In the turmoil of the financial markets, one person’s loss is often another’s gain. This is certainly true for US money market funds. Last month, as depositors worried about the safety of their funds in the banking system, particularly with shaky regional lenders, they moved their cash into money market funds at a rapid pace, with inflows of around $370 billion. As First Republic, the San Francisco-based regional lender, falters, that trend appears to be continuing, albeit at a slower pace.
Money market funds form a core part of the shadow banking system – financial intermediaries that cannot take deposits. As the US Federal Reserve has raised interest rates, the funds have offered investors interest rates well above those offered by banks. By investing in short-term debt, they also allow investors to meet their liquidity needs while providing day-to-day funding for the economy. However, their scale and importance to the installation of the financial system are so great that they represent a major source of risk.
During the 2008 financial crisis, one such money market fund, the Reserve Primary Fund, famously “broke the buck” after the Lehman Brothers bankruptcy – when its net asset value fell below $1. Investors found that the bank-like products promised by the funds did not mean bank-like protection; they are not covered by the deposit insurance. Stricter regulations followed about what money market funds can invest in and what buffers they need. Funds came under renewed pressure in March 2020 as Covid panicked investors rushed to redeem holdings for cash. With total U.S. money market fund assets hitting a record $5.2 trillion last month, there are fears unresolved vulnerabilities lurk. Last month, US Treasury Secretary Janet Yellen pointed to the risks of “runs and fire sales” when investors redeem their shares all at once.
Another risk is that the funds will outperform regional lenders and further weaken their profitability. A third risk is that money market funds are increasingly parking their money in the Fed’s reverse repo facility, where they can earn higher and safer returns. This further drains liquidity from the banking system and increases concerns about credit availability.
The risks are currently manageable. The vast majority of recent inflows have gone into Treasury funds, which are relatively safe as they invest in government-backed securities – although an ongoing political stalemate over the US debt ceiling could yet fuel a liquidity problem. Meanwhile, the potential for an immediate liquidity squeeze caused by cash injections into the RRF seems low as reserve balances are still high and liquidity is available through other Fed facilities. In addition to broader options for investors, money market funds probably also offer welcome competitive pressure for banks.
However, this is the time for moderate reforms to strengthen the sector’s resilience. Money market funds should be required to disclose more data to regulators to help them monitor liquidity and redemption vulnerabilities and raise investor awareness of the risks. Higher liquidity requirements also make sense, but must be moderate enough not to overly strain funds. Inflows into the reverse repo facility also need to be closely monitored.
As authorities prepare to set new rules for the sector, they should keep in mind that overburdening money market funds with onerous restrictions could harm the financial system in the long run. Indeed, recent bank outflows into these funds underscore the role of the shadow banking sector as a key safety valve in times of crisis.
Money market fund oversight is a balancing act: doing too little creates risks to financial stability, but doing too much hampers an important source of liquidity. Regulators need to get it just right.
