The U.S. Treasury's Office of Financial Research just published a study, entitled, "The Intersection of U.S. Money Market Mutual Fund Reforms, Bank Liqudity Requirements, and the Federal Home Loan Bank System." Coauthored by the Federal Reserve Bank of Boston's Kenechukwu Anadu and OFR's Viktoria Baklanova, the paper examines potential risks from money funds' massive holdings of Government securities and FHLB Debt. Its Summary says, "The most recent changes to money market fund regulations have had a strong impact on the money fund industry. In the months leading up to the compliance date of the core provisions of the amended regulations, assets in prime money market funds declined significantly, while those in government funds increased contemporaneously. This reallocation from prime to government funds has contributed to the latter's increased demand for debt issued by the U.S. government and government-sponsored enterprises."

The paper explains, "The Federal Home Loan Bank (FHLBank) System played a key role in meeting this heightened demand for U.S. government-related assets with increased issuance of short-term debt. The FHLBank System uses the funding obtained from money market funds to provide general liquidity to its members, including the largest U.S. banks. Large U.S. banks' increased borrowings from the FHLBank System are motivated, in large part, by other post-crisis regulations, specifically the liquidity coverage ratio (LCR). The intersection of money market mutual fund reforms and the LCR have contributed to the FHLBanks' increased reliance on short-term funding to finance relatively longer-term assets, primarily collateralized loans to its largest members."

It tells us, "This funding model could be vulnerable to 'runs' and impact financial markets and financial institutions in ways that are difficult to predict. While a funding run seems unlikely, it is often the violation of commonly held conventions that tend to pose financial stability risks. Indeed, runs on leveraged financial intermediaries engaged in maturity transformation have produced systemic risks issues in the past and are worthy of investigation and continuous monitoring."

The OFR report's "Introduction and Background" says, "The run on prime money market funds contributed to strains in the U.S. dollar short-term funding markets during the most recent financial crisis. In mid-September 2008, the Reserve Primary Fund, a large prime fund, announced that it could no longer maintain a stable $1.00 transaction price (an event known colloquially as "breaking-the-buck") due to its exposure to Lehman debt. Following this announcement, investors redeemed hundreds of billions of dollars from prime funds, which were invested substantially in short-term corporate debt (e.g., commercial paper (CP) and certificates of deposit (CDs). Simultaneously, investments in government funds increased in a broad-based flight-to-quality."

It adds, "While the Reserve Primary Fund was the only money market fund to "break-the-buck" and, thus, pass through principal losses to its shareholders in 2008, other prime funds were just as vulnerable and could have met a similar fate absent support actions by their sponsors. Unprecedented official sector action stemmed the run from prime money market funds and, in effect, stabilized the short-term funding markets. These emergency actions included the Treasury Department's share price guarantee program for eligible money market funds and the Federal Reserve's liquidity facility for asset-backed commercial paper held by money market funds."

The OFR report continues, "Since the Reserve Primary Fund's failure, the Securities and Exchange Commission (SEC) has adopted two rounds of reforms, one in 2010 and the other in 2014. The reforms were intended to strengthen liquidity and credit risk management practices, enhance reporting requirements, and address run risk in money market funds, among other things. The two main components of the 2014 amendments were a requirement that institutional prime and tax-exempt funds transact at a floating net asset value (NAV), from the then-stable NAV structure, and granting the board of a non-government fund the ability to impose liquidity fees and redemption gates if it breaches certain liquidity thresholds; government funds may opt-in if previously disclosed. In its 2014 adopting release, the SEC noted, among other things, that the floating NAV requirement is intended to reduce the first mover advantage inherent in a stable transaction price, and fees and gates are intended to directly address runs on funds."

It states, "In the months leading to the October 14, 2016 compliance deadline for the floating NAV and fees and gates requirements, significant assets migrated from prime and tax-exempt money market funds, which are statutorily subject to those provisions, into government funds, which are not. One key factor to facilitating this shift is the FHLBank System, which met government funds' increased demand for eligible securities with increased issuance of short-term debt. Available data shows that the largest U.S. banks are the largest borrowers from the FHLBanks. Some of this increase in large U.S. banks' borrowing from the FHLBank System is attributable to the liquidity coverage ratio (LCR) requirement."

