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Testimony of Paul Schott Stevens President and CEO Investment Company Institute on “Investor Protection and the Regulation of Securities Markets” before the Committee on Banking, Housing, and Urban Affairs, United States Senate
March 10, 2009
Table of Contents
II. Financial Services Regulatory Reform
Overview of ICI Recommendations
Systemic Risk Regulator
Capital Markets Regulator
Expected Benefits of These Reforms
III. Selected Other Areas for Reform
Hedge Funds and Other Unregulated Private Pools of Capital
Investment Advisers and Broker-Dealers
IV. Recent Market Events and Money Market Funds
Evolution and Current Significance of Money Market Funds
Impact of Recent Market Events
Actions by Federal Regulators to “Unfreeze” the Credit Markets
Industry-Led Reform Initiative
Thank you, Chairman Dodd, Senator Shelby, and members of the Committee. On behalf of ICI and its members, who serve more than 93 million American investors, I am pleased to have this chance to appear today.
We strongly commend the Committee for the attention it has devoted to improving our system of financial regulation. The current financial crisis provides a public mandate for Congress and regulators to take bold steps to strengthen and modernize regulatory oversight. Like other stakeholders, we have been thinking hard about how to revamp our current system to meet these goals. Last week, ICI published a white paper detailing a variety of reforms. In it, ICI recommends changes to create a regulatory framework that provides strong consumer and investor protections, while also enhancing regulatory efficiency, limiting duplication, closing regulatory gaps, and emphasizing the national character of financial services. I’d like briefly to summarize our proposals for you.
First, we believe it is crucial to improve the government’s capability to monitor and mitigate risks across the financial system. So ICI supports creation of a “Systemic Risk Regulator.” This could be a new or existing agency or inter-agency body responsible for:
- Monitoring the financial markets broadly;
- Analyzing changing conditions, here and overseas;
- Evaluating and identifying risks that are so significant that they implicate the health of the financial system, and
- Acting in coordination with other responsible regulators to mitigate these risks.
In our white paper, we stress the need to carefully define the responsibilities of the Systemic Risk Regulator, as well as its relationships with other regulators. Addressing systemic risk effectively need not and should not mean stifling innovation, retarding competition, or compromising market efficiency.
Second, we urge the creation of a new Capital Markets Regulator that would encompass the combined functions of the Securities and Exchange Commission and the Commodity Futures Trading Commission. The Capital Markets Regulator’s statutory mission should focus sharply on investor protection and law enforcement. It should also have a mandate to consider whether its proposed regulations promote efficiency, competition, and capital formation. We suggest several ways to maximize the effectiveness of the Capital Markets Regulator, including a high-level focus on agency management and mechanisms to stay abreast of market and industry developments.
Third, as we discuss more fully in our white paper, effective oversight of our financial system and mitigation of systemic risk will require effective coordination and information sharing among the Systemic Risk Regulator, the Capital Markets Regulator, and regulators for other financial sectors.
Fourth, we have identified areas where the Capital Markets Regulator needs specific legislative authority to protect investors and the markets by closing regulatory gaps and responding to changes in the marketplace. In my written statement, I identify four such areas:
- Hedge funds;
- Municipal securities, particularly to improve disclosure; and
- The inconsistent regulatory regimes for investment advisers and broker-dealers.
As for mutual funds, they have not been immune from the effects of the financial crisis, any more than other investors. But our regulatory structure, which grew out of the New Deal as a result of the last major financial crisis, has proven remarkably resilient. Under the Investment Company Act of 1940 and other securities laws, fund investors enjoy a range of vital protections:
- Daily pricing of fund shares, with mark-to-market valuation;
- Separate custody of fund assets;
- Minimal use of leverage;
- Restrictions on affiliated transactions and other forms of self-dealing;
- Required diversification, and
- The most extensive disclosure requirements faced by any financial product.
Funds have embraced this regulatory regime and prospered under it. Indeed, recent experience suggests that policymakers should consider extending some of these same disciplines to other marketplace participants.
Finally, let me comment briefly on money market funds. Last September, immediately following the bankruptcy of Lehman Brothers, a single money market fund was unable to sustain its $1.00 per share net asset value. Coming hard on the heels of a series of other extraordinary developments that roiled global financial markets, these events worsened an already severe credit squeeze. Investors feared that other wondered what major financial institution might fail next and how other money market funds might be affected. Concerned that the short-term fixed-income market was all but frozen, the Federal Reserve and the Treasury Department took a variety of initiatives, including establishment of a Temporary Guarantee Program for Money Market Funds.
