SEC Punts on Financial Stability Reform

By Professor Jeffrey Gordon

Sept. 10, 2012

In an all-too-familiar pattern, the U.S. Securities and Exchange Commission (SEC) has backed down in the face of industry pressure and dropped a key proposal to prevent a repetition of the 2008 financial crisis.   Despite the steadfast efforts of Chair Mary L. Schapiro, a divided Commission late last month rejected further steps toward reform of money market funds, a $3 trillion financial intermediary that was at ground zero of the financial crisis and still presents a continuing threat to financial system stability.   

A powerful industry group, mutual funds and some of their clients have persuaded three SEC commissioners to ignore the near implosion of the money market fund sector in 2008.   Here are their names, for now is an accountability moment: Luis A. Aguilar, Daniel M. Gallagher, and Troy A. Paredes. 
At the onset of the financial crisis, the Lehman Brothers bankruptcy forced a large money market fund, Reserve Primary, to “break the buck,” or drop below the $1 fixed net asset value (NAV) that makes a money fund a functional substitute for a bank transactional account. The prospect of receiving less than $1 for each dollar invested in turn triggered a massive run—$300 billion in a week—that was halted only by extraordinary government intervention. The U.S. Treasury guaranteed all existing money fund deposits and the Federal Reserve provided emergency liquidity facilities and took on unprecedented credit risk.   Congress rightly saw these actions as a bailout and subsequently stripped Treasury of its guarantee power and limited the Fed as well. 
In 2010, the SEC adopted measures in an effort to add some stability to money market funds. In particular, it required the funds to hold more liquid assets and limited the types of assets that can be held. These measures were understood as partial, to buy time for the regulators to investigate the money market fund stability problem more thoroughly. 
In subsequent research and analysis, this is what we have learned (or been reminded of): Money market funds buy securities that are not risk-free. Indeed, some funds may “reach for yield” because many investors are attracted by higher yields and the sponsor’s profits typically increase as the pool of managed assets grows larger. It isn’t hard to identify the funds that are “reaching.” The market is very efficient—higher yields mean higher risk. In times of financial distress, the intensity of the investors’ “run” is significantly greater at funds with higher yield (and risk).  
We also have learned that the stability of the money fund industry depends upon implicit sponsor guarantees.   Various analyses from Moody’s, the SEC, and the Boston Fed have agreed that support from sponsors—who subsidize the fund to protect net asset value—was all that prevented more than two dozen funds from breaking the buck during the crisis period that began in 2007. 
The July 2012 report of Treasury’s new Office of Financial Research underscores this continuing problem. Funds are seriously exposed to the credit risk of their portfolio assets. Treasury found that 105 funds are at risk of breaking the buck if any of their largest 20 issuers default. Sponsor support is crucial. 
Yet, in a punishingly low interest rate environment, the industry has been consolidating to maximize scale economies and reaching for yield to minimize losses from fee waivers—all without any testing of sponsor capacity to provide support and without any binding commitment to do it. 
The core problem, which the SEC staff identified and sought to address in the reforms rejected by the three commissioners, is that money funds hold risky assets but have no independent capacity to bear loss—no capital nor any other loss-absorbing layer. In times of systemic instability, money fund users will run because being first in line to redeem may increase the chance of receiving 100 percent of their investments. A required “holdback” of a small percentage of deposited funds for a fixed period would reverse the run dynamics because it would mean that an investor’s best chance to avoid loss is in not running. That plus a small capital layer would add considerable stability to the money market fund industry. These were the crucial elements of the squelched SEC proposal. 
Money market funds assemble diversified packages of short-term credit claims, particularly short-term claims issued by banks and other financial institutions. In their present fixed NAV form, money funds can play a useful transactional role as a bank substitute, especially for large institutions with significant cash balances that exceed the limits of deposit insurance guarantees.   But the stability of the financial system is a public good that cannot be sustained in the presence of pervasive free-riding. The present money fund structure is like a nuclear power plant atop an earthquake fault: The question of a disaster is not whether but when.
But Congress foresaw that a particular financial regulator might be stymied by industry forces. Thus the Dodd-Frank legislation places ultimate responsibility in a “college” of regulators, including the SEC, that make up the Financial Stability Oversight Council. The FSOC has two relevant powers: First, it can “issue recommendations” to the SEC to apply “heightened standards and safeguards” for an activity, like maintaining a money market fund, that it deems a systemic threat. Second, the Council can determine (by a two-thirds vote) to subject particular money market funds or fund complexes to Fed oversight upon a determination that they “could pose a threat to the financial stability of the United States.”
The SEC having punted, the ball is now in the FSOC’s court. This is an accountability moment for other U.S. financial regulators as well. 
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Jeffrey Gordon is Richard Paul Richman Professor of Law and co-director of the Richman Center for Business, Law & Public Policy.