Yellen Hits MMFs in Stability Speech
In "Remarks by Secretary of the Treasury Janet L. Yellen at the National Association for Business Economics 39th Annual Economic Policy Conference," Yellen defends banking regulations and discusses financial stability and recent market turmoil. She comments on "Nonbanks: Money Market and Open-End Funds," "As we strengthen the banking sector, we are also making progress on one of FSOC's top priorities: mitigating vulnerabilities in nonbank financial intermediation. Many of these nonbank institutions engage in liquidity and maturity transformation: they profit by issuing short-term obligations while investing in riskier and longer-term assets. But they are generally not regulated to account for spillovers to the rest of the financial system during times of extreme stress. There are two guiding principles in our work on nonbanks. First, policymakers should address risks regardless of where they emanate from. Substance is more important than form; similar activities that create comparable financial stability risks should be subject to comparable regulatory scrutiny. Second, policymakers should adapt and tailor policies to fit the unique structural features of the institutions and markets they are regulating. For example, systemic liquidity risks should be addressed wherever they exist. But specific policy responses should differ depending on the specific activity involved." Yellen explains, "These principles prevent risks from shifting around in the financial system in response to regulation. They enable us to address risks wherever they are found. We have pursued work on nonbanks that are both inside and outside the traditional financial system. First, let me speak on nonbanks inside the traditional system. If there is any place where the vulnerabilities of the system to runs and fire sales have been clear-cut, it is money market funds. These funds are widely used by retail and institutional investors for cash management; they provide a close substitute for bank deposits. Before the post-crisis reforms implemented by the SEC, all money market funds were generally expected to maintain a fixed $1 net asset value per share. The stable NAV was normally achievable because funds were generally limited to investments that were considered to be low risk. These funds were allowed to round their share prices to $1 when the market value of their investments fell -- as long as it stayed above a certain level. But a fund had to respond if its market value fell below that level -- that is, if it 'broke the buck.' In that case, these funds would have to reprice, and they might cease withdrawals and liquidate their assets." She comments, "This created an incentive for a run in times of extreme stress. The first redeemers could exit the fund at $1 per share, but those who waited might be subject to a reduced market value as they are left with claims on less-liquid assets. This created a 'first-mover advantage' -- an incentive for investors to redeem at the whiff of a problem. During the Global Financial Crisis, anticipated losses on Lehman Brothers commercial paper led to a run on the $62 billion Reserve Primary Fund, the oldest money market fund in the nation. Concerns about Lehman then sparked concerns about commercial paper issued by other banks. This led to runs on other money market funds. A post-mortem report revealed that as many as 28 other funds had NAVs low enough for them to also break the buck." Yellen says, "Even without a fixed NAV, liquidity mismatch in other kinds of funds can still make them vulnerable to runs and fire sales. Open-end funds offer daily redemptions, but some hold assets that cannot be sold quickly -- particularly in large volumes. Like money market funds, this liquidity mismatch does not typically pose problems in normal times when flows to and from funds are not outsized. But in times of market stress, shareholders are incentivized to redeem early -- before fire sales of illiquid assets lower the value of their holdings. Driven by this dynamic amid the pandemic shock, a record $255 billion flowed out of bond mutual funds in March 2020. The structural vulnerabilities at the heart of money market and open-end funds aren't new. In the banking sector, capital and liquidity requirements and federal deposit insurance reduce the likelihood of runs taking place. In case runs occur, access to the discount window helps provide buffers for banks. Yet the financial stability risks posed by money market and open-end funds have not been sufficiently addressed." She adds, "Over the past two years, the SEC has proposed rules to mitigate the vulnerabilities plaguing these funds. The SEC's proposals would reduce the first-mover advantage, reducing run incentives during times of stress. They would also require new liquidity management tools, while mandating more comprehensive and timely information on these funds for the SEC and investors. Abroad, Treasury has worked with the FSB to advance international commitments that enhance the resilience of money market funds. We will soon review the implementation -- and later the effectiveness -- of reforms taken by member jurisdictions. Treasury is also working diligently in the FSB to revise recommendations on liquidity management in open-end funds to bolster their resilience."
