Eric Rosengren, President & Chief Executive Officer of the Federal Reserve Bank of Boston gave a presentation in London yesterday entitled, "Avoiding Complacency: the U.S. Economic Outlook, and Financial Stability," which discussed money funds and risks in the short-term funding markets." Rosengren says in the middle of his talk, "This past financial crisis was a primer on vulnerabilities to short-term funding. Specifically, wholesale funding utilized by large global banks dried up during the financial crisis. As large banks sought to reduce their exposure to counterparties of concern, the term of loans made in the marketplace decreased, and the cost of short-term credit spiked. And many of the problems were occurring outside of traditional depository institutions. Bear Stearns and Lehman Brothers were investment banks, not commercial banks. As counterparties dramatically reduced both unsecured and secured lending to these two entities, funding was no longer available and the firms failed. Similarly, money market mutual funds with exposures to investment banks in many cases required support from parent or sponsoring entities. And one fund without parental support -- the Reserve Primary Fund -- sustained a credit loss that would ultimately lead to its liquidation. This led to a run on prime funds, which in turn further impaired short-term credit markets."
He continues, "As Figure 9 shows, the money market mutual fund industry held $3.5 trillion in assets under management in mid September 2008. Prime funds, which hold a mix of Treasury and agency securities and other short-term debt instruments (including commercial paper and large certificates of deposit), held nearly 60 percent of industry assets, or $2.1 trillion. When the Reserve Primary Fund "broke the buck," outflows from prime funds totaled roughly $500 billion over a four-week period. Although much of the outflow went into government money market mutual funds (which hold only Treasury and agency securities, and repurchase agreements backed by such securities), these inflows did little to ease the strains being felt in the corporate funding markets resulting from the exit from prime funds."
Rosengren explains, "U.S. money market funds are thought of and marketed as highly liquid, low-risk investments with many of the same characteristics as traditional bank deposits. As a result, money market fund investors and money market fund managers should be highly sensitive to changes in underlying risks. The crisis in autumn of 2008 taught us that safeguarding against runs on financial entities like money market funds -- entities that do not have a large, stable, core deposit base and do not have ordinary access to the central bank's "lender of last resort" function -- was and is important, unfinished work if we are to have a more stable financial system."
He comments, "A number of significant reforms are being contemplated by the U.S. Securities and Exchange Commission (SEC) to reduce the risks surrounding money market funds. But even with significant reforms such as these -- reforms, by the way, that I am highly supportive of and will say more about at a conference in Atlanta in two weeks -- money market funds will continue to be a potentially unstable source of U.S. dollar funding. From a financial stability perspective, we need to recognize the possibility of a deterioration in the ability or willingness of the money market funds to keep providing a dependable source of funds to counterparties (for example, the issuers of commercial paper that the funds purchase). This could occur as a result of a change in the risk profile of those counterparties."
Rosengren adds, "Wholesale funding issues also played an important role in recent European banking problems. Some European banks were too dependent on wholesale funding, particularly funding coming from U.S. money market funds. Figure 10 shows the European exposure of U.S. prime money market funds over the past year. Given the changes in the risk profile of some banks, as a result of increases in sovereign debt risk, money market funds have sought to reduce what was their large risk exposure to European financial institutions. Most money market funds in the beginning of 2011 had already dramatically reduced exposure to peripheral financial institutions. Over the second half of last year there was a very significant decline in exposure to euro-zone financial institutions. (In addition, remaining exposure was shortened in tenor, meaning time to maturity). Figure 10 highlights the declines across Europe and Figure 11 shows the decline over the course of 2011 more specifically by certain countries."
He tells us, "Because U.S. money market funds had been a significant source of short-term funds for European institutions, money funds' move away from short-term European debt resulted in a significant shortage of dollar funds available to these institutions. I will show you some market indicators of these shortages in a moment. No money market fund encountered a problem meeting investor redemptions during the European sovereign debt crisis. But even without such a problem, money market funds still had an impact on the availability of credit to financial institutions for which the perception of risk had changed."
Rosengren also says, "Problems with financial stability do not require a failure to create a significant disruption in the flow of credit. In light of the incentives facing money market funds, financial institutions that rely heavily on them for funding put themselves in a position where a short-term change in perceived risk can create significant funding problems. And as we have seen repeatedly over the past several years, funding problems at one institution can quickly spread to the financial system as a whole."
He continues, "Figure 12 highlights that funding challenges for European banks were developing as money market funds reduced their European exposures. The rise in the LIBOR to OIS spread indicates that financial institutions became more concerned about lending to each other as money market funding declined. Similarly, the sharp rise in the rates on the 3-month euro-dollar foreign exchange swap indicates the pressure exerted by reduced dollar funding from the money market funds on European financial institutions' funding."
Rosengren summarizes, "In short, the rational reaction of money market funds to perceived changes in risk -- reducing European exposure -- led to various funding pressures. The issues eventually were addressed by central bank actions that significantly expanded liquidity, both through foreign exchange swaps and through European Central Bank (ECB) term lending to European institutions. While these actions have been very important for stabilizing financial markets, I believe we need to get to the point of having a more resilient financial infrastructure that does not require central bank interventions during times of stress."
Finally, he adds, "For financial institutions and supervisors this implies thinking more carefully about stress scenarios, and specifically about whether critical funding will evaporate when it is needed most. While Basel Capital Accord proposals will help in this respect, I would strongly suggest that stress testing scenarios assess how well risk-sensitive sources of short-term funding will hold up in an environment of heightened risk. This liquidity-focused assessment would be an important complement to current stress testing, and a prudent aspect of risk management."
