The minimum balance at risk: a proposal to mitigate the systemic risks posed by money market funds.

McCabe, Patrick E. ; Cipriani, Marco ; Holscher, Michael 等

V.B. Some Practical Issues for MBR Implementation

Although the focus of this paper is on the conceptual rationale for an MBR, we discuss here some practical policy issues to help illustrate how an MBR might be introduced. We also address some concerns that have been raised about the effectiveness of an MBR.

SHOULD ALL MONEY FUNDS HAVE AN MBR? A number of commenters on the FSOC's proposed recommendations for MMFs have suggested that reforms for money funds should focus exclusively on prime MMFs, which, as noted above, largely hold private debt securities (see, for example, Investment Company Institute 2013, Rosengren 2013). (42) Prime funds do appear to pose the most direct threats to financial stability. These funds mostly provide financing to large global financial institutions (Scharfstein 2012, Hanson and others 2012), and the run in 2008 was focused on these funds.

Other types of MMFs also may be vulnerable to runs, however. The portfolios of government and tax-exempt MMFs have credit and interest rate risks, and each type has experienced strains in recent years. (43) Nonetheless, the top priority for MMF reform probably should be shoring up prime funds. Indeed, the FSOC's Alternative Two, which includes an MBR, would exempt from the MBR requirement any MMFs that invest primarily in Treasury securities (FSOC 2012b). (44)

WHAT OTHER ADJUSTMENTS TO SUBORDINATION RULES MIGHT BE POSSIBLE? As noted in section II.C, the flexibility of the MBR concept allows a variety of adjustments, such as an exemption of the first $50,000 of redemptions from triggering subordination. Another adjustment would cap the amount of an investor's balance that could be subordinated at a fraction of her MBR. This adjustment could limit potentially extreme outcomes if only a few investors redeem shares from a troubled MMF, and although it would reduce the effectiveness of an MBR of a given size, the MBR itself could be increased to offset the subordination limit. (45)

WOULD AN MBR REALLY STOP RUNS BY PANICKED INVESTORS? Some critics of an MBR rule have suggested that investors will redeem shares from MMFs in a crisis, regardless of the incentives created by subordination (see, for example, BlackRock 2012, Investment Company Institute 2013). To be sure, accurate predictions of investors' behaviors in a crisis are difficult. Nonetheless, an MBR rule could reverse pressures on rational investors to exit MMFs during crises. In the event that some investors run regardless of incentives, the rules that we propose would help ensure that they bear the costs of their actions and would provide extra protections for other investors, so that staying invested in the fund could be a rational decision.

COULD INVESTORS "BROKER" THEIR ACCOUNTS TO TAKE ADVANTAGE OF A $50,000 EXEMPTION FOR SUBORDINATION? In principle, investors could divide their large cash holdings into separate $50,000 accounts at different MMFs for this purpose, but the effectiveness of such a strategy likely would be quite limited for large institutional investors. One indicator of the magnitude of the account balances in institutional MMFs is their requirements for minimum initial investments, which averaged $18 million as of March 2013 for institutional prime funds with assets over $1 billion. (46) At the end of 2012, there were 241 prime MMFs, based on their filings of form N-MFP with the SEC. Thus, even if large institutional MMFs dropped their minimum investment requirements and a shareholder with an $18 million balance spread it evenly across all funds in the industry, she still would have more than $50,000 in each fund.

OMNIBUS ACCOUNTS AND IMPEDIMENTS TO IDENTIFYING INDIVIDUAL SHAREHOLDERS A more challenging obstacle to the functioning of an MBR is the use of omnibus accounts by intermediaries (such as broker-dealers) that sell MMF shares. An omnibus account is an aggregated account for multiple customers, and MMFs may have access to information about these accounts only at the aggregated level. An MBR rule applied only at the account level could be counterproductive. For example, even with a 5 percent MBR, a broker-dealer that has two customers with $100 accounts and hence a $200 omnibus account with an MMF could allow one customer to redeem all of his shares. The second customer would effectively face a 10 percent MBR.

To address this issue in its proposed recommendations on MMFs, the FSOC noted that

MMFs would be required to apply the MBR requirement to each of their recordholders. This would include recordholders that are financial intermediaries, such as banks or broker-dealers that hold shares on behalf of their customers, unless the intermediaries provide the MMF sufficient information to apply the MBR requirement to the intermediaries' individual customers directly. Absent such information, an MMF and its financial intermediary recordholders would allocate between themselves the responsibility (and associated costs) of applying the MBR requirement equitably. (FSOC 2012b, p. 44)

However, the lack of transparency associated with omnibus accounts has undesirable effects that go well beyond the difficulties it creates for administering an MBR. Omnibus accounts, for example, played a role in facilitating a widespread abusive-trading scandal that roiled the mutual fund industry in 2003. (47) Hence, there are good reasons to consider rule changes requiring that MMFs have better information about their actual shareholders, which also would allow more effective application of MBR rules.

VI. Conclusion

This paper has described a new proposal, the minimum balance at risk, to mitigate the vulnerability of money market funds to runs. The MBR would be a small fraction of each MMF shareholder's recent balances that is subject to a 30-day redemption delay. An MBR would diminish or eliminate the advantages enjoyed by shareholders who redeem quickly, before others do, when an MMF is in distress, by ensuring that redeeming investors are not able to shift risks and losses to those who remain invested. By discouraging redemptions during crises, an MBR also would help prevent the destabilizing and costly dynamics of a run and the strains that MMF runs can propagate throughout the financial system. Thus, an MBR not only would benefit MMFs and their investors, but also would mitigate externalities associated with these funds.

A key element of our proposal is that a portion of redeeming investors' MBRs would be subordinated, to provide a deterrent to running from an MMF to avoid imminent losses. The disincentive to redeem would be negligible in normal times but would become salient on the rare occasions when investors grow concerned about the risk of losses. When that risk is high, the MBR would create a trade-off for investors, who could either redeem shares to maintain their own liquidity or stay invested in the fund to safeguard their principal. In contrast, under current rules, investors who redeem from a troubled MMF preserve both liquidity and principal, while those who remain behind are put at greater risk of losing both.

An MBR offers some important advantages over other proposals for reducing the vulnerability of MMFs to runs. Importantly, it could allow MMFs to maintain features that are central to their attractiveness to investors, in particular their stable $1 NAVs, their market-based yields, and the immediate liquidity of the vast majority of each investor's balance. An MBR would not require MMFs to raise the large sums of capital needed to create a meaningful capital buffer, and thus likely would be more feasible than a stand-alone capital option (although a capital buffer could complement an MBR rule well). Moreover, an MBR rule would create a deterrent to redeeming in times of stress--one that neither a floating NAV nor a capital buffer can provide. And unlike some proposals for conditional ("standby") restrictions or fees on redemptions, an MBR would not set up incentives for preemptive runs. Indeed, an MBR likely would improve market discipline for MMFs by strengthening investors' incentives to monitor and respond to MMF risks when they first arise, rather than wait to redeem until serious problems are imminent.

On the basis of historical data on MMF losses, including a novel data set from the Treasury and the SEC on losses suffered by MMFs in 2008, we have gauged the size of an MBR that would be needed to protect MMFs from runs. Our analysis also incorporates evidence about the value of preserving liquidity in a crisis, which strengthens investors' incentives to redeem. We find that, for an MMF with a 0.5 percent capital buffer, an MBR of at least 3 to 4 percent probably would be adequate to create disincentives for redemptions. (48)

The run on MMFs in September 2008 underscored that these funds' structural vulnerabilities can have potentially deleterious consequences for the entire financial system. In addition, the 2008 run may have made funds' institutional investors more skittish and thus more prone to run. Heavy redemptions by institutional investors during the summer of 2011, partly in response to increasing concerns about the funds' European holdings, indicate that institutional investors are more responsive to the risks in MMFs than they were before 2008. (49) But policymakers have fewer tools to address MMF runs now than during the financial crisis, particularly because the Treasury's temporary guarantee program, which was instrumental in stopping the 2008 run, is no longer possible under current law.

In this environment the need for MMF reform is particularly salient. Fortunately, there may be near-term opportunities for implementing meaningful reforms. The Financial Stability Oversight Council's proposed recommendations to the SEC, which were published in November 2012, include an alternative featuring an MBR requirement for MMFs. The SEC in June 2013 proposed two options for MMF reform for public comment: a floating NAV for institutional prime MMFs and a requirement that funds impose or consider fees and restrictions for redemptions if their liquid assets fall below a threshold (U.S. SEC 2013). Thus, careful consideration of MMF reform options is timely and potentially very useful to policymakers. We believe that the MBR is a particularly promising option, offering a means of preserving the key features that make MMFs attractive to investors while providing MMFs with the stability needed to ensure that they continue to play an important role in the U.S. financial system, even in the event of another systemic crisis.

