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Money Funds are Far Too Big for Regulators to Ignore

Money market funds are the stepchildren of finance. Though they manage more than $4 trillion in assets, they have not gotten much attention recently. Sen. Chris Dodd (D-Conn.)'s regulatory reform proposal does not even mention money market funds, which we believe is a glaring mistake.

Before the crisis, money funds were considered a safe haven. Since their inception in the 1970s, no fund of significant size ever broke the buck. Thus, it is not surprising that in 2007, when the crisis started, money funds had significant inflows from investors seeking safety.

This perception changed dramatically after Lehman's bankruptcy in September 2008 and Reserve Primary Fund's breaking the buck-setting off a run on money market funds.

Facing this panic, the government acted promptly. Three days after the start of the run, it announced that all money market funds would be guaranteed. This stopped the run, but put the government on the hook for potential losses on more than $3 trillion of assets-almost one-quarter of country's gross domestic product.

What does this all mean for regulation? In effect, the lack of a guarantee for money market deposits was an illusion. Should a large-scale run on the sector recur, the government will have no choice but to step in and bail out money market depositors.

Though the Senate legislative proposal does not address money market funds, a proposal by the Securities and Exchange Commission recognizes that this (implicit) guarantee creates the same old moral hazard problem noted in connection with the largest commercial banks. Hence, the SEC proposes limiting risky investments by money market funds. Though this is a step in the right direction, we do not think it is enough.

We believe the government must explicitly acknowledge that money market funds will get similar wholesale support during times of crisis. Though this may be unpopular in policy circles, it is an honest thing to do.

Once a government guarantee is acknowledged, money market funds must be regulated to contain their risk to the economy. We believe two options exist to deal with money market funds.

The first would be a Volcker-rule equivalent that would charge funds a fee for the government guarantee.

Such a fee would rise depending on the fund's risk. If a portfolio holds only Treasuries, the fee would be negligible. If the fund only holds longer-maturity commercial paper, the fee would increase substantially. The fee would still be smaller than the premium for FDIC insurance, since the guarantee would only cover a systemic run (when the entire industry is in turmoil), not the default of a single fund.

The second option would be a discount-window equivalent for money market funds. The Federal Reserve would set up liquidity facilities against which to lend in times of crisis. The government would charge a hefty interest rate and impose a haircut to ensure that it does not take a loss on its lending. Some money market funds would still break the buck under these conditions, so there would have to be a quick way to dissolve such funds.

The key is to set up the liquidity facilities in such a way that the government does not underwrite another blanket guarantee if times get really rough. This option would not necessarily require a fee beforehand but could be costly for funds afterward. The government needs to acknowledge the elephant in the room. Otherwise, we are poised for a re-run during the next crisis.

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