Recently at a Fed conclave in Atlanta entitled, “Central Banking in the Shadows: Monetary Policy and Financial Stability Postcrisis,” academics and market practitioners offered thoughts on the evolution and importance of the “shadow banking” sector ‒ the wide range of lending and funding vehicles that perform some of the functions of banks but do not fall under banking regulation. Since the financial crisis, shadow banks have gone from the murky shadows to the shining spotlight of finance.
Many people associate shadow banking with money market funds. Since the crisis, regulators have been working on new rules for money market funds to prevent a repeat of 2008, when the Reserve Primary Fund, the oldest money market fund, “broke the buck.” Most recently, the SEC has announced reforms for the industry that will take effect in 2016 and will dramatically alter the liquidity features (via withdrawal gates and redemption fees) and valuation structures (via floating net asset values) of prime money market funds, which can invest in credit securities in addition to government bonds.
The likely impact of the new regulations will be a significant shift in investor assets from prime funds to government-only funds, which should accomplish the Fed’s and regulators’ mutual goal of mitigating excess credit risk-taking in money markets. However, the unintended consequence will be to dramatically increase demand for the safest front-end government assets such as T-bills, Treasuries, repurchase agreements and agency debentures. These same securities will also see a significant pick-up in demand due to the increased need for collateral at derivatives clearing houses and for alternatives to bank deposits as banks look to reduce institutional depository balances.
As a result, short-term government assets ‒ and the strategies that invest in them, namely 2a-7 money market funds ‒ will likely continue to offer little compensation (yield) to investors even as the Fed starts to recalibrate rates higher. With an eye toward better controlling front-end rates, the Fed introduced its reverse repo facility (RRP) in 2013, but it has so far shown a reluctance to utilize the facility to its full potential, and at its current size and with its limited number of counterparties, the RRP does not do enough to meet the increased demand for short-term government assets.
When the time comes to raise the fed funds target rate, the Fed will likely expand the RRP, and it should become an effective tool for lifting front-end rates. Ironically, though, the Fed will be relying on the shadow banking system that it has sought to curtail.