The Board of Governors of the Federal Reserve published its most recent "Financial Stability Report" earlier this month, which briefly discusses money market funds. They write, "This report reviews conditions affecting the stability of the U.S. financial system by analyzing vulnerabilities related to valuation pressures, borrowing by businesses and households, financial-sector leverage, and funding risks. It also highlights several near-term risks that, if realized, could interact with these vulnerabilities. Since the November 2022 Financial Stability Report was released, Silicon Valley Bank (SVB), Signature Bank, and First Republic Bank failed following substantial deposit outflows prompted by concerns over poor management of interest rate risk and liquidity risk. In March, to prevent broader spillovers in the banking system, the Federal Reserve, together with the Federal Deposit Insurance Corporation (FDIC) and the Department of the Treasury, took decisive actions to protect bank depositors and support the continued flow of credit to households and businesses. Owing to these actions and the resilience of the banking and financial sector, financial markets normalized, and deposit flows have stabilized since March, although some banks that experienced large deposit outflows continued to experience stress. These developments may weigh on credit conditions going forward."
The report says about "Funding Risks,"Substantial withdrawals of uninsured deposits contributed to the failures of SVB, Signature Bank, and First Republic Bank and led to increased funding strains for some other banks, primarily those that relied heavily on uninsured deposits and had substantial interest rate risk exposure. Policy interventions by the Federal Reserve and other agencies helped mitigate these strains and limit the potential for further stress (discussed in the box 'The Federal Reserve's Actions to Protect Bank Depositors and Support the Flow of Credit to Households and Businesses'). Overall, domestic banks have ample liquidity and limited reliance on short-term wholesale funding. Structural vulnerabilities remained in short-term funding markets. Prime and tax-exempt money market funds (MMFs), as well as other cash investment vehicles and stablecoins, remained vulnerable to runs. Certain types of bond and loan funds experienced outflows and remained susceptible to large redemptions, as they hold securities that can become illiquid during periods of stress. Life insurers continued to have elevated liquidity risks, as the share of risky and illiquid assets remained high."
Discussing "Funding Risks," the Fed states, "The failures of SVB and Signature Bank, along with strains at some other banks, highlighted vulnerabilities associated with high concentrations of uninsured deposits. Uninsured deposits are prone to runs, in part because they lack an explicit government guarantee. From the start of the pandemic in 2020 to the end of 2021 -- a period when interest rates remained low -- banks received $3.7 trillion in domestic deposits, most of which were uninsured. As interest rates increased throughout 2022, bank deposits became less attractive for depositors and banks experienced outflows, led by uninsured deposits. As of the fourth quarter of 2022, aggregate uninsured deposits stood at $7.5 trillion. Although aggregate levels of uninsured deposits in the banking system were high, SVB and Signature Bank were outliers in terms of their heavy reliance on uninsured deposits, as most banks had a much more balanced mix of liabilities."
They explain, "Overall, estimated runnable money-like financial liabilities decreased 1.6 percent to $19.6 trillion (75 percent of nominal GDP) over the past year. As a share of GDP, runnable liabilities continued their post-pandemic decline but remained above their historical median.... Large banks that were subject to the liquidity coverage ratio (LCR) continued to maintain levels of high-quality liquid assets (HQLA) that suggested that their liquid resources would be sufficient to withstand expected short-term cash outflows."
The report continues, "Prime MMFs and other cash-investment vehicles remain vulnerable to runs and, hence, contribute to the fragility of short-term funding markets. In addition, some cash management vehicles, including retail prime MMFs, government MMFs, and short-term investment funds, maintain stable net asset values (NAVs) that make them susceptible to sharp increases in interest rates. The market capitalization of the stablecoin sector continued to decline, and the sector remains vulnerable to liquidity risks like those of cash-like vehicles. Some open-end bond mutual funds continued to be susceptible to large redemptions because they must allow shareholders to redeem every day even though the funds hold assets that can face losses and become illiquid amid stress. Liquidity risks at central counterparties (CCPs) remained low, while liquidity risks at life insurers appeared elevated."
