U.S. regulators are moving forward with proposed rules for money-market mutual funds that both supporters and opponents say won’t do enough to address risks in the $2.9 trillion industry.
The U.S. Securities and Exchange Commission’s proposal approved yesterday could require funds that cater to institutional investors to abandon the very feature that makes them appear riskless -- their fixed share price.
In response to pushback from the funds, the proposal also included an industry-favored alternate, so-called redemption “gates” that would limit the ability of investors to pull out of a fund that comes under stress. The commission left open the option of adopting either approach or both together.
Commissioner Elisse B. Walter, who as chairman earlier this year worked to break a commission deadlock on the issue, said the SEC could require both a floating share value and the use of gating.
“Each serves a purpose to mitigate systemic risks to financial companies and markets and to protect investors, and each does so in different ways,” Walter said after the commission voted unanimously to move forward on the proposal.
Critics expressed doubt that the SEC plan would achieve its goal: discouraging large investors from withdrawing their money when funds face losses that would cause them to pull back lending to banks and other borrowers. The commission has opened a 90-day comment period for them to make their case.
“When investors see signs of stress, they will have an incentive to redeem sooner rather than later,” said Republican Commissioner Troy A. Paredes. “Even investors that are accustomed to seeing a fund’s net asset value fluctuate may redeem if they expect the fund’s price to fall.”
The plan is a compromise designed to break the impasse that stymied action last year. The five-member commission, now led by Mary Jo White, coalesced around a floating-share price for just the riskiest funds, those that invest in short-term corporate debt. Funds that invest only in U.S. government securities and ones that serve retail investors are exempt from the proposals.
The SEC’s failure to achieve consensus last year prompted former Chairman Mary Schapiro to call on the Financial Stability Oversight Council, an umbrella group of regulators that includes the Federal Reserve, to recommend reforms to the SEC. The FSOC has the authority to declare funds systemically risky if it considers the SEC’s rules insufficient.
The FSOC’s recommendations called for imposing tougher rules on all money funds. One option under FSOC’s approach would have allowed funds to keep a fixed share price if they held capital equal to 1 percent of assets and imposed first losses on large shareholders who recently redeemed shares.
Other experts who favor costlier regulation of money funds, including requiring them to hold a capital cushion as banks do, questioned whether a floating-share price would limit runs. In 2008, the $62.5 billion Reserve Primary Fund collapsed after it “broke the buck” and money funds temporarily required a U.S. government guarantee.
These same critics say the SEC’s alternative to requiring prime funds to float their share values could worsen the probability that savvy investors abandon the funds. The proposal would allow funds to keep their fixed share value if they impose “gates” that would suspend redemptions when their most liquid assets fall below a certain threshold.
Floating the share value “is a zero, it’s just not going to change anything relative to the status quo,” said Adi Sunderam, an assistant professor of finance at Harvard Business School. “Gating is potentially harmful in the sense that if you get investors antsy about when the gates are going to come down, that increases the likelihood they are going to run.”
Sunderam and colleagues have called for imposing capital requirements along the lines recommended by FSOC.
Critics of floating the share price disagree on alternatives. Paredes said he believes gates are the best solution to reduce systemic risk. Under the proposal, fund companies could use the gates for as long as 30 days without having to liquidate the fund.
“Boards have discretion over whether a fee or gate will be instituted,” Paredes said. “Because fund investors do not know what the board will decide, they may find it difficult to redeem preemptively with any confidence that their timing is correct.”
The mutual-fund industry, which has lobbied against costlier regulation, also says requiring funds to float their share price won’t reduce the risk of runs. The Investment Company Institute says European money funds that float their share prices have faced large investor outflows during periods of crisis.
The ICI says gates are the only tool available to stop runs on a fund that can spread to other funds and ripple across the financial system. Requiring investors to pay a fee once the gates drop “aligns perfectly with the goal of stopping large, unsustainable redemptions,” the ICI said in a commentary on regulatory options last year.
“We are particularly pleased that the commission recognized the effectiveness of liquidity fees and gates in addressing risks that might arise in a widespread crisis,” ICI chief executive officer Paul Schott Stevens said in a statement.
Fund boards would have the option to impose a 2 percent fee on investors who sought to withdraw money after the gates went down. The board could decide to impose a lower fee or none at all, under the SEC’s plan.
Michael S. Barr, a top Treasury Department official from 2009 to 2010, said the SEC’s proposal isn’t the best solution but could help improve financial stability. Barr, who helped oversee the Treasury Department’s response to the financial crisis, said the SEC and the FSOC may need to consider further reforms including capital requirements.
“This is clearly a second-best or third-best alternative to that basic set of reforms that in a better world the SEC would take,” Barr said.
Jeffrey N. Gordon, a professor at Columbia Law School, said the commission’s proposal fails to make the system safer, and might even enhance risk because institutional investors might try to time their withdrawals to just before gates are imposed.
“The FSOC should not back down,” Gordon said. “The proposals are lacking and the FSOC should make its own if it thinks it has better ones.”