SEC Commissioner Gallagher and Money Fund Capital Requirements

The question of capital requirements and how to best backstop money market funds has lingered since the Primary Reserve Fund became the first to “break the buck” at the outset of the market crisis. The SEC initially considered proposed rules that would have mandated certain capital requirements. The proposals failed to win three votes so they could be issued for comment. Later the FSOC threatened to take control of the question. That led to the issuance of proposed rules by the SEC last year which differed considerably from those initially under consideration and which are much more limited in scope.

In recent remarks SEC Commissioner Daniel Gallagher discussed the question of whether money market funds should be required to have capital requirements or perhaps have access to the Federal Reserve’s discount window. Commissioner Daniel M. Gallagher, The Philosophies of Capital Requirements, Washington, D.C. (January 15, 2014)(here).

Determining if capital requirements are the answer for money market funds begins understanding the theory behind them, the Commissioner noted. In banking “where the regulated entities operate in a principal capacity and are leveraged institutions, capital requirements are rightly designed with the paramount goal of enhancing safety and soundness, both for individual banks and for the banking system as a whole.” They are not designed to encourage risk taking.

Capital requirements for broker-dealers serve a different purpose. According to Commissioner Gallagher, “In the capital markets, we want investors and institutions to take risks – informed risks that they freely choose in pursuit of a return on their investments . . . Whereas bank capital requirements are based on the avoidance of failure, broker-dealer capital requirements are designed to manage failure by providing enough of a cushion to ensure that a failed broker-dealer can liquidate in an orderly manner . . .” (emphasis original). The two systems are thus like apples and oranges Commissioner Gallagher noted.

The Federal Reserve discount window is the nation’s lender of last resort under the Federal Reserve Act of 1913. It permits the Fed to avert panic by lending against good collateral to solvent firms. Title II of Dodd-Frank added to this with the authority “to manage the liquidation of large, complex financial institutions close to failure . . .”

The question of money market funds arises against this backdrop. As the Commission first considered the question, the FSOC suggest the concept of an “NAV buffer” or a capital requirement. The industry then moved toward a requirement which for the largest funds would require a “1 to 200 ratio – a $500 million buffer [capital requirement] to support $100 billion in investments. This would amount to chicken feed in any serious capital adequacy determinations,” according to the Commissioner. Indeed, the only real purpose for this, Commissioner Gallagher stated “was to serve as the price of entry into an emergency lending facility that the Federal Reserve could construct during any future crisis – in short, the ‘buffer’ would provide additional collateral to facilitate a Fed bailout for troubled MMFs.”

One Fed official, and some academics, have suggested this kind of approach. Another Fed official has opposed it. In this context the question “is the goal to expand the Fed’s role by making it the lender of last resort to non-bank entities such as money market funds . . . or is it to use its Bank Holding Company Authority and its role in the FSOC to dictate capital requirements to non-bank entities in order to prevent those entities from ever gaining access to the discount window?”

This is a significant issue for debate. “If we are to assume that the Fed will not, or cannot, expand its role as the lender of last resort to non-banking entities . . . would it ever be possible to set capital requirements at a level that would guarantee avoidance of 2008-type scenarios? I think not . . .” Commissioner Gallagher stated. Indeed, superimposing bank type capital requirements would simply not make sense.

In the end, “regulatory capital requirements play a tremendous role in incentivizing financial institutions’ holdings. All the more important, therefore, that regulators use the right tool for the right job . . . We’re an entrepreneurial nation, and taking risks, whether with respect to investments or otherwise, is as American as apple pie. Superimposing upon those markets a capital regime based on the safety-and soundness banking paradigm, on the other hand . . .” is like matching apples and oranges, according to Commissioner Gallagher.