by Travis Barker, Outgoing Chairman, Institutional Money Market Funds Association
Critics of MMFs have described them as ‘shadow banks’, engaged in regulatory arbitrage, and requiring ‘bank-like’ regulation (notably, capital requirements). But what is shadow banking? Is it coherent to think of MMFs as shadow banks? And what is the significance of describing MMFs as shadow banks?
What is shadow banking?
Shadow banking was never intended to refer to MMFs at all. Rather, it was intended to refer to conduits used by banks to hold off-balance sheet assets.
Paul McCulley, who originally coined the expression, defined it as “…the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures.” Those conduits issued commercial paper to finance their holdings of securitised loans; the loans were originated/repackaged by banks; and the banks often provided liquidity lines to the conduits to support their issuance of commercial paper (CP). When the sub-prime crisis broke in 2007, investors lost confidence in the conduits and this arrangement fell apart. The conduits were unable to roll over their CP, which caused them to draw down and exhaust their liquidity lines; until, ultimately, many collapsed back into the conventional banking system.
From time to time, commentators sought to expand this original definition of shadow banking to encompass the entities who purchased the conduits’ CP - including MMFs - by likening those entities to ‘depositors’ in the shadow banking system. However, that expanded definition has not caught on, for the simple reason shadow banking did not originate in ‘demand pull’ from investors, but in ‘supply push’ from the banks themselves. The supply push arose because the Basel accord did not require banks to hold risk-weighted assets against the liquidity lines they provided to off-balance sheet conduits; that requirement has now been added, and off-balance sheet conduits/shadow banking has diminished accordingly.
Notwithstanding those reforms, the expression ‘shadow banking’ proved popular with regulators and the media. It continued to be used… and to evolve. A key moment came when Paul Volcker – who has been a consistent critic of MMFs over many years - described MMFs as part of the shadow banking system, not because they funded off-balance sheet conduits, but because an investment in an MMF is ‘like’ a deposit with a bank. Indeed, the expanded definition of shadow banking not only covers MMFs but also repo, securities lending, leveraged exchange traded funds and other financial products and markets. In theory it covers commercial paper, although regulators have (for now) backed off attacking CP.
Is it coherent to think of MMFs as shadow banks?
The European Commission has adopted Volcker’s approach, and in its recent Green Paper proposes to define the shadow banking system as:
“…entities operating outside the regular banking system engaged in one of the following activities: accepting funding with deposit-like characteristics; performing maturity and/or liquidity transformation; undergoing credit risk transfer; and using direct or indirect financial leverage.”
Do MMFs perform any of these activities?
Accepting funding with deposit-like characteristics
The investment objective of an MMF is to provide investors with security of capital and daily liquidity. Insofar as an MMF meets that objective, then investors will enjoy a return equal to their initial subscription plus any interest income that arises (net of fees). That is similar to the return they would have achieved if they had made a deposit with a bank.
However, MMFs cannot be meaningfully compared with deposits on this basis. An MMF merely has security of capital as an investment objective, whereas a bank is under a contractual obligation to return cash to its depositors.