The unintended consequences of the zero lower bound policy for the money market funds industry

Marco Di Maggio, Marcin Kacperczyk 19 July 2016

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In the aftermath of the Global Crisis of 2007-2008, the US Federal Reserve took an unprecedented decision to lower short-term nominal interest rates to zero, a policy commonly known as the zero lower bound policy. This initial action was followed by a sequence of announcements providing guidance that the short-term rate would stay near zero for a longer period. While several economists have argued that the Fed’s policy exerted a positive impact on the US economy by stimulating sluggish economic growth and boosting employment, some critics pointed out that the policy might have also produced undesired consequences, such as inflation in asset prices, or ill-suited incentives to chase higher yields (e.g. Maddaloni and Peydró 2011 and Jimenez et al. 2014, among others). One important part of the financial system that could be significantly impacted by the long-term low interest rates is the money market fund (MMF) industry.

Money market funds

Traditionally, MMFs used to offer relatively low returns for the provision of safety. While this idea has been somewhat shattered by the collapse of the Reserve Primary Fund and the run on MMFs in September 2008 (e.g. Kacperczyk and Schnabl 2013, Chernenko and Sunderam 2014, Strahan and Tanyeri 2015), until then, MMFs had provided investors positive returns, even after paying fees. The consequence of the unprecedented change in interest rates to levels close to zero has been that returns on traditional money market instruments – such as Treasuries, repos, or deposits – declined to similarly low levels. Therefore, any fund investing in these assets was likely to produce negative net-of-fees nominal returns to their investors. It has thus become obvious that such business models cannot be sustained for too long, as money would flow out of funds with negative returns.1

Such a dire situation has posed a dilemma for money funds. On the one hand, they could accept the situation and keep their risk profiles unchanged. This, however, would force them to first reduce or even waive their fees, and in the end, if the low rates persisted, to exit the market. On the other hand, funds could change their product offerings by shifting their risk into securities with higher interest rates, thus accepting higher risk in their portfolios, an idea referred to as reaching for yield. Increasing fund risk would boost returns and investor flows (e.g. Christoffersen 2001), and would likely prevent funds from exiting the market. The cost of increasing risk would be a higher chance of being run on in the event of distress in the money market industry.

Reaching for yield and exit

In recent work, we empirically assess the equilibrium response of MMFs to the low interest rate environment using weekly data on the universe of US prime funds (Di Maggio and Kacperczyk 2016).[2] We exploit both time-series and cross-sectional variation in the data to identify the causal effect of the unconventional monetary policy on MMF strategies. Our main empirical identification comes from an event study analysis of five FOMC announcements, which signalled that interest rates would be kept near zero into the future. These decisions were plausibly exogenous with respect to the funds’ behaviour; hence, they constitute a useful shock. The access to high-frequency fund data allows us to measure empirical effects within short event windows. We compare MMFs' choices of risky product offerings, exit, and expense policy in the fund data.

Our paper sheds new light on the incentives of asset managers to reach for yield –one of the core factors contributing to the build-up of credit that preceded the financial crisis (Rajan 2010, Yellen 2011, and Stein 2013). Popular explanations include competition among fund managers, different preferences for risk, or desire to offset constraints imposed by regulation. We provide a setting in which the incentives to reach for yield are, on the one hand limited by strict regulation; on the other, significantly affected by changes in interest rates and expectations about their future changes.

In the time series, we document an increase in the probability of exit from the MMF industry, higher risk taking, lower expenses charged by MMFs, and higher fund subsidies in the period of three to six months after the announcements. Our results are economically and statistically significant. In the cross section, we find that reaching for yield is particularly strong for independent funds – that is, funds whose sponsors are not affiliated with an insurance company, commercial, or investment bank. In contrast, rather than taking more risk, affiliated funds exit the market. Figure 1 plots the distribution of yields of the securities in the MMF’s portfolio before and after the policy events. The distribution significantly shifts to the right after the events, which suggests that the MMFs reached for yield in response to the increased awareness that the low interest rate environment would have lasted longer.

Figure 1 Yields distribution and ZIRP shocks

Note: Empirical distributions of the fund portfolio yields before and after the three ZIRP shocks.

We further enhance these findings by exploiting a variation in family-level percentage of assets managed by MMFs within a group of independent sponsors. We find that funds whose families invest a greater percentage of their assets in MMFs are less likely to exit and more likely to take more risk. The results are consistent with a hypothesis that reputational concerns shape MMFs’ strategic decisions. In sum, to the extent that any macroeconomic (time-series) shock would likely affect all types of funds in a similar way, the results suggest that ours is a leading mechanism explaining the data. The key novelty of our paper with respect to existing papers on reaching for yield is the new mechanism that explains risk taking. While, for example, in Kacperczyk and Schnabl (2013) the key friction is the increase in yield dispersion of the different investable asset classes, the friction we emphasise is the zero lower bound policy.

