While there are no specific topics addressing money market mutual funds at this year's ICI and FBA "Mutual Fund and Investment Management Conference", which takes place this week in Orlando, ICI President and CEO Paul Schott Stevens spoke on "Financial Stability and U.S. Mutual Funds." Meanwhile, other speakers, including SEC Director of the Division of Investment Management Norm Champ, mentioned money market fund regulations but provided little detail. ICI's Stevens says, "Today I will discuss an emerging issue of critical importance: whether registered funds, or asset managers more generally, pose significant risks to the financial system. Could funds or their managers trigger or accelerate the next great financial crisis? Many of you may be thinking, "That's an easy question, because we all know that they won't. Next topic!" Others may think, "That's not an issue my company has to worry about, because we're not one of the largest asset managers. This isn't our fight.""
He explains, "So, my first challenge today is to dispel those two notions -- because everyone in our industry needs to take note of this matter; to understand what's at stake for funds and their investors; and to engage alongside ICI to help us make the strongest possible case. For those of you who think this whole notion about funds and systemic risk should be easily dismissed on its merits -- think again. Unfortunately, in very short order, we've had reports from both U.S. and international regulators suggesting that asset managers or the funds they offer may well be the next target for enhanced regulation on the grounds of systemic risk. We have serious disagreements with these reports -- but they nonetheless could be the predicate for new, bank-style prudential regulation for our industry."
Stevens continues, "If regulators ultimately decide that certain funds or asset managers should face enhanced prudential regulation, the consequences will reach far beyond the 20 largest managers listed in the U.S. report, or the 14 U.S. registered investment companies singled out under the global authorities' preliminary thresholds. I'm going to describe how we got into this debate ... to lay out why even the largest U.S. mutual funds do not create systemic risk ... and to describe the potential implications of this issue."
He tells us, "Our argument can be summed up in four points: First, mutual funds make little use of leverage -- the essential fuel of financial crises. Second, mutual funds simply do not "fail" the way banks and insurance companies do. Third, the specific risks that the OFR Report hypothesizes have no factual predicate. And finally, the structure and comprehensive regulation of mutual funds and their managers not only protect investors, but limit systemic risks and risk transmission."
Stevens says, "Let's start with leverage. Leverage is the fuel that can turn a financial spark into a bonfire. Indeed, all major financial crises have involved debt that has grown dangerously out of scale. Former Federal Reserve Chairman Alan Greenspan is one of the many authorities who have emphasized the central role of leverage in the 2008 financial crisis. As he writes: "Subprime [mortgages] were indeed the toxic asset, but if they had been held by mutual funds or in 401(k)s, we would not have seen the serial contagion we did.... It is not the toxic security that is critical, but the degree of leverage of the holders of the asset.... In 2008, tangible capital on the part of many investment banks was around 3 percent of assets. That level of capital can disappear in hours, and it did. And the system imploded.""
He asks, "Why does Chairman Greenspan say that mutual funds would not have fueled "serial contagion" -- in other words, systemic risk? Precisely because mutual funds make little or no use of leverage. Then, by the OFR's account, stock and bond funds "face the risk of large [shareholder] redemption requests in stressed markets" -- forcing funds to liquidate portfolio securities at "fire sale" prices. This, according to the OFR, transmits risks across the financial system. These are interesting conjectures. But there is no support for them in the historical record."
Stevens adds, "Actually, we have been hearing claims that fund investing could destabilize markets for quite a while -- since 1929, in fact. ICI Research has scoured every period of market stress since World War II. The data show no evidence that fund investors panicked and stampeded in any of those episodes. Let me repeat: no evidence ... in any of those episodes. Most broadly, we do know the Federal Reserve as a systemic risk regulator would practice "prudential supervision." This brand of regulation concerns itself primarily with preserving the banking system. Certainly, it is not guided by the interests of investors. Nor is it predicated on notions of fiduciary duty, the unwavering responsibility of investment advisers always to act in the best interests of their funds or other clients."
Stevens also says, "So in times of market turmoil, the Fed might well decide that it is necessary for a fund to maintain financing for a troubled company or financial institution -- irrespective of the best interests of the fund's shareholders. We do know that this risk is not purely theoretical. Amidst the rescue of Bear Stearns in March 2008, the collapse of Lehman Brothers in September 2008, and the European banking crisis of 2011, U.S. and other bank regulators harshly criticized funds for pulling back from funding dodgy institutions. Bank regulators apparently expected that, in the interests of "the system," funds would ignore credit risks, accept predictable losses -- in short, "take one for the team" -- with no regard for the interests of their own shareholders."
He comments, "How long would fund investing -- rooted in the trust of our investors -- thrive under such conditions? We do not know how long the consequences of SIFI designation would be confined solely to the largest funds or complexes. New costs and new regulations applied selectively will distort the competitive landscape of our industry, in ways that are both numerous and unpredictable.... Taken together, the consequences of SIFI designation could significantly impair fund investing. For our economy, they could undermine a key source of financing. For individual Americans, these new regulations could harm severely the single best vehicle for retirement saving and investment."
Finally, Stevens adds, "I am encouraged by recent remarks in this vein by SEC Chair Mary Jo White. She said: "We also will continue to engage with other domestic and international regulators to ensure that the systemic risks to our interconnected financial systems are identified and addressed -- but addressed in a way that takes into account the differences between prudential risks and those that are not.... We want to avoid a rigidly uniform regulatory approach solely defined by the safety and soundness standard that may be more appropriate for banking institutions." Substantial efforts already are underway to address regulators' systemic risk concerns in specific areas -- such areas as money markets, repurchase agreements, securities lending, and derivatives trading."
In other news, we're still waiting for Norm Champ's speech to be posted (we didn't go to the ICI's MFIMC so didn't see the speeches live), but the Twitter comments and reporting (or lack thereof) indicate that there wasn't much substance on money funds. (Champ's talk last year at MFIMC was light on specifics as well.) Comments indicate that the SEC is working on money fund regulations, reading comment letters, and planning on issuing rules this year.
