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January 22, 2013

How FSOC Can Regulate Money Market Funds

With the Securities Exchange Commission (“SEC”) at an impasse, the Financial Stability Oversight Council (“FSOC”) has the authority to regulate money market funds (“MMFs”) as systemically significant nonbank institutions.  Why should they do this? Because MMFs provide trillions of dollars in short term funding to the financial industry and much of corporate America.  If those funds are withdrawn from the financial system rapidly, as they were during the last crisis, significant parts of the financial system and the economy seize up and begin to fail.

When people start to worry about their money, they withdraw it, often in very large numbers and at the same time.   During the last crisis, that’s what happened with MMFs, which were referred to as the canary in the coal mind because that is where people withdraw their money the quickest and earliest.  To prevent that “run” on MMFs (really no different than the bank runs of old), the government, meaning U.S. taxpayers, effectively guaranteed the entire $3.7 trillion industry (initially directly and subsequently indirectly with an insurance program).  That $3.7 trillion program was the single largest rescue/bailout program during the last financial crisis.

Since then, many different ideas have been proposed to prevent U.S. taxpayers from being on the hook again and having to bailout the MMFs from losing their investors during the next crisis.  MMFs are regulated by the SEC and it has been at the center of these discussions.  However, yesterday the Chairman couldn’t get three votes to propose a rule to address the systemic issues raised by MMFs.

FSOC is charged with protecting the overall financial system, identifying current and emerging systemic risks, and acting to reduce or eliminate them.  It has the authority to do this directly and as a backup to a primary regulator that fails to do it in the first instance.  Thus, FSOC can regulate MMFs in one of two ways:

First, FSOC has broad authority under the Dodd Frank Act (“DFA”) to impose new or heightened standards on MMFs:

       FSOC can direct the SEC to impose new or heightened standards and safeguards to MMFs


  • Section 120 of the DFA gives FSOC authority to “provide for more stringent regulation of regulated financial activities by issuing recommendations to the primary financial regulatory agencies to apply new or heightened standards and safeguards, including standards enumerated in section 115, for a financial activity or practice conducted by bank holding companies or nonbank financial holding companies under their respective jurisdictions, if the Council determines that the conduct, scope, nature size, scale, concentration, or interconnections of such activity or practice could create or increase the risk of significant liquidity, credit or other problems spreading among bank holding companies and nonbank financial companies, financial markets of the United States,  or low-income, minority or underserved communities.”  (DFA section 120(a); emphasis added)


  • Given what happened in the last crisis, there is no genuine dispute that MMFs “could create or increase the risk of significant liquidity, credit or other problems spreading among bank holding companies and nonbank financial companies, financial markets of the United States….”


  • As described in Section 115 of the DFA, FSOC-recommended prudential standards can include risk-based capital requirements, leverage limits, liquidity requirements, concentration limits, and other requirements.


  • Thus, FSOC has the authority and power to direct the SEC to take systemic risk-mitigating actions regarding MMFs.


  • Interestingly, the DFA does not include specific FSOC voting rules for Section 120.  So it would appear that FSOC could determine to recommend higher standards by majority vote or another standard (provided that it wasn’t arbitrary and capricious).


  • However, FSOC can only make “recommendations” and the SEC could decline to adopt them.  (DFA section 120(c)(2))  While that may be unwise (given that it would have to reject FSOC’s recommendations which would be based on FSOC’s determination of system risk), the Chairperson might still be unable to get the votes to adopt a rule implementing FSOC’s recommendations.

Second, the DFA provided FSOC with a another method of responding to systemic risks if a primary regulator fails to implement its recommendations (or otherwise for that matter). 

  • FSOC can directly designate MMFs for supervision and regulation by the Federal Reserve


  • Under Section 113 of the DFA, if FSOC determines by a 2/3 vote of its 10 voting members, including an affirmative vote of the Treasury Secretary, that “material financial distress at the U.S. nonbank financial company, or the nature, scope, size scale, concentration, interconnectedness, or mix of activities of the U.S. nonbank financial company, could pose a threat to the financial stability of the United States”, then the company will be designated for supervision by the Federal Reserve and subject to prudential standards recommended by FSOC under Section 115 of the DFA. (DFA section 113(a)(1); emphasis added)


  • There is no genuine dispute that MMFs “could pose a threat to the financial stability of the United States,” as proved in the last crisis and by the need for a $3.7 trillion program to stop a run on the MMFs and the contagion that would have followed throughout the entire financial system


  • This statutory authority is broad enough to allow FSOC to designate classes of firms, such as MMFs, for new or heightened standards and safeguards.  (See, Better Markets FSOC comment letter on designation of systemically significant nonbank firms, pp yy zz)
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