Goldman Sachs on Liquidity Challenges
Goldman Sachs Asset Management published a paper this week on "Liquidity Investment Challenges." It says, "For many years prior to the financial crisis that began in 2008, money market funds offered investors three main benefits: high credit quality, liquidity and yield. However, in the years since the crisis, liquidity investing has been at the nexus of massive changes in regulation. On one side, stricter banking regulation has significantly reduced the ability and willingness of financial institutions' to participate in money markets. On the other side, money market funds are subject to new regulations in the US and pending regulatory changes in Europe that are transforming the market. Regulatory changes and other factors have contributed to significant imbalance in the supply/demand dynamics of liquidity investing. This imbalance has played an important role in pushing yields on many traditional money market investments into negative territory. As a result, investors in today's markets will find it increasingly challenging to achieve all three traditional benefits of the money markets. Maintaining liquidity and credit quality now comes at a cost, in the form of negative yields." It continues, "Banking regulations are becoming both stricter and more encompassing, with new regulations being applied across all financial institutions in all areas.... Basel III introduced two key measures designed to ensure that financial institutions have adequate amounts of liquidity. In addition, certain US banks must adhere to a Supplementary Leverage Ratio (SLR), which raises the cost of low margin business and low risk assets. After many years, we finally have clarity regarding the new requirements for money market funds and a specific implementation timeline in the US, while money market reform remains on the legislative agenda in Europe. In some respect, this event is momentous in that it follows a long period of anticipation and debate. In other respects, it is just another step in the evolution of liquidity markets that have been changing over the past several years.... With the increased regulation of the short-term markets, we believe that liquidity investors looking for stability, liquidity, and yield will have to choose the relative priority of those goals and assess their liquidity needs in light of an expanding set of investment solutions. One important goal of stricter banking regulation is to ensure that a financial institution can overcome any short-term liquidity disruption. However, in money markets, this has had the effect of sharply reducing the available supply. Since financial institutions are required to hold a certain level of highly-liquid assets, they are less able to lend out short-term debt, thus decreasing the supply of Commercial Paper, Time Deposits and Repurchase agreements -- securities that form the bedrock of money market fund investing. While the supply of short dated assets has declined, the same cannot be said about the demand for these assets."