These steps have proven highly successful. Over time, investors have regained confidence. As of February, assets in money market funds were at an all-time high, almost $3.9 trillion.
The Treasury Temporary Guarantee Program will end no later than September 18. Funds have paid more than $800 million in premiums, yet no claims have been made—and we do not expect any. We do not envision any future role for federal insurance of money market fund assets, and look forward to an orderly transition out of the Temporary Guarantee Program.
The events of last fall were unprecedented. But it is only responsible that we, the fund industry, look for lessons learned. So in November 2008 ICI formed a working group of senior fund industry leaders to study ways to minimize the risk to money market funds of even the most extreme market conditions. That group will issue a strong and comprehensive set of recommendations designed, among other things, to enhance the way money market funds operate. We expect that report by the end of this month, and we hope to place the Executive Summary in the record of this hearing.
Chairman Dodd, Senator Shelby, and members of the Committee, thank you again for this opportunity. I look forward to your questions.
Overview: Recommendations for Financial Services Regulatory Reform
- The current financial crisis provides policymakers with the public mandate needed to take bold steps to strengthen and modernize our financial regulatory system. It is imperative to registered investment companies (also referred to as “funds”), as both issuers of securities to investors and purchasers of securities in the market, that the regulatory system ensure strong investor protection and foster competition and efficiency in the capital markets. The ultimate outcome of reform efforts will have a direct and lasting effect on the fund industry and the millions of investors who choose funds to help them save for the future.
- As detailed in a recently released white paper (attached as Appendix A), ICI recommends: (1) establishing a Systemic Risk Regulator; (2) creating a Capital Markets Regulator representing the combined functions of the Securities and Exchange Commission and the Commodity Futures Trading Commission; (3) considering consolidation of the bank regulatory structure and authorization of an optional federal charter for insurance companies; and (4) enhancing coordination and information sharing among federal financial regulators.
- If enacted, these reforms would improve regulators’ capability to monitor and mitigate risks across the financial system, enhance regulatory efficiency, limit duplication, close regulatory gaps, and emphasize the national character of the financial services industry.
Systemic Risk Regulator
- The Systemic Risk Regulator should have responsibility for: (1) monitoring the financial markets broadly; (2) analyzing changing conditions in domestic and overseas markets; (3) evaluating the risks of practices as they evolve and identifying those that are of such nature and extent that they implicate the health of the financial system at large; and (4) acting in coordination with other responsible regulators to mitigate such risks.
- Careful consideration should be given to how the Systemic Risk Regulator will be authorized to perform its functions and its relationship with other, specialized regulators.
Capital Markets Regulator
- The Capital Markets Regulator should have oversight responsibility for the capital markets, market participants, and all financial investment products. It should be the regulatory standard setter for funds, including money market funds.
- The agency’s mission should focus on investor protection and law enforcement, as well as maintaining the integrity of the capital markets. Like the SEC, it should be required to consider whether proposed regulations protect investors and promote efficiency, competition, and capital formation.
- The Capital Markets Regulator should be an independent agency, with the resources to fulfill its mission and the ability to attract experienced personnel who can fully grasp the complexities of today’s markets. ICI’s white paper offers recommendations for organizing and managing the new agency and for how the agency can maximize its effectiveness.
Selected Other Areas for Reform
- The Capital Markets Regulator should have express authority to regulate in areas where there are currently gaps that have the potential to impact the capital markets and market participants, and to modernize regulation that has not kept pace with changes in the marketplace. These areas include: (1) hedge funds; (2) derivatives; (3) municipal securities; and (4) the regulation of investment advisers and broker-dealers.
Recent Market Events and Money Market Funds
- Money market funds, stringently regulated by the SEC, are one of the most notable product innovations in American history. These funds—which seek to offer investors stability of principal, liquidity, and a market-based rate of return, all at a reasonable cost—serve as an effective cash management tool for retail and institutional investors, and are an exceptionally important source of short-term financing in the U.S. economy.
- Until September 2008, money market funds, in some cases with support from their sponsors, largely weathered severe pressures in the fixed income markets that had been striking banks and other financial services firms since 2007. In mid-September, a series of extraordinary developments, including the failure of Lehman Brothers, roiled financial markets around the globe, affecting all market participants. In the midst of this market storm, one money market fund holding a substantial amount of Lehman commercial paper was unable to sustain its $1.00 price per share. The news of this fund “breaking the buck,” combined with broader concerns about the building stresses in the money market and possible failures of other financial institutions, led to heavy redemptions in prime money market funds as investors sought safety and liquidity in Treasury securities.