ACKNOWLEDGMENTS We thank the editors for many helpful comments. We are also grateful to Ken Anadu, Steffanie Brady, Wendy Lai-Ching Chan, Darrell Duffle, Matt Eichner, Josh Gallin, Jamie McAndrews, Susan McLaughlin, Eric Rosengren, Nathan Yeung, and seminar participants at the Federal Reserve Bank of New York, the Federal Reserve Bank of Boston, and the Board of Governors of the Federal Reserve System for comments on earlier versions of this paper, and we thank Greg Nini, Henry Shilling, and Sarah ten Siethoff for help in providing and interpreting data. The views expressed herein are those of the authors and do not necessarily reflect the view of the Board of Governors, the Federal Reserve Bank of New York, or the Federal Reserve System.

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Comments and Discussion

COMMENT BY MARTIN NEIL BAILY

Money market funds (MMFs) currently play an important role in providing liquidity to financial intermediaries. At the end of 2012, these funds accounted for over one-fifth of all U.S. mutual fund assets, with $2.7 trillion in assets under management. MMFs typically provide a higher yield than bank deposits, and before the recent financial crisis they were widely thought to be as safe as insured deposits, at least by retail investors, although their value was not in fact guaranteed by the government. As the crisis unfolded, wholesale investors began to doubt the stability of the funds and started to withdraw their shares. As Patrick McCabe and his coauthors point out in this paper, under the current rules governing MMFs, investors who are quick to redeem from a troubled MMF are able to protect both their liquidity and their principal, shifting the risks onto less savvy investors. This problem, inherent in the incentive structure of these funds, provides the context for the authors' proposed reform of MMFs.

The first MMF established was the Reserve Fund, which opened in 1971. From there the number of MMFs grew quickly, as they offered a way to avoid interest rate regulation on bank deposits (Regulation Q) and so reap higher returns. This is an important point, indicating that MMFs are a reflection of regulatory arbitrage, and since Regulation Q has now disappeared, the rationale for the continued existence of MMFs has come into question.

MMFs are regulated under the Investment Company Act of 1940 and under rule 2a-7 of the Securities and Exchange Commission (SEC), adopted in 1983, which allows MMFs to use a variety of procedures to maintain a stable net asset value (NAV) of $1 per share. In only a few cases has an MMF's NAV dropped below this $1 level ("broken the buck"): the authors report only two instances since 1983. Yet there have been other cases where runs on MMFs resulted in portfolio losses, and in some of these the MMF would have broken the buck but for the support of its sponsoring financial institution. The authors note that since the birth of the MMF industry in the 1970s, sponsors have intervened to support an MMF in over 300 instances.

The vulnerability of MMFs to runs results in part from the fact that they generally hold similar portfolios. The restrictions they face--MMFs can hold only assets with the highest short-term ratings--coupled with their need to maintain a stable NAV, severely limit the diversification available to MMF portfolios. The authors point out that as of September 2012, 50 private issuers accounted for 91 percent of all MMF investments in private entities, and that of these 50, all but 4 were financial firms. Because the portfolios of different MMFs have a significant degree of overlap, trouble at one MMF very often has direct implications for others. The authors identify this as a "contagion risk among MMFs," whereby a surge in redemptions from one or more troubled MMFs can depress asset prices and put other MMFs with overlapping portfolios at risk. This gives investors an incentive to redeem preemptively from those MMFs as well.

These concerns became acute during the financial crisis, especially in 2008. In the weeks following the collapse of Lehman Brothers in September 2008, prime MMFs experienced an outflow of $400 billion. During 2008 the Reserve Primary Fund lost 1.6 percent of its value. Almost all of this run behavior was on the part of institutional investors, whose holdings account for over 65 percent of all MMF shares. Retail investors, in contrast, displayed a great deal of inertia, in that they were significantly less likely to run from their MMFs.

In September and October 2008, more than two dozen MMFs received contributions from their sponsors in order to avoid breaking the buck. On September 19, 2008, the U.S. Treasury extended a guarantee to MMF investors that they could withdraw their funds without breaking the buck; that guarantee stayed in place until September 18, 2009. However, the Economic Stabilization Act of 2008 outlawed similar guarantees in the future. Thus, without a change in the law, the Treasury will not be able to guarantee MMFs in any future crisis.

I noted earlier that retail shareholders tended not to run from MMFs in the crisis, but that statement has to be qualified because of the Treasury guarantee. Retail shareholders did not run immediately in the crisis, but they might have run eventually without the guarantee. In 2010, in response to what had happened in the crisis, the SEC tightened its risk requirements for MMFs, mandating that they hold at least 10 percent of their assets in highly liquid assets, such as privately issued securities maturing within a day and Treasury securities, and at least 30 percent in assets maturing within a week.

At prevailing prices, investor demand for risk-free, liquid assets is strong. The government provides backing for a large share of these assets through the insurance of bank deposits by the Federal Deposit Insurance Corporation (up to a limit) and adds directly to the supply by issuing large volumes of short-term Treasury securities. Private markets look for additional ways to supplement the supply. For example, investors can circumvent the regulatory limit on insured bank deposits by spreading their assets across a number of banks. MMFs created demand deposits that technically carried some risk but were assumed by many investors to be risk free. In the crisis the Treasury felt obliged to validate that misperception, and so regulating MMFs must be part of a broader decision about the extent to which government, and hence taxpayers, should be on the hook to support risky assets. The Dodd-Frank legislation was clear in wanting to limit taxpayer liability and to avoid having the federal government dragged into providing such support in another crisis.

One of the things I liked about this paper is that it identifies a market failure in MMFs and devises a policy that is geared directly to addressing that failure. The authors argue that the current set-up of MMFs results in an externality, by allowing savvy investors to withdraw at the first signs of trouble and retain the full value of their principal, in the process passing the losses on to the investors who stay in the MMF. This encourages investors to run at the first hint of trouble, and the potential for such behavior compounds the riskiness of an MMF even if its underlying assets are in fact sound. Any institution that issues demand deposits of fixed value is prone to a run, because it is costless for investors to withdraw their money and hold it in cash or deposit it in an alternative liquid asset. Market failures in finance are often tied to incomplete or asymmetric information, and the authors make such a connection. The more savvy (and presumably richer) investors know more about the quality of a fund's portfolio and are able to pass the losses on to the smaller investors who are less informed.

Yet one can take a different perspective on MMFs and question the severity or even the existence of the market failure. It is important that investors monitor the health of the MMFs in which they place their assets, and take action if the fund managers fail to act in a manner consistent with the risk goals of the fund. In a climate of very low interest rates, fund managers have a tendency to "reach for yield," making risky investments in order to generate an adequate return or to attract investors by offering higher yields than competing funds. Savvy investors who withdraw assets from a fund are giving a signal to the market. Their exit serves as a counterbalance to the inertia of retail investors who pay no attention to the safety of the fund. In this view information is something investors can choose to acquire and use. This argument only goes so far, however, because large corporate investors will have much easier access to information and are better able to understand risks than small retail investors.

POLICY RESPONSES A variety of policy responses have been proposed to diminish the systemic risk introduced by MMFs. The first of these would abolish the fixed NAV. A floating NAV would communicate information to current and potential investors about the risks in an MMF's portfolio; all investors, wholesale and retail, would then be regularly informed about the value of the fund and the nature of its investments. Additionally, it is argued that a floating NAV would discourage risky investments on the part of MMF managers, as these risks would quickly be communicated to potential and current investors, to a much greater degree than is the case currently with the $1 per share peg. Another benefit of this approach is that it would, at the margin, discourage preemptive redemptions by risk-averse investors, as any signal of trouble within the MMF would entail a decrease in the NAV, reducing the amount of their principal they recouped. Under current practice, in contrast, redeeming investors always get the same return of $1. Finally, proponents of this view contend that the floating NAV is simpler than a peg, as the latter involves instruments used in rounding the NAV, which introduce complexities and costs.

One argument against this solution is that if very large investors were to suddenly withdraw their funds, it would be difficult for the fund to come up with the cash, even with a lower NAV. Robert Pozen, a long-time industry practitioner, has pointed out to me, however, that very large withdrawals can be dealt with by giving the redeeming investors a pro rata share of the fund's assets in kind, to dispose of as they wish.

Another argument against the floating NAV, offered by Samuel Hanson, David Scharfstein, and Adi Sunderam (2013), is that it may not prevent runs from becoming a systemic problem. With a floating NAV, they claim, investors will pull out even more quickly to avoid a price decline. One variant of the floating-NAV approach is to separate wholesale and retail funds. Since retail investors are "stickier" and less prone to runs, retail funds may not need the same rules as for wholesale funds.

The authors of this paper propose a second policy solution to MMF regulation, which they call the minimum balance at risk (MBR). The basic idea is that a small proportion of an investor's total holdings in an MMF would be subject to a delay (they propose 30 days) if the investor attempts to redeem during a potential run. A second component of the proposal is that of subordination, whereby in the event of a run, the MBRs of those investors who have chosen to redeem early would be the first assets used to absorb whatever losses the MMF incurs. Rather than spreading the losses evenly across MBRs, the proposal would have the MMF manager preferentially protect the MBRs of those investors who decide to stay put. The virtue of this proposal is that it speaks directly to the externality whereby the first investors to withdraw pass the costs on to the less savvy investors left behind. Instead, under the MBR proposal, the investors who try to get out first would be forced to bear more of the costs. Thus, the proposed solution acts directly to restrain runs on MMFs by penalizing those investors who run.

