August 24, 2012

And so we've marked a defining moment: Securities and Exchange Commission Chairman Mary Schapiro's hard-fought effort to re-regulate money market funds was the first real litmus test of the agency's approach to individual investor protection in a post-financial-crisis world.

Since Schapiro was unable to muster the needed votes from the SEC commissioners, Wednesday proved to be a tough day indeed for investor protection.

Today money market funds are valued at 100 cents on the dollar day in and day out, representing an implicit guarantee to return those full funds to investors on demand. Schapiro proposed either allowing that value to "float" -- to represent the true underlying value of the investments held -- or requiring the funds to hold capital backing as "insurance" for the funds' implicit guarantee of the 100 cents as well as to hold back some customers' money for a period in times of financial stress.

Many of the facts are clear: Money funds are a $2.6 trillion market, representing an important investment vehicle for individual investors, who believe that this money is as good as cash. They hold this belief in good part because, in addition to the unwavering 100 cents on the dollar they see, these funds are shown in the cash section of their brokerage accounts.

Despite this representation, these funds are not fully safe (though certainly safer than they were historically, given investment restrictions the SEC put into place after the financial crisis). But without risk, there is no return, and thus these funds are invested in a variety of risk-bearing securities. These include securities issued by European banks, few people's idea of low risk over the past few years.

The sponsors of money funds include large, well-capitalized financial institutions that arguably have the resources to bail out these funds if the need arises. But they also include asset management firms, which by their nature have no significant capital buffers to support the funds in the event of a downturn. The largest of these asset management firms fought the additional safeguards most vigorously.

In past periods of financial stress, when the vulnerability of money funds became clear, they have been subject to violent "runs on the bank," with institutional investors recognizing the challenge and getting out first, then individuals. Such a run occurred in 2008.

But those who define that scenario as a worst case for financial markets and thus for money funds, with only one fund "breaking the buck," should note the extreme measure the SEC took of guaranteeing money funds with a stabilization fund -- a course of action that has now been prohibited by Congress. It is an ugly, ugly parlor game of "what if" had that backstop not been available.

The money fund industry spent millions of dollars in a high-profile campaign against the proposed additional SEC regulations -- which is their right. They argued that the changes put in place since the downturn should be allowed to burn in. They argued that the implicit nature of the guarantee is clear in the prospectuses sent to investors (which individual investors readily admit they do not read or particularly understand). They argued that any changes in the funds could lead to the money fund industry contracting and even disappearing, and that the follow-on impact would be lost American jobs. And while this was not part of their argument, it was also clear that putting capital behind money funds feels expensive (as insurance always does before one needs it) and that the timing was inconvenient given that profitability is under pressure from the low-interest-rate environment. Finally, they argued that individual investors report that they don't want their money funds changed in any way.

These arguments won the day -- even though none of them, including giving investors what they want (or, in this case, what they erroneously think they have), are part of the SEC's mandate. Investor protection is, however, part of that mandate.

Now that one post-crisis litmus test has come and gone, another looms. The baton is passed to the Financial Stability Oversight Council, established by Dodd-Frank and charged with ensuring the stability of our nation's financial system. This council, chaired by Treasury Secretary Tim Geithner, can choose to designate the money fund industry or individual funds as "systemically important" and recommend that the SEC act or bring them under the oversight of the Fed.

It is hard to believe that the FSOC won't declare a $2.6 trillion industry -- which carries implicit guarantees to individual investors without capital backing and has been subject to destabilizing runs -- as systemically important. (This is perhaps almost as hard to believe as the notion that re-regulation of this industry does not further the goal of investor protection.)

We've had our first significant data point on the regulators' approach to investor protection in the post-financial-crisis world. Now we have the opportunity to mark how well we learned the downturn's crushing lessons on systemic risk. Watch this space.

(Sallie Krawcheck is the former CEO of Merrill Lynch Wealth Management, former CEO of Smith Barney, and former CFO of Citigroup.)

(Edited by James Ledbetter)

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