Anadu and Baklanova tell us, "The LCR, for regulatory purposes, treats short-term funding obtained from FHLBanks more favorably than funding obtained from the private markets (e.g., commercial paper). The LCR is a driver for banks to increase their holdings in HQLA, which are potentially purchased through advances from the FHLBanks. This increased demand for funding from the largest U.S. banks has, in turn, provided an incentive for the FHLBank System to increase its issuance of short-term debt; while money fund reforms have, in turn, increased the demand for FHLBank debt from government money funds. The result is the FHLBank System is increasingly using its balance sheet to intermediate the supply of cash from government money market funds and demand for funding from large U.S. banks."

They write, "Reforms have had a profound impact on the composition of money market funds, but only a transitory, thus far, effect on the broader money markets. In the nine months leading to October 14, 2016, assets in prime funds declined by over $1 trillion (or 64 percent) to $562 billion, while those in government funds increased by a similar magnitude. This shift was driven primarily by money fund investors' preference for stable NAV funds that are not subject to liquidity fees and redemption gates. This asset migration continued right up to the mid-October 2016 compliance deadline, but has since stabilized. Prime money fund assets are in excess of $642 billion as of month-end August 2017."

OFR's report comments, "FHLBank debt held by money market funds has increased rapidly since 2014.... Indeed, money market funds held about $546 billion in debt issued by the FHLBanks or 19 percent of $2.9 trillion in total money fund assets as of month-end July 2017. That total was up from $268 billion in January 2014, or around 9 percent of the total money fund assets at that time. This swift increase in government money funds' holdings of FHLBank debt roughly coincides with U.S. banks' increased borrowing from the FHLBank System. It appears the growth was fueled by the intersection of two regulatory reforms -- money market fund reforms, adopted in 2014 and fully implemented in 2016, and U.S. LCR, finalized in 2014 and phased in from 2015 through 2017."

It continues, "One concern is the FHLBanks' increased reliance on short-term funding could be vulnerable to rollover risks if cash investors' risk appetite for GSE debt were to unexpectedly change. As GSEs, FHLBanks are perceived as enjoying an implicit guarantee from the U.S. government. However, any uncertainty about this GSE status, for example due to changes in the regulatory or legislative environment, could challenge the FHLBanks' ability to rollover their debt. Moreover, an implicit guarantee does not necessarily mean that the U.S. government will step in if the FHLBank System were to experience material distress. The FHFA, the primary regulatory of the FHLBank System, has expressed concerns with the FHLBank System's increased issuance of short-term funding, citing potential safety and soundness issues that may emanate from rollover risk, including in periods when interest rates are rising."

They conclude, "The liquidity coverage ratio generated demand from large U.S. banks for substantial amounts of new advances to meet their regulatory requirements. Separately, money market fund reforms have prompted a significant shift in assets from prime money market funds into government funds. FHLBanks have met this increased demand for advances to members and short-term government securities with increased issuance of short-term and floating-rate debt eligible for investments by money market funds. Analysis of regulatory filings by FHLBanks finds that this increased funding is largely used to subsidize regulatory liquidity requirements to the largest U.S. banks. The FHLBanks are increasingly serving as a link between money market funds and the largest U.S. banks, and this link may generate new unintended vulnerabilities to the U.S. financial system."

Finally, the OFR paper adds, "Although a low probability event, potential risks channels include a run on FHLBanks' liabilities due to uncertainties about their GSE status, operational issues that limit the FHLBanks' ability to rollover its debt, or other events that cause a rapid shift in investors' preferences. The prospect of such an event warrants close monitoring, as it could impact the broader financial markets in ways that are difficult to predict. The FHFA is aware of the increased maturity mismatched and is taking steps to reduce the system's reliance on short-term funding, including its plan to issue proposed liquidity risk management rules by year-end."

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