Untangling the Money Market Fund Problem : A Public-Private Liquidity Fund Proposal

The 2008 Financial Crisis dramatically highlighted the systemic vulnerabilities of the multi-trillion dollar Money Market Mutual Fund (MMF) industry, which developed over the last 40 years as a vital part of the U.S. financial system. Yet, more than 5 years on, the problem of what to do with MMFs remains unsolved, with no broad consensus in development regarding the best way to address the systemic risks posed by these funds. This paper develops a three-part framework to assess the efficacy of existing reform proposals, in the hope of pointing to new directions. First, I analyze the structural susceptibility of MMFs to “runs”, as well their role as a vector for systemic risk via contagion. Concluding that MMF run-fragility and their contagion risks derive from maturity mismatch, coupled with the behavioral dynamics of short-term investors, I argue for the necessity of public support measures for effective reform. Furthermore, any MMF regulation must aim to avoid or limit moral hazard, especially if public support is necessary. I argue that this should be done by internalizing systemic risk costs through ex-ante private payments that are risk-assessed. Finally, I argue that MMF structural reform must take into account meaningful differences between such funds and bank deposits. To the extent MMFs play a conceptually distinct role in the modern financial system that cannot be perfectly substituted by bank deposits, modifying the structural attributes of MMFs that compromise its ability to perform that role would have unintended economic costs and real migration risks. Applying this framework, this paper shows how recent proposals by the SEC and FSOC are fundamentally flawed, as they fail to address the structural weakness created by maturity mismatch and, thus, cannot effectively prevent runs of the scale experienced in 2008. On the other hand, alternative proposals such as deposit-style insurance and “narrow purpose banks” address both the run and contagion problems, but have considerable difficulty mitigating moral hazard costs and migration risk. Given these constraints, this paper concludes with a unique proposal for a Public-Private Liquidity Fund (PPLF) as an optimal paradigm of reform