The Fed's Liberty Street Economics gets it right on gating and fees to prevent runs: they don't work
An August 18th post in the Federal Reserve Bank of New York’s Liberty Street Economics “Gates, Fees, and Preemptive Runs” by Marco Cipriani, Antoine Martin, Patrick McCabe, and Bruno M. Parigi is worth a read. Here is our take.
The underlying issue is gating and punitive redemption fees. Often thought of as a way to slow down runs and fire sales, the authors suggest that gates and fees give investors itchy trigger fingers, making the system more vulnerable and creating self-fulfilling bank runs. The design is part of the problem.
“…Our results show that the option to suspend convertibility has important drawbacks: A bank, MMF, or other FI with the option to suspend convertibility may become more fragile and vulnerable to runs. In other words, we show that instead of offering a solution, policies relying on gates and fees can be part of the problem…”
The post describes a scenario where without a gate mechanism; an investor will wait until things do go sour before pulling out cash. Without the gate, investors retain the option to wait and see it was a false alarm. With a gate, the choices are to pull out preemptively to preserve flexibility, even if it means missing out on returns, or be gated. First and foremost, no one wants to loose flexibility and access to their money.
“…we show that under fairly general conditions, if the FI cannot suspend convertibility by imposing gates or fees on redemptions, informed investors will optimally decide not to run at date 1. Instead, they will wait until uncertainty is resolved at date 2, because waiting may allow them to partake of the positive return on the FI’s investment if it turns out to be profitable. After all, these investors would still have the option of redeeming at date 2 if they learn that the FI’s investment has turned out to be bad…”
“…Giving FIs, such as MMFs, the option to restrict redemptions when liquidity falls short may threaten financial stability by setting up the possibility of preemptive runs…”
And that investment managers will, once the stress becomes evident, gate the fund to preserve it.
Is this one of those regulatory problems that by pressing on one side you exposure issues on the other? Slow down fire sales on the far end at the cost of increasing the chance of investors running at the first signal of stress (false or otherwise)? Some would call this an unintended consequence. We think these tradeoffs are known and embedded in the system…only some regulators don’t get it. Hats off to the New York Fed’s researchers for making the point. But we should also note that the Fed is dealing with their own fire sale demons in the tri-party repo market and gating was one option under consideration. The debate is not just about the SEC and money market funds.
A link to the Fed’s more complete staff report “Gates, Fees, and Preemptive Runs”, by Marco Cipriani, Antoine Martin, Patrick McCabe and Bruno M. Parigi (Staff Report No. 670, April 2014) is here.
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