By HAL S. SCOTT and JOHN GULLIVER
Originally published by CNBC on October 14, 2016
A new Securities and Exchange Commission rule goes into effect Friday that can restrict investors from withdrawing their cash from the money-market funds that were at the heart of the 2008 financial crisis. If the G-20’s international regulator (the Financial Stability Board) has anything to say about it then a similar rule will soon apply to the $16 trillion invested in all U.S. mutual funds. This would be a dangerous mistake.
The FSB’s proposal is to charge investors’ penalty fees if they try and sell their mutual-fund investment during a crisis and would even include a complete prohibition of such sales in extreme circumstances. It is expected to finalize its proposal later this year and then the SEC, U.S. Treasury and Federal Reserve are expected to promptly implement them in the U.S.
But there are several problems with the FSB’s recommendation. First, runs on mutual funds have never caused a financial crisis, so it is unclear that further regulation is needed. Second, the FSB’s proposal may actually exacerbate a crisis, because investors will try and pull their cash before the penalty fees or redemption restrictions apply.
The FSB has also failed to consider investors’ response to the SEC’s new rule for prime money market funds. In the last six months alone the money funds covered by the SEC’s redemption restrictions have suffered almost $600 billion in total outflows and now manage only $150 billion in total assets. Even more withdrawals are expected.
These rapid withdrawals clearly show that investors want to avoid the SEC’s money-fund rules and that expanding them to all mutual funds could drive significant outflows from the broader $16 trillion industry.
Do we want investors to withdraw their money from mutual funds and invest directly in the market to avoid such restrictions? The answer is no. We want investors to get the benefit of professional management.
And what would significant outflows from mutual funds mean for financial stability? A market dominated by professional investment advisers is much more stable, as the Chinese experience with their highly retail market has recently demonstrated.
While the FSB is targeting the private mutual-fund industry for these ill-advised reforms, it is also completely ignoring the significant risk posed by public-sector investors that are critical actors in today’s financial markets.
The biggest of these investors are the central banks that buy and hold foreign assets to control the value of their currency. These foreign-exchange reserves have grown from $1 trillion in 1995 to a staggering $11 trillion in 2016.
Governments also use sovereign wealth funds to invest excess revenues from natural resources. These funds have also dramatically grown in recent years and now manage over $7 trillion in total assets. To put that into perspective, that is more than twice the assets under management of all the hedge funds in the world.
Forex reserves and sovereign wealth funds pose a particular risk to the U.S. financial system, because their assets are concentrated in the U.S., so significant asset sales by either of these public-sector investors could cause a panic in U.S. markets. For example, the Federal Reserve estimates that 60 percent of China’s $3.5 trillion in forex reserves is held in U.S. dollar assets, like Treasurys or bank deposits.
Worse yet is that neither sovereign wealth funds nor forex reserves are subject to any disclosure requirements, so we know very little about the specific risks that they pose. Although there is likely no way to entirely mitigate their risk, disclosures regarding their assets would allow for enhanced market discipline and better monitoring by regulators.
But the FSB has not considered the need for more transparency of sovereign wealth funds or forex reserves, despite their G-20 mandate to identify and mitigate risks to the financial system.
Another serious problem is the tremendous underfunding of public-sector pension funds. There are roughly $78 trillion in unfunded or underfunded public pension commitments across 20 OECD countries, according to a report from Citigroup. In the U.S. alone, unfunded pension commitments to government employees are estimated to be in the range of $1 trillion to $3 trillion.
The problem is that government workers have been promised fixed payouts after retirement that governments will be unable to provide, largely due to record low returns on fixed income investments. When these pension funds run out of assets, a global crisis could result, as these governments could default on their extensive financial contracts. But again, the FSB has made no mention of this risk.
The FSB has clearly fallen down on the job. It has failed to consider the significant risks posed by large public-sector investors and it is calling for reforms to mutual funds that would make our financial system less stable. U.S. regulators need to exert their legal independence and ignore the FSB’s potentially dangerous recommendations.
Commentary by Hal S. Scott and John Gulliver. Scott is a professor at Harvard Law School and the director of the Committee on Capital-Markets Regulation. He is also the author of the law-school textbook “International Finance: Transactions, Policy and Regulation” and “Connectedness and Contagion: Protecting the Financial System from Panics.” Follow him on Twitter @HalScott_HLS. Gulliver is the executive director of research at the Committee on Capital-Markets Regulation. Follow him on Twitter @gulliver_john.