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This chapter discusses the impact of the 1970s bear market on the mutual fund industry. Just as three decades of a strong stock market, from 1940 to 1970, spurred mutual fund growth, the prolonged bear market of the 1970s devastated mutual funds. Fund assets plummeted due to falling portfolio values and net redemptions of fund shares. The 1970s were also a terrible time for consumers, who paid high interest rates on their borrowings but were limited by federal law to receiving low interest rates on their savings. The mutual fund industry turned lemons into lemonade by sponsoring money market funds, which earned high short-term rates that were passed on to shareholders. Money market funds enjoyed spectacular success and revolutionized the fund industry and the entire American financial system.

The prolonged bear market of the 1970s devastated mutual funds. Fund assets plummeted due to falling portfolio values and net redemptions of fund shares. Consumers paid high interest rates on their borrowings but were limited by federal law, Regulation Q, to receiving low interest rates on their savings. The fund industry sponsored money market funds, which earned high short-term rates that were passed on to fund shareholders. Money funds enjoyed spectacular success and revolutionized the fund industry and the entire American financial system.

The dramatic changes in the fund industry during the 1980s and 1990s led the SEC and the industry to seek to modernize SEC requirements. SEC disclosure requirements relating to fund prospectuses, shareholder reports, advertisements, and newsletters were updated, although disclosure of “shelf space” went unaddressed. Similarly, a number of substantive SEC requirements and industry best practices in areas such as permissible investments by money market funds, 12b-1 plans, personal investing, and the qualifications and duties of fund directors, were modernized, although hedge funds were left unregulated But in the area of compliance the SEC did not adopt the industry's recommendation to require funds to establish formal compliance systems.

Prime money market mutual funds (MMF) are particularly susceptible to runs given the inherently short-term nature of their liabilities and the riskiness of their assets as compared with government funds. Thus, it is a proper object of policy to minimize the possibility of prime money market fund runs. This chapter discusses the SEC's approach to MMF reform. The approach incorporates three elements: (1) enhanced liquidity requirements; (2) a floating net asset value (NAV) requirement for certain classes of money market funds; and (3) the possibility of imposing liquidity fees and redemption gates on money market funds, which would limit rapid MMF creditor outflows in times of stress. It specifically rejected imposing a capital requirement on these funds. At the outset it should be clear that the concern with contagion should only be with prime money market funds and municipal funds, and not with government funds, which are all but immune from runs.

Today, huge numbers of investors rely on money market funds, investing more than $2.6 trillion in them. The administrators of retirement plans routinely designate money market funds as a default setting in our IRAs and 401(k) accounts. That status means that these funds often serve as a central way station through which large volumes of our contributions and exchanges flow. Indeed, so safe is the reputation of money market funds that many investors may think of them as something contrary to an investment; that is, as a refuge beyond the reach of threatening financial conditions. But a closer examination of their origin and operations reveals some vulnerabilities. Before we can be so sanguine about treating these funds as our financial redoubt, we must look closely at these failures and at their alternatives.

Until 2011, money market mutual funds (MMMFs) represented the second largest category of the mutual fund industry in the United States. With $2.7 trillion in total net assets (TNA) as of December 2013, MMMFs account for about 18 percent of the TNA held by mutual funds in the United States. MMMFs are an important investment vehicle for individual investors and are vital liquidity providers to financial intermediaries. Investors regard MMMFs as safe money market instrument investments that provide yields above those of bank deposits. The main difference between bank deposits and MMMFs is that the Federal Deposit Insurance Corporation (FDIC) does not insure MMMFs. As evidenced by the Lehman Brothers bankruptcy in 2008 and the 2011 European banking crisis, MMMFs may threaten the stability of the financial system. This chapter offers a general overview of the history, structure, performance measures, and role of MMMFs in the financial system.

This chapter analyzes the possible need for insurance of money market mutual funds. The issue is of particular concern given the vulnerability of those funds, in particular, prime institutional funds, to contagious runs due to the money-like nature of their liabilities. It argues that the true competitive impact of expanded insurance on the banking and money market industries requires more detailed study of the appropriate cost and pricing of insurance, before any firm conclusions can be drawn. Given all of the difficulties of extending an insurance regime to money market funds, a more practical approach might be to make clear funds are eligible for lender-of-last-resort support either directly or indirectly through the banks. Liquidity support may be sufficient by itself to stop runs.

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 as “liability connectedness.” This chapter first examines whether the connectedness of money market funding to banks caused a problem in the crisis, concluding that it did not. It then examines a possible future source of connectedness, the tri-party repo market. While this market could cause systemic risk, it has been altered in significant ways to avoid this possibility.

