If the new money market rules go into effect, banks will likely get a huge influx of cash -- but what happens next?

The New York Times' DealBook section has a think-piece by Peter Eavis about what money market fund reform will mean for the financial system. His thesis should not be a shock to anyone in the funds industry: most of the $2.6 trillion currently in MMFs will be redeposited into the banks, and this is what the SEC and others who have been touting reform really want.

"In some ways, regulators might favor a greater shift of money to the banks they oversee," Eavis writes, since that would mean less money in the "shadow banking" sector. And the "big cash windfall" that banks would receive following MMF reform might make new liquidity rules easier for them to meet.

But Eavis' logic gets shaky when he says that this could make the system more stable because the banks might invest the "in a more rational way" than MMFs do -- precisely because they're not subject to the same strict investment rules. Eavis writes that MMFs often invest in foreign banks with high credit ratings, which, despite their ratings "may be shakier than American corporations with lower ratings.

"With the freedom to care less about ratings, an American bank could invest less in foreign banks," Eavis writes.

Sure, that's possible. Also possible that they invest in far riskier, lower-rated paper, and whatever else they feel like, since bank balance sheets don't have the transparency rules that MMF holdings do. Eavis' argument only makes sense if you assume risk and credit rating are inversely correlated.

Eavis does, to his credit, lay out the reasons why MMF reform might make the financial system less stable and transparent. First, as noted, MMF holdings are transparent while banks' are not. Second, a "significant portion" of the money leaving MMFs would probably flow into investment vehicles like offshore funds and private funds that are less subject to regulation than MMFs are. And third, this cash inflow to banks can only exacerbate too-big-to-fail and all the regulatory nightmares associated therewith. 

Edited by: Chris Cumming


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