WASHINGTON (MNI) – The following is an excerpt from the letter
Treasury Secretary and Financial Stability Oversight Council Chairman
Tim Geithner sent to Council member agencies Thursday:

September 27,2012

Members of the Financial Stability Oversight Council,

Last month, the Securities and Exchange Commission (SEC) announced
that it would not proceed with a vote to solicit public comment on
potential structural reforms of money market funds (MMFs). This comes
after a long and concerted effort by the SEC to develop reform options.

Further reforms to the MMF industry are essential for financial
stability. MMFs are a significant source of short-term funding for
businesses, financial institutions, and governments. The funds provide
an important cash-management vehicle for both institutional and retail
investors. However, the financial crisis of 2007- 2008 demonstrated that
MMFs are susceptible to runs and can be a source of financial
instability with serious implications for broader financial markets and
the economy. In the days after Lehman Brothers failed and the Reserve
Primary Fund, a $62 billion prime MMF, “broke the buck,” investors
redeemed more than $300 billion from prime MMFs. Commercial paper
markets shut down for even the highest quality issuers. Only Treasury’s
guarantee of more than $3 trillion of MMF shares, a series of liquidity
programs by the Federal Reserve, and support from many fund sponsors
stopped the run and helped MMFs meet their shareholders’ redemption
requests in a timely manner.

The SEC took important steps in 2010 to improve the resilience
of MMFs by amending Investment Company Act Rule 2a-7 to strengthen the
liquidity, credit-quality, maturity, and disclosure requirements of MMFs.
But the effort toward reform should not stop there. The 2010 reforms did
not attempt to address two core characteristics of MMFs that leave them
susceptible to destabilizing runs: (1) the lack of explicit
loss-absorption capacity in the event of a drop in the value of a
portfolio security and (2) the “first-mover advantage” that provides an
incentive for investors to redeem their shares at the first indication
of any perceived threat to the fund’s value or liquidity.

Both the President’s Working Group on Financial Markets and the
Financial Stability Oversight Council (Council) have consistently called
for the SEC to pursue additional reforms to address structural
vulnerabilities in MMFs, including unanimous recommendations in the
Council’s 2011 and 2012 annual reports. The Dodd-Frank Wall Street
Reform and Consumer Protection Act (Dodd-Frank Act) gives the Council
both the responsibility and the authority to take action to address
risks to financial stability if an agency fails to do so. Accordingly, I
would like the Council to consider taking a series of additional steps
to address this challenge.

Path Forward to Protect Investors and the Economy

As its Chairperson, I urge the Council to use its authority under
section 120 of the Dodd-Frank: Act to recommend that the SEC proceed with
MMF reform. To do so, the Council should issue for public comment a set
of options for reform to support the recommendations in its annual
reports. The Council would consider the comments and provide a final
recommendation to the SEC, which, pursuant to the Dodd-Frank Act, would
be required to adopt the recommended standards or explain in writing to
the Council why it had failed to act. I have asked staff to begin
drafting a formal recommendation immediately and am hopeful that the
Council will consider that recommendation at its November meeting.

The proposed recommendation should include the two reform
alternatives put forward by Chairman Schapiro, request comment on a
third option as outlined below, and seek input on other alternatives
that might be as effective in addressing MMFs’ structural
vulnerabilities. Option one would entail floating the net asset values
(NAVs) of MMFs by removing the special exemption that allows them to
utilize amortized-cost accounting and rounding to maintain stable NAVs.
Instead, MMFs would be required to use mark-to-market valuation to set
share prices, like other mutual funds. This would allow the value of
investors’ shares to track more closely the values of the underlying
instruments held by MMFs and eliminate the significance of share price
variation in the future.

Option two would require MMFs to hold a capital buffer of adequate
size (likely less than 1 percent) to absorb fluctuations in the value
of their holdings that are currently addressed by rounding of the NAV.
The buffer could be coupled with a “minimum balance at risk”
requirement, whereby each shareholder would have a minimum account
balance of at least 3 percent of that shareholder’s maximum balance over
the previous 30 days. Redemptions of the minimum balance would be delayed
for 30 days, and amounts held back would be the first to absorb any
losses by the fund in excess of its capital buffer. This would
complement the capital buffer by adding loss-absorption capacity and
directly counteract the first-mover advantage that exacerbates the
current structure’s vulnerability to runs.

Option three would entail imposing capital and enhanced liquidity
standards, potentially coupled with liquidity fees or temporary “gates”
on redemptions that may be imposed as an alternative to a minimum
balance at risk requirement.

We should also be open to alternative approaches that satisfy the
critical objectives of reducing the structural vulnerabilities inherent
in MMFs and mitigating the risk of runs. We should use this opportunity
to seek informed perspectives on the extent to which any mix of the
specific reforms described above or other reforms would achieve the same
level of protection for investors and the broader economy. The Council
should engage with key stakeholders as part of this overall process.

The proposal should take into account the concern expressed that
reform of MMFs may result in outflows from MMFs to less-regulated parts
of the cash-management industry. While investors should welcome enhanced
protections in MMFs, experience tells us that we cannot ignore the
potential for capital, in times of relative stability, to flow to
less-regulated sectors with fewer protections. Our objective should be
to propose reforms to MMFs that protect the stability of MMFs without
creating a competitive advantage for unregulated cash-management
products.

Alternative Paths to Reform

The SEC, by virtue of its institutional expertise and statutory
authority, is best positioned to implement reforms to address the risks
that MMFs present to the economy. However, while we pursue this path,
the Council and its members should, in parallel, take active steps in
the event the SEC is unwilling to act in a timely and effective manner.

Under Title I of the Dodd-Frank Act, the Council has the authority
and the duty to designate any nonbank financial company that could pose
a threat to U.S. financial stability. The Council should closely
evaluate the MMF industry to identify firms that meet this standard.
Designating MMFs or their sponsors or investment advisers would subject
those firms to supervision by the Federal Reserve and would give the
Federal Reserve broad authority to impose enhanced prudential standards,
potentially including the options discussed above. Alternatively, the
Council’s authority to designate systemically important payment,
clearing, or settlement activities under Title VII of the Dodd-Frank Act
could enable the application of heightened risk management standards on
an industry-wide basis.

Other Council member agencies have the authority to take action to
address certain of the risks posed by MMFs and similar cash-management
products. For example, the bank regulatory agencies should evaluate
their authorities to impose capital surcharges on regulated entities
that sponsor MMFs, or restrict financial institutions’ ability to
sponsor, borrow from, invest in, and provide credit to MMFs that do not
have structural protections. As currently conducted, such activities can
pose risks to financial institutions’ safety and soundness in a variety
of ways, including the potential for MMFs to curtail funding for
financial firms abruptly in times of market stress and the implicit
support provided by firms that sponsor MMFs. Additionally, the
potentially destabilizing role of MMFs in the tri-party repo market
should be carefully assessed as part of the ongoing efforts to improve
the safety, soundness, and resiliency of that market. I urge the members
of the Council to accelerate their evaluation of these alternatives. The
members of the Council should move ahead to consider how best to give
effect to these alternative paths as they consider public comments on
reform options for the SEC.

** MNI Washington Bureau: 202-371-2121 **

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