- Unprecedented government initiatives—designed to provide stability and liquidity to the markets and to support money market funds—successfully bolstered investor confidence. To date, the Treasury Temporary Guarantee Program for Money Market Funds has received no claims for its guarantee, and none are anticipated. Assuming continued progress in restoring the health of the money market, there will be no need to extend the Temporary Guarantee Program beyond its current one-year maximum period.
- To capture the lessons learned from recent experience, ICI formed a Money Market Working Group of senior fund industry leaders, led by John J. Brennan of The Vanguard Group. The Working Group has conducted a thorough examination of how the money market can function better, and how all funds operating in that market, including registered money market funds, should be regulated. The Working Group intends to report its findings, conclusions, and recommendations later this month. We believe that prompt implementation of its recommendations will help assure a smooth transition away from the Temporary Guarantee Program.
My name is Paul Schott Stevens. I am President and CEO of the Investment Company Institute, the national association of U.S. investment companies, including mutual funds, closed-end funds, exchange-traded funds (ETFs), and unit investment trusts (UITs). Members of ICI manage total assets of $9.88 trillion and serve over 93 million shareholders. ICI is pleased to testify today about investor protection and the regulation of securities markets.
This hearing takes place at a time when the United States and a host of other nations are grappling with the most significant financial crisis in generations. In this country, the crisis has revealed significant weaknesses in our current system for oversight of financial institutions. At the same time, it offers an important opportunity for robust dialogue about the way forward. And it provides policymakers with the public mandate needed to take bold steps to strengthen and modernize regulatory oversight of the financial services industry. We strongly commend this Committee for the substantial attention it is devoting to examining the causes of the current crisis and considering how the regulatory system can best be improved, with particular focus on protecting consumers and investors.
It is no exaggeration that the ultimate outcome of these reform efforts will have a direct and lasting impact on the future of our industry. By extension, the decisions you make will affect the millions of American investors who choose registered investment companies (also referred to as “funds”) as investment vehicles to help them meet the costs of college, their retirement needs, or other financial goals. Funds themselves are among the largest investors in U.S. companies, holding about one quarter of those companies’ outstanding stock. Funds also hold approximately 40 percent of U.S. commercial paper, an important source of short-term funding for corporate America, and more than one third of tax-exempt debt issued by U.S. municipalities. It is thus imperative to funds, as both issuers of securities to investors and purchasers of securities in the market, that our financial regulatory system ensure strong protections for investors and foster competition and efficiency within the capital markets.
Like other stakeholders, we have been thinking very hard about how to revamp our current system so that our nation emerges from this crisis with stronger, well-regulated institutions operating within a fair, efficient, and transparent marketplace. Last week, ICI released a white paper outlining detailed recommendations on how to reform the U.S. financial regulatory system, with particular emphasis on reforms most directly affecting the functioning of the capital markets and the regulation of investment companies.1 Section II of my testimony provides a summary of these recommendations.
In addition to demonstrating the need to reform our financial regulatory system, events of the past year have highlighted the need for greater protections for both investors and the marketplace in several specific areas. Section III of my testimony outlines ICI’s recommendations for legislative authority to address certain regulatory gaps that have the potential to affect the capital markets and market participants, and to modernize regulation that has not kept pace with changes in the marketplace.
Finally, as discussed in Section IV of my testimony, events of the past year have brought into sharp focus the significance of money market funds and the critical role they play as a low-cost funding vehicle for the American economy. While the regulatory regime for money market funds has proven to be flexible and resilient, lessons learned from recent events suggested the need for a thorough examination of how the money market can function better and how all funds operating in that market should be regulated. To that end, ICI last November formed a working group of senior fund industry leaders with a broad mandate to develop recommendations in these areas. The Money Market Working Group is chaired by John J. Brennan, Chairman of The Vanguard Group, and expects to issue a detailed report by the end of March. We would welcome the opportunity to discuss with this Committee the recommendations of the Money Market Working Group following the release of its report.
