Federal Reserve Chairman Ben Bernanke spoke today a the Federal Reserve Bank of Chicago on "Monitoring the Financial System" and mentioned money market funds on a couple of occasions. He says, "Shadow banking, a second area we closely monitor, was an important source of instability during the crisis. Shadow banking comprises various markets and institutions that provide financial intermediation outside the traditional, regulated banking system. Shadow banking includes vehicles for credit intermediation, maturity transformation, liquidity provision, and risk sharing. Such vehicles are typically funded on a largely short-term basis from wholesale sources. In the run-up to the crisis, the shadow banking sector involved a high degree of maturity transformation and leverage. Illiquid loans to households and businesses were securitized, and the tranches of the securitizations with the highest credit ratings were funded by very short-term debt, such as asset-backed commercial paper and repurchase agreements (repos). The short-term funding was in turn provided by institutions, such as money market funds, whose investors expected payment in full on demand and had little tolerance for risk to principal."

Bernanke explains, "As it turned out, the ultimate investors did not fully understand the quality of the assets they were financing. Investors were lulled by triple-A credit ratings and by expected support from sponsoring institutions--support that was, in fact, discretionary and not always provided. When investors lost confidence in the quality of the assets or in the institutions expected to provide support, they ran. Their flight created serious funding pressures throughout the financial system, threatened the solvency of many firms, and inflicted serious damage on the broader economy."

He continues, "Securities broker-dealers play a central role in many aspects of shadow banking as facilitators of market-based intermediation. To finance their own and their clients' securities holdings, broker-dealers tend to rely on short-term collateralized funding, often in the form of repo agreements with highly risk-averse lenders. The crisis revealed that this funding is potentially quite fragile if lenders have limited capacity to analyze the collateral or counterparty risks associated with short-term secured lending, but rather look at these transactions as nearly risk free. As questions emerged about the nature and value of collateral, worried lenders either greatly increased margin requirements or, more commonly, pulled back entirely. Borrowers unable to meet margin calls and finance their asset holdings were forced to sell, driving down asset prices further and setting off a cycle of deleveraging and further asset liquidation."

Bernanke tells us, "We have other potential sources of information about shadow banking. The Treasury Department's Office of Financial Research and Federal Reserve staff are collaborating to construct data sets on triparty and bilateral repo transactions, which should facilitate the development of better monitoring metrics for repo activity and improve transparency in these markets. We also talk regularly to market participants about developments, paying particular attention to the creation of new financial vehicles that foster greater maturity transformation outside the regulated sector, provide funding for less-liquid assets, or transform risks from forms that are more easily measured to forms that are more opaque."

He adds, "A fair summary is that, while the shadow banking sector is smaller today than before the crisis and some of its least stable components have either disappeared or been reformed, regulators and the private sector need to address remaining vulnerabilities. For example, although money market funds were strengthened by reforms undertaken by the Securities and Exchange Commission (SEC) in 2010, the possibility of a run on these funds remains--for instance, if a fund should "break the buck," or report a net asset value below 99.5 cents, as the Reserve Primary Fund did in 2008. The risk is increased by the fact that the Treasury no longer has the power to guarantee investors' holdings in money funds, an authority that was critical for stopping the 2008 run. In November 2012, the FSOC proposed for public comment some alternative approaches for the reform of money funds. The SEC is currently considering these and other possible steps."

Finally, Bernanke says, "With respect to the triparty repo platform, progress has been made in reducing the amount of intraday credit extended by the clearing banks in the course of the daily settlement process, and, as additional enhancements are made, the extension of such credit should be largely eliminated by the end of 2014. However, important risks remain in the short-term wholesale funding markets. One of the key risks is how the system would respond to the failure of a broker-dealer or other major borrower. The Dodd-Frank Act has provided important additional tools to deal with this vulnerability, notably the provisions that facilitate an orderly resolution of a broker-dealer or a broker-dealer holding company whose imminent failure poses a systemic risk. But, as highlighted in the FSOC's most recent annual report, more work is needed to better prepare investors and other market participants to deal with the potential consequences of a default by a large participant in the repo market."

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