The authors do a nice job of laying out the specifics of their proposal, and they show that if an MMF also maintains a small capital buffer in place (0.5 percent), the MBR could be set at a level of about 3 to 5 percent of shares. They examine the impact of different shocks and the nature of the protection provided by MBRs of different sizes and structures.

A concern about the MBR proposal is that it works against one of the major appeals of MMFs, namely, that they provide an investment vehicle for highly liquid assets that can respond rapidly to changing market opportunities. Instituting a 30-day delay on a portion of redemptions may adversely impact investors' business decisions. It may also dampen the appeal of the MMFs themselves. Even if the MBR were applied only where there is a risk of a run, its imposition may discourage the use of MMFs out of concerns about the possible implementation of the MBR plan. At the retail level, investors concerned about paying taxes on time or being surprised by medical expenses will be reluctant to wait 30 days to redeem their funds. Aware of this problem, the authors discuss possible exemptions for smaller retail investments.

The third possible approach to MMF regulation is the capital buffer proposal made by Hanson and coauthors, which has also been endorsed by the Squam Lake Group, of which I am a member. The idea is straightforward. MMFs would be required to hold loss-absorbing capital equal to some percentage of their assets, so that if the value of the assets declines, the capital can be used to preserve the fixed NAV and allow investors to withdraw their funds at par. The presence of a capital buffer, it is argued, would discourage investors from running and thus avoid or at least mitigate the systemic risk problem.

One problem with a capital buffer is determining how large the buffer should be in practice. A buffer that is too small may be quickly overwhelmed, putting the fund back in a floating-NAV situation. But if the buffer is too large, it will reduce the returns that the MMF is able to achieve, possibly destroying its economic viability. A second problem with a capital buffer is that it may bolster the all-too-common but mistaken belief that MMF investments are without risk.

WEIGHING THE ALTERNATIVES The problem of MMF regulation has no easy answer--witness the slowness of the SEC to implement new rules. In fairness, the SEC did act promptly to require MMFs to keep a set proportion of their assets liquid, a step that made the funds more robust to sudden withdrawals.

Some of the participants in the Brookings Panel discussion of this paper argued that MMFs are really an anomaly that grew out of Regulation Q and have now outlived their usefulness. I am quite sympathetic to that view, provided that any transition away from MMFs is made smoothly. At present, MMFs provide short-term funding to other financial institutions, but if they were to lose their competitive advantage, the wholesale and retail shares they now hold would flow back into bank accounts or into other financial institutions, where they would be available to be recycled.

If instead MMFs are given a chance to survive and compete, my preferred regulatory proposal is that they eliminate the fixed NAV. Wholesale investors understand fluctuations in asset values and can decide whether or not they wish to continue keeping funds in an instrument with a variable price. Many retail investors in MMFs also hold stock and bond mutual funds and are quite aware of the ups and downs of the market. Investors in floating-NAV funds should be warned that their principal is at risk, and if they do not like small price variations, they should hold their money in insured bank accounts instead. It is important to have clarity about the extent of government insurance of demand deposits.

There is not a generally accepted theory of what causes financial market panics, but it seems that most runs occur when some party tries to maintain a fixed price for some asset in the presence of fluctuating demand and supply. As soon as the fixed price comes into jeopardy, everyone rushes for the exit. For example, in currency crises a country tries to maintain a fixed exchange rate but eventually is forced to devalue. Having a capital buffer for MMFs seems rather similar to having foreign exchange reserves, with the same danger that in very adverse circumstances, investors will try to run before the reserves are used up. The MBR proposal is actually rather like the capital buffer, except that the buffer is provided by setting aside a percentage of each shareholder account. Since I am not sure what drives unstable financial dynamics, some humility is in order, but I do not buy the argument that a variable NAV will make investors more likely to run in a new crisis. And as noted earlier, a variable NAV communicates the message beforehand that there is principal risk.

Since the Panel meeting, the SEC has issued proposed new rules, described in a 700-page document with a request for comments. The SEC proposal suggests that MMFs could choose to have a floating NAV, but it offers an alternative option whereby they could keep a fixed NAV as long as their liquidity ratio (the fraction of the fund's assets with maturity of one week or less) remains above 15 percent. Once the ratio falls below that point, the fund's board could decide either to impose a 2 percent fee on withdrawals ($98 back for every $100 invested) or to "gate" (put a hold on) redemptions for a period of time. Although not the same as the MBR proposal, the SEC has thus opted for a restriction on withdrawals as the leading alternative to a floating NAV.

REFERENCE FOR THE BAILY COMMENT

Hanson, Samuel, David Scharfstein, and Adi Sunderam. 2013. "An Evaluation of Money Market Fund Reform Proposals." Working paper. Harvard Business School.

COMMENT BY SAMUEL G. HANSON

Many academics, policymakers, and market participants have recently been pushing for a significant overhaul of money market fund (MMF) regulations. Others oppose any significant changes in these regulations. Why has this historically sleepy corner of the mutual fund sector become a frontline battle in the postcrisis debate about financial regulation? And what can this debate tell us about the theory and practice of financial regulation and its future prospects for success?

In this superb and timely paper, Patrick McCabe, Marco Cipriani, Michael Holscher, and Antoine Martin put forth a novel proposal for MMF reform, which they call the minimum balance at risk (MBR). I begin this discussion by providing some further background on MMFs and explain why a growing number of observers believe that MMFs pose a significant threat to financial stability. I contrast various approaches to financial regulation and argue that the current debate over MMF regulation is best understood through the lens of systemic financial regulation: the goal of these proposals is to better safeguard the stability of the financial system. Drawing heavily on my own recent paper with David Scharfstein and Adi Sunderam, I then lay out what I see as the main goals of MMF reform. Finally, I evaluate three prominent reform proposals--floating net asset values (NAVs), the MBR proposal, and subordinated capital buffers--in light of these goals. I note that the MBR is a form of subordinated capital, so the second and third proposals are close cousins. I argue that these two proposals are far more likely to achieve the goals of MMF reform than floating the NAV.

BACKGROUND ON MMFS A money market fund is a type of mutual fund that is required by law to invest in short-term, low-risk securities. MMFs pay dividends that reflect the level of short-term interest rates. MMFs come in institutional and retail varieties. Institutional MMFs are high-minimum-investment, low-expense funds marketed to large firms and institutional investors. Retail MMFs are low-minimum-investment, higher-expense funds marketed to households.

Like other mutual funds, MMFs are not insured by the Federal Deposit Insurance Corporation (FDIC) and are regulated by the Securities and Exchange Commission under the Investment Company Act of 1940. However, because MMFs have very low risk compared with other mutual funds, they are exempt under rule 2a-7 of the act from certain regulations that apply to mutual funds more broadly. Specifically, an MMF is not required to mark its assets to market as long as its NAV per share is greater than $0.995. Instead MMFs, like banks, are allowed to use amortized-cost accounting. However, MMFs are subject to a variety of bank-like regulations that explicitly restrict their asset risk, again setting them apart from other mutual funds.

In November 2012 the Financial Stability Oversight Council (FSOC) solicited public comment on a range of structural reform proposals for MMFs. (1) The principal concern cited by the FSOC is that a wide-scale run on MMFs could result in a systemwide run on large financial firms. Such a run would, in turn, disrupt credit markets and the payments system, with severe adverse consequences for the real economy. This is the "systemic risk posed by MMFs" that motivates the proposal of McCabe and coauthors.

The FSOC asked for comments on three reform proposals for MMFs: the first would require MMFs to "float" their NAVs; the second would require MMFs to maintain a 1 percent subordinated capital buffer and adopt a 3 percent MBR; the third would require MMFs to maintain a 3 percent subordinated capital buffer but no MBR. The second alternative is a variant of the proposal described by McCabe and coauthors and draws heavily on their work.

WHAT DO MMFS DO? Like the authors in this paper, I focus here on prime MMFs, which are thought to pose the greatest systemic risk. Prime MMFs invest in short-term debt instruments issued by private borrowers, mainly large, global banks; only 3 percent of prime MMF assets are in paper issued by nonfinancial firms. (2) Thus, the core function of prime MMFs is to collect savings from households and firms to provide short-term financing to financial institutions (Hanson, Scharfstein, and Sunderam 2013). In other words, prime MMFs function like "correspondent banks" that take deposits and invest those funds in the deposits of other banks.

Prime MMFs create a number of bank-like benefits. On the liability side, they provide savers with money-like, demandable claims--that is, claims with a highly stable nominal value that are redeemable on demand--and offer a variety of transactional services. In addition, MMF shares pay an interest rate that closely tracks movements in short-term market rates such as the federal funds rate, making them attractive relative to the savings products offered by commercial banks (such as savings and money market deposit accounts), which typically pay below-market rates. On the asset side, prime MMFs function as delegated monitors and asset managers, providing savers with access to a diversified portfolio of the short-term liabilities of many large banks. Access to a more diversified portfolio is useful to savers, and delegation may reduce duplicative monitoring in the spirit of Douglas Diamond (1984).