Broadly speaking, ICI recommends changes to our regulatory structure that would create a framework to enhance regulatory efficiency, limit duplication, close regulatory gaps, and emphasize the national character of the financial services industry. To improve the government’s capability to monitor and mitigate risks across the financial system, ICI supports the designation of a new or existing agency or inter-agency body as a “Systemic Risk Regulator.” A new “Capital Markets Regulator” should encompass the combined functions of the Securities and Exchange Commission and the Commodity Futures Trading Commission, thus creating a single independent federal regulator responsible for oversight of U.S. capital markets, market participants, and all financial investment products. ICI further recommends that Congress consider consolidating the regulatory structure for the banking sector and authorizing an optional federal charter for insurance companies. Such a regulatory framework—with one or more dedicated regulators to oversee each major financial services sector—would maintain specialized regulatory focus and expertise, as well as avoid the potential for one industry sector to take precedence over the others in terms of regulatory priorities or the allocation of resources.
To ensure the success of this new financial regulatory structure, there must be effective coordination and information sharing among the financial regulators, including in particular the Systemic Risk Regulator. Stronger links among these regulators should greatly assist in developing sound policies and should facilitate U.S. cooperation with the international regulatory community. In our white paper, we discuss why the President’s Working Group on Financial Markets, with certain modifications, may be the most logical mechanism through which to accomplish these purposes.
The current financial crisis has exposed the vulnerability of our financial system to risks that have the potential to spread rapidly throughout the system and cause significant damage. Analyses of the causes of the current crisis suggest that systemic risks may be occasioned by, for example, excessive leveraging, lack of transparency regarding risky practices, and gaps in the regulatory framework.
ICI agrees with the growing consensus that our regulatory system needs to be better equipped to anticipate and address systemic risks affecting the financial markets. Some have called for the establishment of a “Systemic Risk Regulator.” Subject to important cautions, ICI supports designating a new or existing agency or inter-agency body to serve in this role. We recommend that the Systemic Risk Regulator have responsibility for: (1) monitoring the financial markets broadly; (2) analyzing changing conditions in domestic and overseas markets; (3) evaluating the risks of practices as they evolve and identifying those that are of such nature and extent that they implicate the health of the financial system at large; and (4) acting in coordination with other responsible regulators to mitigate such risks.
The specifics of creating and empowering the Systemic Risk Regulator will require careful attention. By way of example, to perform its monitoring functions, this regulator likely will need information about a range of financial institutions and market sectors. The types of information that the regulator may require, and how the regulator will obtain that information, are just two of the discrete issues that will need to be fully considered.
In ICI’s view, legislation establishing the Systemic Risk Regulator should be crafted to avoid imposing undue constraints or inapposite forms of regulation on normally functioning elements of the financial system, or stifling innovations, competition, or efficiencies. For example, it has been suggested that a Systemic Risk Regulator could be given the authority to identify financial institutions that are “systemically significant” and to oversee those institutions directly. Despite its seeming appeal, such an approach could have very serious anticompetitive effects if the identified institutions were viewed as “too big to fail” and thus judged by the marketplace as safer bets than their smaller, “less significant” competitors.
Additionally, the Systemic Risk Regulator should be carefully structured so as not to simply add another layer of bureaucracy or to displace the primary regulators responsible for capital markets, banking, or insurance. Legislation establishing the Systemic Risk Regulator thus should define the nature of the relationship between this new regulator and the primary regulators for these industry sectors. The authority granted to the Systemic Risk Regulator should be subject to explicit limitations, and the specific areas in which the Systemic Risk Regulator and the primary regulators should work together will need to be identified. We believe, for example, that the primary regulators have a critical role to play as the first line of defense for detecting potential risks within their spheres of expertise.
Currently, securities and futures—and their respective markets and market participants—are subject to separate regulatory regimes under different federal regulators. This system reflects historical circumstances and is out of step with the increasing convergence of these two industries. It has resulted in jurisdictional disputes, regulatory inefficiency, and gaps in investor protection. To bring a consistent policy focus to U.S. capital markets, ICI recommends the creation of a Capital Markets Regulator as a new agency that would encompass the combined functions of the SEC and the CFTC. As the federal regulator responsible for overseeing the capital markets and all financial investment products, the Capital Markets Regulator—like the SEC and the CFTC—should be established as an independent agency, with an express statutory mission and the rulemaking and enforcement powers necessary to carry out that mission.
It is critically important that the Capital Markets Regulator’s statutory mission focus the agency sharply on investor protection and law enforcement, as distinct from the safety and soundness of regulated entities. At the same time, the Capital Markets Regulator (like the SEC today) should be required to consider, in determining whether a proposed regulation is consistent with the public interest, both the protection of investors and whether the regulation would promote efficiency, competition, and capital formation. The Capital Markets Regulator’s mission also should include maintaining the integrity of the capital markets, which will benefit both market participants and consumers. Congress should ensure that the agency is given the resources it needs to fulfill its mission. Most notably, the Capital Markets Regulator must have the ability to attract personnel with the necessary market experience to fully grasp the complexities of today’s global marketplace.
