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NY Fed Staff Report: MMFs Make Banking System More Unstable

The New York Federal Reserve Bank has issued a staff report asserting that money market funds (MMFs) make the banking system more unstable.  The paper compares two market structures – direct finance, where investors deposit directly into the banks, and MMF intermediation, where the relationship between investors and banks is intermediated through MMFs:

Under direct finance, unexpected withdrawals cause bank bankruptcy only if the amount withdrawn is large enough to force the bank into liquidation. In contrast, with MMF intermediation, when a fraction of investors unexpectedly redeem from the MMF, their actions represent a (noisy) signal on the state of the world for the MMF. If this signal is strong enough, the MMF will run the bank, withdrawing all its funds and causing bankruptcy even if the fraction of the unexpected redemptions was small enough that bankruptcy would not have occurred under direct finance. The instability of MMF intermediation stems from the fact that the negative information content of an unexpected redemption from an intermediary such as an MMF amplifies the effect of the redemptions themselves. Because of this, an economy intermediated by MMFs is generically more unstable than a direct finance structure.

The amplification mechanism is possible given that MMFs are subject to run-like redemptions because they offer investors demandable liabilities in order to satisfy their liquidity needs. When an [sic] MMF experiences large unexpected redemptions, it runs the bank to protect all its investors, and not just those initiating the redemptions. Because of the bank’s fixed promise, the MMF, receiving negative information on the bank’s assets, obtains a higher payoff for its investors if it runs than if it does not.