5. Liability Connectedness: Money Market Funds and Tri-Party Repo Market

Modern financial markets are a highly complex system of financial institutions with a high degree of interdependence and interconnections. Financial institutions are not only connected through exposure on the asset side of the balance sheet but also on the liability side through funding relationships, referred to herein as “liability connectedness,” as discussed earlier.

Lehman’s failure did not present liability connectedness issues, primarily because Lehman was not a significant funder of the US financial system. The money market funds, which some have suggested are important sources of liability connectedness, as substantial investors in the short-term liabilities of banks, were not, in my view, a significant source of systemic risk. Liability connectedness becomes a problem when one institution’s failure (a funder) and consequent cessation of funding of other financial institutions (borrowers), through a variety of forms, including loans, commercial paper purchases or repos impacts the ability of borrowing institutions’ ability to fund their operations. Economic theory has explored the network effects of interbank lending, examining both direct funding links between banks (e.g., Bank A lends directly to Bank B)1 and indirect liquidity links through common exposure to aggregate funding (e.g., Bank A and Bank B both contribute to and rely on an aggregate liquidity market).2 In general, in this context, network theory studies the tendency of a decision by a single bank to hoard liquidity to propagate to other connected banks throughout the financial system. A review of the literature was provided earlier in this book.

The Lehman failure did not did not directly lead to failures of other financial institutions via liability connectedness because Lehman was not among the most significant providers of short-term funding to the financial industry. At the time of its fall, Lehman held $4.8 billion of commercial paper and other money market instruments in aggregate,3 representing only 0.27 percent of all commercial paper in 20084 and only 0.61 percent of financial commercial paper.5 Furthermore, in the repo market, Lehman held $170 billion of repos,6 which is estimated to be only 1.7 percent of the total repo market.7

5.1  Money Market Funds and Liability Connectedness

Prime money market mutual funds invest heavily in the short-term debt of large global banks and thus have been widely considered a potential source of liability connectedness risk. David S. Scharfstein of Harvard Business School testified before the Senate Committee on Banking, Housing, and Urban Affairs that as of May 2012, of the roughly $1.4 trillion in prime money market fund assets, approximately 22 percent was invested in government-backed securities, 3 percent in nonfinancial firm securities, and the remaining 75 percent in the money market instruments of global banks.8 Indeed, of the top 50 nongovernment issuers whose obligations are held in prime MMF portfolios, 48 are financial institutions.9 However, while the importance of global banks to the balance sheets of money market funds is indisputable, the role of money market funds as a transmission mechanism for systemic risk via the provision of short-term funding to these banks has been vastly overstated.

Systemically important banks are not dependent on money market funds for funding. Scharfstein has estimated that prime money market funds are responsible for 25 percent of the aggregate short-term wholesale funding of large financial firms, where such funding is defined as uninsured domestic deposits, primary dealer repos, and financial commercial paper.10 However, this definition excludes insured deposits and any long-term funding. Similarly a FRBNY Staff Report suggests that the money market industry’s role as funder of the financial system is a significant source of instability, citing, for example, that prime funds hold 43 percent of the total volume of financial commercial paper in the United States.11 Then again, the mere fact that money market funds hold a large percentage of the outstanding financial commercial paper does not imply that the funds represent a significant funding source from the perspective of a particular recipient financial institution.

The Investment Company Institute has estimated that money market funds provide only approximately 2.4 percent of total funding (including insured deposits and long-term liabilities) to US banks with over $10 billion in assets.12 Recent data suggest that individual large US banks’ reliance on funding from US prime money market funds is limited. Such funds provided no more than 3.0 percent of funding as a percentage to any of the largest foreign or domestic banking groups as of June 30, 2013.13 Table 5.1 shows the low level of dependence on money market funds as a percent of total funding for several of the largest US banks as of June 30, 2007, prior to the financial crisis. Baba et al. (2009) find that European banks also relied on US prime money market funds to finance large portfolios of dollar-denominated assets.14 However, even foreign banks’ reliance on US prime money market funds is now limited. As demonstrated in table 5.1, EU banks’ reliance on US prime money market funds has declined since US prime money market funds reduced their exposure to European banks following the 2011 eurozone crisis.15

Regardless of the importance of money market funding to the financial system in aggregate, the liability connectedness concerns that may arise from a sudden loss of this funding depends on the extent to which individual significant banks rely on prime funds. If an important financial institution were to draw a substantial portion of its funding from money market funds, then a collapse of the fund industry could theoretically lead that institution to the brink of collapse. The liability connectedness of the fund industry would in such a case become a significant source of systemic risk. Considering that large banks have balance sheets typically exceeding $1 trillion and that Rule 2a-7 permits a given money market fund to invest up to only 5 percent of its assets in the securities of an individual issuer, losing funding from a single institutional prime fund complex alone could not in itself endanger a large bank.

