Markets are Asking: So What Part of No Did You Not Understand?

The crisis of 2008 made clear that wholesale funding markets for banks are inherently unstable. In the absence of extraordinary central bank action it is likely that this method of bank funding would have been wiped out by the market. The question this raises is whether the market for financial commercial paper should be wiped out. That is, is it such an unstable funding source that the economy as a whole is better off without it?

Note that I am not asking (yet) whether the central banks should not have intervened in 2008 or today to protect wholesale funding markets. I am asking what should have been the long-term plan after the 2008 intervention — and what should be the long term plan after today’s intervention.  I am asking why we are seeing the same problem arise, when there were 2-3 years of relative stability in which to move away from this reliance on wholesale funding.

The fact that a form of funding that was rejected by the market in 2008 was approved by regulators in 2011 is frightening.  The fact that many of the largest money market fund providers are still trying to get away with selling generic “prime” funds and filling them with financial commercial paper is frightening:  where are the money funds that have non-financial exposure only?  Where are the money funds that offer (taxable) US exposure only? Why are our money fund choices so limited?

As far as I can tell the history is pretty clear:  Once there has been a bailout on the scale of what took place, long-term financial stability is best served not just by announcing an end to the bailouts, but by acting on that announcement when, inevitably, the market challenges your will.  Holding the line both shakes the financial system to its core and, simultaneously, creates the faith that this is a financial system with central bankers who know how to do their jobs.

What events am I thinking of?   The Bank of England’s bailout of the Dutch banking system in 1763, followed by its refusal to bail it out in 1772 (when the cause of the crisis was speculation).  (I happen to think that this is turning point when the center of the European economy switched decisively from Amsterdam to London, but I digress.)  The Bank of England’s bailout of the bill brokers (mostly Overend) in 1857, followed by its announcement not to support them in the future, and its decision in 1866 not to support them in a crisis.  Watching the structure of the financial system shake to its foundations was probably the impetus that drove Bagehot to write Lombard Street — and to write approvingly of the Bank of England’s decision not to support Overend.  Observe how robust the British financial system was when it came out of this crisis; Britain had decades of stable banking, precisely because the banks and shadow banks (i.e. bill brokers) were scared of the central bank.

History of course is not destiny.  It should be possible for regulators to read the events of 2008 and force the changes that the market is demanding without the economy experiencing another major financial failure that shakes the financial system to it’s foundations.  It will, however,  require strong-willed regulators who are capable of demanding changes in our financial structure that will most likely have the effect of significantly reducing the profitability of banks.  The question is whether the regulators here and in Europe are up to this job.  I certainly hope so, but the continued reliance of banks on wholesale funding is a very bad sign.

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Socializing costs: the ICI money market plan

Bloomberg reports on the mutual fund industry’s proposal for socializing its costs:

Under the ICI plan, fees collected from money-market funds would be used to capitalize a state-chartered bank or trust. The facility would purchase holdings at face value from funds during a crisis. That could prevent a fund fielding heavy redemption requests from taking losses because it is forced to sell healthy holdings at a discount.

As a bank, it would also have access to the U.S. Federal Reserve’s discount lending window, according to the ICI, making taxpayers the ultimate backer of money-market funds’ liquidity.

Why on earth should the federal reserve allow money market funds indirect access to the discount window?  So the banks continue to face undercapitalized competition for their deposits?

If the money market fund managers think they need access to the discount window, then they need to turn themselves into banks — and maintain the same capital positions that banks are required to maintain at every point in time.  Hopefully Larry Fink’s opposition to this proposal (per Bloomberg) means the Fed won’t be pressured to take it seriously.

Money funds and the problem with successful regulation

I am a firm supporter of regulation where it is successful.  But I’m also a firm believer in thinking hard about what it means for regulation to be successful.  Perhaps money market funds are an example of an investment product that was made dangerous by “successful” regulation.

Money market funds are built on a contradiction.  They are investment funds — and like any investment fund expose investors to losses; however, they are allowed to report and calculate their returns as if the Net Asset Value of one share in the fund is always equal to $1.  This subterfuge means that under normal circumstances a well managed money market fund will behave a lot like a bank savings account:  any money an investor puts in the account stays there until it is withdrawn and periodically the account accrues interest.

In the absence of regulation this subterfuge would be recognized for what it is — because there would always be a bunch of high-flying money funds malinvesting assets and going bust.  Every investor would know to take the warning about possible losses seriously and would spend time evaluating the quality of money market funds.

Over the past couple of decades, however, money market funds have been carefully regulated and in the 25 years preceding the Reserve Fund failure there was only one small money fund failure.  This successful regulation bred complacency amongst investors who began to to view money market funds as excellent substitutes for bank deposits.

In my view the fact that investment funds were treated as having NAVs of $1 was misleading in an environment where these bank-like investment funds almost never failed.  Investors were told that money funds (i) were investment accounts that could lose value and (ii)  would almost certainly preserve a NAV of $1 per share.  For obvious reasons both statements can not be true simultaneously.

Each shareholder in an investment fund has a right to his or her share of the underlying assets — neither more, nor less.  The use of a fixed NAV for money funds makes it appear that shareholders have a right to more than the simple fraction of assets that they own.

Despite the fact that money funds advertise a NAV of $1 per share, their only assets are the assets of the investment fund.  Thus, money funds have no way to support the NAV that they advertise. This is a problem.

In my view, any fund that seeks to maintain a fixed NAV per share must necessarily establish a reserve fund that will be used to support the fixed NAV in the event that value of the investment fund in fact falls.  Any fund that claims to maintain a fixed NAV without maintaining a reserve fund is guilty of false advertising.

In short, because money funds are inherently contradictory financial products, regulators made a mistake by permitting their development.  And compounded this mistake by regulating the product so strictly that failures were effectively eliminated.  The lesson I take from this:  Either regulators need to be very critical of financial innovation and repress products that are based on contradictory premises, or regulators need to remember that markets are often strengthened, not weakened by failures and allow unsafe versions of such products to be sold to investors.

The worst outcome for regulators is the current money market fund situation: the product is inherently contradictory, but it is so heavily regulated that the market’s faults have become the responsibility of regulators.  We must not forget that there are tensions between protecting investors from bad products, promoting efficient financial innovation and allowing failure to act as a market force that limits systemic risk.