By Simon Johnson
Prior to September 2008, few officials focused on "systemic risk" — the idea that a single firm or a particular asset class could create a vulnerability that would bring down the financial system and do great damage to the real economy. Then Lehman Brothers failed and the repercussions threatened to shut down the global financial system.
The Dodd-Frank financial reform legislation of 2010 created a new Financial Stability Oversight Council (FSOC), charged with helping to identify and coordinate regulatory efforts to address systemic risk. Now the FSOC faces its first serious challenge — ironically, on an issue that was central to the crisis events of fall 2008: money market mutual funds.
Money market funds were originally created, in the high inflation environment of the 1970s, as a way for investors to earn higher returns than they could on bank deposits. And many investors see their money market accounts as essentially the same as their bank accounts — they appear to have a stable principal value, interest accrues, and you can write checks.
But there is a fundamental difference between money market funds and banks. Retail bank deposits are backed by shareholder capital, insured by the Federal Deposit Insurance Corporation (FDIC), and subject to ongoing examination and oversight by fully-funded regulators. No one, in the nearly 80 year history of the FDIC, has ever lost a cent of their insured deposits when the bank involved fails. As a result, runs on the banks by retail depositors — people lining up to get their cash out — are seen only in the black-and-white images of history.
An Illusion of Security
But money market funds have none of these protections. They have no capital, no insurance, and they are overseen and examined only infrequently by an outgunned and underfunded SEC. On the asset side of their balance sheet, money market funds hold primarily short-term securities issued by federal, state, and local governments, as well as by private corporations and other entities. On the liability side, they have accounts payable on demand, which are perceived by investors to have a stable nominal value — implying you cannot lose money on such an investment. But that is an illusion.
Illusions matter most when they are shattered. As a result of relatively small holdings of Lehman Brothers' commercial paper (about 1.25 percent of its total assets), a prominent money market fund — the Reserve Primary Fund — suffered losses in September 2008 and was forced to "break the buck," meaning that the reported value of investors' accounts fell below par (i.e., less than $1).
Many investors worried that the same thing could happen to other money market funds, as they tend to hold similar assets, and panicked — reminiscent of what used to happen with banks until the creation of the FDIC in the 1930s. There was a run on money market funds, with investors withdrawing their money in droves and shutting down the commercial paper market.
There were no lines on the streets but the potentially disruptive effects on the financial system could have been as large as what was experienced when banks failed in the 1930s.
Or the effects could have been bigger.
The run only ended when the George W. Bush administration used the exchange stabilization fund to establish a blanket guarantee to all money market fund accounts. In effect, taxpayers provided downside insurance, after the fact, to investors in money market funds. While that run was stopped, Congress subsequently prohibited the Treasury Department from using the same measures in the future.
Still No Meaningful Change
The money market fund industry is not unhappy with the current situation. There have been some modest improvements to the rules — including higher liquidity requirements for assets. But structurally, the situation remains as it was in 2008 — the money market funds are vulnerable to a run that can spread to the entire financial system. If another destabilizing run occurs, money funds will either need to be bailed out again by taxpayers, or the entire system will suffer the consequences. In either case, money market funds are not bearing the full costs of their activities.
The Securities and Exchange Commission has jurisdiction over money market funds. Mary Schapiro, chairman of the SEC, has attempted to open an official discussion period on options for reform — including requiring more equity and less debt in such funds, perhaps combined with ending the illusion of a stable Net Asset Value. (To understand more about the issues and the need for reform, I recommend this testimony by Mary Schapiro.)
Unfortunately, the industry has persuaded a number of other SEC commissioners to block efforts to obtain public comment on reform and that regulator cannot move forward. The FSOC, however, does have the power and responsibility to act. Tim Geithner, Treasury Secretary and chair of the FSOC, has moved tentatively in that direction — publicly acknowledging the scale of system risks involved.
The FSOC should use its authority to get this risk addressed before it is too late.
Simon Johnson is the Ronald A. Kurtz (1954) Professor of Entrepreneurship at the MIT Sloan School of Management and a senior fellow at the Peterson Institute for International Economics. He is also a member of the Systemic Risk Council. The Council is an independent non-partisan group which monitors and encourages regulatory reform of U.S. capital markets focused on systemic risk. It is comprised of a diverse group of prominent academics, financial experts and former government officials. For more information please visit, http://www.pewtrusts.org/our_work_detail.aspx?id=328809 and http://www.cfainstitute.org/ethics/integrity/Pages/src.aspx.
(Editor's Note: This is the second in a series of op-ed columns by members of the Systemic Risk Council on a variety of financial reform topics. The views expressed are their own.)