As we wrote in Tuesday's Crane Data News ("Comment Letters Argue Against Added FSOC Supervision for MMFs"), a number of investment managers have recently written to the new Financial Stability Oversight Council, arguing that mutual funds and money market funds should not be "designate[d] nonbank financial companies for enhanced supervision" under the Dodd-Frank Act. Today, we excerpt more from Vanguard's "Advanced Notice of Proposed Rulemaking Regarding Authority To Require Supervision and Regulation of Certain Nonbank Financial Companies (FSOC-2010-0001)" letter.
Vanguard's Gus Sauter and John Hollyer write, "We appreciate the opportunity to comment on the Advanced Notice of Proposed Rulemaking Regarding Authority to Require Supervision and Regulation of Certain Nonbank Financial Companies.... On behalf of the mutual fund investors we serve, we are deeply committed to working with financial regulatory authorities to improve the efficiency, stability, and liquidity of our financial markets. As the financial crisis has demonstrated, our markets can be vulnerable when certain interconnected financial companies engage in risky lending and financial engineering involving highly complex transactions coupled with the use of leverage." The letter "explains why mutual funds and their advisers should not be supervised by the Board or be subject to the prudential standards contemplated by the Act."
The comment continues, "In the recent financial crisis, some money market funds had to liquidate assets quickly when faced with unusually high redemption activity. The demand on certain funds to sell assets in short order to satisfy redemption requests demonstrated the need for money market funds to maintain minimum liquidity thresholds. Money market fund regulations have since been revised to require all funds to maintain such liquidity thresholds. We believe the revised regulations ... make money market funds resilient to liquidity pressures. We do not believe the market-wide illiquidity that occurred in the recent market crisis resulted from money market fund activity, but rather from banking entities' unwillingness to accept each others' credit risk. We believe it is unlikely that the liquidity challenges of any one money market fund would produce severe market-wide illiquidity."
Sauter and Hollyer also say, "Equity, bond, and money market mutual funds may experience losses, however, these losses do not infect the broader financial markets. Rather, they are shouldered by the funds' investors, who have agreed to accept the risk of loss. In the two instances where money market mutual funds have 'broken the buck,' the losses amounted to pennies on the dollar. [A footnote here says, "The Reserve Primary Fund and the Community Bankers fund are the only two money market funds that have 'broken the buck' in the industry's thirty-nine year history. The Reserve fund eventually paid out .99/share to its shareholders, while the Community Bankers fund paid out .96/share in 1994."] Such small losses do not pose a threat to financial stability, especially where the loss is borne by the shareholders of the fund, not the U.S. taxpayer. In the recent market crisis, one institutional prime money market fund's loss on its Lehman holdings prompted investors in other institutional prime money market funds to redeem their fund shares. These investors had no way of knowing whether their money market funds had similar Lehman holdings, as money market funds did not, at that time, frequently disclose portfolio securities. Faced with this uncertainty, investors began to redeem their shares. We believe the new money market portfolio holdings disclosure requirements ... adequately address this issue and mitigate the risk that a credit event experienced by one fund will prompt investors in other funds to redeem their shares."
They explain, "Complexity was one factor that contributed to market participants' inability to plan for and respond to the crisis; lack of transparency was another.... The Council should focus on identifying those nonbank financial companies that do not have transparent balance sheets (i.e., have off-balance sheet liabilities) and engage in leveraged trading activities with other important financial companies.... The existence of a primary regulator is another factor to be considered when determining whether a company presents systemic risk. The Council should not further regulate entities that have a primary regulator. Any gaps or weaknesses in regulation identified by the Council should be referred to and addressed by the primary regulator."
Vanguard writes, "Mutual funds and their investment advisers are subject to comprehensive regulation by the SEC under the Investment Advisers Act of 1940, Investment Company Act of 1940 and other federal securities laws. This regulatory framework provides investor protections including regular reporting to the SEC and fund shareholders, safekeeping of fund assets, transparency in disclosure, corporate governance requirements, prohibitions on affiliated transactions, limitations on leverage and illiquid securities, valuation standards, and audit and compliance policies and procedures. We do not believe further regulation by the Council would offer additional protection to investors and could detract from efforts to monitor and assess companies that do pose systemic risk."
Vanguard also says, "In short order, the SEC proposed and adopted a comprehensive overhaul of Rule 2a-7, embracing many of the proposed recommendations of the ICI's Working Group and adopting some additional changes. From the time the Guarantee Program expired to the present, the money market fund industry has not sought, nor needed, federal assistance to maintain the stable NAV. [This footnote adds, 'Unlike money market funds, support for banks has only increased since the financial crisis ended. For example, FDIC insurance has increased from $100,000 to $250,000/account. Most recently, the FDIC proposed a rule that would expand its insurance program and permit for taxpayer support in an unlimited amount on all non-interest bearing transaction accounts for a two-year period.']"
They add, "As acknowledged in the recent President's Working Group on Financial Markets report, Rule 2a-7 has been revised extensively in many important respects since the termination of the [Treasury] Guarantee Program. The revised Rule 2a-7 has several components designed to make money market funds self-provisioning for liquidity and more resilient: 1) Daily and weekly liquidity minimums.... 2) 'Know Your Customer' procedures... 3) Maximum weighted-average maturity (WAM) of 60 days (down from 90 days), coupled with a maximum weighted average life (WAL) of 120 days.... 4) Stress testing of portfolios.... 5) Portfolio holdings disclosure requirements.... and, 6) Rule 22e-3, which permits fund boards to suspend redemptions and payment of redemption proceeds if a board concludes that a fund must liquidate."
Finally, the Vanguard letter concludes, "We believe these changes strike the appropriate balance between allowing money market funds to continue to finance the short-term needs of private and public borrowers and mitigating any one fund's systemic risk. To the extent the Council has any remaining concerns with respect to money market funds, we believe they should be addressed by the options in the PWG Report, and not through the Council's authority to designate financial companies for further supervision by the Board."