ICI envisions the Capital Markets Regulator as the regulatory standard setter for registered investment companies, including money market funds (as is the case now with the SEC). In so authorizing this new agency, Congress would be continuing the important benefits that have flowed from the shared system of federal and state oversight established by the National Securities Markets Improvement Act of 1996. Under this system, federal law governs all substantive regulation of investment companies, and states have concurrent authority to protect against fraud. We believe that this approach is consistent with the national character of the market in which investment companies operate and would continue to achieve the regulatory efficiencies Congress intended, without compromising investor protection in any way.
The Capital Markets Regulator should continue to regulate registered investment companies under the Investment Company Act of 1940. While funds are not immune to problems, the substantive protections embodied in the Investment Company Act and related rules have contributed significantly to the protection of investors and the continuing integrity of funds as an investment model. Among these protections are: (1) daily pricing and redeemability of the fund’s shares, with a requirement to use mark-to-market valuation; (2) separate custody of fund assets (typically with a bank custodian); (3) restrictions on complex capital structures and leveraging; (4) prohibitions or restrictions on affiliated transactions and other forms of self-dealing; and (5) diversification requirements. In addition, funds are subject to more extensive disclosure and transparency requirements than any other financial product. This regulatory framework has proven resilient through difficult market conditions, and has shielded fund investors from some of the problems associated with other financial products and services. Indeed, recent experience suggests that consideration should be given to extending the greater discipline that has worked so well in core areas of fund regulation—such as valuation2, independent custody, affiliated transaction prohibitions, leveraging restrictions, diversification, and transparency—to other marketplace participants.
With the establishment of a new Capital Markets Regulator, Congress has a very valuable opportunity to “get it right” in terms of how the new agency is organized and managed. Our white paper outlines several recommendations in this regard, including the need for high-level focus on management of the agency. We stress the importance, for example, of the agency’s having open and effective lines of internal communication, mechanisms to facilitate internal coordination and information sharing, and a comprehensive process for setting regulatory priorities and assessing progress.
ICI’s white paper also suggests ways in which the Capital Markets Regulator would be able to maximize its effectiveness in performing its responsibilities. I would like to highlight two of the most significant suggestions for the Committee. First, the Capital Markets Regulator should seek to facilitate close, cooperative interaction with the entities it regulates as a means to identify and resolve problems, to determine the impact of problems or practices on investors and the market, and to cooperatively develop best practices that can be shared broadly with market participants. Incorporating a more preventative approach would likely encourage firms to step forward with self-identified problems and proposed resolutions. Second, the Capital Markets Regulator should establish mechanisms to stay abreast of market and industry developments. Ways to achieve this end include hiring more agency staff with significant prior industry experience and establishing by statute a multidisciplinary “Capital Markets Advisory Committee” comprised of private-sector representatives from all major sectors of the capital markets.
If implemented, the recommended reforms outlined above and discussed in detail in our white paper would help to establish a more effective and efficient regulatory structure for the U.S. financial services industry. Most significantly, these reforms would:
- Improve the U.S. government’s capability to monitor and mitigate risks across our nation’s financial system;
- Create a regulatory framework that enhances regulatory efficiency, limits duplication, and emphasizes the national character of the financial services industry;
- Close regulatory gaps to ensure appropriate oversight of all market participants and investment products;
- Preserve specialized regulatory focus and expertise while avoiding the potential for uneven attention to different industries or products;
- Foster a culture of close consultation and dialogue among U.S. financial regulators to facilitate collaboration on issues of common concern; and
- Facilitate coordinated interaction with regulators in other jurisdictions, including with regard to risks affecting global capital markets.
We recognize that some have criticized sector-based regulation because it may not provide any one regulator with a full view of a financial institution’s overall business, and does not give any single regulator authority to mandate actions designed to mitigate systemic risks across financial markets as a whole. Our proposed approach would address those concerns through the establishment of the Systemic Risk Regulator to undertake this market-wide monitoring of the financial system and through specific measures to strengthen inter-agency coordination and information sharing.
