Although MMFs are taking a licking in the court of public opinion, they are nonetheless ecstatic after having forced the SEC Chair to abandon her quest for new prudential standards and/or a floating NAV. I would caution restraint not just for decorum’s sake, but also because gloating will stiffen regulatory resolve to restructure MMFs. The industry may have taken the club out of the SEC’s hand, but the FRB has a meat-axe it can deploy whenever it wants. Given the SEC impasse, the FRB must either stand down despite its systemic-risk fears or act, perhaps in concert with the FSOC. I think it will act, not only because it thinks it should, but also because the MMFs have made it mad.
The FRB had so far stayed its hand first and foremost out of courtesy to the SEC – Chair Schapiro had asked the central bank to honor her agency’s jurisdiction – but it also knew that unilateral Fed action would be less effective than an across-the-board rule. The latter, which can only come from the SEC, cannot be characterized as an adverse competitive blow to big banks – a charge the FRB is already beating back on other fronts. Substantively, SEC action would also have avoided potential regulatory arbitrage if investors flocked to less-costly MMFs out of the Fed’s reach.
So, what could the FRB do on its own? A client report FedFin sent yesterday spells out in detail what the Fed could do to whom, with or without the FSOC. I think the most immediate action – one that doesn’t require a formal rulemaking – will be to incorporate break-the-buck capital scenarios in the next round of big-bank stress tests. These are clearly on the Fed’s radar – the head of the Boston Federal Reserve Bank floated this idea earlier in the summer. Under it, BHC parents of MMF sponsors – some of the biggest in the industry – would need to run trading-book risk scenarios akin to those done in the CCAR2012 exercise for the EU. If value-at-risk or other methodologies – the Fed could try a bit of expected-shortfall here – show a risk of buck-breaking, this would need to be capitalized by the parent BHC. How much capital would depend on which model and what scenarios, but it would likely be a non-trivial additional charge for the biggest MMF sponsors under the Fed’s thumb.
Big enough to make them turn on their nonbank MMF peers? So far, the industry has been relatively unified, although BlackRock and a couple of others have proposed alternative regulatory regimes to the SEC. With differential regulation could well come a different industry alignment and, perhaps, a new chance for the SEC.
Any such political change is, at best, uncertain. As a result, we think the FRB won’t stand down on MMFs after imposing a new capital charge on those under its control. The Fed and other bank regulators are also the guardians of some of the very biggest MMF counterparties. It was for this reason that the FRB and Treasury poured a trillion or so in support behind MMFs in 2008 and why they wanted the new rules so badly. Absent rules and stripped of the authority to backstop MMFs (even if they wanted ever to do so again, which I doubt), the Fed will do what it can in concert with the other banking agencies to wean banks off MMFs. It can do so through the new liquidity rules over time, but exercise a lot of clout very quickly by simply sending the word that it will join other global regulators by limiting MMF holdings at banking organizations.
If MMFs can’t invest in U.S. banks, they will need a radical strategic rewrite. The EU isn’t looking so hot these days and EU regulators aren’t any more enamored of MMFs than their U.S. colleagues. Could the MMFs find places to put their money with comparable safety at reasonable return to investors? Current interest rates mean MMFs are already scraping bottom. A little push downward from the Fed could make them hit it, hard.