The International Monetary Fund released its latest "Global Financial Stability Report last week, which contained a chapter on "The Risks of Central Bank Policies and some comments on money market mutual funds. The piece, which we believe demonstrates unfamiliarity with funds and contains inaccuracies, says, "The prolonged period of low interest rates increases risks in money markets, including through developments in money market mutual funds (MMMFs). With interest rates remaining near zero in the maturities at which MMMFs are permitted to invest, these institutions are experiencing very low (in some cases zero or negative) returns that in many cases fail to cover the costs of fund management. As a consequence, U.S. MMMFs have raised credit risk modestly (within the confines of regulatory restrictions), engaged in more overnight securities lending, granted fee waivers, and turned away new money." (See also, a Wall Street Journal blog's, "IMF Warns Easing Could Threaten Future Stability".)
The IMF report mysteriously suggests, "The fundamental problem is that to become profitable the MMMF industry needs to shrink further, and the risk is that it may do so in a disorderly fashion. For example, another run on MMMFs may occur if downside credit risks materialize or securities lending suddenly halts, fueling investors' fear of MMMFs "breaking the buck" (that is, failing to maintain the expected stable net asset value)."
It explains, "Once started, a run may accelerate because investor guarantees that were established in the wake of the Lehman Brothers bankruptcy have been removed, and the Dodd-Frank Act precludes the Federal Reserve from unilaterally stepping in to provide liquidity to the sector. [The footnote says: The U.S. Treasury Department introduced the Temporary Guarantee Program, which covered certain investments in MMMFs that chose to participate in the program and has now expired. The Federal Reserve created an Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, through which it extended credit to U.S. banks and bank holding companies to finance their purchases of high-quality asset-backed commercial paper from MMMFs.]"
We're not sure what they mean by "overnight securities lending" (repos?), but the IMF report tells us, "Although the assets of MMMFs are already shrinking in the low interest rate environment as investors seek higher returns elsewhere, an outright run would be undesirable and could have systemic consequences if the funding that these institutions provide to banks -- directly and through overnight securities lending -- dries up. Central bank interventions in the interbank markets were a response to a significant reduction in interbank lending activity that mostly resulted from increased sensitivity to counterparty risk."
It adds, "With indirect credit easing policies, central banks made longer-term funds available at fixed low rates and softened collateral rules, aiming to avoid a severe credit contraction. This form of credit easing lowered interbank spreads during the crisis, especially in the euro area and Japan. By partially replacing the interbank market, central banks play a crucial role in the distribution of bank funding in some areas."
Finally, the IMF writes, "From a money-market perspective, risks stem not so much from central bank intervention itself as from a misstep in the eventual withdrawal from the market. If central banks exit from interbank markets before underlying conditions are addressed and the private bank funding market is fully restored, renewed strains could resurface, with the costs of short-term bank financing turning significantly higher for some banks. These risks are difficult to quantify because central bank intervention may mask the dysfunction it was designed to address. A decomposition of interbank spreads may offer some insights."
