Maryland Smith Research / April 21, 2022

The Secret Safety Net for Money Market Funds

What’s the difference between prime institutional money market funds sponsored by bank holding companies (BHCs) and those funds that aren’t? Money market funds backed by these holding companies have an inherent safety net, according to research from Maryland Smith.

It’s referred to as “shadow insurance,” which aids ailing funds by charging investors significantly higher expense ratios and paying lower net yields. There are two distinguishing features about them until the 2008 Crisis: They provided implicit access to FDIC insurance through the sponsoring BHC, and they did not have similar regulatory constraints.

Haluk Unal, professor of finance at the University of Maryland’s Robert H. Smith School of Business, along with co-author Stefan Jacewitz from the Federal Reserve Bank of Kansas and a Chengjun Wu, a PhD student in finance at Smith, developed the research and produced the paper, published in The Review of Corporate Finance Studies.

Bank holding companies don’t actually offer banking services but are overarching corporations that simultaneously operate subsidiaries that do – such as Bank of America, Citigroup and JPMorgan Chase & Co. – and uninsured nonbanks, such as insurance or brokerage services.

Looking at data from the 2008 financial crisis, the researchers found that after September 2008, the period during which industry risk was dramatically increasing with worsening economic conditions, expense ratios for bank holding company (BHC)-sponsored prime institutional money market funds (PI-MMFs) were seven basis points higher than non-BHC-sponsored MMFs.

“This increase is of similar size to the average deposit insurance premium charged by the FDIC in 2008,” the researchers write. “We also show, despite higher expense ratios, the redemptions in BHC-sponsored MMFs were lower in contrast to expectations of prior literature.”

In the United States, funds allocated in a bank, like through a money market account, are insured by the FDIC in the form of a government safety net. In 2008, the FDIC guaranteed an average of $4.6 trillion in insured deposits, while collecting $3 billion in insurance premiums – equalling the 7 basis points insurance premium per insured dollar.

With bank holding companies having no reserve or capital requirements as well as no obligation to pay fees to federal insurers against the risks assumed from sponsorship of the fund, they essentially were operating in the shadows to circumvent less favorable regulations.

“Thus, the bank sponsors benefited from potential government support without bearing any additional costs, leading to regulatory arbitrage,” the researchers write.

Similar to the 2008 financial crisis, disruptions to the money market fund industry caused by the COVID-19 pandemic have sparked policy debate related to prime institutional money market funds, write the researchers. This research may provide additional context to policymakers as it pertains to shadow insurance.

“These funds are often treated as riskless but are not federally insured and have historically faced widespread redemption of funds in times of stress presenting risks to the financial system as a whole,” the researchers write. “Once considered once-in-a-lifetime events, the MMF displacements during the pandemic were the second such event in just 15 years, following a similar disruption after the 2008 financial crisis.”

Read More: “Shadow Insurance? Money Market Fund Investors and Bank Sponsorship”, published in The Review of Corporate Finance Studies, in December 2021.

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