In late 2008, the freezing of global credit markets on fears of exposure to subprime mortgages in the United States led to an acute shortage of dollars in international financial markets. With the International Monetary Fund (IMF) incapable of managing the global crisis, the Federal Reserve stepped in to provide more than $600 billion in liquidity to foreign jurisdictions. What motivated the Fed to act as an international lender of last resort (ILLR)? This chapter argues that the international dimensions of the crisis threatened vital US financial interests in two key ways. First, US banks and money market funds were directly threatened by the prospects of a foreign bank default. Second, frozen global credit markets were severely impairing the transmission of the Fed's interest-rate cuts to the real economy. Analysis of the international financial risks facing the United States, statistical analysis of the Fed’s credit-line selection, and a review of Fed transcripts during the crisis support these assertions.

This chapter describes how human capital is equivalent to an implicit investment in bonds for an investor who knows his income in advance with perfect certainty, and argues that properly designed life-cycle funds are better default investment choices than money market funds in defined contribution (DC) pension plans. Life-cycle mutual funds are one of the fastest growing segments in the mutual fund industry. The long-standing practice of sponsors of DC pension plans choosing a money market fund as the default option for plan participants might not be appropriate if the goal is to choose a safe investment. The issuance of inflation-indexed bonds by the Treasury has a significant impact on welfare. Life-cycle funds are inexpensive to manage, and most mutual fund companies do not charge fees on top of the fees they already charge to the underlying funds.

Collective investment vehicles, and the asset managers that sponsor them, are key market intermediaries in the financial system. In this chapter, we explore their impact on financial stability. Many such vehicles, but by no means all, have robust business models which pass investment risk through to end-investors or which promise only constrained liquidity to investors. Where this is not so, for example, with money market mutual funds or insurance companies engaging in non-insurance activities a move towards ‘bank-like’ regulation is appropriate. Even robust business models may not always flourish. A decline in the fund manager may generate systemic risk through transactions with systemically important counterparties or by investors drawing adverse inferences about similarly situated firms. However, it may also generate possibilities for contagion across markets: where one investment vehicle becomes financially distressed and has to liquidate its portfolio, this may depress assets values for other firms holding similar assets. As we will see, there lurks within this area a troubling tension between the regulatory goals of investor protection and mitigation of systemic risk.

The Glass-Steagall Act created a decentralized financial system composed of three separate and independent financial sectors—commercial banking, securities markets, and insurance. The Bank Holding Company Act of 1956 reinforced Glass-Steagall’s policy of structural separation by prohibiting bank holding companies from engaging in any activities that were not “closely related to banking.” Glass-Steagall’s structural barriers prevented the occurrence of systemic financial crises for more than four decades. During that period, federal regulators could deal with problems arising in one financial sector without need to rescue the entire financial system. Despite Glass-Steagall’s success, federal agencies and courts undermined its prudential buffers during the 1980s and 1990s by opening loopholes. Those loopholes allowed banks to convert their loans into asset-backed securities and to offer derivatives that functioned as synthetic substitutes for securities and insurance products. Regulators and courts also allowed money market mutual funds and other nonbanks to issue short-term financial claims that served as deposit substitutes, despite Glass-Steagall’s prohibition against deposit-taking by nonbanks.

This chapter discusses the diagnosis of the economic crisis presented by previous chapters. The chapter first argues against the statement that the Glass-Steagall Act disrupted the period of financial stability between the 1930s to the early 1980s. The chapter then goes on to explain that the decision to allow the market in over-the-counter derivatives to balloon without any public oversight was a public-policy error of the first order. Therefore, the Glass-Steagall act was not a principal cause of the recent crisis. The chapter then discusses the problem of money-market mutual funds, which is viewed to have become a source of systemic risk that warranted action from the Department of the Treasury. The chapter goes to outline some theories and examples for how to balance these risks. The chapter ends with the imperative that practicing finance is more important than simply regulating finance. Hence, effective financial oversight is a necessity.

This chapter introduces the first signs that the United States is emerging from a period of failure of liquid markets such as markets for money-market mutual funds, for asset-backed commercial paper, and for auction-rate securities. It is the chapter’s view that this crisis and all its problems could not have been prevented by regulation alone. Instead, a more robust regulatory framework with oversight responsibility for cross-market activities and a focus on systemic risk is what could have discovered and pre-empted the dangers on the economy. The chapter goes on to discuss a blueprint for a modernized financial regulatory structure that could help improve the mortgage-origination process and establish some federal presence in the insurance markets. This blueprint is aimed to address the regulatory problems of market stability, prudential supervision, and oversight of business conduct and consumer protection. It focuses on systemic risk in order to improve regulatory efficiency and allow competition on an economic basis.