Published: August 01, 2011
The banking system has been subjected to increased scrutiny over the last few years, and it is only now that we have more certainty on the future regulatory structure of this system. The principal change to banking regulation is the Basel III framework. Money market funds purchase a significant volume of bank debt, and are subsequently impacted by most changes which occur within banking regulation. Therefore, as banks change and adapt to the new Basel III requirements, money market funds will also have to change and adapt.
All banks are required to hold sufficient capital to allow them to operate, with the capital held intended to offset any risk associated with the business and activities they perform. In 1988, the Basel Committee, which comprised banking regulators from around the globe, published a set of minimum capital requirements which large, internationally active banks should adhere to. These requirements were revised in 2004 (the Basel II framework) as the obligations imposed on banks increased in maturity and coverage. However, this framework revealed some inadequacies when faced with a stressed financial system.
The Basel Committee thus instigated new discussions aimed at improving the robustness of banks, and in December 2010 published the Basel III framework. This framework, to which all of the major economies of the world have agreed, includes revised capital requirements which banks must follow, and for the first time, liquidity obligations. In combination, these requirements are designed to deliver a more robust banking system which is better able to withstand stresses.
The changes which the Basel III framework will instigate are fundamental. The structure of a bank’s balance sheet will be significantly different post-Basel III, and banks will likely assess their business models to ascertain what remains viable under the new regulatory structure. Much of the initial focus of banks and commentators has been on the capital requirements within Basel III. These will see banks having to hold at least twice as much equity as they do today. With increased emphasis on equity, the appetite of banks to issue debt may be reduced compared to the situation today.
The Basel III framework whilst designed for banks, will have significant consequences for money market funds and their investors.
However, the liquidity requirements will also result in a material change to the operation of all banks. Under the two liquidity ratios, banks will be required to hold more liquid assets and more stable, long-term funding. Consequently, banks will favour retail deposits over institutional investment, and will seek funding which is invested for a year or more. This will again reduce the appetite of banks to issue short-term debt or to receive investment from any financial institution compared with the current position.
Although the Basel III framework directly impacts banks, its influence will be felt elsewhere. A money market fund provides a pooled investment vehicle which purchases numerous securities in order to diversify risk. All of these securities must be of a high quality in order to limit the risk of loss of capital. Although the portfolio of securities within a money market fund will be issued by a range of institutions, research by Fitch1 confirms that, as at February 2011, over 73% of the securities purchased by US money market funds were issued by banks across the globe. This figure is likely to be similar for European money market funds. The regulatory changes primarily directed at banks will therefore have consequent impacts upon money market funds given their predilection for securities issued by banks.
Although the Basel III framework will not come into effect until January 2013 (and not be fully implemented until 2019), there is already evidence that banks are moving towards the standards required. Banks may view the attainment of the new standards in advance of others as a competitive advantage. Such achievement is likely to provide the market with greater assurances around the financial health of a bank. As a result, money market fund managers are already reporting that the appetite of banks for short-term funding from institutional investors is reduced. [[[PAGE]]]
The changes which Basel III introduces will occur at a time when the credit quality of issuers in general remains subdued. With money market funds only purchasing high quality securities, their universe of investable securities could further shrink when Basel III comes into effect if the number of high credit quality non-bank issuers has not increased. Money market fund managers will therefore face further challenges as they seek to source sufficient volumes of high quality securities in order to deliver a product that is capable of providing security and liquidity.
Although short-term debt will still be available, both the volume and the yield payable are likely to be reduced. If the banks derive limited benefit from short-term debt issuance, there will be little reward payable to those investors who purchase such securities. As a consequence, the yield which money market funds are able to provide may also reduce.
Money market funds are managed with the objectives of providing security of capital and liquidity. The provision of a competitive return is secondary to these principal objectives, but has historically been achieved. The recent period of low interest rates has provided a stern challenge to the ability of fund managers to achieve a competitive return. However, this challenge will likely pale into insignificance when compared to the future, when the yield payable on short-term bank debt will be comparatively lower than it is today.
Although the yield payable on money market funds is likely to reduce, the key objectives of providing security and liquidity should be unaffected by the Basel III framework. Money market funds will still purchase high quality, liquid securities, with little risk of loss to the investor. In addition, and as now, money market funds will provide the fundamental benefit of risk diversification, and allow investors access to a professional treasury management service which can be provided at only a fraction of the incurred cost if managed in-house.
However, in the future investors must understand and appreciate what can realistically be achieved by a money market fund. It will become increasingly important for investors to segregate their cash into balances which prioritise security, liquidity and yield. The relationship between risk and reward will remain as true in the post-Basel III world as it is today, and therefore a money market fund that is yielding at a level materially higher than its peers is likely to have accepted additional risk in order to achieve this yield. Investors will then need to be able to understand the differences between funds and what those funds can realistically achieve. To assist in this risk assessment, the Institutional Money Market Funds Association (IMMFA) is mandating its members to provide additional disclosures. This will ensure that investors and prospective investors are provided with more information on which to assess risk, and should allow the identification of a fund whose risk appetite mirrors that of any investor.
The Basel III framework, whilst designed for banks, will have significant consequences for money market funds and their investors. The future is likely to see money market fund managers place even greater emphasis on the provision of security and liquidity, and the ability to deliver a competitive return may be severely challenged. To allow investors to conduct thorough due diligence in the identification of a suitable money market fund for investors, IMMFA will ask its members to provide additional disclosures.
However, it is equally important to note that the changes delivered by the Basel III framework should not detract from the ability of a money market fund to provide a viable treasury management solution. The product will still provide the fundamental benefits of risk diversification and access to professional cash management. Therefore, if investors can further appreciate that the product should not be viewed as a yield generator, its use should continue to grow.
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