“Law Matters” for money market funds
By Viktoria Baklanova and Joseph Tanega
In the name of financial stability, institutional and product regulations since the 2008 financial crisis have forced banks and non-bank banks (the so-called “shadow banks”) to create insatiable compliance regimes. But the juggernaut does not stop here. These regulations typically require new “skin in the game” and consolidated regulatory reporting of financial products. In this midst of this vast mixture of regulations, money market funds (MMFs) have been demonized by academics and ideologues stating categorically that since they are “shadow banks,” they must be instruments of contagion posing systemic risks to the financial systems in both the United States and the European Union. But where is the evidence for this claim? And more importantly, on what basis are these claims made? In fact, very little to no research has been done that would justify confirmation or rejection of these claims. Unlike the doctrinaire and ideological motivated opinions of those who believe all financial products and especially MMFs should be regulated at the institutional level with capital requirements, it is important to see the facts.
The major threat, if any at all, to money market funds (MMFs) is not the lack of regulations, but rather the introduction of incoherent regulation, which would treat MMFs as bank-like culprits rather than as investment funds. Many authors who hold the view that MMFs should be treated as banks claim that the social insurance which MMFs appeared to have taken for free post-hoc the credit crisis under the Treasury Guarantee program, also claim that MMFs were the cause as well as the transmitter of contagion. We would beg to differ with this view, since a carrier of risk contagion presupposes that the carrier is somehow infected with the failure itself. This was simply not the case.
From the vestiges of law and regulatory history, we can trace the emergence of money market funds was an outcome of restrictive banking regulation both in the US and Europe. The Reserve Fund was the first US MMF having been established in New York in September 1972. At that time US banking laws had limited the amount US banks could pay on deposits to 4½%. Institutional investors could purchase US treasury bills or bank certificates of deposit in large denominations, but paid market rates of interest. Retail investors, however, having invested cash, suffered low-paying deposit accounts. The original raison d’etre of MMFs was to help small investors receive a higher rate by pooling their small investments and purchasing money market securities in the wholesale market.
In Europe, France led the development of MMFs in the early 1980s. As in the US case, French regulation capped interest rates that banks could pay their clients on term deposits. To contain the resulting client exodus, many banks set up in-house MMFs. These funds circumvented the interest rate cap and offered competitive yields. Within a decade, French MMFs accounted for 90% of the annual inflow into all of the country’s investment funds.
Targeted regulation of money market funds was pioneered by the US Securities and Exchange Commission (SEC), which codified the then existing MMF portfolio management practices in Rule 2a-7 under the Investment Company Act of 1940s in the early 1980s. Governed by Rule 2a-7, US MMFs developed considerable product standardisation. This was in stark contrast to European MMFs that offered varying risk profiles depending on the risk tolerance of local investors and their investment preferences.
Lawmakers had not considered pan-European regulation of MMF until after the financial crisis. In 2009, as a part of a broader reform of financial regulation, the de Larosière’s Group attempted “a much stronger coordinated supervision for all financial actors in the European Union,” which included establishing a common definition for all European MMFs. Guidelines on a common definition of European MMFs were implemented in the summer of 2011 and are currently administered by the European Securities and Markets Authority. These pan-European guidelines draw substantially on the risk-limiting parameters set out by Rule 2a-7 for US MMFs, while leaving many aspects of disclosure and corporate governance for consideration by national regulators.
Despite the existing regulation, the strengths and weaknesses of money market funds continue to be debated on both sides of the Atlantic. We urge an objective examination of the facts: MMFs are important because they are relied upon for daily liquidity and funding needs by many economic agents. Some authors have argued that the uncontrolled risks of MMF activities contributed to the 2008 crisis and there has to be more regulations to address these risks. This poses a public policy dilemma since MMFs operate by their very nature without social insurance and without access to a “lender of last resort.” There is a lively debate as to how this policy dilemma should be resolved.
Viktoria Baklanova is Chief Credit Officer and Acacia Capital, New York. Joseph Tanega is Reader in International Financial Law, University of Westminster, London, Adjunct Professor of Law and Finance, Grenoble Ecole de Management, Professor of Regulation and Supervision of Retail Banking, Alma Graduate School, University of Bologna, and Professor of Law, King Abdulaziz University. They are the authors of Money Market Funds in the EU and the US.
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Image credit: The US Treasury. By Almonroth (Own work) [CC-BY-SA-3.0], via Wikimedia Commons