The U.S. Treasury's Financial Stability Oversight Council met late last week to discuss the SEC's recent money fund reforms, and indicated that they won't act until they've had a chance to monitor the impact, which would be well over two years from now. FSOC's release states, "During the meeting, the Council discussed its ongoing assessment of potential industry-wide and firm-specific risks to U.S. financial stability arising from the asset management industry and its activities. The Council directed staff to undertake a more focused analysis of industry-wide products and activities to assess potential risks associated with the asset management industry. The Council also discussed the Securities and Exchange Commission's (SEC's) final rule on money market mutual fund (MMF) reform. The Council recognizes the SEC's work to adopt a significant set of structural reforms of MMFs, in particular a floating net asset value (NAV) for institutional prime MMFs. These structural reforms, along with enhanced transparency and diversification requirements as well as strengthened rules for government MMFs, are intended to reduce the risks to financial stability posed by MMFs."
The release continues, "Since the financial crisis, MMFs have represented an unaddressed source of risk to the financial system. MMFs proved susceptible to destabilizing runs that necessitated extraordinary government support during the financial crisis. Since then, the Council has highlighted this risk and recommended that the SEC undertake structural reforms of MMFs. In 2012, the Council used its authority under Section 120 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) to propose specific recommendations to the SEC for reform. The SEC proposed reforms in 2013 and adopted them last week. While not proceeding at this time to a final Section 120 recommendation, the Council intends to monitor the effectiveness of the SEC's reforms in addressing risks to financial stability. In particular, the Council believes it will be important to better understand any unintended consequences of liquidity fees and gates, as well as the treatment of retail funds."
The FSOC statement adds, "After these measures have been implemented, the Council will report on the effects of these reforms and their broader implications for financial stability. During the meeting, the Council continued its discussion of nonbank financial company designations under section 113 of the Dodd-Frank Act. Consistent with the Council's rule and guidance, the Council will not name any company under review in this process until a final designation has been made. This discussion also included an annual review of two nonbank financial companies designated in July of 2013, American International Group, Inc., and General Electric Capital Corporation. The Council did not rescind either company's designation."
FSOC also release the minutes from its June 24, FSOC meeting, where the Council discussed "Short-term Wholesale Funding Markets. The minutes state, "The Chairperson introduced the first agenda item, a presentation on risks in short-term wholesale funding markets. He introduced Mark Van Der Weide, Deputy Director of the Division of Banking Supervision and Regulation at the Federal Reserve, and Susan McLaughlin, Senior Vice President at the Federal Reserve Bank of New York. Mr. Van Der Weide discussed certain reforms to date, including increased bank capital requirements, reduction of liquidity risk in the banking system, and efforts to reduce structural risks in the market through tri-party repo reforms. With respect to tri-party repo reforms, he noted that although much has been accomplished, significant risks remain for potential fire sales of collateral held by lenders in the event of a large dealer default. He then discussed regulatory options to reduce residual risks by discouraging reliance on short-term wholesale funding and reducing lenders’ incentives to run. Ms. McLaughlin then discussed global and national initiatives to collect data to monitor securities financing transactions. After the presentation, members of the Council asked questions and had a discussion about topics including the global nature of the risks identified, the potential timing for implementing regulatory reforms, and proposed money market mutual fund reforms."
The Wall Street Journal wrote about FSOC on Friday, "Asset Managers Notch an 'Important' Win." Writes Andrew Ackerman: "After months of lobbying, large asset managers such as BlackRock Inc. and Fidelity Investments won a battle in their fight against tighter regulation Thursday. A panel of top financial regulators agreed to revamp their review of asset-management firms to focus on potentially risky products and activities rather than individual firms. The shift by the Financial Stability Oversight Council lessens the likelihood individual asset managers will be labeled "systemically important" -- a designation that would draw them in for greater oversight by the Federal Reserve."
In other news, Fitch Ratings says that SEC money fund regulations "represent a dramatic overhaul for the liquidity management industry." According to a Fitch report, "the operational changes necessary to continue using institutional prime and municipal money funds will likely prove too burdensome for many users of NAV-money funds, which are heavily represented by corporate and public sector cash managers. In surveys conducted by both Treasury Strategies and the Association for Financial Professionals, a majority of cash investors who use money funds have indicated that they will stop using, or reduce usage, of money funds with a floating NAV. Many investors in institutional prime and municipal money funds are expected move cash into government money funds exempt from the new rules, and/or bank deposits, assuming there is capacity to absorb the inflows. Corporate and public sector cash managers will likely also explore alternative liquidity management options like separately managed accounts, or increase their direct investments in the short-term markets."
Adds Fitch, "Many institutional investors will need to re-examine and update their written investment policies to be able to use the new money fund structures or access alternative liquidity management solutions.... For example, some policies specifically dictate that money funds must have a stable NAV, and corporations and municipalities will have to determine whether they would be comfortable investing cash in a floating NAV fund. In addition, fund managers are expected to introduce new liquidity products, but these may need to be added as approved investments to treasurers' policies."
The reforms will also create problems for local government investment pools (LGIPs), states Fitch in a July 31st release. "The SEC's reforms could mean that many LGIPs will no longer be able to price their shares at a stable $1.00 net asset value (NAV) as they have done in the past. Potential changes to the way LGIPs operate as a function of the new rules could also impact investors. Many LGIPs are "money market fund-like" investment pools that are required by state law, and under generally accepted accounting principles to operate consistently with the Securities and Exchange Commission rule governing money market funds (Rule 2a-7)."
Fitch continues, "LGIPs are governed by the Governmental Accounting Standards Board (GASB), which allows LGIPs to use amortized cost as long as their policies and operations are consistent with Rule 2a-7. However, given the SEC's new rules, it is unclear whether LGIPs will now need to adopt floating NAVs if they invest in nongovernment securities (including municipal securities). GASB is aware of the ambiguity and has identified it as an agenda item to address in 2014, although LGIPs will remain in limbo while new rules are being written. Subject to GASB's interpretation, it's possible that LGIPs could continue to offer stable NAVs and maintain amortized cost accounting by investing in government and agency securities. However, while LGIPs generally operate with low expense ratios, investing exclusively in government securities may not cover operating expenses for the pool. Finally, the costs of making changes to systems and operations to comply with a floating NAV, as well as fees and gates, may also be prohibitive for LGIPs run by municipalities."
Further, Fitch states, "We believe that the new rules also create uncertainty for LGIP investors, whether captive or voluntary, because of the potential changes to LGIP structures. Captive investors are typically required by state law to invest in LGIPs, and in some cases specifically in those that transact at a stable NAV. Absent statutory or accounting relief, this change will leave some municipalities with limited or no alternative cash management options. For example, there is limited appetite from banks to accept institutional deposits given changes to bank regulations. Voluntary LGIP participants may elect to invest their cash elsewhere, but have historically favored LGIPs as a low-cost investment alternative."
They add, "Moreover, municipal treasurers' investment policies will need to be updated to account for the change to floating from stable NAV, a potentially time-intensive endeavor. While investment policies are usually updated on a yearly basis, this can be a complicated and costly process that will require a careful, strategic approach. We understand many investors have been waiting for clarity on the new regulations before making investment policy changes. The SEC set the implementation period for the main aspects of reform at two years, giving LGIP managers and participants time to adjust to the new rules. However, while private sector money fund managers and their clients can begin to respond to the new regulatory regime, LGIPs and their investors must still wait for guidance from GASB or statutory authorities. Without further guidance from various constituents, LGIPs are unable to make the necessary changes, causing uncertainty in the near term."