We further believe that retaining some elements of the current multi-agency structure would offer advantages over a single, integrated regulator approach. Even though a single regulator could be organized with separate units or departments focusing on different financial services sectors, it is our understanding that, in practice, there can be a tendency for agency leadership or staff to gravitate to certain areas and devote insufficient attention to financial sectors perceived to be less high profile or prone to fewer problems. Such a result has the potential to stifle innovation valuable to consumers and produce regulatory disparities.
Finally, we believe that a streamlining of the current regulatory structure may be more effective and workable than an approach that assigns regulatory responsibilities to separate agencies based on broad regulatory objectives, such as market stability, safety and soundness, and business conduct. These functions often are highly interrelated. Not only could separating them prove quite challenging, but it would force regulators to view institutions in a less integrated way and to operate with a narrower, less-informed knowledge base. For example, a Capital Markets Regulator is likely to be more effective in protecting investors if its responsibilities require it to maintain a thorough understanding of capital market operations and market participants. And while an objective-based structure could be one way to promote consistent regulation of similar financial products and services, it is not the only way. Under our proposed approach, minimizing regulatory disparities for like products and services would be an express purpose of enhanced inter-agency coordination and information sharing efforts.
Recent experiences in the markets have underscored the need for the Capital Markets Regulator (or, until Congress creates such a new agency, the SEC) to have express authority to regulate in certain areas where there are currently gaps that have the potential to impact the capital markets and market participants, and to modernize regulation that has not kept pace with changes in the marketplace.3 ICI supports reforms for these purposes in the areas discussed below.
- Hedge funds and other unregulated private pools of capital. The Capital Markets Regulator should have the power to oversee hedge funds and other unregulated pooled products with respect to, at a minimum, their potential impact on the capital markets. For example, the Capital Markets Regulator should require nonpublic reporting of information, such as investment positions and strategies, that could bear on systemic risk and adversely impact other market participants.
- Derivatives. The Capital Markets Regulator should have clear authority to adopt measures to increase transparency and reduce counterparty risk of certain over-the-counter derivatives, while not unduly stifling innovation.
- Municipal Securities. The Capital Markets Regulator should be granted expanded authority over the municipal securities market, and should use this authority to ensure that investors have timely access to relevant and reliable information about municipal securities offerings. Currently, the SEC and the Municipal Securities Rulemaking Board are prohibited from requiring issuers of municipal securities to file disclosure documents before the securities are sold. As a result, existing disclosures are limited, non-standardized, and often stale, and there are numerous disparities from the corporate issuer disclosure regime.
- Investment Advisers and Broker-Dealers. The Capital Markets Regulator should have explicit authority to harmonize the regulatory regimes governing investment advisers and broker-dealers. What once were real distinctions in the businesses of advisers and broker-dealers are no longer so clear, to the point that retail investors are largely unable to distinguish the services of an adviser from those of a broker-dealer. These two types of financial intermediaries, and their customers and clients, deserve a coherent regulatory structure that provides adequate investor protections without overlapping or unnecessary regulation. Of particular importance is devising a consistent standard of care in which investor protection must be paramount. The standard thus should be a high one. We recommend that both types of intermediaries be held to a fiduciary duty to their clients. 4
Money market funds are registered investment companies that seek to maintain a stable net asset value (NAV), typically $1.00 per share. They are comprehensively regulated under the Investment Company Act and subject to the special requirements of Rule 2a-7 under that Act that limit the funds’ exposure to credit risk and market risk.
These strong regulatory protections, administered by the SEC for nearly three decades, have made money market funds an effective cash management tool for retail and institutional investors. Indeed, money market funds represent one of the most notable product innovations in our nation’s history, with assets that have grown more than 2,000 percent (from about $180 billion to $3.9 trillion) since Rule 2a-7 was adopted in 1983. Money market fund assets thus represent about one third of an estimated $12 trillion U.S. “money market,” the term generally used to refer to the market for debt securities with a maturity of one year or less.5
Money market funds also are an exceptionally important source of short-term financing in the U.S. economy. They lower the cost of borrowing to the U.S. Treasury, businesses, and banks and finance companies by investing in a wide array of money market instruments. By way of example, money market funds hold roughly 40 percent of the commercial paper issued by U.S. corporations. In addition, tax-exempt money market funds are a significant source of funding for state and local governments. As of December 2008, these funds had $491 billion under management. Tax-exempt money market funds held more than 20 percent of all state and local government debt outstanding.
