Federal Reserve Chairman Jerome Powell spoke yesterday on "The Federal Reserve's Framework for Monitoring Financial Stability," and he mentioned money market funds more than once for the first time during his tenure. He says, "For seven years during the crisis and its painful aftermath, the Federal Open Market Committee (FOMC) kept our policy interest rate unprecedentedly low--in fact, near zero--to support the economy as it struggled to recover.... [A]bout three years ago the FOMC judged that the interests of households and businesses, of savers and borrowers, were no longer best served by such extraordinarily low rates. We therefore began to raise our policy rate gradually toward levels that are more normal in a healthy economy. Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy that is, neither speeding up nor slowing down growth."
On the "New approach to financial stability," Powell tells us, "Compared with other economies, lending and borrowing in the United States depend less on bank loans and more on funds flowing through a wide array of capital market channels. The crisis revealed that this capital market centric system, despite its many benefits, also provides more places where systemic risks can emerge. In response, Congress and the regulatory agencies have made many stability-enhancing changes outside of the banking system.... Tri-party repurchase agreement (repo) reforms have substantially improved the resilience of that marketplace, in particular by limiting intraday loans. Before the crisis, prime institutional money market funds were permitted to report a constant, $1 share price so long as the value of the underlying assets remained near $1. This reporting convention, combined with the implicit support of the plans' sponsors, led investors to treat those funds like bank deposits, even though they were not likewise insured. These funds are now required to report floating net-asset values, and after this reform investors chose to migrate to government-only funds, which are safer and less susceptible to runs.... These and other measures have reduced the risk that key non-bank parts of the system would freeze up in the face of market stress."
He explains, "The first vulnerability is excessive leverage in the financial sector. If a highly leveraged segment of the financial system is buffeted by adverse events, the affected entities may all need to deleverage at the same time by selling assets, leading to what is called a 'fire sale'.... The second vulnerability is funding risk, which arises when banks or nonbank financial entities rely on funding that can be rapidly withdrawn. If depositors or market participants lose faith in the soundness of an institution or the system as a whole, unstable funding can simply vanish in what is called a "run." During the crisis, we saw widespread runs, including at broker-dealers, some segments of the repo market, and money market mutual funds. These runs did severe damage, contributing to a generalized panic at the time. Had the authorities not stepped in, the damage could have been even more severe."
Powell continues, "Today we view funding-risk vulnerabilities as low. Banks hold low levels of liabilities that are able and likely to run, and they hold high levels of liquid assets to fund any outflows that do occur. Money market mutual fund reforms have greatly reduced the run risk in that sector. More generally, it is short-term, uninsured funding that would be most likely to run in a future stress event, and the volume of such funding is now significantly below pre-crisis peaks."
The Board of Governors of the Federal Reserve System also published its "Financial Stability Report" yesterday, which discussed many of the same themes as Powell's speech. Its Overview says, "In the years leading up to the 2007–09 financial crisis, many parts of the U.S. financial system grew dangerously overextended. By early 2007, house prices were extremely high, and relaxed lending standards resulted in excessive mortgage debt. Financial institutions relied heavily on short-term, uninsured liabilities to fund longer-term, less-liquid investments. Money market mutual funds and other investment vehicles were highly susceptible to investor runs. Over-the-counter derivatives markets were largely opaque. And banks, especially the largest banks, had taken on significant risks without maintaining resources sufficient to absorb potential losses."
The report states, "As a result of these vulnerabilities, a drop in house prices precipitated a financial panic. A broad initial retrenchment in asset prices led to sharp withdrawals of short-term funding from a wide range of institutions. These funding pressures resulted in fire sales, which contributed to additional declines in asset prices and generated further losses and even more withdrawals of funding. Some financial institutions failed, and many more pulled back on lending. As home prices continued to fall, and mortgage credit became scarce, millions of mortgages, many held in complex financial vehicles that increased investor leverage, could not be refinanced. Many mortgages ultimately went into default, creating devastating and widespread losses for homeowners."
It adds, "Reforms undertaken since the financial crisis have made the U.S. financial system far more resilient than it was before the crisis. Working with other agencies, the Federal Reserve has taken steps to ensure that financial institutions and markets can support the needs of households and businesses through good times and bad. Banking institutions have built stronger capital and liquidity buffers that, together with reforms to the rules governing money market funds, strengthen the ability of institutions to withstand adverse shocks and reduce their susceptibility to destabilizing runs."
The report explains, "Borrowing by households has risen roughly in line with household incomes. However, debt owed by businesses relative to gross domestic product (GDP) is historically high, and there are signs of deteriorating credit standards. The nation's largest banks are strongly capitalized, and leverage of broker-dealers is substantially below pre-crisis levels. Insurance companies have also strengthened their financial position since the crisis. Funding risks in the financial system are low relative to the period leading up to the crisis. Banks hold more liquid assets, and money market mutual funds are less vulnerable to destabilizing runs by investors."
In the chapter on "Funding Risk," the Fed writes, "A measure of the total amount of liabilities that are most vulnerable to runs, including those issued by nonbanks, is relatively low.... Banks are holding higher levels of liquid assets and relying less on funding sources that proved susceptible to runs than in the period leading up to the crisis, in part because of liquidity regulations introduced after the financial crisis and banks' greater understanding of their liquidity risks. Money market fund reforms implemented in 2016 have reduced 'run risk' in that industry." A table shows "Total runnable money-like liabilities at $13.153 trillion, which includes: Uninsured deposits ($4.652T), Repurchase agreements ($3.190T), Domestic money market funds ($2.821T), Commercial paper ($1.052T), Securities lending ($684B), and Bond mutual funds ($3.920T).
They add, "During the financial crisis, runs occurred in the markets for asset-backed commercial paper, repos, and money market fund shares, as well as on individual institutions, greatly aggravating the economic harm from the crisis. An aggregate measure of private short-term, wholesale, and uninsured instruments that could be prone to runs -- a measure that includes repos, commercial paper, money funds, uninsured bank deposits, and other forms of short-term debt -- currently stands at $13 trillion, significantly lower than its peak at the start of the financial crisis."
Finally, the report says, "Money market fund (MMF) reforms implemented in 2016 have reduced run risk in the financial system. MMFs proved vulnerable to runs in the past, largely because they almost always maintained stable share prices by rounding net asset values to $1, which created an incentive for investors to redeem their shares quickly in the face of any perceived risk of losses to the assets held by the funds. The reforms required institutional prime MMFs, the most vulnerable segment, to discontinue the use of rounding and instead use 'floating' net asset values that adjust with the market prices of the assets they hold. As the deadline for implementing the reforms approached, assets under management at prime MMFs fell sharply.... Many investors in those funds shifted their holdings to government MMFs, which continue to use rounded $1 share prices but have assets that are safer and less prone to losing value in times of financial stress. A shift in investments toward short-term investment vehicles that provide alternatives to MMFs and could also be vulnerable to runs or run-like dynamics would increase risk, but assets in these alternatives have increased only modestly compared to the drop in prime MMF assets."
