Fed report on MMF risk to banks has the right philosophy but potential bias in the model

A new staff Report from the Federal Reserve Bank of New York, “Money Market Funds Intermediation, Bank Instability, and Contagion,” beats the drum about the problem of money market funds (MMFs) creating potential instability for bank funding. The basic thesis is that money market funds could withdraw from a bank’s funding en masse leaving the bank unable to meet its own financial obligations. This is pretty much accepted from a philosophical standpoint. The real point of this paper however is to build the theoretical case that MMFs are unsound, and we wonder about bias in the argument.

The problem as stated by authors Marco Cipriano, Antoine Martin and Bruno Parigi, is that:

“The ampli…cation mechanism is possible given that MMFs are subject to run-like redemptions because they offer investors demandable liabilities in order to satisfy their liquidity needs. When an MMF experiences large unexpected redemptions, it runs the bank to protect all its investors, and not just those initiating the redemptions. Because of the bank’s fi…xed promise, the MMF, receiving negative information on the bank’s assets, obtains a higher payoff for its investors if it runs than if it does not.”

In order words, MMFs that take the first mover advantage and get out of a bank’s assets fare better than if they wait. This encourages MMFs to bail out sooner rather than later, which destabilizes the bank and potentially the entire banking system.

Here’s a new part of the argument: “The mechanism through which instability arises is the release of private information on bank assets, which is aggregated by MMFs and lead them to withdraw en masse from a bank.” So, MMFs control large blocks of assets and can make decisions over those assets based on information in the pricing, terms or other information in the MMF investments. Individual investors would not have the same level of information nor concentration of assets and hence would not be able to withdraw as a group leaving a bank without a funding resource.

The authors, at least one of whom has a strong and consistent bias towards much tougher MMF regulation, rely on a mathematical model of an economy to prove their point. We’re not going to argue about the mechanics of the model, but we do wonder about the framework that the authors are using to test their hypothesis. We think it could be argued that a group wanting to show that MMFs would not be a root cause of a bank’s demise could create an opposing model that proves their point as well. We agree that MMFs in their current form could destabilize banks given their large exposure to repo, Commercial Paper, etc and bank deposits if they ran as a group, and we don’t think anyone would argue the contrary these days. But we aren’t so sure that models like what the authors have presented can’t just be disproven by other models. We are more inclined to buy the philosophical arguments here than the theoretical ones based on the math.

Our thanks to the Federal Reserve for continuing to provide us such meaty reports and articles to wrangle over – while we don’t always agree, the Fed is generating thought-provoking points that we take seriously and want to have the conversation about.

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