Money market funds seek to offer investors stability of principal, liquidity, and a market-based rate of return, all at a reasonable cost. Although there is no guarantee that money market funds can always achieve these objectives (and investors are explicitly warned of this), they have been highly successful in doing so. Since Rule 2a-7 was adopted over 25 years ago, $325 trillion has flowed in and out of money market funds. Yet only twice has a money market fund failed to repay the full principal amount of its shareholders’ investments. One of these instances is directly related to recent market events and is discussed below. The other occurred in 1994, when a small institutional money market fund “broke the buck” because it had a large percentage of its assets in adjustable-rate securities that did not return to par at the time of an interest rate readjustment. Shareholders in that fund ultimately received $0.96 per share (representing a 4 percent loss of principal). In contrast, during roughly the same time period, nearly 2,400 commercial banks and savings institutions have failed in the United States.
Until September 2008, money market funds largely had weathered severe pressures in the fixed income market that had been striking banks and other financial services firms since 2007.6 That changed as a series of extraordinary events, in rapid succession, roiled financial markets both in the United States and around the globe:
- On September 7, the U.S. Government placed Fannie Mae and Freddie Mac into receivership, wiping out shareholder equity;
- Long-circulated rumors about the stability of Merrill Lynch, AIG, and Lehman Brothers gained traction;
- Over the weekend of September 13-14, Merrill Lynch hastily arranged to be sold to Bank of America;
- On September 15, the federal government declined to support Lehman Brothers, despite having arranged a buyout of Bear Stearns, a smaller investment bank, earlier in the year. Unable to find a buyer, Lehman declared bankruptcy; and
- On September 16, the Federal Reserve Board announced a bailout of AIG, in which the Federal Reserve Bank of New York agreed to lend AIG up to $85 billion and to take a nearly 80 percent stake in the company.
Beginning with news of the Lehman bankruptcy on Monday, September 15, money markets in the U.S. and elsewhere began to freeze, with a severity that was unexpected. Although Lehman’s viability had been questioned for several months, its failure—and that of Bear Stearns several months earlier—led to mounting concerns about the health of other financial institutions such as Wachovia, Citigroup, and many foreign banks. There was also growing uncertainty about whether and how the U.S. and foreign governments would support these institutions and their creditors.
With investors running for cover, yields on Treasury securities fell, while those on commercial paper jumped. Inter-bank rates soared with the uncertainty about financial institutions’ exposure to Lehman and other failing financial institutions. Governments around the globe, attempting to calm panicked markets, injected billions of dollars of liquidity into their markets. The U.S. stock market declined nearly 5 percent on September 15 alone, reflecting broad losses to financial companies.
Certainly the Federal Reserve seems to have been surprised by the market’s reaction to this chain of events. Appearing before this Committee on September 23, 2008, Federal Reserve Chairman Ben Bernanke noted:
The failure of Lehman posed risks. But the troubles at Lehman had been well known for some time, and investors clearly recognized—as evidenced, for example, by the high cost of insuring Lehman's debt in the market for credit default swaps—that the failure of the firm was a significant possibility. Thus, we judged that investors and counterparties had had time to take precautionary measures. While perhaps manageable in itself, Lehman's default was combined with the unexpectedly rapid collapse of AIG, which together contributed to the development last week of extraordinarily turbulent conditions in global financial markets.
Intense pressure in the money market was brought to bear, affecting all market participants. In the midst of this market storm, a further pressure point occurred for money market funds. The Lehman bankruptcy meant that securities and other instruments issued by Lehman became ineligible holdings for money market funds, in accordance with the requirements of Rule 2a-7. One such fund that held a substantial amount of Lehman Brothers commercial paper, the $62 billion Reserve Primary Fund, received $25 billion in redemption requests on September 15; the following day, September 16, its NAV dropped below $1.00 per share. News of this development, combined with investors’ broader concerns about the building stresses in the money market and possible failures of other financial institutions, led to heavy redemptions in prime money market funds as investors sought safety and liquidity in Treasury securities. To meet these unprecedented redemption requests, many money market funds were forced to sell commercial paper and other assets. It should be emphasized that other market participants, including unregistered cash pools seeking to maintain a stable NAV but not subject to Rule 2a-7, and money market funds in other jurisdictions, experienced difficulties as least as great as those experienced by U.S. registered money market funds.
The Federal Reserve and U.S. Treasury Department, seeking to cope with completely illiquid short-term fixed income markets, on September 19 announced a series of unprecedented initiatives designed to provide market stability and liquidity, including programs designed to support money market funds and the commercial paper market. The Federal Reserve established the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) and the Commercial Paper Funding Facility (CPFF).7 The Treasury Department announced its Temporary Guarantee Program for Money Market Funds, which guaranteed account balances as of September 19 in money market funds that signed up for, qualified for, and paid a premium to participate in the program. According to press reports, virtually all money market funds signed up for the initial term of the Treasury Temporary Guarantee Program.
