by Mark Roe
CAMBRIDGE – Last month, at a US Federal Reserve Bank conference on the money market, officials lamented the market’s enduring fragility. Indeed, six years after a run on the money market nearly brought the United States – indeed, global – financial system to its knees, critical risks that underpinned that crisis still have not been brought under control.
At its core, the money market serves the need of a firm or nonprofit institution to store cash that it can access on a moment’s notice. A university, for example, must set aside a portion of students’ tuition payments to cover unexpected expenses. But the sum is larger than $250,000 – the maximum that the government insures in a single account. Seeking more security for its cash, the university may turn to US Treasury bonds.
The process is simple. The university deposits the money in a bank for a short period – often just one day – with the bank providing a US Treasury bond as collateral. If the bank does not return the cash the next day, the university can sell the bond, keep the cash it is owed, and return any excess to the bank. It is almost as safe as a government-insured bank deposit.
If only universities engaged in such practices, the money market would not have grown large enough to damage the economy so deeply in 2008 and 2009. But large businesses waiting to invest excess cash make the same types of cash deposits with banks – millions of dollars at a time – owing to the same unwillingness to rely solely on a bank’s promise to safeguard anything over $250,000.
Moreover, ordinary savers use their cash to buy shares in money-market funds, which lend that cash to financial institutions, getting long-term US Treasury bonds as collateral and promises of next-day repayment. And hedge funds park the cash that they receive from investors in the money market while waiting for promising long-term investments to arise.
In short, the money market is not just a few institutions managing a few billion dollars of cash. It is a massive multi-trillion-dollar market. Indeed, it was a $4 trillion market just before the financial crisis, with its reduction to less than $3 trillion during the crisis disrupting real economic activity.
But the money market’s size is not the only reason for its fragility. Another problem is that banks are not the only institutions managing it.
The key to making money-market transactions work is the borrower’s ownership of a Treasury bond that it can offer to the “depositor” as collateral. Given this, any sufficiently large institution with such bonds can imitate the bank’s lending role – and many non-bank institutions do, often obscured from the watchful eye of regulators. The money market thus extends well beyond the regulated banking system into so-called “shadow banking.”
The final problem is that such thinly capitalized non-banks do not just offer solid US Treasury obligations as collateral; they also provide weaker securities, such as aggregations of mortgages. These securities are not US obligations, carry no government guarantee, and do not retain their intrinsic value in a crisis.
When a crisis erupts and lenders cannot return the cash, “depositors” prepare to sell the collateral. But while prices for US government bonds can withstand a large-scale sell-off, those for mortgage bonds cannot – especially if, as during the recent financial crisis, the housing market is weakened. The prospect of that sell-off put the solvency of many financial institutions at risk, leading the US government to bail out the money market, the mortgage-bond market, and the infamous Fannie Mae and Freddie Mac, which backed many of the mortgage securities.
There are three ways to make the money market safer. The first is to make the institutions providing the quasi-money safer by increasing their capital. The second is to limit the total size of unregulated transactions that any one institution can conduct.
The third is to allow this kind of lending only against rock-solid collateral, such as Treasury bonds – not mortgage-backed securities, which can lose value quickly during a crisis, requiring a government bailout. The government should decide up front which types of collateral it will guarantee in a crisis, instead of being backed into a corner when markets, institutions, and collateral that it never pledged to support are on the brink of collapse.
Money-market institutions cannot be counted on to take these systemic safety-oriented steps themselves. The transactions are too profitable in ordinary economic times, and they know that, if another crisis arises, the government will again be compelled to support the market and shore up weakened financial institutions.
It is therefore up to policymakers to reduce the financial risk that the money market generates. But the prevalence of shadow banking institutions, which do not hold traditional bank charters and are not subject to bank regulation, complicates such efforts.
A full solution would focus on preventing all institutions from offering weaker forms of collateral. As Ed Morrison, Christopher Sontchi, and I proposed at the end of last month’s Fed conference, US regulators must change the rules to prohibit mortgage-backed and other weak securities from being used so extensively in the money market, unless the government decides up front to back them fully. The weaker collateral could be used elsewhere – just not for parking money overnight. For that, safer securities should be required.
If US policymakers adopt this approach, the tone of the Fed’s next money market conference could be much more optimistic.