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Managing Money Market Funds in a Post-Basel III World

by Nathan Douglas, IMMFA Secretary General

The banking system has been subjected to increased scrutiny over the last few years, and it is only now that we have more certainty on the future regulatory structure of this system. The principal change to banking regulation is the Basel III framework. Money market funds purchase a significant volume of bank debt, and are subsequently impacted by most changes which occur within banking regulation. Therefore, as banks change and adapt to the new Basel III requirements, money market funds will also have to change and adapt.

What is Basel III?

All banks are required to hold sufficient capital to allow them to operate, with the capital held intended to offset any risk associated with the business and activities they perform. In 1988, the Basel Committee, which comprised banking regulators from around the globe, published a set of minimum capital requirements which large, internationally active banks should adhere to. These requirements were revised in 2004 (the Basel II framework) as the obligations imposed on banks increased in maturity and coverage. However, this framework revealed some inadequacies when faced with a stressed financial system.

The Basel Committee thus instigated new discussions aimed at improving the robustness of banks, and in December 2010 published the Basel III framework. This framework, to which all of the major economies of the world have agreed, includes revised capital requirements which banks must follow, and for the first time, liquidity obligations. In combination, these requirements are designed to deliver a more robust banking system  which is better able to withstand stresses.

Why is this important?

The changes which the Basel III framework will instigate are fundamental. The structure of a bank’s balance sheet will be significantly different post-Basel III, and banks will likely assess their business models to ascertain what remains viable under the new regulatory structure. Much of the initial focus of banks and commentators has been on the capital requirements within Basel III. These will see banks having to hold at least twice as much equity as they do today. With increased emphasis on equity, the appetite of banks to issue debt may be reduced compared to the situation today.

The Basel III framework whilst designed for banks, will have significant consequences for money market funds and their investors.

However, the liquidity requirements will also result in a material change to the operation of all banks. Under the two liquidity ratios, banks will be required to hold more liquid assets and more stable, long-term funding. Consequently, banks will favour retail deposits over institutional investment, and will seek funding which is invested for a year or more. This will again reduce the appetite of banks to issue short-term debt or to receive investment from any financial institution compared with the current position.

Although the Basel III framework directly impacts banks, its influence will be felt elsewhere. A money market fund provides a pooled investment vehicle  which purchases numerous securities in order to diversify risk. All of these securities must be of a high quality in order to limit the risk of loss of capital. Although the portfolio of securities within a money market fund will be issued by a range of institutions, research by Fitch1 confirms that, as at February 2011, over 73% of the securities purchased by US money market funds were issued by banks across the globe. This figure is likely to be similar for European money market funds. The regulatory changes primarily directed at banks will therefore have consequent impacts upon money market funds given their predilection for securities issued by banks.

The impact on money market funds

Although the Basel III framework will not come into effect until January 2013 (and not be fully implemented until 2019), there is already evidence that banks are moving towards the standards required. Banks may view the attainment of the new standards in advance of others as a competitive advantage. Such achievement is likely to provide the market with greater assurances around the financial health of a bank. As a result, money market fund managers are already reporting that the appetite of banks for short-term funding from institutional investors is reduced.

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