U.S. Risk Council Says Money Funds Can Be Vulnerable During Runs

A U.S. council of regulators looking at whether asset managers pose a potential threat to the financial system said money-market funds can be vulnerable to runs during periods of volatility.

The funds and other firms that lend securities “are vulnerable to same-day calls for liquidity, creating strong pressure to sell assets quickly,” the Financial Stability Oversight Council said in its annual report released today in Washington. Money-market funds “can experience runs when perceived by shareholders to have worrisome risk exposures.”

The panel of financial regulators, or FSOC, has been studying whether the largest asset managers, such as BlackRock Inc. and Fidelity Investments, could be systemically important and need Federal Reserve supervision. Any decision on whether to designate asset managers potentially risky could be months away.

Asset managers, which offer money funds to investors, argue that they weren’t bailed out in the 2008 financial crisis and that they’re different from large banks because they don’t make big trades with their own assets, and clients direct their investments and can withdraw them at any time.

The Securities and Exchange Commission is weighing a rule that could require a class of money-market funds to float their share price, abandoning a stable $1 target that makes them appear riskless to many investors.

Regulators have been calling for additional restrictions on money-market funds since the September 2008 collapse of the $63 billion Reserve Primary Fund. Its closure triggered a run on money funds that helped freeze global credit markets.

Panel Members

Treasury Secretary Jacob J. Lew is chairman of the council, whose 10 voting members include Fed Chair Janet Yellen and the heads of the SEC and Federal Deposit Insurance Corp.

The council, which highlighted the risk of reliance on short-term wholesale funding, also raised potential concerns over asset managers providing securities lenders with protections from losses.

“There are likely benefits for asset managers from combining indemnification provision with securities lending, but there also is the potential for enhanced risks,” according to the report. “Unlike banks, asset managers are not required to set aside capital when they provide indemnification.”

The risk of “fire sales continues to be a major source of financial instability” in the market for tri-party repurchase agreements, according to the report. The council cited a “potential vulnerability emanating from liquidity pressures that could force many investors to sell assets simultaneously.”

Mortgage Servicers

The council’s report also underscored innovations in finance since the 2008 crisis.

For example, mortgage-servicing rights are increasingly being transferred to non-bank servicers, the council said. Many of the companies “are not currently subject to prudential standards such as capital, liquidity, or risk management oversight.”

On private-equity funds, the council said the issuance of sponsor-backed payment-in-kind bonds, financing vehicles that are “typically viewed as highly risky for investors,” rose sharply in the third quarter of 2013.

The council expressed concern about the potential impact a sharp rise in interest rates could have on financial stability, noting that the “prolonged period of low interest rates and low volatility has led financial institutions and investors to search for yield.”

The FSOC reiterated its concerns over cybersecurity, saying industry and regulators are cooperating to counter threats.

High-Frequency Trading

Regulators also should examine risk created by the complex technology that powers automated trading strategies and venues such as exchanges, said Trent Reasons, a senior policy adviser at the Treasury Department. Errors and outages can disrupt trading and hurt confidence in securities markets, the council said in the report.

The council also approved a revised policy on transparency requiring it to give the public a week’s notice before meetings with an agenda of what will be discussed. Financial industry executives and some Republican lawmakers have criticized the FSOC for not being open or public enough in its decision-making.

“Since its inception, FSOC has been operating like a black box, leaving uncertainty in the marketplace,” David Hirschmann, president of the U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness, said in an e-mail before today’s meeting.

The council is authorized under the Dodd-Frank Act of 2010 to identify companies that could threaten stability. Those companies are subject to oversight by the Fed, which can impose tighter capital, leverage and liquidity rules, and demand measures including stress testing for crisis scenarios and plans for winding them down should they start to fail.

The FSOC has designated three non-banks for Fed oversight: Insurer American International Group Inc., General Electric Co.’s finance unit and Prudential Financial Inc. MetLife Inc., the largest U.S. life insurer, is in the final stage of review.

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