Table 5.1

Select US financial institutions’ reliance on US prime money market mutual funds in June 2007

Select European financial institutions’ reliance on US Prime Money Market Mutual Funds in June 2013

a. Methodological note: Aggregate data regarding prime money market funds’ asset holdings was not available prior to the financial crisis. In order to determine prime money market fund asset holdings as of June 30, 2007, we searched Form N-CSRs, the semi-annual reports by registered investment companies. This allowed us to review the asset holdings of prime money market funds with total assets of $1.05 trillion. However, based on iMoneyNet, the prime fund industry had aggregate assets of $1.65 trillion as of June 30, 2007. Thus, for the remaining $600 billion in prime fund assets that we were unable to identify, we assumed that these prime funds had invested in each of the largest US banks as much as legally allowed (5 percent of total money market fund assets). We were, however, unable to get data on the investments of European banks as of June 2007.

b. Crane data (Jun. 30, 2013), available at http://cranedata.com.

5.2  Tri-Party Repo Market and Liability Connectedness

The tri-party repo market, in which sellers trade securities (collateral) to buyers in exchange for cash with an agreement to return the cash and get back their securities at an agreed date, is a large and important source of short-term funding for securities dealers who need short-term cash to fund their positions; consequently, this market is a potential source of systemic risk through the resultant liability connectedness.16 As of October 2013, the total value of the tri-party repo market was approximately $1.6 trillion with approximately 81 percent involving treasuries or agency securities.17 The total value of tri-party repo market peaked in 2008 at approximately $2.8 trillion.18 Repos constitute a significant portion of the funding for large US financial institutions. As a percentage of total assets at the end of 2014, repos accounted for 10.3 percent of Goldman Sachs’ funding, 6.5 percent of JPMorgan’s, 8.0 percent of Citigroup’s, 9.6 percent of Bank of America’s, and 8.7 percent of Morgan Stanley’s.19

In the repo market, the repo seller—the party receiving cash—pays the repo buyer—the supplier of the cash—a return that reflects the low level of risk due to the posting of the securities as collateral.20 In the tri-party repo market, a clearing bank both supplies cash to the seller and holds the securities on behalf of the buyer. Because it may not receive both cash and securities simultaneously, from the two parties to the transaction, the clearing bank is thus exposed to potential losses in the event that either side of the repo were to default.21 This phenomenon is referred to as “intraday credit risk.” In the United States, two banks, JPMorgan Chase and BNY Mellon, serve as the clearing banks in the tri-party repo market.

In the wake of the financial crisis, the FRBNY has sponsored an industry-led effort to study the problem of the concentration of a dangerous amount of counterparty risk on the two clearing banks.22 Significantly, in 2009, the FRBNY established the Tri-Party Repo Infrastructure Reform Task Force.23 Since then, the task force has convened workshops and issued a series of reports recommending ways to reduce intraday credit dependence, and thus the exposure of the clearing banks.24 The FRBNY also released its own white paper in May 2010, discussing possible reforms.25 Since the establishment of the task force, several concrete steps have been taken to reduce intraday credit exposures. First, the two clearing banks have implemented various collateral optimization capabilities that reduce intraday credit exposures.26 The task force has already met its goal of reducing the share of tri-party repo volume that is financed with intraday credit from a clearing bank: today, 3 to 5 percent of tri-party repos are financed with intraday credit, compared to 100 percent in 2012. 27 Second, the daily “unwind” of most tri-party repo transactions has been moved from early morning to midafternoon, reducing the duration of intraday credit extensions.28 Third, many dealers have undertaken efforts to reduce their reliance on intraday funding in accordance with Basel III liquidity regulations.29 Finally, both clearing banks are implementing key changes in their respective settlement processes. These changes are expected to reduce intraday credit risk further while improving the resiliency of the settlement process.30

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While the deeper integration of modern financial markets has been said to lead to a “robust-yet-fragile” system, neither the Lehman’s failure nor the runs on MMF presented important liability connectedness risks, primarily because neither Lehman nor money market funds were significant funders of major banks. However, the tri-party repo market remains a liability connectedness risk.