However, MMFs also pose a set of bank-like risks to the stability of the financial system. Since MMF shares are subject to redemption on demand each day, the existence of MMFs arguably raises the risk of a systemwide run due to the greater systemwide maturity transformation they provide. For instance, imagine a world in which large banks financed themselves by issuing 10-day certificates of deposit (CDs). In such a world, the banking system would need to roll over 10 percent of its funding every night. Now imagine that an MMF sector is inserted between savers and banks. Specifically, suppose that savers invest all of their funds in MMFs, which then buy the banks' 10-day CDs. Because the MMF shares are redeemable on a daily basis, the financial system would now need to roll over 100 percent of its funding each night, so it is reasonable to conclude that the risk of a systemwide run has increased.

Delegated monitoring also opens the door to agency problems and raises the classic question of "who monitors the monitor?" Indeed, a number of recent studies suggest that MMFs have strong private incentives to take on excessive portfolio risk ex ante (Kacperzyck and Schnabl forthcoming, Chernenko and Sunderam 2013). An increase in an individual fund's risk will increase that fund's yield. This increase in yield is likely to result in significant additional inflows from institutional investors, who seek out riskier MMFs with higher yields because they believe they can redeem their shares before bearing any losses. But when investors protect themselves in this way, they exacerbate stresses on MMFs ex post, potentially triggering more widespread financial instability. This yield-seeking behavior also means that MMFs take risk at the worst times from a systemic perspective: the imposition of market discipline occurs in a disorderly fashion late in a crisis, rather than in an orderly fashion in the early stages of a crisis.

FINANCIAL REGULATORY APPROACHES Before I discuss the specific goals of MMF reform, it is worth contrasting several different regulatory approaches: traditional securities regulation, traditional bank regulation, and systemic financial regulation. This contrast is relevant since proponents of overhauling MMF regulations typically adopt the systemic perspective, whereas opponents of significant MMF reform typically advocate more traditional regulatory approaches.

The primary goals of traditional securities regulation--for example, as embodied in the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Company Act of 1940--are to ensure that all investors are properly informed about investment products and can transact at fair market prices. More specifically, the goal of traditional securities regulation is to increase transparency, reduce asymmetric information, and protect unsophisticated retail investors.

The goal of traditional bank regulation is to ensure that each individual bank is sufficiently "safe and sound"--for example, that it has enough equity capital--to ensure that FDIC losses and taxpayer bailouts are highly unlikely. For this reason traditional bank regulation is sometimes described as "microprudential" in nature. The market imperfection motivating microprudential bank regulation stems from moral hazard. Given the existence of mispriced deposit insurance, banks have incentives to take excessive risks to maximize the expected value of taxpayer support. Thus, traditional bank regulation is seen as a necessary counterweight to this moral hazard. Since this view is tied to the existence of deposit insurance, traditional bank regulation is institutional rather than systemic in nature--for example, from this perspective there is no need to regulate a bank that has no recourse to the taxpayer safety net.

Following Hanson, Anil Kashyap, and Jeremy Stein (2011), I take the goal of systemic financial regulation to be that of mitigating the excessive contractions in credit or disruptions of payments that may arise when the financial system is hit with an aggregate shock. Since the goal is to ensure that the financial system as a whole is safe and sound, this is often described as "macroprudential" regulation. In contrast to traditional securities and bank regulation, systemic regulation is decidedly general equilibrium in conception. The idea is that because the financial system is subject to fire-sale and credit-crunch externalities, the amount of leverage and maturity mismatch that is privately optimal for individual financial firms may not be socially optimal, since it makes the system as a whole overly vulnerable to costly financial crises. Since these externalities can arise even in the absence of FDIC-induced moral hazard, systemic regulation is functional as opposed to institutional. Indeed, the systemic regulator worries about credit disruptions from regulated depository institutions, nonbank financial institutions, and markets alike.

GOALS OF MMF REFORM For proponents of systemic financial regulation, prime MMFs appear to be a prime example of regulatory arbitrage. MMFs perform the core economic activities that define banking--they finance illiquid assets with demandable liabilities and undertake liquidity transformation--and pose risks to financial stability similar to those posed by banks. However, unlike banks, MMFs are not subject to subordinated capital requirements and only recently have become subject to bank-like liquidity requirements, two regulatory tools often advocated by proponents of systemic regulation.

Thus, in Hanson and others (2013), we look at MMF regulation through the lens of the systemic approach to financial regulation. We argue that the primary objectives for MMF reform should be threefold. First, regulation should reduce MMFs' incentives to chase yield and take excessive risk ex ante. Second, regulation should reduce the likelihood of a widespread and systemically disruptive run on MMFs. And third, regulation should attempt to preserve the monetary services that MMFs provide to savers. Otherwise one worries that savings will flow toward unregulated, MMF-like products that would continue to pose the same risks to financial stability.

EVALUATION OF REFORM PROPOSALS I now discuss the three main alternatives for structural MMF reform that have been put forward by the FSOC: floating the NAV, subordinated capital buffers, and the MBR provision.

Floating the NAV The first proposal is to require MMFs to float their NAV, that is, to report their true NAV and allow investors to transact at it every day, just as all other mutual funds do. This proposal has natural appeal for adherents of traditional securities regulation, since it increases the transparency of MMFs. It may also address the worry that a fixed $1.00 NAV per share places retail investors at a disadvantage because institutions are able to pull their money out more quickly when trouble arises.

However, proponents of floating the NAV also cite two potential systemic benefits. First, moving to a floating NAV may lower the probability of "strategic" runs on MMFs. Currently, if the true NAV falls, investors who redeem early receive $1.00 per share, while those who redeem late receive less. This cliff effect creates a strategic motive to run. Second, moving to a floating NAV might lower the probability of "panicked" runs, because it would remove the regulatory imprimatur of safety that MMFs enjoy and force skittish, risk-averse investors to recognize that MMFs are not completely safe.

In Hanson and others (2013) we argue that these systemic benefits are likely overstated. First, since most prime MMF assets tend to be quite illiquid--secondary markets for short-term private paper are extremely thin--the strategic incentive for MMF investors to run at the first sign of danger is likely to remain. Specifically, the incentive to run stems from the combination of demandable liabilities and illiquid assets, as in Diamond and Philip Dybvig (1983), not simply from the cliff effect due to a fixed $1.00 NAV. Investors who redeem early get paid in full but consume the fund's more liquid assets. By contrast, investors who redeem late will receive the depressed, fire-sale value of the fund's more illiquid paper. Indeed, the recent crisis also saw widespread runs on MMF-like products with variable NAVs, including ultra-short bond funds in the United States and variable-NAV MMFs in Europe.

Second, floating-NAV MMFs would continue to attract a highly skittish, risk-averse investor base. They would still be subject to strong risk-limiting provisions under rule 2a-7 and thus would continue to benefit from a strong regulatory imprimatur of safety. Furthermore, since the NAV would fluctuate little, if at all, in normal times, highly risk averse investors would still be drawn to the product, setting the stage for runs at the first sign of danger.

Subordinated capital buffers The idea of a junior capital buffer is quite simple. A capital buffer divides the risks and rewards of MMF assets between subordinated capital, which bears the first losses, and ordinary, senior MMF shares. In return for the protection provided by a subordinated capital buffer, the latter would earn a slightly lower yield in normal times.

In Hanson and others (2013) we argue that subordinated capital buffers are the preferred regulatory solution from the standpoint of reducing systemic risk, for several reasons. First, junior capital reduces the probability of systemwide runs. Senior MMF shares will be protected by the capital buffer, so MMFs would have to suffer larger losses than under current rules before ordinary MMF investors are endangered. Second, because subordinated capital providers bear the first losses, they will have an explicit incentive to discipline ex ante risk taking. Indeed, Marcin Kacperzyck and Philipp Schnabl (forthcoming) show that fund sponsors, who implicitly have capital at stake, rein in the risk taking of their MMFs. Finally, subordinated capital preserves--and potentially enhances--the monetary benefits enjoyed by ordinary MMF shareholders and would be unlikely to trigger a migration to less regulated savings products.

Hanson and others (2013) perform a calibration based on Oldrich Vasicek's (2002) model of credit portfolio losses. For a well-diversified portfolio of MMF assets, our estimates suggest that a 4 percent subordinated capital buffer would reduce the probability that senior shares suffer losses to 0.1 percent, the tolerance level used in the Basel II bank capital regulations. In return for this protection, we estimate that senior shares would earn just 0.05 percent less in normal times.

Minimum balance at risk Under the minimum balance at risk proposal of McCabe and coauthors, some fraction (say, 3 or 5 percent) of each investor's recent balances would be available for redemption only with a delay of 30 days. This would ensure that sophisticated investors cannot chase yield and then run at the first sign of danger, sticking less sophisticated investors with all the losses. Furthermore, the "strong MBR" proposal advocated by these authors adds a conditional subordination feature whereby the MBRs of redeeming investors become subordinated relative to those of nonredeemers and bear the first losses if the MMF breaks the buck. As the authors argue, this strong MBR provision provides an explicit disincentive for MMF investors to withdraw when concerns about moderate fund losses arise.

