Academic journal article Brookings Papers on Economic Activity

The Minimum Balance at Risk: A Proposal to Mitigate the Systemic Risks Posed by Money Market Funds

Academic journal article Brookings Papers on Economic Activity

The Minimum Balance at Risk: A Proposal to Mitigate the Systemic Risks Posed by Money Market Funds

Article excerpt

ABSTRACT This paper introduces a proposal for money market fund (MMF) reform to mitigate the systemic risk and externalities that arise from the funds' vulnerability to runs and to protect shareholders who do not redeem quickly when runs occur. Our proposal would require that a small fraction of each MMF shareholder's recent balances, called the "minimum balance at risk" (MBR), be available for redemption only with a delay of 30 days. Most regular transactions in the fund would be unaffected; the requirement would only affect redemptions of the shareholder's MBR. In addition, in the rare event that a fund suffers losses, the MBRs of investors who have recently made large redemptions would absorb losses before those of nonredeeming investors. This subordination of redeeming investors' MBRs would create a disincentive to redeem if the fund is likely to have losses, but would have little effect on incentives when the risk of loss is remote. We use empirical evidence, including a novel data set from the U.S. Treasury and the U.S. Securities and Exchange Commission on MMF losses in 2008, to calibrate an MBR rule that would reduce the vulnerability of MMFs to runs.

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By many measures, money market funds (MMFs, or "money funds") are a popular financial product. With $2.7 trillion in assets under management at the end of 2012, MMFs represented over a fifth of all U.S. mutual fund assets, according to the Investment Company Institute. MMFs are key intermediaries of short-term funding and hold large fractions of the short-term debt issued by financial institutions in capital markets. (1) The popularity of money funds largely reflects the attractiveness of their defining feature for many investors: MMFs, unlike other mutual funds, typically maintain a stable $1.00 share price (also known as the fund's "net asset value," or NAV). Their stability of principal allows MMFs to serve as an important cash management tool for individuals, firms, institutions, and governments.

However, MMFs are vulnerable to runs, and given the size of the money fund industry and its importance in allocating short-term funding to financial institutions, this vulnerability poses considerable risk to the financial system. The potentially dire consequences of a run on MMFs were evident in September 2008, when the Lehman Brothers bankruptcy caused one fund to "break the buck" (that is, its NAV fell below $1, so its investors suffered principal losses) and triggered massive and widespread redemptions from other MMFs. (2) These outflows were a key factor in the virtual shutdown of short-term funding markets and a broader curtailment of credit supply (see, for example, Federal Open Market Committee 2008, Board of Governors of the Federal Reserve System 2009, U.S. Securities and Exchange Commission 2009, President's Working Group on Financial Markets 2010). The severity of the damage to financial stability caused by the run in 2008 led to unprecedented government interventions to support MMFs in order to halt the run. Since then, the funds' vulnerability has continued to pose risks to the financial system. The heavy exposures of MMFs to European financial institutions, for example, have put the funds at risk of transmitting strains from Europe very rapidly to U.S. short-term funding markets (Financial Stability Oversight Council 2011, Chernenko and Sunderam 2013). Yet policymakers have fewer tools available now to address MMF runs than they did in 2008; in particular, the Treasury's Temporary Guarantee Program for Money Market Funds, which effectively halted the run in 2008, would no longer be possible under current law: the Emergency Economic Stabilization Act of 2008 specifically prohibits the Treasury from reusing that mechanism. In light of the systemic risk stemming from MMFs' susceptibility to runs, calls for reform have come from government agencies (for example, Schapiro 2010, 2011, 2012, President's Working Group on Financial Markets 2010, Financial Stability Oversight Council 2011, 2012a, 2012b), from academics (for example, Squam Lake Group 2011, Hanson, Scharfstein, and Sunderam 2012), and from the financial industry (for example, Mendelson and Hoerner 2011, Goebel, Dwyer, and Messman 2011). …

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