Eric Rosengren, President & Chief Executive Officer of the Federal Reserve Bank of Boston, gave a speech Wednesday morning at the Federal Reserve Bank of Atlanta's 2012 Financial Markets Conference ("Financial Reform: The Devil's in the Details") entitled, "Money Market Mutual Funds and Financial Stability. Rosengren says, "The focus of my remarks today will be financial stability. Both the financial crisis in 2008 and the more recent sovereign debt problems in Europe underscored the significance of money market fund flows to short-term credit markets, and the potential for disruptions in those flows and markets to create broader economic difficulties. I will leave it to other panelists to focus on the impact of recently implemented and proposed regulations on individual funds or suppliers of short-term funds. Instead I will look at potential reforms in the context of whether they promote financial stability."
He continues, "Money market funds serve as important intermediaries between investors who want low-risk, highly liquid investments, and banks and corporations that have short-term borrowing needs. Money market funds are a key buyer of the short-term debt instruments issued by banks and corporations -- commercial paper, bank certificates of deposit, and repurchase agreements. Given the importance of short-term credit markets to both investors and businesses, any disruptions to those credit markets represent a potential financial stability issue of both domestic and global significance. I would add that in discussions about ways that financial problems could, potentially, be amplified into a financial crisis, I hear money market funds often brought up."
Rosengren explains, "My comments today are going to focus on prime money market funds, as opposed to government funds or tax-free funds. Prime funds hold a mix of short-term debt instruments including commercial paper and large certificates of deposit, as well as Treasury and agency securities. Prime funds played a critical role in the amplification of financial problems in recent years. To summarize, my key points today will be the following: Some prime funds have taken on significant credit risk -- at times incurring losses that necessitated the support of the parent or sponsor of the fund, and in one case substantial government support. In my view the assumption of significant credit risk is not appropriate for intermediaries that have no capital and implicitly promise a fixed net asset value (NAV)."
He adds, "Without additional reforms, this structural problem could trigger or amplify future financial stability problems. Issues of potential financial instability were not fully resolved by the 2010 reforms, although those reforms were important steps forward. Fragilities related to money market funds could be significantly mitigated by proposed SEC reforms and, potentially, by monitoring and reducing the credit risk taken by prime funds."
Rosengren reviews past issues with Prime funds, and says, "Going forward, one cannot necessarily assume that sponsors will choose to provide financial support; and also, to the extent that the sponsor is a regulated financial institution that requires regulatory approval to provide support, approval of such support is not guaranteed. I would suggest that the ability to assume excessive credit risk under these conditions reflects a potential flaw in the design of money market funds that still needs to be addressed. The credit risk taken by some money market funds is still significant, even after the financial problems experienced from 2007 to 2010 and the recent SEC reforms. As recently as the fall of 2011, a sponsor provided support to a fund as a result of its holding of downgraded Eksportfinans paper."
He states, "A significant source of the credit risk in many prime money market funds over the past year has been the large exposure to European banks. Figure 5 shows the exposure of the industry to financial institutions in France, Italy, and Spain. While these exposures were substantially reduced as the risks became more apparent, I have to question whether investors in money market funds would have been willing to directly hold such large exposures in foreign financial institutions, and whether such investments were consistent with the perceptions of very low credit risk that many investors expect to be associated with prime money market funds. Figure 6 shows that while the exposure to Europe declined significantly through December 2011, 36 percent of prime money market fund assets remain in Europe (granted, generally in the stronger countries). So, when considering the so-called "tail" risk from unexpected problems in Europe, money market funds remain an important potential transmission channel to the United States."
Rosengren claims, "Despite the experience of the Reserve Primary Fund during 2008, a number of money market funds held securities that posed significant credit risk during the 2011 period of European problems. While there were significant outflows, no losses or runs occurred -- but in my view this should provide us little solace. We should care not only about the realized losses, but also about the potential losses associated with risk exposures. From a public policy perspective, we should in short care that significant risks were taken even though the potential bad outcome did not occur. The willingness of multiple money market funds to take excessive credit risk even after the 2010 reforms suggests that money market funds, absent some changes, still pose some risks to financial stability. Simply put, my view is that taking large credit risks is incompatible with being an intermediary that has no capital and implicitly promises a fixed net asset value."
