Initial Comments On Sissoko Paper: Money Markets

I ran across Carolyn Sissoko’s working paper “Financial dominance: why the ‘market maker of last resort’ is a bad idea and what to do about it” (link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4240857). Although I agree that non-bank finance (“market-based finance”) is going to be the source of financial instability under current institutional arrangements in the developed countries, I am not too sympathetic with her framing of the issues. Private sector balance sheets have been tilted towards non-bank finance as a result of institutional and demographic trends, and the traditional banking system has been de-risked courtesy of banks relying on tools provided by non-bank finance.

In this article, I just want to respond to the discussion of money market funds from a technical standpoint, and will not address what Sissoko presents as the major concerns — a movement away from market-based finance. Even if we grant the argument that there should be a movement away from market-based finance, we need to look at how that is supposed to be implemented.

Traditional Banking versus “Banks”

One immediate thing that always has to be kept in mind that the “banks” we see discussed on financial television are in most cases the parent holding company that has a number of divisions. At present, if those holding companies are large, those divisions include both traditional bank divisions and what was historically non-bank finance: securities and derivatives trading, asset management, investment banking, trade finance.

My terminology ignores the complications created by these sprawling holding companies, I divide the financial sector into “traditional banking” (which consists of loan-deposit relationships backstopped by a central bank that has a loan-deposit relationship with traditional bank units), and non-bank finance, which is everything else. This traditional banking system is usually what is encountered in economist discussions of banking.

Note that my usage of “traditional” is not a statement about historical conditions — I perhaps should switch to calling it “conventional banking.” Since government bills and bonds are a form of non-bank finance and banks historically relied upon those instruments to manage liquidity, even “old time banks” had to interact with what I refer to as “non-bank finance.”

Aside: Money Market Funds

I am neither an accountant nor a securities lawyer, but I will attempt to give an overview of the structure of money market funds, which are an important part of the working paper. By way of background, I worked for a team that managed an institutional money market fund. I knew what the fund would invest in, but not an expert on the accounting.

Mutual funds (called unit trusts in the United Kingdom) are a typically a trust structure that holds assets on the behalf of unit holders (although they could be incorporated). These “units” are economically equivalent to equity — the unit holders have a proportional claim on the assets that are managed by the company running the mutual fund (which charges a fee against the portfolio). The Net Asset Value (NAV) is the market value of the assets divided by the number of units, which is the price of a unit. For an open-ended fund, inflows and outflows by clients result in increases/decreases in the unit holdings based on the end of day valuation.

Funds are typically split by asset class. The fixed income universe is split into “bonds” and “cash,” with “cash” being short duration bonds that are expected to hold their nominal value over short periods of time. (“Bonds” will be sub-divided into governments, credit, high yield, etc.) Standard portfolio management involves splitting a portfolio into allocations between risk assets/bonds/cash.

However, people realised that since mutual funds distribute their incoming cash flows periodically, a portfolio of money market instruments will have a NAV that will not move much over time (as long as there are no defaults!). If the NAV were in fact constant, it would be possible to completely ignore capital gains/losses on the fund when it came time to do income taxes.

Thus the money market fund was born. In the United States, these funds also allowed unit holders to write cheques (“checks” in the local lingo), making the money market funds look like a bank account. Economists dutifully lumped money market funds into their money supply measures.

One important thing to keep in mind that the “money markets” are a somewhat vaguely defined section of the broader fixed income markets, just referring to relatively high grade short-dated instruments that use a different quote convention than bonds (since they do not have coupons, unlike most bonds). These markets are traded by pretty much every entity that operates in fixed income markets, and not just money market funds.

Regulate Money Market Funds Like Banks?

The following statement was found in the abstract of the Sissoko paper, and my eyebrows immediately jumped.

… requiring that all monetary run-risk intermediaries, such as money market funds and finance companies, be brought onto bank balance sheets;

On its face, this statement does not appear to make sense. If we list the money market funds in a jurisdiction, the vast majority are retail/institutional funds run by asset managers that have no affiliation to a bank (including the fund I provided analysis for). There is no “bank” with a balance sheet to put the money market fund onto. My suggestion is that this statement be re-written, but I am not entirely sure what the replacement should be.

One interpretation of Sissoko’s statements is that she believes that banks are dominant in providing in money market funds. This is only true in the sense that banks bought up a significant portion of the asset management business in many countries, but those asset management subsidiaries are regulated independently of the traditional banking business. This also runs into the reality that there are large institutional investors with sponsored money market funds.

