The regulatory response to the 2007-08 financial crisis is far from over, as much of the rulemaking stemming from the Dodd-Frank Act remains incomplete. Money market mutual funds (MMMFs) were subject to some modest regulatory changes in 2010, but many observers argue that the industry is in need of a more substantial overhaul. The $2.9 trillion MMMF industry is objecting, pointing out that the effects of the 2010 reform should be thoroughly examined before further changes are adopted and that radical changes would threaten the industry’s survival.
Although the problems experienced by the money market industry during the financial crisis were not widely known by the public, the government felt compelled to intervene. Just one day after Lehman Brothers declared bankruptcy in September 2008, the Reserve Primary Fund’s share price fell below a dollar because the fund’s holdings of Lehman-issued commercial paper became worthless. Investors swamped the fund with redemption requests, causing the fund to be closed and eventually liquidated. Analysts at the Boston Fed conservatively estimate that at least 20 other funds would have “broken the buck” if not for direct support from fund sponsors during the financial crisis.1 The U.S. Treasury also stepped in, setting up a guarantee program for MMMF investors to stem redemptions at other prime money funds and shore up the industry; that program expired in September 2009.
In 2010, the Securities and Exchange Commission (SEC) adopted a number of regulatory changes meant to strengthen the industry by reducing risk. Portfolio quality, stress-testing, liquidity and diversification requirements were imposed, along with limits on portfolio maturity and mandates for disclosure and reporting. A recent analysis by SEC staffers of the 2010 reforms indicates that MMMFs are less likely to “break the buck” now than they were before the reforms because the SEC-mandated maximum weighted average maturity (WAM) of portfolios has fallen from 90 days to 60 days. The staffers found that the 2010 changes have made funds more resilient to portfolio losses and investor redemptions but that none of the reforms would have prevented the 2008 meltdown of the Reserve Primary Fund.
Although the 2010 reforms have seemingly lessened the risk of losses to investors, many observers believe they did not go far enough to prevent runs. SEC Chairman Mary Schapiro, who recently left the agency, spearheaded an internal effort to impose more stringent requirements on money market mutual funds. The most controversial reform effort she championed was to allow the net asset value (NAV) of an MMMF share to float, reflecting its market value, rather than being fixed at $1, as is currently the practice. A floating NAV would put money market funds on par with other types of mutual funds. Schapiro abandoned that effort and others in August 2012 when she could not produce the three votes necessary to enact those changes.
The Financial Stability Oversight Council (FSOC) took up MMMF reform following the SEC impasse. In November, the FSOC voted unanimously to put out for public comment three reform options that align with those proposed by the SEC; while the FSOC is prepared to enact reforms, the FSOC has made it clear that it would prefer that the SEC took action. The three proposals are 1) require funds’ NAVs to float; or 2) require funds to hold a capital buffer to manage losses plus place restrictions on the number of shares redeemable at one time; or 3) require funds to have capital buffers of 3 percent in addition to some other measures. The FSOC noted that the final proposal could be a mix of the three options suggested, with the goal of maximizing industry stability. The comment period for the proposal closes in mid-February. Based on comments received, the FSOC will provide a recommendation to the SEC, which then has 90 days to respond. The SEC can agree with the FSOC recommendation, propose its own or explain in writing why it won’t do either.
Since the FSOC’s proposals came out in mid-November, two events have heightened the pressure on the SEC and the MMMF industry. As part of its recommended overhaul of the shadow banking system, the Financial Stability Board (FSB)—an umbrella organization of central bankers—called for the MMMF industry to eliminate its stable pricing mechanism, where feasible, to stanch runs.2 Functionally equivalent measures to a floating NAV should be adopted, according to the FSB, in cases where stable pricing is deemed necessary. The FSB’s stance adds an international regulatory voice to that of U.S. banking and financial markets regulators.
More recently, the FSOC has discussed the idea of designating MMMFs or their sponsors as systemically important financial institutions (SIFIs), thus posing a potential threat to U.S. financial stability.3 A SIFI designation under Section 113 of the Dodd-Frank Act would lead to tighter regulation of the money market industry, as well as direct supervision by the Federal Reserve. Individual bank regulators could also act on their own by imposing capital charges on MMMFs that are bank-sponsored.
The money market fund industry has for the most part opposed the reform proposals suggested by the SEC, the FSOC and the FSB. The Investment Company Institute (ICI), the trade group for the mutual fund industry, has criticized all three primary regulatory changes suggested—floating NAVs, capital requirements and redemption holdbacks. The ICI maintains these changes would not necessarily make the industry safer but would put money funds at a competitive disadvantage relative to other cash management products. Some of the larger mutual fund companies have offered proposals of their own to head off what they view as more draconian changes.
U.S. financial regulatory authorities are united in their desire to impose tighter regulations on money market mutual funds. If the SEC does not pass a reform package, Treasury Secretary Timothy Geithner has said the FSOC will.4 Most observers believe some sort of reform effort will be approved by the end of 2013. With the money fund industry so firmly against floating share prices, the most likely outcome will be some sort of capital requirement, perhaps coupled with limits on redemptions in times of financial stress.
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