarter of all prime money market fund assets were invested in Eurozone banks. Our results point to franchise value and operating leverage as important determinants of risk taking."
The pair concludes, "We use the market turmoil involving Eurozone banks in the summer of 2011 to explore the instabilities associated with money market funds. We document how money market funds transmitted distress from Eurozone banks to other issuers. Money market funds with large exposures to Eurozone banks suffered significant outflows between June and August 2011. Due to institutional and market frictions, other issuers that historically raised financing from these funds were unable to immediately and completely substitute to other money market funds. As a result, these issuers raised less overall financing from the money markets in the short run."
Finally, they write, "We make several contributions. First, we document how financial intermediaries transmit distress across firms. Our results demonstrate that problems at some firms raising financing from an intermediary can be detrimental to other firms raising financing from the same intermediary. Second, we show that fund-issuer relationships are important in the commercial paper market. Since these issuers are large, highly rated firms, this suggests that relationships always play a central role in finance -- arm's length financing is never completely arm's length. Third, we study the consequences of money market fund risk taking for issuers. We show that creditworthy issuers may encounter financing difficulties because of risk taking by the funds from which they raise financing. Our results suggest that money market fund risk taking may have spillover effects to the broader economy."
