Fed Posts Financial Stability Report
The Federal Reserve published, "Financial Stability Report May 2021" last week, which covers a range of topics including money market funds, March volatility and funding risks. They explain (on p.45), "In 2020, the total amount of liabilities that are potentially vulnerable to runs, including those of nonbanks, is estimated to have increased 13.6 percent to $17.7 trillion ...; that amount was equivalent to about 85 percent of GDP.... Much of this net increase reflected growth in uninsured deposits and government MMF assets under management. This growth more than offset declines in the second half of the year in the size of prime and tax-exempt MMFs, which are particularly vulnerable to runs. Meanwhile, bond mutual funds continued to grow, on net, in 2020." The report tells us, "As noted in previous Financial Stability Reports, rapid redemptions from MMFs and fixed-income mutual funds contributed to market turmoil at the start of the pandemic, and Federal Reserve actions in the form of emergency lending facilities and regulatory relief provided support to prime and tax-exempt MMFs. Although flows and activities in associated markets have since returned to typical levels, structural vulnerabilities remain at NBFIs such as some types of MMFs as well as bond and bank loan mutual funds. Regulatory agencies are exploring options for reforms that will address these vulnerabilities." A section entitled, "Structural vulnerabilities remain at prime and tax-exempt money market funds," explains, "Assets under management at prime and tax-exempt MMFs have declined since the middle of last year, but vulnerabilities at these funds remain and call for structural fixes. In particular, assets under management at prime MMFs declined over the second half of last year, when some large prime funds closed or converted to government funds, and they have continued to decline modestly since then.... However, vulnerabilities associated with liquidity transformation at these funds remain prominent. A fund engages in liquidity transformation by offering daily redemptions to investors even when the fund's underlying assets may be difficult to sell quickly. The President's Working Group on Financial Markets released a report in December 2020 outlining potential reforms to address risks from the MMF sector. Subsequently, the SEC issued a request for comment on these potential reforms. If properly calibrated, some of these reforms -- such as swing pricing, a minimum balance at risk, and capital buffers -- could significantly reduce the run risk associated with MMFs. Meanwhile, the Money Market Mutual Fund Liquidity Facility and the Commercial Paper Funding Facility, which were deployed during the COVID-19 pandemic to backstop short-term funding markets, expired at the end of March with no material effect on these markets." It adds, "Other cash-management vehicles, such as dollar-denominated offshore funds and short-term investment funds, also invest in money market instruments and are vulnerable to runs, and some of these vehicles experienced heavy redemptions in March 2020. Currently, between $400 billion and $1 trillion of these vehicles' assets are in portfolios similar to those of U.S. prime funds, and a new wave of redemptions could destabilize short-term funding markets. The Financial Stability Board's (FSB) Holistic Review of the March Market Turmoil highlighted vulnerabilities from NBFIs, including from these cash management vehicles. The FSB, coordinating with other international organizations, will continue work that addresses risk factors that amplified stress and furthers an understanding of systemic risks in NBFIs and policies that could address these risks."