Thus, the proposed MBR is a form of subordinated capital. The main differences between an actual capital buffer and the MBR have to do with who provides the capital and when they provide it. With an MBR, risk-averse MMF investors are forced to provide junior capital ex post. With a capital buffer, other, more risk tolerant investors or the fund sponsor provide this junior capital ex ante.

There are costs and benefits of each approach. The MBR may be more effective at discouraging excessive risk taking, because the MMF investors themselves are forced to bear the costs of chasing yield ex ante. With respect to reducing the tendency for investors to run ex post, note that the MBR assigns losses to skittish, risk-averse investors in a complex fashion, whereas a capital buffer assigns losses to more risk tolerant investors in a simple fashion. If one adopts a rational, strategic view of runs, the MBR may be more effective at discouraging them. However, if one adopts a more behavioral, panic-based view of runs, one might worry that the MBR would be less effective. Finally, the MBR may partially diminish the value of the monetary services provided by MMFs. As a result, one may worry that a large MBR requirement might lead savers to substitute away from MMFs and toward other unregulated products, which may also pose threats to financial stability.

Overall, a subordinated capital buffer and an MBR are quite similar, and either could largely achieve the goals of MMF reform. Furthermore, as the authors note, these approaches may be complementary, so that a hybrid of buffer and MBR solutions may be most effective.

CONCLUSION In the aftermath of the crisis, the broad question is where to draw the line between investment products that can be left largely unregulated, such as hedge funds, and core financial and payments services that require stronger regulation. The debate on MMF reform reflects this broader question. Floating-NAV proposals hope to move MMFs firmly into the investment category, a realm where policymakers are typically happy to stop at the objectives of traditional securities regulation. Proposals for capital buffers and MBRs would bring MMFs further under the regulatory umbrella in the name of systemic risk regulation. I have argued that the combination of demandable liabilities and illiquid assets that defines MMFs means that a systemic or macroprudential approach is essential and, thus, that the latter approach is likely to be most effective.

REFERENCES FOR THE HANSON COMMENT

Chernenko, Sergey, and Adi Sunderam. 2013. "Frictions in Shadow Banking: Evidence from the Lending Behavior of Money Market Funds." Working paper. Harvard Business School.

Diamond, Douglas. 1984. "Financial Intermediation and Delegated Monitoring." Review of Economic Studies 51, no. 3: 393-414.

Diamond, Douglas, and Philip Dybvig. 1983. "Bank Runs, Deposit Insurance, and Liquidity." Journal of Political Economy 91, no. 3: 401-19.

Hanson, Samuel, Anil Kashyap, and Jeremy Stein. 2011. "A Macroprudential Approach to Financial Regulation." Journal of Economic Perspectives 25, no. 1: 3-28.

Hanson, Samuel, David Scharfstein, and Adi Sunderam. 2013. "An Evaluation of Money Market Fund Reform Proposals." Working paper. Harvard Business School.

Kacperczyk, Marcin, and Philipp Schnabl. Forthcoming. "How Safe are Money Market Funds?" Quarterly Journal of Economics.

Vasicek, Oldrich. 2002. "Loan Portfolio Value." Risk 15: 160-62.

(1.) The FSOC was created by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which grants the FSOC broad authority to monitor and respond to emerging threats to financial stability.

(2.) MMFs are classified as prime, government, or tax-exempt. According to the Investment Company Institute, MMFs managed a total of $2.60 trillion in assets as of November 2012. Most of these assets ($1.45 trillion) were in prime MMFs. The remainder were in government MMFs ($0.87 trillion), which hold Treasury bills and other short-term U.S. government and agency paper, and in tax-exempt MMFs ($0.27 trillion), which hold short-term paper issued by states and municipalities.

GENERAL DISCUSSION

Robert Pozen argued that those money market funds that invest only in government-issued securities should be exempt from any minimum balance at risk, because these funds carry very little risk and hence are unlikely to experience a run. Indeed, during the 2008 crisis, many of these funds received inflows from the prime money market funds, which invest primarily in nongovernment securities.

Pozen, who noted by way of disclosure that he had formerly been president of FMR Company, the investment adviser to the Fidelity funds, also pointed out that prime money funds have average maturities of only about 60 days and are required to hold at least 97 percent of their assets in the highest-rated short-term paper, and the remainder in the next-highest category. Thus, any notion that these funds might invest in highly risky securities was unfounded. Moreover, these funds are now required to hold 30 percent of assets in so-called liquidity buckets, which are redeemable in either one or seven days, making them highly liquid. Finally, among those money market funds that cater to large institutional investors, some have offered redemptions in kind at times when liquidity was strained: institutions seeking to make large withdrawals were instead given a pro rata share of the securities in the fund's portfolio. That option, Pozen suggested, could be used more widely. All these arguments weakened the case, in his view, for further regulation of money market funds.

Pozen nevertheless recognized that a credible case could be made for further regulation of institutional money market funds. The institutions that park money in these funds often hold very large positions, and they monitor the markets closely and trade actively, so that a run becomes a real danger. It was no coincidence, Pozen observed, that the only two money funds to date that have broken the buck were both institutional funds.

By contrast, an MBR--and indeed any of the regulatory proposals currently on the table--would essentially put the retail money market funds out of business, in Pozen's estimation. The small investors that currently use such funds would simply shift their money to banks, which do not face such restrictions. Further regulation of these funds seemed to Pozen unnecessary in any case, because most retail money fund investors did not run even during the 2008 crisis, and since then the 30 percent liquidity bucket requirement has made those funds even safer.

On the asset side, Pozen noted that money market funds, with some $3 trillion in assets, are today the most important short-term lenders to many large companies, banks, and municipalities. If further regulation led investors to abandon these funds, he asked, who would step up to do that lending in their stead? Banks probably would not, because they are more interested in longer-term lending where their specialization in maturity transformation produces greater profits. If banks did take up the slack, they would need to increase their equity capital, at a time when they are already struggling to raise capital. A likely scenario, Pozen thought, was that new types of hedge funds or private equity funds would emerge to meet the short-term needs of banks. These new lending vehicles would be largely unregulated and would likely trade more actively than the institutions that today finance the short-term market for money market instruments. The result, ironically, could be to increase the likelihood of a run in the short-term market.

Raquel Fernandez was unclear about how the authors were able to calculate that runs would occur with lower probability with an MBR than without one. As she saw it, the situation was essentially characterized by multiple equilibria: if a sufficiently large fraction of investors decide to run, a run will occur. She did not see how an MBR would change that dynamic so that a probability of a run could be calculated.

Benjamin Friedman thought that more regulation of money market funds was called for, and his own preference would be to do away with the fixed share price and mandate a floating net asset value. More fundamentally, however, Friedman asked what difference it would make if the institutional money fund industry simply went out of business. As Samuel Hanson had pointed out in his discussion, prime institutional money funds today are mainly lending to banks, and in particular the broker-dealer operations of foreign banks: a recent paper by David Scharfstein showed that of the 50 largest borrowers from these funds, almost all were banks, and indeed most were non-U.S, banks; hardly any were nonfinancial businesses. Although there was nothing wrong with borrowing and lending taking place between consenting parties, domestic or foreign, Friedman saw no reason such lending should be a public policy priority. However, intermediation of such activity by money market funds in particular gave rise to a systemic risk that needed to be regulated, Friedman argued. It was thus worth asking whether the institutional money fund industry needed preserving in the first place.

Retail money market funds, on the other hand, do provide a worthwhile service to small investors, Friedman argued. But that, in his view, did not necessarily imply a need for further regulation of that part of the industry. Mutual fund families like Fidelity operate money market funds so that when investors decide to sell their shares in, say, the Fidelity Magellan Fund, and are not yet ready to buy shares of another Fidelity fund, the money stays with Fidelity. The fund families thus have an incentive to subsidize their money funds, as indeed they have proved willing to do, to assure investors of their safety.

Kristin Forbes wondered what evidence was available about the likely response of money market fund investors to the MBR proposal. Would they in fact shift their money to banks? or perhaps to foreign money market funds? If the latter, what impact would that have on total liquidity in the United States? She was also interested in knowing more about how the mutual fund industry itself rank-ordered the various reform proposals. Given their evident opposition to all of them--floating NAVs, increased capital requirements, MBRs--which did they see as the least of the various evils, and why?

George Perry, who like Pozen had been active in the mutual fund industry, also saw money market funds as providing a valuable service within the financial system and to retail investors in particular. When interest rates rose in the 1970s, bank deposit rates were prevented by Regulation Q from rising in tandem, effectively excluding small investors from reaping the higher returns. Money funds, he felt, should not be regulated out of existence just because they compete with banks. And with interest rates currently at almost zero, any additional cost due to increased regulation would erase the remaining margin and effectively wipe out the money fund industry.

Perry also questioned whether any of the proposed reforms would have their intended effect in a real crisis like that of 2008-09. Larger capital buffers could in principle help smooth out fluctuations of the magnitude that occur in normal times, thus allowing the one-dollar NAV to be maintained, but would not protect against an event like the Lehman Brothers bankruptcy. In Perry's view, a reform that worked only some of the time, but not when needed most, was unlikely to justify its additional cost.

