Prof Sharfstein to Congress.pdf - Testimony of DAVID S...

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Testimony of DAVID S. SCHARFSTEIN PROFESSOR OF FINANCE HARVARD BUSINESS SCHOOL PERSPECTIVES ON MONEY MARKET MUTUAL FUND REFORMS Before the Senate Committee on Banking, Housing, and Urban Affairs June 21, 2012 at 10:00 am Room 538, Dirksen Senate Office Building Chairman Johnson, Ranking Member Shelby and members of the Committee, thank you for the opportunity to appear here today to offer my perspectives on money market mutual fund reform. My name is David Scharfstein, and I am the Edmund Cogswell Converse Professor of Finance and Banking at Harvard Business School. I am also a member of the Squam Lake Group, which is comprised of 13 financial economists who offer guidance on the reform of financial regulation. Our group has issued a policy brief that advocates the introduction of capital buffers for money market funds. I would like to provide a rationale for our recommendations, but my statement, though aided by feedback from members of the Squam Lake Group, is not being made on its behalf or any other organizations with which I am affiliated. 1. Introduction Observers of the first 35 years of money market fund (MMF) history might have concluded that MMFs are a relatively safe investment and cash management tool with no significant implications for financial system stability. But the events surrounding the financial crisis of 2007-2009 suggest otherwise. When the Primary Reserve Fund “broke the buck” after the failure of Lehman Brothers, it precipitated large redemptions from prime MMFs, mainly by institutional investors who were concerned that large MMF exposures to stressed financial firms would lead to losses. This “run” on prime MMFs added to stresses on the financial system at the peak of the financial crisis because large banks depend on MMFs for short-term funding. Faced with large withdrawals, MMFs were unable to invest in the commercial paper (CP), repurchase agreements (repo) and certificates of deposit (CDs) issued by large banks, broker-dealers, and finance companies. To stop the run, stabilize the money markets, and ease the funding difficulties of large financial institutions, the U.S. Treasury had little choice but to temporarily guarantee MMF balances. While extreme, the events of 2008 point to fundamental risks that prime money market funds pose for the financial system. The main points that I want to make are as follows: 1. Prime MMFs have evolved into a critical source of short-term, wholesale funding for large, global banks. They are now a much less important funding source for nonfinancial firms.
2 2. Prime MMF portfolios embed financial system risk because they are short-term claims on large, global banks. Moreover, during periods of stress to the financial system, some MMFs have actively taken on systemic risk by investing in higher- yielding, risky securities in an effort to grow their assets under management.

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