One of the great unspoken scandals of the post-2007 financial crash era is that no reform of the banking system has been put in place, though domestically the bank bail-out will cost UK taxpayers some £1.4 trillions by 2015 and globally the crash nearly collapsed the world economy. Despite those gigantic detriments, 5 years on next to nothing has been done. The Vickers Commission was set up, but failed to recommend the obvious remedy – splitting investment banking from the retail operations. Then the capital ratios proposed, inadequate as they were, were watered down after City lobbying, and then postponed to come into operation till 2019! Not only that, another source of great instability has been studiously ignored.
The reform of money market funds should be an obvious target if another crash is to be avoided. Money market funds were established in the 1970s as competitors to banks and have become one of the main short-term funding mechanisms for US and European banks. Dangerously, however, these funds and the banks feed on each other in potentially unstable ways. This was illustrated in 2008 when the Reserve Primary Fund signalled it couldn’t maintain its fixed value because it helf $875 of Lehman Brothers securities. That led to a rapid run on its deposits and the authorities had to intervene to prevent other funds toppling.
The US Treasury has estimated that as many as 105 money market funds holding total assets of $1 trillion could fail in the same way as the Reserve Primary fund did if any of their top 20 counterparties defaulted. The latter include many European banks since 30% of the assets of money market prime funds are European bank debt. So there could be another cascading crisis with weak banks drained of funding, only this time it won’t be queues of depositors lining up outside banks to withdraw cash – it will be corporate treasurers wiring money out of money market funds at any evidence of risk.
At such an event the investment companies that sponsored these funds would normally move to support them. But, as in 2008, if a parent won’t or cannot support them, investors have an incentive to take their money out and run. A money market fund is indeed like a banking system, except that there is no capital buffer at all. That means there is nothing to stop a run happening again. Last time it was the shadow banking system’s invention of financial derivatives that set off the financial hurricane; this time round it may well be the inherent instability of money market funds.