Richard Cooper seconded Friedman in questioning the paper's basic assumption that the money market fund industry was something worth preserving. He agreed with Perry that these funds had served an important purpose in the 1970s, but that purpose was one of regulatory arbitrage and presumably disappeared when the regulation did. Cooper also challenged Pozen's contention that banks are interested only in lending long. Historically, Cooper noted, an important function of banks was to provide trade credit, an inherently short-term activity; he saw no reason why banks today could not again profitably operate at the short end of the yield curve. Cooper acknowledged that the sheer volume of assets involved made it prudent to establish a period of transition, and he suggested a period of five or six years for the funds to either adapt, become banks themselves, or exit.

Justin Wolfers argued that the difficulty in judging among regulatory proposals for money market funds stemmed from the underlying presumption that demand exists for an asset of perfectly stable value, which implies a discontinuity in the utility function. It was unclear to Wolfers how that discontinuity arises, and thus unclear how to evaluate the welfare consequences of any given proposal. Approaching the issue in terms of Kahneman-Tversky-style risk aversion seemed unhelpful, because the players involved in the institutional segment of the market are more sophisticated than typical Kahneman-Tversky-type actors.

Laurence Ball added his voice to those questioning the need to preserve money market funds as an institution. In their absence, savers seeking maximum safety could use ordinary insured bank accounts, and short-term borrowers could take out lines of credit from the same bank. He pointed out that even if short-term lending is an unattractively low margin business today, it might become less so as savers and borrowers shift their activity from money funds to banks. Ultimately, he asked, if people are attracted to money funds because they are bank-like, what prevents banks from providing the same service?

Ricardo Reis agreed with Samuel Hanson that the key underlying problem raised by money market funds was the fire-sale problem: a fund experiencing large redemptions must sell off large amounts of assets, pushing their market price downward and thus lowering the firm's NAV. Anticipating this, investors redeem even more, even sooner, and the result is a rush toward the exits at the first hint of trouble. From that perspective, Reis thought, the MBR proposal made sense as far as it went, because in effect it turned what were one-day-callable deposits into 30-day-callable deposits. But the MBR would still perform liquidity transformation only over a longer time frame. Thus, Reis saw the proposal as vulnerable to the Lucas critique: with an MBR in place, funds will be led to invest in somewhat longer term assets: 60-day options, say, instead of 30-day options. A term mismatch will remain, and investors will still have an incentive to run when trouble looms. With the transition to the 60-day options, bank runs will simply take place over the longer period. Moreover, Reis observed, banks, too, are subject to the fire-sale problem, and this led him to wonder: If MBRs are a good idea for money market funds, why are they not also a good idea for banks?

Frederic Mishkin focused on the authors' point that an MBR actually creates a disincentive to redeem when the fund is facing difficulties. As he saw it, that implied that the MBR made funds even more illiquid than the authors claimed: not only was the amount subject to subordination--5 percent in the authors' example--less liquid than before; rather, the entire amount invested was less liquid. If that was the case, it defeated the whole purpose of such funds.

Mishkin was agnostic as to whether money market funds had any distinct rationale in the post-Regulation Q era. Some innovations, he suggested, arise by historical accident, under stressful conditions that ultimately prove temporary, but once discovered are found to have lasting value. Money market funds could be such an innovation. That said, if present arrangements in the money fund market are seen as subsidizing risk taking in some way, his recommendation was to either remove the subsidy or tax it away, and then let the market determine whether the funds survive or become extinct. Unfortunately, Mishkin noted, the money market funds industry has devoted enormous resources to avoiding any kind of regulation, and so far it has largely succeeded. Hence, aside from the pure economics of the issue, there was also an issue of political economy to be addressed, which Forbes had touched on: are any of the current regulatory proposals both effective and sufficiently salable to the interests involved to have a chance of being enacted?

David Romer pointed out that nothing in the authors' proposal would prevent money fund investors from, in effect, buying insurance against becoming subject to an MBR, for example by creating derivatives that imposed on a third party the obligation to pay the MBR when it bound. Such an instrument would effectively convert the MBR into a capital requirement, with the third party providing the capital. Or, more precisely, it gave market participants the option of submitting to the MBR or paying in capital. That flexibility seemed to Romer a point in the proposal' s favor.

Romer also noted that the existence of money market funds was seen by some as an important constraint on monetary policy: in this view, one reason the Federal Reserve has refrained from lowering the federal funds rate all the way to zero is that doing so would wipe out any margin the money funds still earn, causing every one of them to break the buck. This kind of monetary forbearance, Romer argued, imposes a real social cost: a further 50 basis points of interest rate reduction in the current environment would do a lot of economic good. Was preserving the money fund industry worth it, or might some form of regulation be found that removed that barrier to further monetary ease?

Gerald Cohen lamented the widespread misconception among retail money fund investors that they were reaping a higher return than they could get at a bank, with no countervailing increase in risk. Although the danger of a run comes mainly from the institutional money fund investors, the misplaced confidence of retail investors that their money fund will never break the buck is potentially costly as well, because it may give rise to a disequilibrium.

Donald Kohn sought to reassure the money funds' defenders that the various reform proposals were not intended to drive the funds out of business, but only to internalize the externality they created. Kohn himself saw the need for such measures as all the greater, given that the Dodd-Frank legislation has set limits on potential government support for these funds in a future crisis. For example, the Federal Reserve now has to jump through many more regulatory hoops when it wishes to extend section 13(3) loans to nonbank institutions, and there is a much greater emphasis on security and collateral than before the act was passed. Now that Congress has decided that money funds will not be bailed out in the next crisis, Kohn saw it as imperative that the systemic risks they pose be minimized. He agreed that neither increased capital nor MBRs nor floating NAVs would suffice to prevent another major crisis, but such measures might at least alert the public to the fact that money funds have risks.

Liliana Rojas-Suarez cautioned the Panel against expecting too much from a single reform of one part of one side of the financial system's ledger. As she saw it, the core of any systemic banking crisis is on the asset side--not the liability side, which the MBR addressed. She doubted that a reform that focused only on one type of bank funding would do much to reduce systemic risk, and she worried that reform of the money fund industry undertaken in isolation would lead to regulatory arbitrage, causing assets to be channeled to other, unregulated or less regulated instruments and institutions, possibly in foreign financial havens.

Steven Davis expanded on Reis's point that if MBRs would be good for the money market funds, they should be good for banks as well. He observed that many of the costs associated with a run are internal to the institution--broadly defined to include both shareholders and depositors-experiencing the run. That implies that financial institutions themselves have strong incentives to prevent runs, especially when no public provider of deposit insurance or lender of last resort is present. This observation led Davis to wonder whether there was anything to learn from the pre-deposit insurance era in the United States. Did banks back then experiment with MBRs or MBR-like mechanisms? If not, why not?

Bradford DeLong, addressing Davis's question, said that the New York banks, at least, of that era dealt with crises by explicitly suspending payment on deposit accounts. They gave depositors the choice of taking their money out on the spot at 98 cents on the dollar, or forbearing while J. P. Morgan and the other captains of finance tried to resolve the crisis, and receiving 100 cents on the dollar if they succeeded. This kind of private ad hoc central banking worked reasonably well, as evidenced by the fact that the public did not abandon their use of banks in the crisis's aftermath. Jeffrey Miron added that the banks in these episodes often took these extreme steps in the face of explicit prohibition by state and other regulators, which under the circumstances either looked the other way or actively encouraged or even directed the banks to suspend payment. DeLong cited similar instructions from the British chancellor of the Exchequer to the governor of the Bank of England during the 19th century.

The discussion of past policy responses prompted Christopher Carroll to cast the net further. Many countries today, he observed, have well-developed financial systems today that did not have them in J. P. Morgan's day. Have any of these experimented with solutions to runs from which lessons could be drawn?

Responding to the discussion, Patrick McCabe suggested a general framework for thinking about money market funds. He observed that these funds at present claim to offer three benefits: principal stability, immediate and complete liquidity, and market-based yields that reflect holdings with some credit risk. That, he posited, was not a tenable combination, and because of the externalities it generated, something had to be given up. If one believes that by sacrificing one of these three features, the money fund industry becomes nonviable, that says something about whether it should have existed in the first place. He and his coauthors were persuaded, however, that a portfolio system of regulation could be devised where investors themselves could choose which of the three mutually incompatible features to give up, and the money fund industry could in principle survive. In the end the authors were agnostic as to whether the industry should survive, but they believed that it could survive without creating a permanent and costly distortion.

McCabe remarked further that the paper's intention was not to offer a global solution but only to describe the specific MBR proposal. That said, the authors believed that an MBR could usefully complement increased capital requirements. Large capital buffers might prove effective for a number of years only to be overrun in a major crisis, as Perry had noted; the MBR provided a disincentive to such a run. The two measures could thus work in tandem.

McCabe also addressed the question of the money fund industry's rank ordering of preferences. Essentially the industry wanted none of the above--neither floating NAVs nor increased capital requirements nor MBRs--but instead was leaning toward a fourth proposal: when a fund's liquidity drops below a certain level, all redemptions would be suspended or fees would be imposed. This approach would avoid taking any of the three benefits listed above off the table, at least in normal times, but in the authors' view it would heighten rather than dampen the probability of preemptive runs, contagion, and the like when markets become jittery. It was akin, McCabe remarked, to spreading kindling in a dry forest.

