Money Market Mayhem

Dodd-Frank regulatory board targets money market mutual funds

• May 23, 2012 5:00 am


A regulatory board created by the Dodd-Frank financial reform could push trillions of dollars into big banks, driving up costs for struggling businesses and the government by doing away with alternative investment accounts, according to industry insiders.

Securities and Exchange Commission Chairwoman Mary Schapiro is pushing for tougher regulations on the $2.7 trillion money market fund industry (MMF) and may use the Financial Stability Oversight Council (FSOC)—a 10-member board made up of top financial regulators created by Dodd-Frank—to implement the restrictions.

"As a regulator who saw the damaging effects of the 2008 run on money market funds, I find it hard to remain on the sidelines despite calls to declare victory on this issue," Schapiro told the Society of American Business Editors and Writers in March.

But financial experts say this will have devastating consequences on money market funds, such as Fidelity Investments, which would lose out on customer accounts because of increased costs.

"There’s already been this massive shift of assets from MMFs to banks; so much so that banks don’t know what to do with the money," said financial attorney Melanie Fein. "New regulations would suggest that the government is pursuing policies that would increase the size of the banking system, which is already having adverse systemic consequences."

MMFs operate as low-cost, conservative alternatives to traditional investment banking. They are restricted to trading low-risk, short-term equities, bonds, and currency holdings and are forced to disclose their assets every 30 days.

MMFs have become staples in short-term borrowing, making quick maturity loans to businesses and local governments to fund payrolls or capital projects. Clients borrow through MMFs because they are 5 to 10 times cheaper than banks, which have also been more tightfisted than MMFs in the credit markets since the 2008 collapse. Investors look to MMFs to diversify their portfolios with modest gains at cheaper cost than investing with banks.

That could change if Schapiro is able to muscle through increased regulations that would drive up costs for consumers by regulating the quick-hitting industry as though the funds were in traditional investment banks.

Schapiro has backed capital increases in order to ensure that MMFs have enough cash on hand to serve as a buffer, as well as a floating net asset value, as opposed to the industry standard $1 NAV. She believes the lack of a floating value causes panic on Wall Street in the event that a fund’s NAV drops below the $1 mark. Both measures would take away from the low-cost flexibility that has made MMFs profitable.

"I have very legitimate concerns about the risks that are posed by the stable NAV and the potential to cause runs," Schapiro said on May 11. "We all know what happened in 2008."

Schapiro has repeatedly invoked the September 2008 collapse of the Reserve Primary Fund, a multi-billion dollar MMF, when discussing bank runs. On September 16, 2008, the Reserve Fund fell below the $1 NAV, leading investors to withdraw from the company. Unlike banks, MMFs are not protected by the Federal Deposit Insurance Corporation (FDIC). That makes them prime targets for nervous investors, Schapiro says.

However, Schapiro has it backwards if she blames MMFs for the bank runs that accompanied the bankruptcy of investment giant Lehman Brothers, Fein said. The Reserve Fund collapsed because it loaned money to Lehman Brothers that the investment house used to finance its risky sub-prime mortgage bets.

"They are shifting the blame from the banking system to MMFs," Fein said. "They are going after MMFs because [MMFs] are so risk averse that they will pull back, and what the Fed seems to want them to do [in crisis] is take their losses and stand as a backstop for a market dominated by banks."

Brian Reid, chief economist of MMF association Investment Company Institute (ICI), said the regulations would make the financial industry less stable by pushing trillions of dollars into big banks or less regulated markets such as hedge funds.

"For the retail investor: There’s no other solution other than to go into a bank product," he said. "The institutional investors, they aren’t going to want an undiversified exposure to a single bank portfolio. It’s likely to end up in cash managers looking to invest in unregistered and unregulated pools or overseas in other markets—they’ve just increased the systemic risk."

Customer accounts would not be the only thing to disappear. Revenue-starved businesses and governments would be forced to borrow from the banking system, driving up costs and leading to tightening of credit markets, according to Fein. She added that removing MMFs also would not solve the threat of bank runs in a crisis.

"The average (MMF) account is $5 million, which greatly exceeds the $250,000 limit that the FDIC provides," she said. "That would be of great concern. Rather than moving money to conservative Treasury bonds through [an MMF], those people are going to be running to their bank to get their money out at the drop of a hat."

Schapiro may not have the votes to push through the regulation despite her role as the nation’s most powerful financial regulator. When the SEC unveiled the new regulations in April, three members of the agency’s 5-member governing board—Democrat Luis Aguilar and Republicans Troy Paredes and Dan Gallagher—opposed the proposed rules.

"We feel that it is important to state for the record that the consultation report does not reflect the views and input of a majority of the commission," Paredes and Gallagher said in a statement. "In fact, a majority of the commission expressed its unequivocal view that the commission's representatives should oppose publication of the consultation report and that the commission's representatives should urge Iosco to withdraw it for further consideration and revision."

Schapiro has allies among other regulators, including Federal Reserve Chairman Ben Bernanke. Both serve on FSOC and could use backdoor measures to rein in MMFs. Dodd-Frank gives the council broad authority to impose stricter regulations on large firms designated as "systemically important financial institutions" (SIFIs).

Although FSOC’s rules were designed to regulate banks and insurance companies, nothing could stop FSOC from imposing the rules on non-banks such as MMFs. The Economist likened the broad authority given to regulators by Dodd-Frank to the Hydra of Greek mythology, which "can grow new heads as needed."

"Laws classically provide people with rules. Dodd-Frank is not directed at people. It is an outline directed at bureaucrats and it instructs them to make still more regulations and to create more bureaucracies," Yale Law Prof. Jonathan Macey told the British magazine.

ICI’s legal team said there is little hope that MMFs could survive under the increased penalties associated with the regulations.

"It wouldn’t be an appropriate way to strengthen the regulation of money market mutual funds," ICI Deputy Senior Counsel Frances Stadler said. "The consequences of being designated are that the (money market fund) would be subjected to bank-oriented prudential standards, which we think would be unworkable with money market mutual funds and inconsistent with their structure."

Some financial experts credited the desire to further regulate MMFs with the investment banking background of many regulators. As Fed chairman, Bernanke interacts on a frequent basis with banks on monetary and depository policy, and Schapiro spent her career regulating investment banks at the Financial Industry Regulatory Authority. Neither seems to have a full grasp of the role MMFs play in the economy, according to Mercatus Center economist Hester Peirce.

"A lot of this reform effort is being driven by bank regulators, and they like to treat everything like it’s a bank," Peirce said. "If the SEC doesn’t do anything, then FSOC will do something because FSOC is made up of banking regulators."

MMFs have cooperated with regulators in the past. When regulators raised concerns over capital buffers in 2010, ICI influenced new SEC rules that restricted MMF investments to top grade securities and mandated that they have enough flexibility to pay its investors within 60 days.

"We supported by and large all of the recommendations the SEC implemented in 2010; we had put out some of the same recommendations in 2009," Reid said. "But there’s been strong concern raised about these proposals because they would all render the instrument unattractive and economically unviable."

The industry is watching closely to see if Dodd-Frank will soon muscle its way into MMFs.

"All of the Dodd Frank mechanisms are new and untested, and there are a lot of unknowns here," Stadler said.