A perfect storm is brewing in the cash markets – one that could lead to a dramatic and costly schism between money market liquidity funds and banks.
After the Lehman Brothers’ debacle, there was little disagreement that something had to be done to address funding issues for banks. The financial crisis was, after all, spawned by a liquidity crisis.
Two years and billions of pounds later, regulators and their chastened governments are understandably anxious to avoid a repeat. Money market funds and banks alike have been getting their houses in order but at what cost to each other?
The fundamental issue is liquidity. New regulations proposed will mean the length of assets that each must now hold are targeted at opposite ends of the maturity spectrum. For money market liquidity funds – a key provider of bank funding – the emphasis is on the short term; for banks, it is focused on the longer term.
Looking at liquidity funds. In the boom years that preceded the financial crisis, the primary focus for investors in these funds was yield. Security of principal was largely taken for granted.
After a crisis which saw the $63bn Reserve Primary Fund breaking the buck thanks to its exposure to Lehman Brothers’ paper and the $14bn Putnam Prime Fund pulling down the shutters due to “significant redemption pressures”, investors began examining money market funds more closely.
In response, Immfa (the money market fund industry body) made stress-testing of portfolios mandatory for the €450bn industry.
Perceived riskier assets – floating-rate notes, corporate bonds, etc – were replaced by other safer, shorter-dated, lower-yielding assets. Counterparty lists were reviewed and, in many institutions, reduced. Several asset classes, such as asset-backed commercial paper, found themselves out of favour, too tainted by the structured invest vehicle crisis, to continue the widespread growth seen in the early part of the decade.
Targets were set for the amount of overnight deposits a fund should carry, as well as the amount that matures within one week. Weighted average maturities (Wam) of funds were reduced across the board by cautious investment managers.
As a result of the new environment, rating agency Moody’s has proposed dramatic changes to its rating methodology, designed to differentiate between the safer and the more risky funds in the market. For example, in order for a liquidity fund to achieve the highest rating the Wam of the portfolio will not be allowed to exceed 30 days, half of the current industry standard of 60 days. A fund must also keep a minimum of 30 per cent of assets in overnight deposits.
Contrast this with the new banking regulations, specifically the FSA’s individual liquidity adequacy standards. Under these rules, for any assets under 90 days maturity, banks must hold the same amount in capital – a costly affair. It also means that short-dated funding in the cash markets will be prohibitively expensive, yields will plunge, as will the return a liquidity fund can deliver.
These new regulations are clearly at loggerheads. The consultation process has been practically non-existent.
In the past, there was an overlap in funding requirements between banks and liquidity funds, to the benefit of both. Now, by taking such a myopic approach to regulatory reform, this overlap could be removed.
As a consequence, money market funds will start to look abroad to banks with less stringent regulatory requirements to generate their yield or be forced into loweryielding short-term deposits with UK banks. Lenders, meanwhile, will struggle to obtain funding on the scale and at the price that they currently do, which will have a knock-on effect to the “real” economy.
There could also be other hidden negative ramifications of the new regulations, as investors debate how much capital security they are willing to risk in return for greater returns.
Due to length of assets they can hold, banks will increasingly turn their attentions towards longer-term depositors at the expense of short-term cash.
Spurned, corporate treasurers who have been increasing their cash reserves will turn to other areas of the market.
Money funds are an ideal location for this but with the paucity of yield that could potentially be available, investors may look elsewhere.
This could see many turn to less conventional, less secure products, thereby creating a poorly regulated shadow financial system.
In our view, limiting the Wam of a liquidity fund so severely is unnecessary.
As we highlighted, stresstesting of portfolios, prevalent before, is now mandatory.
This procedure puts a fund through all manner of “disaster scenarios”, from extreme interest rate stresses, to collapses in credit and mass investor redemptions. Had banks had similar procedures in place we may not have suffered the biggest financial crisis in generations.
Further, credit teams on money market desks are now widespread. They ensure that the counterparties a fund manager trades with have been fully scrutinised and tested, their creditworthiness assured.
This improved transparency means an investor knows what areas of the market the fund is exposed to, whom it deals with and what its risk profile is. As such, a prospective client can have absolute confidence in a product – a premium currency in a climate where hidden debt nearly collapsed the system.
Lastly, the obligation to provide diversification, same-day liquidity and preserve capital investment remain sacrosanct within the money market fund industry.
In an attempt to make money markets safer, regulators may have inadvertently made things worse but there is still time to make the necessary changes before the storm breaks.