The government’s programs successfully bolstered investor confidence in the money market and in money market funds. Shortly after the programs were announced, prime money market funds stabilized and, by mid-October 2008, began to see inflows once again. By February 2009, owing to renewed confidence in money market funds at both the retail and institutional levels, assets of money market funds had achieved an all-time high of just less than $3.9 trillion.
The initial three-month term of the Treasury Temporary Guarantee Program expired on December 18, 2008, but the Treasury Department extended the program until April 30, 2009. If extended again, the program will expire by its own terms no later than September 18, 2009. At the time of this hearing, an estimated $813 million has been paid in premiums.8 There has been—and we are hopeful that there will be—no occasion for the Treasury Guarantee Program to pay any claim. Assuming continued progress in restoring the health of the money market, we would not anticipate any need to extend the Treasury Guarantee Program beyond the one-year maximum period.
The market events described above have brought into sharp focus the significance of money market funds and the critical role they play as a low-cost funding vehicle for the American economy. To us, these events and their impact also signaled a need to devote serious effort to capturing the lessons learned—by conducting a thorough examination of how the money market can function better, and how all funds operating in that market, including registered money market funds, should be regulated.
To that end, in November 2008 ICI formed a Money Market Working Group, led by John J. Brennan, Chairman of The Vanguard Group. The Working Group was given a broad mandate to develop recommendations to improve the functioning of the money market as a whole, and the operation and regulation of funds investing in that market. The Working Group intends to report its findings, conclusions, and recommendations later this month, and we look forward to sharing that information with the Committee at that time. We believe that prompt implementation of the Working Group’s recommendations will help assure a smooth transition away from the Treasury Guarantee Program.
ICI applauds the Committee for its diligent efforts on the very important issues discussed above, and we thank you for the opportunity to testify. We believe our recommendations for reforming financial services regulation would have significant benefits for investors and the capital markets. We look forward to continuing to work with the Committee and its staff on these matters.
2From the perspective of funds as investors in corporate and fixed income securities, ICI believes that financial reporting that requires the use of mark-to-market or fair value accounting to measure the value of financial instruments serves the interests of investors and the capital markets better than alternative cost-based measures. For a more detailed discussion of our views, see Letter from Paul Schott Stevens, President and CEO, Investment Company Institute, to The Honorable Christopher Cox, Chairman, U.S. Securities and Exchange Commission, dated November 14, 2008.
3Although not necessitating legislative action, another area for reform is regulation of credit rating agencies. ICI has long supported increased regulatory oversight, disclosure, and transparency requirements for credit rating agencies. We strongly support recent regulatory initiatives that will impose additional disclosure, reporting, and recordkeeping requirements on a nationally recognized statistical ratings organization (NRSRO) for products that it rates. These requirements, which are intended to increase disclosure and transparency surrounding NRSRO policies and procedures for issuing ratings and to increase an NRSRO’s accountability for its ratings, are a welcome step forward that should help to restore investor confidence in the integrity of credit ratings and, ultimately, the market as a whole. We expect to file a comment letter on the SEC’s latest proposal to enhance NRSRO regulation at the end of this month.
4Securities and Exchange Commission v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 84 S. Ct. 275 (1963) (holding that Section 206 of the Investment Advisers Act of 1940 imposes a fiduciary duty on investment advisers by operation of law).
5Other participants in the money market include corporations, state and local governments, unregistered cash pools, commercial banks, broker-dealers, and pension funds.
6During the period from September 2007 to September 2008, many money market fund advisers or related persons did purchase structured investment vehicles from, or enter into credit support arrangements with, their affiliated funds to avoid any fund shareholder losses.
7The AMLF provided non-recourse loans at the primary credit rate to U.S. depository institutions and bank holding companies to finance purchases of high-quality asset-backed commercial paper (ABCP) from money market funds. The CPFF provided a backstop to U.S. issuers of commercial paper through a special purpose vehicle that would purchase three-month unsecured commercial paper and ABCP directly from eligible issuers. On February 3, 2009, the Federal Reserve extended these and other programs for an additional six months, until October 30, 2009.
8Shefali Anand, “Treasury Pads Coffers in Bailout,” The Wall Street Journal (February 17, 2009), available at http://online.wsj.com/article/SB123483112001495707.html.