Barclays Strategist Joseph Abate proposes FDIC-like insurance for money market funds in the latest "Market Strategy Americas" update. He says, "Regulators and the industry appear to be at an impasse with respect to reforming money funds to reduce systemic risk. Moreover, current proposals are less than adequate in addressing investor risk run. Could it be time to consider alternatives? To the extent that run risk is driven by loss of principal fears, there might be a case for limited money fund insurance. Limited ex ante FDIC coverage could be set at a fixed amount, with a premium determined at a quarterly auction subject to a minimum. In 2008, money funds were willing to pay between 1 and 1.5bp/quarter for coverage from the Treasury. To mitigate moral hazard, funds buying insurance would be subject to capital requirements -- the capital would act as the insurance deductible. Alternatively, the Fed could sell liquidity options to money funds that would entitle the holder to a future collateralized loan from the central bank."
Abate explains, "Any government-sponsored insurance or liquidity program would face stiff opposition from banks and regulators. This was reiterated by a Bloomberg editorial that noted that "taxpayers shouldn't be forced to take this risk [systemic risk from money funds] again". Although such support would be difficult to secure, we believe that a corresponding reduction of destabilizing run risk in money funds would have overwhelmingly positive benefits."
He continues, "Regulators seek to avoid a replay of September 2008 where the buck-breaking of one large money fund precipitated a surge in prime fund redemptions that destabilized CP and repo markets, exacerbating the financial crisis. Floating NAVs, redemption gates (or minimum deposits, however structured), and capital buffers are deeply unpopular with institutional investors. Besides being expensive and difficult to implement, these solutions may not adequately reduce the propensity of institutional money fund investors to flee in a crisis. Dissatisfied with the SEC proposals, institutional investors (who account for 70% of all taxable money fund deposits or about $1.6trn in balances) may shift their funds to other accounts with same day liquidity and stable principal. Such a shift into bank deposits or other, possibly off-shore investments, would simply transfer systemic risk from one sector to another."
Abate tells us, "Although money fund balances are not covered by an explicit insurance guarantee like bank deposits, there is a strong implicit assumption that a fund sponsor will maintain the fund's stable NAV and same-day liquidity by either buying out assets above par or providing some liquidity guarantee. The strength of the implicit guarantee is backed by reputational concerns -- a money fund that breaks a buck and loses money for its investors is out of business. But, as was the case for the Reserve Primary Fund, while the will to back up the stable NAV and meet redemptions was there, the ability was not. The fund very quickly experienced redemption demands that overwhelmed its available resources and forced it to close. Unsurprisingly, this led to a surge in redemptions at other prime funds as investors began to worry about their implicit support."
Abate writes, "Instead, there may be a case for insuring MMF investments along the lines of FDIC bank deposit insurance -- in effect, applying a banking "solution" to a money market "problem." Money fund investors and bank depositors (at least checking account holders) are very similar -- each puts a premium on same-day liquidity and principal protection. Thus, to the extent that depositors are driven by fears of impending principal loss to rush to withdraw their money in a run, the existence of deposit insurance prevents -- or at least slows -- "impatient" redeemers from overwhelming the bank's available liquidity and forcing it to close.... [T]his is not to imply that there were no deposit runs at the height of the financial crisis in 2008 -- depositors still lined up outside the branches of some big name bank failures to withdraw money. But the reduced frequency of runs at banks does suggest that some form of insurance might be useful in slowing or reducing the probability of investor runs at money funds."
He adds, "The usefulness of explicit insurance for money funds became clear following the collapse of the Reserve Primary Fund. The Treasury created an insurance program for money funds using the $50bn in the Exchange Stabilization fund (ESF). Under the "Guaranty Program for Money Market Funds", money funds paid a fee of 1-1.5bp per quarter to guarantee their balances (as of September 19) for one year. Coverage was back-dated so that it would not tempt bank depositors or other investors to pour money into money fund balances following the creation of coverage. Interestingly, the Dodd-Frank provision of unlimited bank deposit insurance on non-interest bearing transaction accounts was not back-dated. We estimate that perhaps as much as $500bn or more in money fund balances has moved to banks since FDIC coverage was expanded last year.... The pace of prime fund redemptions quickly slowed following the introduction of the Treasury's insurance program."
Abate's piece continues, "Congress was deeply unhappy with the program even though the ESF never experienced a loss and instead collected $1.2bn in premiums from the industry. The nature of its displeasure may have had more to do with the program's ad hoc creation by the Treasury Department than with a philosophical objection to insuring money funds. That said, a fair number of members of Congress were unhappy about using tax payer money to "bail out" another sector of financial markets. Interestingly, in a letter to SEC Chair Schapiro, two members of the House Financial Services Committee expressed concern about additional money market reform on the grounds that the SEC needs to undertake more ("rigorous economic") research on the "effectiveness of the 2010 amendments to Rule 2a-7"."
He explains, "Replacing the Treasury's insurance program with a private sector version, however, is probably not feasible.... Instead, we propose that limited coverage be provided by the FDIC. Coverage could be limited to a small amount -- say, $50bn or roughly the size of the Treasury's ESF program. The size of the insurance fund would be determined by the FDIC and itself could be a policy variable -- coverage could be lowered (or raised) to influence risk-taking by money funds. Interestingly, there has been relatively little academic work on figuring out the optimal level of bank deposit insurance. Work that has been done on the optimal amount of deposit insurance suggests that higher liquidity requirements reduce the optimal level of coverage. Thus, the SEC's high liquidity requirements help to mitigate the risk that the FDIC's insurance fund would be tapped and ultimately reduces the optimal size of the insurance pool."
Abate says, "The size of the insurance pool might also be small because losses from money funds are small and exceedingly rare. The Reserve Primary Fund lost less than 0.5% for its investors even after all of its $0.8bn of Lehman paper was marked down to 0. Moreover, expected losses are probably even lower now as the SEC's 2010 reforms have lowered concentration limits and shortened up WAMs. Money funds would internalize the cost of their coverage by paying a premium to the FDIC, where the premium is determined via a competitive auction subject to some minimum level. Money funds would have the option of participating (or not) and their coverage premium would be determined by the market demand for insurance. Coverage would start at the beginning of the following quarter to reduce the moral hazard of weak funds purchasing immediate coverage when they are in distress."
He states, "Further, any potential loss risk to the FDIC could be reduced by requiring money funds buying insurance coverage to maintain a reasonable capital buffer. In the event that a money fund breaks the buck, the FDIC would take it over, sell off assets (or wait for them to mature) and deduct any losses from the fund's capital buffer. Only after the entire capital buffer had been depleted would additional losses be applied to the FDIC's insurance fund. In effect the capital buffer would become the insurance deductible for money funds buying FDIC insurance."
Finally, Abate tells us, "Ultimately, these proposals may require considerable additional work in estimating optimal coverage and liquidity amounts. Expanding the FDIC's role would likely require congressional approval not to mention the support of the Federal Reserve and the SEC, both of whom are pushing strenuously for significant reform. By adding FDIC insurance coverage to money funds, the funds would become closer substitutes for checking account balances and the proposal would probably face stiff opposition from banks. Similarly, enabling the Fed to sell liquidity options from the discount window to non-banks would also likely face stiff opposition from Congress and regulators. Moreover, money funds may have little interest in purchasing any of these instruments as the industry feels that they have more than ample liquidity to meet a pick-up in redemptions and their underlying assets are already extremely safe. But, given the distance between regulators and the money fund industry around the current proposals of capital buffers, redemption gates and floating NAVs, it might be time to consider alternatives."
