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On Thursday, September 28, 2011, Federal Reserve Bank of Boston President Eric Rosengren addressed the need for stricter oversight of money market mutual funds at a conference held by the Global Interdependence Center in Stockholm, Sweden. U.S. money market funds are a $2.5 trillion industry that consists of cash and “cash equivalents,” or high-quality, short-term debt securities. Laws require money market funds to be low risk and very liquid, meaning that investors should be able to sell them for cash quickly without losing money because of transaction costs or decreases in market value. According to Rosengren, increased foreign bank reliance on money market funding has left the short-term credit markets particularly vulnerable to the European debt crisis. Banks, including foreign banks, issue short-term bonds to raise cash, money market funds buy the bonds for their portfolios, and investors subsequently buy the money market funds. Thus, money market funds (and their investors) are holding increasing amounts of European bank debt, which are quickly becoming riskier investments.
The short-term credit markets are of particular concern because banks rely heavily on short-term funding to raise cash. However, investors are increasingly reluctant to buy bonds from European banks that hold large amounts of Greek debt for fear that the banks would fail if Greece defaults, and, thus, investors would lose their money. As the European debt crisis escalates, money market funds that own bank debt are more susceptible to losses due to credit downgrades that reduce the value of the banks’ outstanding bonds. It also makes it more expensive for the banks to access funding because the interest rate they must pay on loans increases. This creates the potential for large numbers of investors to sell their shares of money market funds at once as they try to avoid losses on their investment, a phenomenon called a “bank run.” A bank run creates massive cash shortages for banks and, according to Rosengren, regulators are not doing enough to protect banks. Cash shortages are problematic because banks need cash for daily operations and fulfillment of capital adequacy requirements.
Rosengren’s comments are noteworthy as the Federal Reserve Bank of Boston led the money market fund rescue programs used in the U.S. during the 2008 economic crisis, and his experience may provide some insight into the current European crisis. As a result of the 2008 U.S. economic crisis, the Boston Federal Reserve Bank successfully urged the Securities and Exchange Commission (SEC) to significantly reform money market fund regulations. Under the revised regulations, adopted in January of 2010, the SEC changed fund reporting periods from semi-annually to monthly, increased liquidity requirements, improved credit quality, and implemented capital and risk assessment protocols. Although the reforms improved transparency and reduced risk, they have proven inadequate in identifying actual risk in the face of the increasingly volatile European markets. Rosengren points out that some money market funds simply clean up or “window dress” their portfolio holdings in time for monthly reports, and thus avoid providing an accurate picture of the actual risk profile or fund value on a day-to-day basis. Such actions mislead investors and can understate the overall risk of the money market funds.
Rosengren believes that regulators can prevent bank runs by increasing the transparency of money market funds to allow investors to better gauge the risk of their investments. To avert such a crisis, Rosengren proposes greater transparency of risk profiles, more stringent value reporting mechanisms, and increased capital requirements, all of which would protect investors. However, such reforms might also make it more costly for banks to raise funds, which could worsen the European crisis.