Sissoko writes in the recommendations section (page 23):

Overall, any companies that make loans (other than repo) or purchase financial assets (excluding derivatives) and are funded predominantly by wholesale bank lines of credit should be treated as bank regulated activities and incorporated into the banking system.

The statement about credit lines questionable. Although some non-financial firms and households will use credit lines (or overdraft facilities, which were quite popular in U.K. practice), bank lines of credit are an expensive form of funding. Attempting to fund positions with bank credit lines for an extended period would tend to eliminate any trading profits by the extra financing spread. Financial entities would typically get credit lines as a form of liquidity insurance — but they and their bankers would not expect the lines to be drawn outside of unusual circumstances.

“Funding” refers to emitting liabilities to finance the purchase of assets (people jump between “finance” and “fund” a position purely as a matter of writing style), an undrawn credit line cannot fund anything. Getting liquidity insurance is a prudential act, and should be rewarded by regulation, not punished. One counter-argument might be that the banking system should cut any connections to non-bank financial system and just tell it to drop dead in a crisis so that the central bank does not risk any losses bailing it out. In my view, this is a stance that would survive roughly five minutes in a serious financial crisis like 2008, since the meltdown in the real economy would drag the banking system down with anyway due to credit losses.

Even if we put aside my concerns about the wording around credit lines, we face the fundamental question: can we regulate money market funds using the same regulatory tools that banks face?

The answer is no.

The short justification of that assertion is as follows. Look at the balance sheet of money market fund in a regulatory environment that resembles the Canadian one.

• 100% of the asset side of the balance sheet consists of money market assets, with interest rate and credit risk very strictly controlled.

• 100% of the other side of the balance sheet is equity (the unit holders).

If you sent a bank regulator with the existing bank regulations to look at the fund’s balance sheet, they would finish their investigation in less than five minutes, since that would be the safest “bank” the regulator would have ever seen.

One might dispute my assertion about the 100% equity financing on a money market fund, but may I refer you to the disclaimers found on a semi-randomly picked non-bank sponsored Canadian money market fund:

Mutual funds are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer and are not guaranteed or insured. Their values change frequently. There can be no assurances that any money market fund will be able to maintain its net asset value per unit at a constant amount or that the full amount of your investment will be returned to you. Past performance may not be repeated.

There is no promise to keep a money market fund NAV constant — at most, there is a moral obligation for a plan sponsor to intervene to save its reputation. Since there is no guarantee about the future value of the units, they qualify as being economically equivalent to equity.

The “original sin” of money market funds is allowing them to use accrual accounting to keep a constant NAV. If the NAV were allowed to vary, then even investors that do not read fund legal disclaimers (almost all of them) would be aware that losses are possible on their investments. To what extent that there can be a panicked “run” (which I find to be of secondary importance) on money market funds, the sacredness of the constant asset value is part of the problem.

Bringing in the central bank as a regulator makes the situation worse, not better. Central banks regulate banks so that there are hopefully no losses on depositors and senior creditors, but they are supposed to throw subordinated claimants under the bus. If we are going to worry about people mis-interpreting the smoothed nature of money market fund NAVs, we need to worry more about the expectations created by having money market funds regulated by the central bank, as that adds to the expectation that they will be treated like bank deposits.

The desire to push losses onto subordinated parts of bank’s capital structure is why regulators pushed for the introduction of conditional convertibles after the 2008 Financial Crisis: if regulators declare a crisis, they convert what were previously subordinated fixed income instruments (with contractual cash flows) to equity that has no contractual payments. Banks survive crises by having their equity holders effectively absorb credit losses via a reduction of dividend payments. Credit losses can be drawn out courtesy of the accrual style accounting used on bank loans (“extend and pretend”), so the bank will eventually be able to earn its way out of its predicament. If a money market fund takes credit losses, if we use the same principle that is applied to banks, the unit holders should take the loss immediately — which is how money market funds work right now.

Providing funding cannot correct credit losses. If the central bank extends a loan to a money market fund at an artificially high value versus dubious collateral, the correct course of action of unit holders is to run, hollowing out the fund and ultimately leaving the central bank with the loss, since all of the unit holders would have amscrayed at the artificially high NAV. (And I note that Sissoko repeatedly notes concerns about private sector losses being pushed onto the public sector.)