He continues, "While the 2010 reforms improved the liquidity and credit risk of money market funds, I believe the data I have presented today suggest that more substantial initiatives are needed to reduce the risks to financial stability. One possible way to mitigate the risks is to no longer transact at a fixed net asset value. This has several possible benefits, but also potential drawbacks. As with other mutual funds, a floating NAV would highlight that the underlying asset values do fluctuate, and that the investor is taking some risk. By observing movements in the NAV, investors would have regular reminders that investments in money market funds are not riskless, and that absent sponsor or government support the fund cannot guarantee that it will always be able to return an investor's money dollar for dollar."
Rosengren also comments, "Furthermore, a money market fund that takes credit risk simply cannot guarantee that it will on its own pay a fixed net asset value. Should a large credit loss occur, the fixed net asset value will not be able to be maintained unless the sponsor is willing and able to provide financial support. Still, there are two potential negatives to a floating rate NAV. First, it transforms the product from a near-substitute for bank deposits into an asset with a fluctuating price. Those fluctuations in price, and the taxable gains or losses that result, would make money market funds less attractive as a transaction account for many investors -- in part due to the taxable gains or losses. Second, it only partially prevents runs, because as soon as investors become concerned about credit losses, there is a strong incentive to get out of the fund early. The first investor to leave the fund (to redeem) avoids the large drops in valuation and loss of liquidity that typically accompany a run."
He adds, "While the incentive to run is not eliminated by a floating NAV, it is certainly less than for a fund with a fixed NAV that risks "breaking the buck." Interestingly, floating NAV funds are used in Europe. In sum, a move to a floating NAV would more accurately reflect the fundamental nature of the product actually offered, rather than making implicit promises to investors that cannot always be kept during stressful times."
Rosengren continues, "Another alternative would be to require money market funds to hold capital, and to impose a cost on redemptions. An appropriate redemption policy could substantially reduce the incentives to run. With appropriately calibrated capital and redemption policies, the incentive to run (and thus the inability to fully pay investors) would be greatly reduced. To digress for a moment, it is important to distinguish between solvency issues and liquidity problems. Slowing down redemptions would assist in situations where there is underlying value but a drying up of liquidity may lead to losses from "fire sale" prices."
He tells us, "These remedies also raise potential concerns and have costs. In general any reforms that, in the language of economists, would "internalize the costs" associated with systemic risk would to some degree make money market funds less attractive for investors. Raising capital in a low interest rate environment would be challenging and, depending on how it is raised, would impact returns to sponsors or investors. A change in redemption practices would pose a potential risk to investors that would make the money market fund less attractive relative to other products. But despite these concerns, appropriately calibrated capital and redemption policies would reduce the risk that investors would not be able to get full value on their redemptions or that runs would occur."
Rosengren says, "Beyond the two alternatives I have discussed, there may be additional ways to address these issues. There may be opportunities for SEC policymaking and monitoring to inhibit funds from taking on excessive credit risk. As I have shown today, the extent of credit risk taken by some money market funds is shown by the number of times sponsors have needed to provide support and by the makeup of underlying assets in certain funds. The SEC limitations placed on credit risk are currently too broad to avoid significant credit risk exposure and there may be ways to use market information to determine if assets in the funds are inconsistent with the intent to limit significant credit risk exposures at money market funds."
He concludes, "In summary and conclusion, I believe the approaches I have mentioned today could significantly mitigate financial stability concerns around money market funds. Of course, none of the proposals eliminate the risk entirely, and none are costless. Neither are they mutually exclusive -- elements could be adopted in some combination. Everyone knows the SEC is working very hard on this, and could have a proposal for reforms out in the coming months. I strongly commend their efforts to arrive at reforms that reduce the risks surrounding money market funds. The bottom line, in my view, is that the status quo is not acceptable. As I have shown today, a number of money market funds took significant credit risk that ultimately led to them needing sponsor support in the period from 2007 to 2010. Substantial government support was required after the Reserve Primary Fund experienced losses. Moreover, a significant number of money market funds continued to take substantial credit risk during the recent European financial problems. So, I must conclude that reforms enacted to date do not seem to sufficiently limit money market funds' ability to assume excessive credit risks."
Finally, he says, "A money market fund with a fixed net asset value set by an intermediary with no capital that takes on credit risk will, eventually, result in the failure to meet obligations in the absence of outside support by either a sponsor or government. Funds need to be structured so that neither sponsor support nor government support is likely or necessary, even during times of stress. I realize the industry is opposed to measures that would decrease the attractiveness of funds but in the end a stronger industry could result, beyond the financial stability improvements that are my main focus. But all in all I believe the risks to the stability of the financial system that underpins the economy are too great not to take the actions that will make the industry, and our financial system, more stable."
