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August 11, 2022

Money Market Funds: A Bank-Like Product Without Bank-Like Regulations or Protections Needlessly Creates Systemic Risks

As part of a series of reports on Shadow Banking, Better Markets released a report on money market funds (MMFs) and the systemic risks they pose to the U.S. financial system. The report is the second in the series on the shadow banking sector. You can find the first report in the series, which provides an overview of shadow banking here.

Money Market Funds, marketed and sold as an alternative to traditional bank checking or savings deposit accounts, play a prominent role in the shadow banking system. Although little more than demand deposit bank accounts suggest dollar-for-dollar guarantees, they are not subject to similar regulations as banks and, therefore, do not have either insurance or an adequate financial cushion to withstand market stresses.

That is why the Fed and the American public have had to bail out the MMF industry twice, first during the 2008 Crash when the industry was about $3 trillion in size and then again in 2020 pandemic when the industry was $4.5 trillion in size. In the report, Better Markets argues that it is long past time that MMFs are properly regulated and sufficiently resilient to market stress that taxpayers never again have to bail them out.

Part of the proliferating problems with MMFs arise from their extensive interconnections with vital parts of the financial system and, therefore, the contagion they can quickly precipitate.  MMFs provide a significant amount of funding to key short-term funding markets like commercial paper and repo markets that are used by banks, other financial institutions, and larger corporations for their day-to-day operational needs.

A lack of sufficient regulations for the MMF industry has repeatedly led to panic among investors and massive runs in 2008 and 2020 that resulted in near-crippling turmoil in those markets, which threatened to shut down the financial system and economy. Large banks in particular face pressure on multiple fronts from runs on MMFs – from turmoil in the short-term funding markets, on which they heavily rely, and from corporate customers in need of borrowing.  Therefore, in the report (as well as a recent comment letter to the SEC) we urge the SEC to adopt the following regulatory requirements for MMFs in addition to those that are in place:

  1. Minimum capital buffers that will allow MMFs absorb losses in periods of market stress while continuing to fulfil client redemption requests and maintain investor confidence; and
  2. Floating share values (or net asset values) for all types of MMFs that reflect the true market value of the assets held in the portfolio of the MMF rather and the MMFs true nature as an investment product.

Another channel of impact to the financial system, and another source of pressure for large banks, is through the sponsorship of MMFs. In the U.S., MMFs that are sponsored by banks hold about 45% of the industry’s assets, with the remainder held by those sponsored by large investment management companies. These relationships create exposures, and even losses, to the sponsoring bank in times of stress when those sponsoring banks deplete their capital when they inject it into their MMFs to keep them solvent and prevent them from failing. To address these risks, capital requirements should be in place:

  1. The federal banking agencies should modify capital requirements to capture some level of exposure that results from bank sponsorship of MMFs, either through leverage requirements or stress-related requirements; and
  2. The SEC should require investment management funds to capitalize against exposures to the MMFs they sponsor.

MMFs are the proverbial “canary in the coalmine” whereby MMF runs quickly transmit into the short-term money markets and then into the core of the banking and nonbank financial systems, pushing them to the brink of collapse and precipitating bailouts. The industry finally must be sufficiently regulated to protect the taxpayer, financial system, and economy.

You can find the full report here.





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