What To Do About Money Market Funds?

Since we cannot regulate money market funds using the same principles as used for regulating banks, we are stuck with regulating money market funds using their own specific regulations — which is already done. Retail money market funds have their own accounting treatment, and tight rules with regards to investment policies. I have no opinions on whether any changes ought to be made, but I have serious doubts that changes would make any macroeconomic difference.

If something resembling the status quo is deemed as not acceptable, we can just throw out the special status for money market funds and force sponsors to just have short maturity fixed income funds.

Regardless of what happens to money market funds, we should still expect that future financial crises will pop out of the money markets — which has been an ongoing pattern since the 1960s (as discussed by Minsky).

Why Do Money Markets Always Blow Up?

The periodic explosion of money market mayhem is the result of the economics of money market trading. Although I believe that Minsky discussed this, the best explanation was provided by an ex-colleague.

The fundamental problem with money markets is that the people who bury risk in money market products are paid much better than the people analysing credit risk in money markets. The duration on 30-day paper is negligible, and so spread movements provide almost no opportunity for added value. Unless you have an extremely large portfolio, it is nearly impossible for an analyst to provide recommendations that add more value than their compensation package costs. And if you have a large portfolio, guess what — your ability to exploit analysis is limited since you need to take large positions.

Risk managers, credit agencies, and market participants will react to the last crisis and tighten up some aspect of what they invest in. However, the busy beavers on the sell side will eventually find a way to dump a large pile of toxic waste on them.

Why Have Money Markets In The First Place?

Some readers might ask why we have money markets at all, given that they are a fertile ground for financial crises? The first answer is that “money markets” is just an arbitrary subset of short maturity fixed income instruments — and every single non-perpetual bond that does not default will eventually end up in that maturity zone. To get rid of money markets, you need to get rid of all bond markets. The second answer is that non-bank fixed income/funding markets are used as risk control by banks. One of the reasons that traditional banking systems are not blowing themselves up in recent decades — even in the Financial Crisis of 2008, only the dumbest traditional banks blew themselves up, the problem in most bank holding companies was that the securities divisions had run amok.

Take as an example a common occurrence during the genesis of bond markets: traditional banks extended a loan to investors who bought railroad bonds, let us assume it was $90 securities loan against a $100 bond which is used as collateral.

Although one might argue that the funding was largely provided by the bank and so the bond issue was unnecessary, that is the danger of looking at funding (which is typical of economist bank models) and ignoring credit risk. The bank still has indirect credit exposure to the railroad, but the investor is sitting in between and has to default before the railroad collateral matters. In addition, the investor has provided a $10 equity cushion for the position — the railroad needs a default loss of greater than 90% for the bank to lose money on the collateral.

Another aspect of risk management is liquidity management. Banks do not want to spend their time lending to competing banks, nor would a halfway competent bank want to depend upon getting financing from its competitors on demand. This means that inter-bank loans are not going to be the optimal way for banks to settle cash transfers between banks. So banks either need to use government liabilities (Treasury bills, or settlement balances at the central bank) or private money market securities to manage liquidity.

On paper, the central bank could just provide banks with settlement balances. There are two problems with that option: banks would be forced to hold low-yielding settlement balances which then forces loan spreads wider, and the amount of government liabilities in existence is determined by fiscal policy. If fiscal policy does not provide a large enough liability pool to allow adequate liquidity management, the central bank would need to “monetise” private sector assets, which is a form of fiscal policy that exposes the central government to losses.

If we reject relying solely on government liabilities, we are left with private securities traded in a money market, and that money market has to be liquid enough to easily support relatively large inter-bank flows, as well as the flows created by securities trading.

Concluding Remarks

I expect that I might return to other points in this working paper later. However, I would just want to make a general remark on the tone of the working paper: the reason why traditional banking has not been blowing up in recent decades is because liquidity, interest rate, borrower concentration, foreign exchange, and credit risks were dumped by banks onto the non-bank markets.

One might wish to roll back the clock and revert to stricter separation of financial activities — what used to be referred to as the “pillar system” in Canada. Although such a move has some attractions, we need to address the reasons why the pillar system was abandoned. And even if did manage to achieve such a step, we will just end up with old school financial crises: traditional banks are very good at blowing themselves up as a group, leaving the economy dependent upon crippled zombie banks as they try to rebuild their balance sheets.

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(c) Brian Romanchuk 2022