Volcker's crusade to rein in money market funds

For 30 years, Paul Volcker, the former chairman of the Federal Reserve, hasn't concealed his distaste for money market mutual funds. As chairman of President Obama's Economic Recovery Advisory Board, he may finally have the power he needs to impose regulations on money market funds that would make them operate more like banks.

Volcker told Bloomberg in an interview that he does think they play a major role in the commercial paper market, but that they are just funneling money that should go to the banks.

Money market mutual funds developed into a $3.5 trillion dollar market outside of the regulated banking industry. They provide short-term funding to thousands of companies and financial institutions at rates below those the banks can offer as conventional loans. But, the reason they can offer those better deals is because they aren't bound by the same regulations as the banks, which include federal insurance requirements and reserve requirements, yet they can offer a guaranteed $1 NAV, which makes them at least appear as safe as a bank deposit.

But now that the money mutual fund market is so large it can significantly impact the financial system. For example when the $62.5 billion Reserve Primary Fund collapsed in September 2008, investors ran from the funds. That in turn froze the commercial paper market and threatened many businesses with a cut off of their funds.

The mutual funds held approximately $578.7 billion or 41 percent of outstanding commercial loans as of March 31, according to Fed data. Commercial banks hold the rest. As of August 12, Fed data shows that commercial banks held $1.46 trillion in outstanding commercial and industrial paper. In addition to commercial paper funds also buy bank-issued securities such as certificates of deposits and repurchase agreements.

In interviews with Bloomberg the mutual fund trade group said that Volcker's proposals would eliminate funds as we know them. Fidelity manages the largest potion of money market mutual funds with $506.3 billion as of July 31, according to Crane Data. BlackRock (BLK) and Vanguard are two other major players in this market place. JP Morgan Chase (JPM) is the largest player on the banking side with $390.3 billion in money-fund assets.

So far, the SEC has not proposed drastic changes. On June 24 the changes proposed were in line with what the mutual fund industry recommended. But, a second, possibly more critical hurdle, approaches on Sept. 15. That's when the President's Working Group on Financial Markets will release a report on the industry. The Obama administration asked the group to consider whether money-market funds should be forced to abandon the practice of maintaining a $1 net asset value (NAV) or be required to set up "emergency liquidity facilities." Volcker said he is not involved directly with the group in his Bloomberg interview.

Even if Volcker does win out with his plans to impose more regulation on money-market mutual funds, it won't be the death of the industry, but it will likely result in their being less popular. With more regulation, their returns probably will be closer to those of the banks. But, if regulated than the money-market mutual funds should also be able to offer FDIC guarantees as do the banks. Do we really want to put any more burden on the FDIC insurance fund at this time? Or would the new fees generated help to bridge the gap now in the insurance fund following 101 bank failures this year?

Lita Epstein has written more than 25 books including The Complete Idiot's Guide to the Federal Reserve and Reading Financial Reports for Dummies.

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