On the question of differentiating between institutional and retail investors, McCabe said that he and his coauthors were mindful of the fact that the latter did not run from money funds during the recent crisis. Accordingly, the paper called for an exemption from subordination for redemptions under $50,000, but the authors were not wedded to that figure. One of the proposals offered by the Financial Stability Oversight Council suggested a $100,000 exemption.

Replying to Reis, McCabe argued that the MBR proposal was expressly designed to give institutional managers an incentive to carefully monitor the money funds in which they were investing well in advance of any problems. He noted that the Reserve Primary Fund had maintained an extremely conservative portfolio until the summer of 2007, when it dramatically increased its yield, and it tripled its assets between August 2007 and mid-2008. But the smart money in this institutional fund believed, correctly as it turned out, that in a crisis they could get their money out before everyone else. An MBR, McCabe suggested, would have dissuaded investors from piling into this increasingly risky fund in such unstable conditions.

PATRICK E. McCABE

Board of Governors of the Federal Reserve System

MARCO CIPRIANI

Federal Reserve Bank of New York

MICHAEL HOLSCHER

Federal Reserve Bank of New York

ANTOINE MARTIN

Federal Reserve Bank of New York

(1.) For example, at the end of 2012, MMFs owned over 40 percent of outstanding dollar-denominated financial commercial paper (short-term debt issued by financial corporations, usually with maturities of under 90 days). The funds also owned 29 percent of banks' large time deposits (deposits with fixed maturities in amounts of $100,000 or more) issued in the United States. These figures come from MMF filings of U.S. Securities and Exchange Commission form N-MFP, the Depository Trust & Clearing Corporation, and Federal Reserve Flow of Funds data.

(2.) Like other "open end" mutual funds, MMFs transact directly with shareholders (investors), who can purchase shares from the MMF or redeem shares (sell them back to the fund) at a price equal to the fund's NAV. In a run on an MMF, investors redeem shares immediately, possibly only because they believe they otherwise would be harmed by the effects of other investors' redemptions.

(3.) We originally proposed the MBR in a July 2012 working version of this paper, available at www.newyorkfed.org/research/staff_reports/sr564.pdf. The Financial Stability Oversight Council subsequently incorporated the MBR, much as we described it there, in its "Proposed Recommendations Regarding Money Market Mutual Fund Reform" (Financial Stability Oversight Council 2012b). Alternative Two in the Financial Stability Oversight Council's proposed recommendations would require MMFs to have MBRs. See section I below.

(4.) The SEC adopted rule 2a-7 under the Investment Company Act of 1940 to allow MMFs to use procedures that help maintain a stable NAV. Most notably, rule 2a-7 allows a fund to round the underlying market value of its shares to the nearest cent when calculating its NAV. In return for allowing these procedures, rule 2a-7 places restrictions on MMF portfolios with regard to credit quality, liquidity, maturity, and diversification. Rule 2a-7 has been amended several times since 1983, most recently in 2010, when portfolio restrictions were tightened and new reporting requirements added.

(5.) These figures are based on our own calculations using SEC form N-MFP data for prime MMFs. See also Scharfstein (2012) and Hanson and others (2012).

(6.) The PWG, which was essentially the predecessor of the Financial Stability Oversight Council, comprised the secretary of the Treasury, the chairman of the Board of Governors of the Federal Reserve System, the chairman of the SEC, and the chairman of the Commodity Futures Trading Commission.

(7.) "Taxpayers and Money Market Funds [Editorial]," Wall Street Journal, May 9, 2011.

(8.) Section IV.E discusses the appropriate length for the delay period in more detail. In addition, the period over which R is computed should be as long as the redemption delay period, since a shorter period for calculating R would allow investors to circumvent the delay period for all but a tiny portion of their shares by redeeming all available balances and waiting a few days for the reference amount to decline.

(9.) If the investor's reference amount is his high-water mark, his balance cannot exceed his reference amount.

(10.) Alternative Two of the FSOC's proposed recommendations would provide a $100,000 exemption both from the MBR and from any subordination (FSOC 2012b).

(11.) We are grateful to Eric Rosengren for suggesting, during discussions with staff at the Federal Reserve Bank of Boston, the possibility of a threshold below which subordination would not apply.

(12.) Retail MMFs were much less likely than their institutional counterparts to suffer very large outflows during the run in 2008 (PWG 2010, McCabe 2010), and retail funds experienced relatively small net outflows in the summer of 2011, when concerns about MMFs' European exposures and the possible consequences of a breakdown in debt ceiling negotiations triggered large redemptions from institutional MMFs (see, for example, Chernenko and Sunderam 2013). Indeed, differences in the riskiness of retail and institutional funds led the SEC to consider different liquidity requirements for the two types in its proposed amendments to rule 2a-7 (U.S. SEC 2009). However, many MMFs have both retail and institutional investors--this was one factor that led the SEC not to adopt such a distinction (U.S. SEC 2010).

(13.) This assumption rules out an MMF rounding up its share price to $1 and hence redeeming shares for more than their underlying value ("dilutive redemptions"). See section III for further discussion.

(14.) We analyze these incentives more formally in a simple model in section 4 of our working paper.

(15.) A money fund's shadow NAV is essentially the market value of its portfolio divided by the number of its shares. Under current rules an MMF can maintain a stable $1 NAV as long as its shadow NAV does not deviate by more than one-half cent from $1.

(16.) Relaxing this assumption would generally increase the advantages enjoyed by redeeming shareholders, so MMFs that allow dilutive redemptions would need larger MBRs to reduce the threat of runs than would funds that do not allow dilutive redemptions.

(17.) Strictly speaking, the MMF modeled in this section differs in two respects from the status quo: it has a 0.5 percent NAV-stabilizing buffer, and it allows no dilutive redemptions (it closes when losses exceed the buffer).

(18.) In contrast, a comparison of investors' losses as a percentage of the shares they hold at the time of a fund's closure would fail to take into account the cash that redeeming investors have removed from the fund. Thus, it would overstate the redeeming investors' total losses as a share of their holdings at the time they make the decision to redeem or remain invested.

(19.) In section IV.C we review empirical evidence suggesting that this assumption about the cost of lost access to MMF shares is not unreasonable (section 6.2 of our working paper discusses the evidence in more detail). But the qualitative points we make here are important as long as the liquidity cost is material to investors. Note that these liquidity costs to investors whose MMF shares are unavailable for an indefinite period after a fund's closure are distinct from the costs that a still-open fund may incur to liquidate assets to meet shareholders' redemptions.

(20.) This result does not depend on our assumption here that preservation of liquidity is worth 0.5 percent to investors; any nontrivial price for liquidity makes redeemers relatively better off.

(21.) In this example, because no other investor redeems, the redeeming investor is effectively leveraged by the ratio of the fund's assets to her assets when the fund's losses exceed its capital buffer, up to the point at which the redeeming investor's subordinated MBR is absorbed. This stark allocation of losses is admittedly an extreme example. Data from the Investment Company Institute (2012) show that monthly redemptions in MMFs from 2009 to 2011 averaged 45 percent of the funds' assets, so the likelihood that a 30-day period might pass in which only one or a few investors redeem shares seems remote. Notably, the retail exemption discussed in section II.C also would help ensure that small redemptions never lead to subordination of those investors' MBRs.

(22.) Put differently, when many investors redeem, each redeeming investor's MBR is less highly leveraged than the MBR of a single redeeming investor if no one else redeems.

(23.) Figure 7 can also be used to illustrate the effect of relaxing our assumption that all investors are small. Consider, for example, the case in which no other investor redeems. Then, the loss function of an investor who owns 25 percent of all outstanding shares in the fund and who redeems all of her shares is the same as for the small, fully redeeming investor when others redeem 25 percent. Because the larger investor owns a greater portion of the fund, the subordination creates less effective leverage for her MBR than it would for the MBR of a smaller investor (in the limit, the loss function of an investor who owns all the shares in a fund is unaffected by an MBR or subordination). The loss function for the larger investor, if she does not redeem, is the same as for the small, nonredeeming investor when others do not redeem.

(24.) These points are developed more formally in a simple model in section 4 of our working paper. Although our focus here is on investors' expected losses, we believe that the key insights of the section would be similar if we considered other moments of the loss distribution.

(25.) Diana B. Henriques, "Money Funds Could Face More Changes," New York Times, January 7, 2012. www.nytimes.com/2012/01/08/business/mutfund/money-market-funds-may-soon-face-more- changes.html?pagewanted=all&_r=0.

(26.) The SEC's 2010 rule amendments for MMFs introduced new requirements for disclosure of support that should assist in estimating the value of such interventions. Even so, precise estimates of the real-time value of support actions are likely to remain elusive.

