How to make US money market funds safer

In the rough and tumble of financial markets, one player’s loss is often another’s gain. That is certainly true for US money market funds. Last month, as depositors fretted over the safety of their funds in the banking system, particularly in shaky regional lenders, they shifted their cash into MMFs at a rapid rate, with inflows of roughly $370bn. With First Republic, the San Francisco-based regional lender, teetering, that trend seems set to continue, albeit at a slower pace.

MMFs form a core part of the shadow banking system — financial intermediaries that cannot take deposits. As the US Federal Reserve has raised interest rates, the funds have offered investors rates well above those that banks pay. By investing in short-term debt securities, they also allow investors to manage their cash needs while providing day-to-day finance to the economy. Their scale and importance in the plumbing of the financial system is such, however, that they are a key source of risk.

During the 2008 financial crisis one such MMF, the Reserve Primary Fund, infamously “broke the buck” — when its net asset value fell below $1 — in the wake of Lehman Brothers’ bankruptcy. Investors found out that the banklike products promised by the funds did not mean banklike protection; they are not covered by deposit insurance. Stricter regulations followed on what MMFs could invest in, and what buffers they needed. The funds again came under strain in March 2020 as Covid-panicked investors rushed to redeem holdings for cash. With US MMFs’ total assets last month hitting a record $5.2tn, there are fears that unaddressed vulnerabilities still lurk. Last month, US Treasury secretary Janet Yellen highlighted the risks of “runs and fire sales” if investors rush to redeem their shares all at once.

Another risk is that the funds are outcompeting the regional lenders and weakening their profitability further. A third risk is that MMFs have been increasingly parking their cash in the Fed’s reverse repo facility, where they can obtain higher and safer returns. This further drains liquidity from the banking system, adding to worries about credit availability.

For now, the risks are manageable. The vast majority of inflows recently have been into Treasury funds, which are relatively safe given they invest in government-backed securities — although a prolonged political stand-off over the US debt ceiling could yet stoke a liquidity problem. Meanwhile, the potential for an immediate liquidity crunch caused by cash moving into the RRF seems small, with reserve balances still high and liquidity available via other Fed facilities. MMFs also arguably provide welcome competitive pressures for banks alongside wider options for investors.

This is the time, however, for moderate reform to raise resilience in the sector. MMFs should be required to disclose more data to regulators to aid their monitoring of liquidity and redemption vulnerabilities, and raise investor awareness of the risks. Higher liquidity requirements make sense too, though these need to be modest enough not to overly squeeze the funds. Flows into the reverse repo facility need to be closely watched too.

With the authorities preparing to set out new rules for the sector, they should keep in mind that overburdening MMFs with onerous restrictions risks harming the financial system in the long run. Indeed, the recent outflows from banks into these funds highlight the shadow banking sector’s role as an important safety valve in times of crisis.

Oversight of MMFs is a balancing act: do too little and risks to financial stability emerge, but do too much and an essential source of liquidity gets stymied. Regulators need to get it just right.