Last month, the Federal Reserve Bank of New York published a staff report with a very interesting proposal to reduce the systemic risk of runs on money market mutual funds (Patrick E. McCabe, Marco Cipriani, Michael Holscher and Antoine Martin, “The Minimum Balance at Risk: A Proposal to Mitigate the Systemic Risks Posed by Money Market Funds”, Federal Reserve Bank of New York, Staff Report No. 564, July 2012).
I found the proposal very innovative and my only quibble with the proposal is that I see no need at all to limit the idea to just money market mutual funds. I think that the same idea can be applied to bank deposits, liquid mutual funds and many other pools that offer high levels of liquidity.
The proposal is that when an investor redeems his or her investment, a small percentage (say 3-5%) of the investment is held back for a short period (say 30 days). If losses are detected at the fund during this period, the balance held back from the redeeming investor is available to absorb the losses. McCabe and his co-authors show that it is possible to design the loss allocation mechanism in such a way that runs on the fund are discouraged without eliminating market discipline. A fund that pursues risky investment strategies would see redemption from rational investors who anticipate losses in the long term (beyond 30 days). But investors who did not redeem before the losses are revealed do not gain anything by redeeming at the last minute. This eliminates panic runs and allows orderly liquidation.
I think this idea could be extended to bank deposits and many other savings vehicles. All “safe assets” or “informationally insensitive assets” to use Gorton’s phrase could be subject to this rule to prevent disorderly runs without requiring taxpayer bailouts.
The authors themselves suggest that small balances could be exempted from some of the subordination requirements and clearly insured deposits do not need to be subject to the minimum balance at risk requirement. The major impact of the proposal would be on large investors, and I do not believe that large investors have any god given right to safe and liquid assets. In fact, society can make such assets available to them only by imposing losses on the taxpayer.
Pozsar and Singh have pointed out that:
Asset managers do not just invest long-term, but also have a large demand for money (or more precisely, money-market instruments). … The money demand aspect of the asset management complex … involves massive volumes of reverse maturity transformation, whereby significant portions of long-term savings are transformed into short-term savings. It is due to portfolio allocation decisions, the peculiarities of modern portfolio management and the routine lending of securities for use as collateral. This reverse maturity transformation occurs in spite of the long-term investment horizon of the households whose funds are being managed. This reverse maturity transformation is the dominant source of marginal demand for money-type instruments in the financial system.
If the minimum balance at risk leads to a re-engineering of the asset management industry to reduce the demand for safe and liquid assets, I think that would be a good thing.