Real effects of disruptions in the money market funds industry

We further show that the disruptions in the MMF industry have real effects. On the one hand, in the absence of search frictions we would not expect any effect on the availability of credit to firms as they could easily substitute one fund with another. On the other hand, firms might find it difficult to borrow from different institutions with which they do not have a prior relationship. To test this hypothesis, we collect information on the leverage of non-financial firms borrowing from MMFs. We show that within a six-month period after the closure of a given fund, the leverage of firms borrowing from the fund is significantly reduced compared to that of firms borrowing from funds that remain active. This effect, however, is short lived, as it disappears a year after the fund closure.

In our final set of results, we show that the strategic adjustment in the MMF industry has broader industry organisation implications for the entire mutual fund sector. We investigate whether the fund families that decide to close their MMFs in response to the monetary shock open new funds in a different asset class, possibly less stressed by low interest rates. Empirically, we compare fund closures and fund creations of fund families that have closed their MMFs with those that did not. We find that the former are significantly more likely to open new bond funds, but not equity or balanced funds. Figure 2 plots the evolution of total net assets for money market funds and bond funds.

Figure 2 Money funds vs. bond funds AUM: 2005-2014

The figure presents the evolution of weekly total net assets for the universe of prime money market funds and bond funds over the period 2005-2014

We also show active reallocation of managerial talent either to other MMFs or to bond funds. The above results suggest that the prolonged period of low interest rates leads to the reallocation of resources across largely similar asset classes.

Conclusion

Overall, our results highlight an important channel for transmission of monetary policy that has been completely overlooked by the academic literature, but one that is extremely relevant for practitioners and policymakers, especially in the current regime of unusually low interest rates worldwide. This message resonates well with the August 2009 Fitch report about US MMFs that states: "Over the longer term, more conservative portfolio composition, combined with the current low interest rate environment, may result in fund closures, fund consolidation, and/or a resurgent appetite for credit and liquidity risk.”[3]

References

Chernenko, S and A Sunderam (2014) “Frictions in shadow banking: Evidence from the lending behavior of money market funds”, Review of Financial Studies, 27: 1717-1750.

Chevalier, J and G Ellison (1997) “Career concerns of mutual fund managers”, Quarterly Journal of Economics, 114: 389-432.

Christoffersen, S K (2001) “Why do money fund managers voluntarily waive their fees?”, Journal of Finance, 56: 1117-1140.

Di Maggio, M (2013) “Market turmoil and destabilizing speculation”, Unpublished working paper, Columbia Business School.

Di Maggio, M and M Kacperczyk (2016) “The unintended consequences of the zero lower bound policy”, Journal of Financial Economics, forthcoming.

Di Maggio, M, A Kermani and C Palmer (2015) “Unconventional monetary policy and the allocation of credit”, Unpublished working paper, Columbia Business School.

Jimenez, G, S Ongena, J-L Peydro and J Saurina (2014) “Hazardous times for monetary policy: What do twenty-three million bank loans say about the effects of monetary policy on credit risk-taking?”, Econometrica, 82: 463-505.

Kacperczyk, M and P Schnabl (2013) “How safe are money market funds?”, Quarterly Journal of Economics, 128: 1073-1122.

Maddaloni, A and J-L Peydró (2011) “Bank risk-taking, securitization, supervision, and low interest rates: Evidence from the Euro-area and the US lending standards”, Review of Financial Studies, 24: 2121-2165.

Rajan, R (2010) Fault lines, Princeton University Press.

Stein, J C (2013) “Overheating in credit markets: Origins, measurement, and policy responses”, Delivered at Restoring household financial stability after the great recession: Why household balance sheets matter, a symposium sponsored by the Federal Reserve Bank of St Louis, St Louis.

Strahan, P and B Tanyeri (2015) “Once burned, twice shy: Money market fund responses to a systemic liquidity shock”, Journal of Financial and Quantitative Analysis, 50: 119-144.

Yellen, J (2011) “Remarks at the international conference: Real and financial linkage and monetary policy”, Bank of Japan.

Endnotes

[1] A standard portfolio theory suggests that investors should look at fund spread – returns net of Treasury bill – rather than fund returns, as a way of assessing their decisions. But in times of zero interest rates both returns and spreads are virtually the same.  In addition, our regression estimates account for any business cycle variation in the data.

[2] Various papers have studied the role of money funds. To the best of our knowledge our paper is the first to examine the impact of monetary policy on the industrial organisation of money funds – the change in product offerings (risk taking) and in market structure (exit) – and its implications for capital supply to fund borrowers, and the allocation of resources within the industry.  In this regard, the closest studies to ours are Kacperczyk and Schnabl (2013), Strahan and Tanyeri (2015), and Di Maggio (2013), which analyse risk taking of MMFs before and after the collapse of Lehman Brothers, and during the European debt crisis, respectively. 

[3] “US Prime Money Market Funds: Managing Portfolio Composition to Address Credit & Liquidity Risks" is available on Fitch's web site at www.fitchratings.com.

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Topics:  Financial markets Financial regulation and banking Monetary policy

Tags:  zero lower bound, money market funds, reaching for yield, monetary policy

Assistant Professor of Business Administration, Harvard Business School

Professor of Finance, Imperial College London Business School

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