It also says, "Data on bank assets and liabilities show that small domestic banks -- defined as banks outside the top 25 in terms of domestic assets -- initially experienced rapid deposit outflows in the wake of the SVB and Signature Bank failures. However, these outflows had slowed considerably by the end of March. The Federal Reserve, together with the U.S. Department of the Treasury and the FDIC, took decisive actions to reduce funding strains in the banking system (see the box 'The Federal Reserve's Actions to Protect Bank Depositors and Support the Flow of Credit to Households and Businesses'). Banks with funding needs increased borrowing from the Federal Reserve, including a notable increase in discount window borrowing and additional borrowing from the new Bank Term Funding Program (BTFP). In addition, Federal Home Loan Banks' total debt outstanding grew about $250 billion, to $1.5 trillion, during the week ending March 17, 2023, to meet a surge in demand for borrowing by their member banks."
The Financial Stability Report comments, "Prime MMFs remain a prominent vulnerability due to their susceptibility to large redemptions and the significant role they play in short-term funding markets. Since the November report, AUM in prime MMFs offered to the public increased $270 billion (53 percent), driven by $240 billion in inflows into retail prime funds.... In the immediate aftermath of the failures of SVB and Signature Bank, government MMFs had a surge in inflows, but prime MMFs experienced a jump in redemptions. Although outflows from prime MMFs eased after a few days, the episode illustrated again that these funds continue to be at risk of large redemptions during episodes of financial stress."
It adds, "Other cash-management vehicles, including dollar-denominated offshore MMFs and short-term investment funds, also invest in money market instruments, engage in liquidity transformation, and are vulnerable to runs. Since November, estimated aggregate AUM of these cash-management vehicles has edged up to about $1.7 trillion. Currently, between $600 billion and $1.5 trillion of these vehicles' AUM are in portfolios like those of U.S. prime MMFs, and large redemptions from these vehicles also have the potential to destabilize short-term funding markets."
They write, "Many cash-management vehicles -- including retail and government MMFs, offshore MMFs, and short-term investment funds -- seek to maintain stable NAVs that are typically rounded to $1.00. When short-term interest rates rise sharply or portfolio assets lose value for other reasons, the market values of these funds may fall below their rounded share prices, which can put the funds under strain, particularly if they also have large redemptions."
The report says about Stablecoins, "The total market capitalization of stablecoins, which are digital assets designed to maintain a stable value relative to a national currency or another reference asset, has fallen 21 percent since the beginning of 2022 to $130 billion. While not widely used as a cash-management vehicle by institutional and retail investors or for transactions for real economic activity, stablecoins are important for digital asset investors and remain structurally vulnerable to runs. On March 10, 2023, amid reports of large outflows of uninsured deposits at SVB, Circle Internet Financial, which operates the $31 billion stablecoin USD Coin (USDC), disclosed that it had $3.3 billion in dollar reserves held at SVB. This disclosure triggered large redemptions of USDC and caused it to drop temporarily below its target $1 value to as low as 87 cents. Following news of the government interventions assuring depositors of the safety of uninsured deposits at SVB and Signature Bank, USDC's price stabilized near $1."
Finally, the Fed comments on bond funds, "Mutual funds that invest substantially in corporate bonds, municipal bonds, and bank loans may be particularly exposed to liquidity transformation risks, given the relative illiquidity of their assets and the requirement that these funds offer redemptions daily. The total outstanding amount of U.S. corporate bonds held by mutual funds fell to its lowest level since 2013 on an inflation adjusted basis, primarily driven by a drop in valuations.... Mutual fund holdings at the end of 2022 were approximately 13 percent of all U.S. corporate bonds outstanding. Total AUM at high-yield bond and bank-loan mutual funds, which primarily hold riskier and less liquid assets, decreased sharply in real terms in 2022.... Bond and loan mutual funds experienced negative returns and notable outflows during most of 2022."
