First of two parts.
“Never has the ground under my feet felt as shaky as it did on September 16, 2008, when I received a call on my office phone telling me the Reserve Primary Fund – a money market fund – had broken the buck and indefinitely suspended redemptions of its shares. That meant investors could not withdraw their money. That day, and the days that followed, were marked by chaos and confusion as hundreds of thousands of panicked clients called their advisors.”
— Stewardship: Lessons Learned from the Lost Culture of Wall Street
On September 16, 2008, the Reserve Primary Fund “broke the buck,” bringing the world’s financial system to the brink of collapse. Triggered by the the Lehman Brothers bankruptcy on September 15, money market fund investors got dragged into the crisis.
The experience I had helping clients manage the fallout from the Reserve Fund’s failure led me to write a book on the lost stewardship values of the financial industry. The point of the book was that financial services firms need to refocus on, and recommit to, what should be their sole mission and purpose—helping their clients.
The good news is that the themes of the book are as relevant today as they were when it was published 18 months ago. Unfortunately, that’s also the bad news.
On the five-year anniversary of the watershed Reserve Fund collapse, it’s appropriate to ask fundamental questions about whether financial markets, financial services firms and the financial system are doing enough to live up to society’s expectations for the role they should play in promoting economic growth and enhancing standards of living.
Have We Fixed Money Market Funds?
As the CEO of a leading wealth management firm whose clients were unable to access their cash in the fall of 2008, I experienced the Reserve Fund’s collapse first hand. So I'm particularly interested in understanding what progress we’ve made shoring up this small but important segment of the financial markets, where efforts to make money market funds safer runs parallel to sprawling global efforts to reform the world's financial system.
Money market funds, like the overall financial system, are indeed safer, sounder and more secure today than they were five years ago—though the journey to get here has been an arduous process of "two steps forward, one step back” and it could take years before the money market reform process will be complete.
About $2.62 trillion in money market funds are part of the shadow banking system—nonbank financial institutions that represent key links in the chain of money flows that, if they get into trouble, can bring the financial system to its knees. The risk presented by these funds is the mutual fund equivalent of an old-fashioned “run on the bank.”
That’s what happened to the Reserve Primary Fund five years ago, when news leaked that their holdings of $785 million in Lehman Brothers commercial paper (a form of short-term borrowing) had dropped precipitously in value the day after Lehman declared bankruptcy.
Decisive Emergency Measures
The Reserve Fund wasn’t the only money market fund to suffer portfolio losses large enough to threaten to break the buck in 2008 and 2009. More than 100 funds experienced a similar problem during this same period. But the Reserve Fund was the only one whose sponsor didn’t have the financial resources to fix the problem.
Such was the crisis of faith following the Reserve Fund’s failure that the U.S. Treasury Department immediately put into place a voluntary program that guaranteed the net asset value of $2.5 billion to $3 billion in participating funds. And such was the success of this program that the U.S. Treasury was able to discontinue it one year after the Reserve Fund crisis.
Then, in 2010, the SEC mandated a series of regulatory quick wins designed to keep runs on the bank from happening again in the near future. These reforms changed the way investment advisors manage money market fund portfolios, imposing higher liquidity requirements and limits on exposure to lower-quality securities.
In the wake of these changes, the money market fund industry hasn’t experienced anything close to a repeat of the “break the buck” incidents we saw in 2008 and 2009.
Structural Reforms Still A Work In Process
Today, we’ve reached the part of the money market reform story that’s about putting into place more significant structural changes. These reforms have evolved in fits and starts.
Under former Chairman Mary Schapiro, SEC commissioners initially failed to agree on whether to propose structural reforms to money market funds. Earlier this year, the SEC was sent back to the drawing board by the Financial Stability Oversight Council (FSOC) and proposed a combination of variable net asset value reporting requirements and “gating” on shareholder redemptions that no one seems to fully understand.
Like many systemic reform proposals facing the financial services industry, these latest money market fund proposals are still mired in controversy as to how they will work, whether they will be effective or whether they should even be adopted.
But slowly, in a process that’s just as messy and arduous and difficult as everyone expected it would be, sponsors of mutual funds, investment advisors, industry advocacy groups and regulators are negotiating a compromise set of structural reforms.
When all is said and done, before the next five years is up, we may actually be able to declare victory in the effort to make money market funds safer and more stable than they’ve ever been.
Do We Have the Balance Right Between Stability And Growth?
Efforts to reform money market funds since 2008 are only one of hundreds of ways politicians and regulators have been working to improve the safety and stability of the global financial system.
They’re not even close to being done.
According to the law firm Davis Polk, 15 million words (more than 28 copies of Tolstoy’s War and Peace) and 13,789 pages of rules have been written (one every 2.8 days) to implement the Dodd-Frank Act—the legislation driving financial regulatory reform in the U.S. But three years after it was signed into law, only 39 percent of the act’s requirements have been put in place.
In soldiering through their post-crisis reform agenda, policy makers have been making an explicit choice: reduce the volatility of the financial system, even if it means sacrificing economic growth.
Our standard of living over the next decade depends on how we answer this question: Do we have the balance right between not enough regulation and too much regulation?
Yet incredibly, almost nothing has been done to try to answer this question. The honest response is: We don’t know!
The Institute of International Finance and the International Monetary Fund both published papers on the subject with widely divergent assessments. The Government Accountability Office essentially punted on the topic, writing, “Measuring the costs of financial regulation to the broader economy is challenging because of the multitude of intervening variables, the complexity of the global financial system, and data limitations.”
The Brookings Institute was not any more helpful, telling us, “[It] is extremely hard to determine the right size of the financial system based on… economic theories.”
Absent any hard, reliable, data-driven evidence, efforts to prevent the pendulum from either swinging too far or being pushed to swing even farther are starting to show up in the political arena. An odd-couple combination of senators, Sen. Elizabeth Warren (D-Mass.) and Sen. John McCain (R-Ariz.) introduced a bill that would go a step beyond Dodd-Frank, reimposing Glass-Steagall Act prohibitions against banks engaging in both banking and brokerage activities. Conversely, in the House of Representatives, Republicans have introduced several bills to roll back provisions of Dodd-Frank or curb the authority or resources of various regulators.
Recently, on the same day President Obama stressed “the need to expeditiously finish implementing the critical remaining portions of Wall Street reform,” House Financial Services Committee Chairman Jeb Hensarling (R-Texas) called the Dodd-Frank Act “an incomprehensibly complex piece of legislation that is harmful to our floundering economy and in dire need of repeal.”
We all know there is no free lunch. The more stability we choose, the more we build safeguards against market disruptions and the lower our potential for economic growth. What we don’t know—and what we need to know—is how many chips we have moved from the growth side of the table to the safety and stability side of the table.
Until we do know that we are literally flying blind.
In the second part of this article, I will conclude this discussion by questioning if the financial services industry has done enough to improve ethics and reconnect with their stewardship mission, purpose and responsibilities of putting the interests of clients first.
John G. Taft is CEO of RBC Wealth Management - U.S. and author of Stewardship: Lessons Learned from the Lost Culture of Wall Street (Wiley, 2012).
Five Years After We Broke the Buck: Are We Better Off?
September 10, 2013
First of two parts.