An Evaluation of Money Market Fund Reform Proposals

Samuel G Hanson,David S Scharfstein,Adi Sunderam

doi:10.1057/imfer.2015.14

Abstract

U.S. money market mutual funds (MMFs) are an important source of dollar funding for global financial institutions, particularly those headquartered outside the United States. MMFs proved to be a source of considerable instability during the financial crisis of 2007–09, resulting in extraordinary government support to help stabilize the funding of global financial institutions. In light of the problems that emerged during the crisis, a number of MMF reforms have been proposed, which are analyzed in this paper. The paper assumes that the main goal of MMF reform is safeguarding global financial stability. In light of this goal, reforms should reduce the ex ante incentives for MMFs to take excessive risk and increase the ex post resilience of MMFs to system-wide runs. The analysis suggests that requiring MMFs to have subordinated capital buffers could generate significant financial stability benefits. Subordinated capital provides MMFs with loss absorption capacity, lowering the probability that an MMF suffers losses large enough to trigger a run, and reduces incentives to take excessive risks. Other reform alternatives based on market forces, such as converting MMFs to a floating net asset value, may be less effective in protecting financial stability. The analysis sheds light on the fundamental tensions inherent in regulating the shadow banking system.

Highlights

The shadow banking system—the nexus of market-based short-term financing and securitization that has grown rapidly over the last 15 years—was at the heart of the recent global financial crisis
Our analysis suggests that requiring market mutual funds (MMFs) to adopt a floating net asset values (NAVs) structure may be insufficient to address the instabilities associated with MMFs
Since our analysis suggests that floating NAV reforms may be ineffective in protecting global financial stability, it suggest that wholesale funding vehicles outside of the US may require further regulation

Summary

Introduction

The shadow banking system—the nexus of market-based short-term financing and securitization that has grown rapidly over the last 15 years—was at the heart of the recent global financial crisis. Many MMFs again took advantage of this opportunity by taking on excessive portfolio risk (Chernenko and Sunderam (2013)) In this way, MMF incentives to take risk when there are warnings of future system-wide stress may impede the orderly and healthy imposition of market discipline, whereby riskier banks are gradually deprived of funding at the early stages of a crisis. MMFs forced to liquidate such assets may have to sell them at heavily discounted, “fire-sale” prices This creates run risk because early investor redemptions can be met with the sale of liquid short-term government debt, which generate enough cash to fully pay early redeemers. When the Primary Reserve Fund “broke the buck” on September 16, 2008 after the failure of Lehman Brothers, it precipitated a massive run on prime MMFs, mainly by institutional investors who were concerned about MMF exposures to troubled financial firms. Given the heavy reliance of foreign and European banks on MMFs for wholesale dollar funding, the potential of a run on US MMFs is an important threat to both domestic and global financial stability

The Goals of Structural MMF Reform

Conclusion

Subordinated share class

Standby liquidity facility or escrow account

Findings

B CCC CC-C