Money Markets and the Purpose of Banking

Matt Yglesias is annoyed that people have forgotten about the run on money market funds touched off by the failure of Lehman Brothers in September of 2008.

There’s a good reason people have forgotten about that little incident: because people are terrifically bored with anything to do with how finance works. But come on – make an effort, people!

When people talk about the “shadow banking system” that threatened to overwhelm the, I don’t know, “in broad daylight” banking system, it sounds like they are talking about something obscure. But what we’re talking about is stuff like money market funds. Boring, ordinary money-market funds.

Money market funds buy commercial paper, corporate debt that matures within 270 days. Generally, the average maturity is much less than that. A money market fund is thus a classic mechanism for disintermediation of the financial system.

If you didn’t have money market funds, corporations would borrow short-term through a bank line of credit. The bank, in turn, would be able to provide this line of credit because it had a large, stable base of deposits – stable, in part, because of FDIC insurance. And the bank earned a spread for taking the credit risk of lending to the corporation, earning more on that line of credit than they paid in interest on deposits.

Money market funds take the bank out of the equation. The corporation may or may not still have a line of credit, but that’s now just for emergencies. For routine short-term funding needs, they just issue commercial paper, which is purchased by money market funds. The corporation is taking a bit more risk – the CP market just might be closed to them if they run into trouble, whereas the bank (hopefully) knows their business well and can make a less-panicked judgment. In return, they pay less interest on CP than they do in interest and fees for a line of credit. The investor is taking a bit more risk – instead of an insured deposit, they’ve got an uninsured fund. No problem so long as markets function efficiently – but in a crisis, if the CP market should shut down, it may be impossible to get your money back – exactly what happens in a bank run which FDIC insurance is intended to prevent, and exactly what happened in September, 2008. In return for taking this additional risk, the investor gets a higher interest rate than that generally available from a bank deposit.

Once you’ve created the CP market, of course, anyone can use it. And since issuing CP is similar to creating a deposit base – in both cases, you’re “borrowing short” – anybody with a CP program get then start “lending long” and become a quasi bank. Voila: a shadow banking system. And, of course, once the system is in place, anybody can use it, including special purpose vehicles that enable banks to expand their balance sheets invisibly, and investment banks that can effectively compete with Fed-regulated banks in variations on their historic lending businesses, and so forth. By the time of the crisis, the “shadow” banking system was as important as ordinary deposits in funding actual FDIC-insured banks, to say nothing of the vast universe of financial institutions that are not banks.

Matt talks about TARP and the AIG bailout as responses to the collapse of the CP market and the runs on money market funds, but it’s worth pointing out that the AIG bailout was over-determined and was basically agreed upon before the CP market froze, and that TARP, a bailout of banks, wasn’t directly relevant to the money market funds problem at all. The more direct actions taken were: the Fed intervened to buy enormous amounts of commercial paper, basically becoming the only buyer in that market, and the government temporarily guaranteed money-market funds as if they were bank deposits, a guarantee that expired in September of 2009.

What happened since then is FinReg, which changed the assessment base for charging deposit insurance fees. Basically, the idea is that right now, banks have an incentive to seek other forms of funding than deposits (such as the issuance of CP) because deposits cost them for FDIC insurance while other forms of funding do not. If they were charged on some other measure of liabilities than just deposits, that would be an incentive to seek deposits rather than fund through CP or repo or other uninsured means. That, in turn, is supposed to make banks more stable. The FDIC is still working on new guidelines and, I believe, is moving in the direction of a risk-based calculus for deposit insurance that would in some ways mimic the Basel process for calculating capital requirements, something that would give banks credit for improving their liquidity and that would penalize them for entering into funding arrangements that are less liquid.

Will this make banks safer? Well, to the extent that it reduces bank reliance on CP and induces them to collect more good-old-fashioned deposits, probably. But whether that makes the financial system safer depends on what else happens – whether, for example, you’ve created a big incentive for other entities that don’t pay deposit insurance to get into businesses that compete with insured banks by utilizing the funding mechanisms that have now become more expensive for the banks to use.

My point isn’t to say that money market funds are bad, or that shadow banking is bad, or really that anything is bad. My point is just this: innovations like money market funds that consumers take for granted are part of the new financial system that is so much more difficult to regulate precisely because it is not directly tied to the deposit base of banks. And I don’t think that’s something most people are aware of.