Shadow Banking System Emerges Unscathed

September 10, 2012

The chair of the Securities and Exchange Commission (SEC) failed to pass a proposal that would reform the $2.5 trillion money market mutual fund (MMMF) industry. This industry is the primary lifeline of the "shadow banking" industry. The shadow banking industry refers to institutions that perform banking functions but do not have the safety net associated with a traditional banking system since they are not regulated, says Economic Policies for the 21st Century.

The MMMF industry allows the issuance of money-like liabilities which allow "shadow banks" to attract deposits and operate traditional bank functions. The proposed regulations by the chair of the SEC would restrict the role of shadow banks by:

  • First, holding capital and imposing a redemption limit on investors.
  • Second, allowing net asset value to fluctuate instead of being fixed at $1 per share.
  • These reforms would reduce the perceived benefits of MMMF liabilities, which is the key attraction.

The impact of this system is that the MMMFs used to issue money-like liabilities mismatch what they own and what they owe. For instance, $474 billion of the $2.5 trillion of assets held by MMMFs consist of Treasury securities and the rest involved credit risk. Yet, the MMMFs issue refundable shares to the public at a fixed value of $1. But net asset value fell below the fixed rate of $1 per share due to Lehman commercial paper and caused panic in the sector.

Rather than letting the shadow banks fail, the federal government took several steps to save them, including:

  • $3.2 billion in bailouts from affiliated bank parents.
  • The Treasury guaranteed $2.4 trillion of MMMF liabilities.
  • The Federal Reserve created the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, which indirectly gave $150 billion in bailout funds to MMMFs.

The results of having a shadow banking industry have taught policymakers an important lesson. First, the mismatch between what MMMFs owe will inevitably result in disaster. Investors will simply run before the price of the refund drops below the fixed rate. Second, the government has to bailout in these situations because MMMFs provide short-term financing to businesses and other institutions. Failure to provide these services would have the potential to result in liquidity crises and mass defaults.

Source: "Shadow Banking System Emerges Unscathed," Economic Policies for the 21st Century, August 27, 2012.


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