(27.) The Primary Fund's losses were caused largely by its $785 million in holdings of Lehman debt obligations (1.3 percent of the fund's assets) at the time of Lehman's bankruptcy. RCMI, the adviser to the fund, announced at about 4 pm on Tuesday, September 16, 2008, that the NAV of the fund's shares had dropped by 3 percent, to 97 cents, presumably because large redemptions had further eroded the NAV. However, a June 2009 court order regarding distribution of the Primary Fund's assets indicated that the value of those assets ultimately would allow shareholders to receive 98.4 cents per share, although this amount included income earned on the assets after the Primary Fund was closed. See the plaintiffs complaint in SEC v. Reserve Management Company, Docket no. 09-cv-4346, U.S. District Court for the Southern District of New York, May 5, 2009, p. 3, www.sec.gov/litigation/complaints/2009/ comp21025.pdf, and the court order in the same case, June 8, 2009, p. 35, www.sec.gov/spotlight/ reserve_primary_fund_investors/gardephe_order.pdf. Some statements by the fund's sponsor have referred to the portion of the fund's assets--some of which lost significant value--that have been returned to investors as part of the fund's liquidation process, rather than to investors' principal losses as claimants upon those assets. An example is the following, quoted in Anderson (2010) from a Reserve press release: "Including this seventh distribution, $50.7 billion, or approximately 99.04% of Fund assets as of the close of business on September 15, 2008, will have been returned to investors."

(28.) In addition, Moody's (Moody's Investors Service 2010) found that between 2007 and 2010, 21 MMF sponsors spent at least $12.1 billion to maintain stable NAVs for their funds, although that figure includes support for some European funds and some nonregistered investment pools. Moody's totals were not stated as shares of the supported funds' NAVs.

(29.) The Treasury's temporary guarantee program was announced on September 19, but some funds provided data for shadow NAVs on dates before the program's inception.

(30.) This total could exclude MMFs that received direct cash infusions from sponsors or benefited from sponsors' outright purchases of securities from the fund at above-market prices.

(31.) Here we assume that the investor can take out such a loan. An investor who faces borrowing constraints presumably would have larger liquidity costs.

(32.) Since we lack sufficient data to estimate reliably the density function of realized losses in the event that an MMF breaks the buck, we use the exponential distribution as a means of capturing the relatively high frequency of extreme returns in financial market data. Our aim is to calibrate an MBR of sufficient size to provide stability for the typical MMF in distress. The investor's decision to redeem or not must come before that loss is known, since a realized loss exceeding 0.5 percent would lead to the fund's closure and preclude further redemptions. Our calibration also assumes that the investor knows only that losses are drawn from the industry-wide distribution described here. More realistically, an investor in a given MMF would have information about the size of the fund's exposure to distressed assets and could base her decision on that more specific information.

(33.) Because other investors' redemptions can provide a protective (subordinated) buffer in an MMF with a strong MBR rule, the assumption that other investors do not redeem generally has relatively minor effects on our calibration. Section 6.3 of our working paper examines how changes in these assumptions affect our estimates of the appropriate size of the MBR.

(34.) For further discussion of these externalities, see FSOC (2012b), section VI.

(35.) Raising the cost of short-term borrowing could be a desirable outcome of reform, given that such borrowing itself may have negative externalities (see, for example, Brunnermeier and Oehmke 2013).

(36.) Comments on the FSOC's proposed recommendations can be found at www.regulations. gov/#!docketBrowser;rpp=50;po=0;D=FSOC-2012-0003.

(37.) Less regulated substitutes for MMFs already exist and hold sizable portfolios. For example, data from iMoneyNet indicate that "offshore" MMFs that denominate their shares in dollars had about $400 billion in assets under management at the end of 2012, and "enhanced cash" funds that rely on exemptions from the Investment Company Act to avoid MMF rules had about $200 billion in assets in mid-2012. In general, such substitutes are available only to institutional investors. For more on potential shifts of assets to MMF substitutes, see U.S. SEC (2012).

(38.) A prerequisite for these benefits is that the share prices of MMFs actually fluctuate on a regular basis. Under current rules MMFs can round their share prices to the nearest cent, so any variations of less than 0.5 percent in the value of an MMF's portfolio are rounded away. The values of MMF portfolios typically vary only by a few hundredths of I percent, so share prices almost never vary. One proposal for floating NAVs would allow MMFs to maintain $10 NAVs and round to the nearest cent, so variations of less than 0.05 percent still would be rounded away. That approach likely would preserve stable share prices and undermine the potential benefits of a floating NAV.

(39.) The sources cited here mention only that MMFs may be seen as an impediment to easing of policy; they do not focus in detail on those concerns.

(40.) MMFs pay their expenses (for example, for managing portfolios, processing transactions, and maintaining shareholder account data) out of the yields they earn on portfolio securities. Under current practices a fund that maintains a stable NAV and charges expenses that exceed portfolio yields would experience a destabilizing decline in the underlying value of its shares. MMFs have avoided this option, so the very low interest rates that have prevailed in recent years have diminished the revenue that MMFs can feasibly earn. Recently, however, stable-NAV money funds have explored novel options for handling low or even negative rates on short-term instruments. For example, euro-denominated funds have announced plans to pay expenses by decreasing the number of shares that investors own, rather than charging fees that reduce the value of those shares (see Moody's Investors Service 2012a, 2012b).

(41.) The effect of capital on ex ante risk mitigation would depend on how the capital is financed. If capital were raised by creating a subordinated class of shares, the investors who purchased those shares would face strengthened incentives to monitor risks (BlackRock 2011, Hanson and others 2012). In contrast, if a small buffer were raised by retaining a portion of the fund's own income over many years (as proposed by Goebel and others 2011), the effect on incentives for monitoring risks is less clear. A sponsor-provided capital buffer presumably would reduce incentives for risk taking, although the considerable record of sponsors already providing implicit support ("ex post" capital) for their money funds clearly does not provide incentives adequate to prevent MMFs from taking risks that pose threats to financial stability.

(42.) Prime MMFs accounted for 58 percent of the industry's assets at the end of 2012. Two other types of MMFs account for the rest: government MMFs generally hold securities issued by the U.S. Treasury, federal agencies, and government-sponsored enterprises such as Freddie Mac and Fannie Mae, as well as repos backed by such securities; and tax-exempt MMFs hold municipal securities.

(43.) Tax-exempt MMFs, especially those sold to institutional investors, also experienced substantial outflows in September 2008, but the magnitude of the decline was far smaller than that for prime MMFs. (Weekly data from the Investment Company Institute indicate that assets in institutional tax-exempt MMFs fell 12 percent from September 10 to October 1, 2008, while assets of institutional prime funds plummeted 29 percent in the same period.) Government MMFs also have experienced strains at times: one such fund operated by Reserve experienced very heavy redemptions in 2008, and many government funds had heavy outflows in the summer of 2011 amid concerns about the federal debt ceiling impasse (FSOC 2012b).

(44.) Alternatively, the size of the MBR could depend on the composition of the fund's portfolio. Both the FSOC's proposed recommendations and Hanson and others (2012) suggest such an approach in determining the required size of a capital buffer.

(45.) In our working paper we call this adjustment the "effective MBR rule." We show that an effective rule that caps subordination at 40 percent of the MBR, in combination with an MBR of 5 percent, would achieve about the same degree of stability as a strong MBR rule (one that allows all of the MBR to be subordinated) and an MBR of 3 percent.

(46.) Funds with assets greater than $1 billion accounted for over 80 percent of institutional prime MMF assets. Data on minimum initial investments are from iMoneyNet.

(47.) For example, the SEC found in 2005 that "one of the biggest obstacles to preventing short-term trading is the existence of omnibus account platforms" (U.S. SEC 2005, p. 49) and that "a number of the market timing abuses identified through our investigations reveal that certain shareholders were concealing abusive market timing trades through omnibus accounts" (U.S. SEC 2005, pp. 6-7).

(48.) Section 6 of our working paper provides more details of that analysis, including sensitivity analyses to address the uncertainties of estimating expected losses in a distressed MMF and the challenges of pinpointing liquidity costs to investors who lose access to shares in a closed fund.

(49.) The outflows in 2011 occurred despite the fact that the European exposures caused no losses for MMFs (see FSOC 2012b, Chernenko and Sunderam 2013). In contrast, in August 2007, as the asset-backed commercial paper (ABCP) crisis unfolded and many MMFs suffered substantial losses due to holdings of distressed ABCP, institutional investors generally did not redeem MMF shares (McCabe 2010).

Table 1. Minimum Shadow NAVs of Reporting Money Market Funds,
September 5 to October 17, 2008 (a)

                                                 Average minimum
                                      No. of   reported shadow NAV
                                       MMFs    (dollars per share)

All reporting MMFs                      72            0.989
MMFs reporting a minimum shadow NAV
  under $0.995                          29            0.978
MMFs reporting a minimum shadow NAV
  between $0.95 and $0.995              26            0.985
Memorandum: Minimum reported shadow
  NAV for any MMF                        1            0.903

Sources: U.S. Department of the Treasury and U.S. Securities and
Exchange Commission.

(a.) Reported shadow NAVs exclude the effects of guarantees from
sponsors but may include the effects of some other forms of sponsor
support, such as direct cash infusions to the fund or outright
purchases of securities from the fund at above-market prices.