Money Market Funds in the shadow…

Shadow on the MMF’s

Does the EU shift change this important class of asset sector in considering it as shadow banking? EU Regulator wants to tighten scrutiny on the Money Market Funds (MMF’s) sector. These funds come under the so-called “shadow banking”, CRD 4 reporting rules. The European Banking Authority (EBA) has announced temporary MMFs rule shift until ESMA’s sector review turns into effective law. If we consider MMFs as shadow banking entities, they will fall under the relevant banking regulations. EU banking watchdogs want to (re)define criteria to identify shadow banking entities that banks in Europe hold exposure to. They plan to report under the Capital Requirement Regulation.

Defensive products can become a danger for the economy

Obviously, among these entities, EBA has highlighted the growing importance and weight of short-term monetary funds. It is not surprising, when these funds gave signs of potential liquidity crunch at the early days of the health crisis. Therefore, they made a remarkable comeback into the global regulatory agenda. The worrying signs of problems woke up regulators’ attention. Despite the huge reform, consequence of last GFC, but achieved years later, in view of significant liquidity issues which affected the whole sector, discussions were engaged at EU and international level to contemplate ways to better protect investors by better identifying shadow banking entities.

Behind any crisis, there are opportunities

When situation is uncertain, as we faced since March 2020, these funds face huge redemption risks from investors on the liability side. But they are also exposed to severe liquidity deterioration of MMF’s vehicles on the asset side. They believe the risks have maybe not been fully covered by existing rules and prudential requirements. It requires further analysis to add the missing pieces of regulations. Any single crisis is an opportunity to revisit existing rules and adapt them accordingly. Every supervisor is afraid of the hunt for cash repayments, as we saw a year and half ago, as they could destabilize markets and create panic movements. The defensive approach of EBA consists of considering MMFs as shadow banking entities until the European Securities and Markets Authority (ESMA) will have completed an in-depth review of Short-Term Monetary Fund regulation. Of course, at best, they plan a new reform not before next Summer and likely in 2023. It will be therefore essential to keep this temporary reallocation in mind until the whole reform is set up.

Consequences for bankers?

By including these funds under shadow banking requirements, the FC’s exposed to these MMF’s will be required to comply with the stricter CRR rules, especially around capital exposure limits provisions. In terms of risk reporting, it will consequently increase disclosures to prevent contagion and credit risks. However, increasing reporting and disclosures is not always the best response to problems. As said, sometimes it is better to leave well enough alone.

Preventing risks without killing an industry

Paradoxically, MMF’s before the last GFC were considered as low risk investments. Then they fall under scrutiny as they contributed to the leverage of financial systems. A low-risk investment (as assimilated to “cash and cash equivalent under IAS 7) suddenly became a risky asset by the fast and massive potential exits or redemptions. They feared financial runs and cascading effects they could initiate. Each financial crisis, although the last one came from a pandemic, reactivate worries of liquidity crunches. Financial Stability Board (FSB) and the International Organization of Securities Commissions (IOSCO) are always pushing for stronger policies and better controls on MMFs. We can understand risks and fears from international Supervisors. However, the prevention of risks should not drive regulators to impose unpracticable rules and destroy useful assets and a huge industry. Over last crises, they have proved a certain resilience, reinforced by recent reforms. Not going too far will be the challenge.

F. Masquelier – ATEL  August 2021