Published: September 01, 2012
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?
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.
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.”
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. [[[PAGE]]]
Performing maturity and/or liquidity transformation
MMFs perform maturity transformation, insofar investors have the right to redeem same- or next-day, but their subscriptions are invested at term.
However, the maturity transformation performed by MMFs is an order of magnitude less than that performed by banks, and is subject to tight controls. For example, IMMFA funds must maintain: a maximum final maturity per instrument of 397 days; a maximum weight average life of 120 days; a maximum weighted average maturity of 60 days; a minimum 10% of the portfolio available in cash/overnight; and, a minimum 20% of the portfolio maturing within one week. Furthermore, each IMMFA fund is required to have a ‘liquidity policy’ explaining how they manage liquidity. For example, that policy might deal with investor concentration.
So, although MMFs do perform maturity transformation, they do so subject to tighter controls than are imposed on banks (which is sensible, since, unlike banks, they don’t and shouldn’t have access to the discount window) and consequently their maturity mismatch is modest.
Undergoing credit risk transfer
MMFs are investment products. Their prospectuses make clear that all of the risks and rewards of investment in an MMF belong to its investors, and create no expectation of explicit or implicit underwriting of those risks by the fund manager or any other party. MMFs perform neither credit transformation nor credit transference.
Using direct or indirect financial leverage
MMFs are ‘long only’ investment funds, and do not employ leverage as part of their investment strategy. By contrast, banks’ ability to lever their balance sheets is essential to any meaningful account of their role in the economy, the systemic risks that they pose, and the regulatory regime they are subject to.
This is just one of a number of fundamental differences between MMFs and banks. There are also profound legal/structural differences between the two, which explain the need for a different regulatory approach…
Bank regulation addresses the conflicts of interest that arise between bank shareholders and depositors. Bank shareholders make a profit on the spread they earn between interest payments to depositors and interest receipts from creditors; they are incentivised to maximise profit by maximising that spread, i.e., by making risky loans; but that conflicts with the interest of uninsured depositors (and underwriters of deposit insurance) who would prefer banks to make less risky loans in order to reduce credit risk. Bank regulation manages that conflict in a number of ways, including the imposition of capital charges in proportion to the riskiness of a bank’s loans to its creditors. MMFs have a completely different incentive structure. The shareholders and depositors of an MMF are one and the same, i.e. the investor in an MMF bears all the risks and rewards of the fund’s investments. An MMF manager is remunerated on the basis of a fee. Although conflicts of interest may exist between the manager and the investor, the conflicts are quite different from those that exist in a bank.
In conclusion, it does not seem coherent to think of MMFs as shadow banks, even given the European Commission’s own definition. But, in the event that regulators disagree with that conclusion, then what would be the significance of thinking of MMFs as shadow banks...?
What is the significance of thinking of MMFs as shadow banks?
Traditionally, MMFs have been thought of as a type of investment fund. Now, following Volcker, they are thought of as a type of shadow bank. What is the significance of this change in thinking?
Investment funds and banks perform different economic activities, which give risk to different risks, and therefore are subject to different forms of regulation. If an MMF is thought of as a shadow bank then, by implication, its economic activities and risks have been ‘mismatched’ with its regulation. Consequently, investors could use an MMF to achieve a bank-like return whilst avoiding the rigours of bank regulation. This concern about regulatory arbitrage animates much of the debate about shadow banking.
Given the premise that MMFs are shadow banks, it follows that MMFs should either be subjected to bank regulation, or should be required to become less bank-like – most obviously by forcing constant net asset value (CNAV) MMFs to adopt a variable net asset value (VNAV). For example, Paul Tucker, Deputy Governor of the Bank of England, has said:
“Echoing the concerns that Paul Volcker is reported to have expressed at internal Federal Reserve meetings around thirty years ago, the Bank of England believes that Constant-NAV money funds should not exist in their current form. They should become either regulated banks or, alternatively, Variable NAV funds that do not offer instant liquidity.” [[[PAGE]]]
There is near-uniform agreement within the MMF industry that either outcome would be disastrous:
If MMFs were subjected to bank regulation then, amongst other things, MMF providers would be required to hold very substantial amounts of capital. The cost of that capital would overwhelm both the (modest) fee received by providers for managing MMFs, and the (equally modest) yield received by investors for holding MMFs. MMFs would be priced out of business.
Alternatively, American surveys indicate that if CNAV MMFs were required to adopt a VNAV, then investors would largely stop using the product. (The CNAV/VNAV issue is discussed more in the second of these articles.)
Therefore, either way, it matters very much indeed whether MMFs are thought of as shadow banks.
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