Implicit Guarantees and Risk Taking: Implicit Guarantees and Risk Taking: Implicit Guarantees and Risk Taking: Implicit Guarantees and Risk Taking: Evidence from Money Market Funds Evidence from Money Market Funds Money and Payments Workshop Money and Payments Workshop Money and Payments Workshop Money and Payments Workshop October 7, October 7, 2011 2011 Marcin Marcin Kacperczyk Kacperczyk (NYU Stern/NBER) (NYU Stern/NBER) Philipp Schnabl (NYU Stern/CEPR) Philipp Schnabl (NYU Stern/CEPR) pp pp ( ( / / ) )
Motivation Motivation � Implicit guarantees Implicit guarantees � Firm’s termination generates bankruptcy costs Firm’s termination generates bankruptcy costs � Generate incentives for owner or third � Generate incentives for owner or third Generate incentives for owner or third-parties to bail out a firm Generate incentives for owner or third-parties to bail out a firm parties to bail out a firm parties to bail out a firm � Can affect firm’s risk taking outside bankruptcy Can affect firm’s risk taking outside bankruptcy � Importance of implicit guarantees Importance of implicit guarantees � Difficult to measure (similar to costs of financial distress) Difficult to measure (similar to costs of financial distress) � Often � Often Often exist Often exist exist between parent company and subsidiary exist between parent company and subsidiary between parent company and subsidiary between parent company and subsidiary � Important in financial industry (to avoid inefficient runs) Important in financial industry (to avoid inefficient runs)
Research Question Research Question � How do implicit guarantees affect risk taking? How do implicit guarantees affect risk taking? � � Theory (largely Theory (largely in banking) emphasizes two effects: in banking) emphasizes two effects: � Beneficiary of guarantee increases risk taking (moral hazard) Beneficiary of guarantee increases risk taking (moral hazard) � Provider of guarantee reduces risk taking (internalizes the cost) Provider of guarantee reduces risk taking (internalizes the cost) � But limited empirical work But limited empirical work �
Empirical challenges Empirical challenges Implicit guarantees are non Implicit guarantees are non- -contractual contractual 1. 1. Risk taking is difficult to measure Risk taking is difficult to measure 2. 2. Provision of implicit guarantees is endogenous Provision of implicit guarantees is endogenous 3. 3.
S Setting: Money Market Funds Setting: Money Market Funds S i i M M M M k k F F d d � Money market funds are regulated by SEC Money market funds are regulated by SEC Money market funds are regulated by SEC Money market funds are regulated by SEC � Must invest in safe money market instruments (high ratings, Must invest in safe money market instruments (high ratings, short maturity, etc.) short maturity, etc.) � In exchange, can value investments at cost and sell demand In exchange, can value investments at cost and sell demand deposits with stable Net Asset Value ($1 per share) deposits with stable Net Asset Value ($1 per share) � Str ct red like a “narro � Structured like a narrow bank Str ct red like a “narro Structured like a narrow bank bank” bank” � Money market funds are subject to bank runs Money market funds are subject to bank runs � “Breaking the buck” is one mechanism to stop run (before 2008 “Breaking the buck” is one mechanism to stop run (before 2008 Breaking the buck is one mechanism to stop run (before 2008, Breaking the buck is one mechanism to stop run (before 2008, � only used once by small fund in 1994) only used once by small fund in 1994) � Alternatively, fund sponsor provides guarantee to stop run Alternatively, fund sponsor provides guarantee to stop run
S Setting: Money Market S Setting: Money Market Mutual Funds i i M M M M k k M Mutual Funds M l F l F d d Sponsor Provides implicit guarantee Provides implicit guarantee Chooses managers Chooses managers Money Market Funds Money Market Funds Certificate of Deposits Demand Deposits Demand Deposits (A (Asset-Backed) Commercial Paper B k d) C i l P (sold at a fixed NAV, usually $1) Repurchase Agreements Obligations Treasury Bills Treasury Bills 6
Ad Ad Advantage of our setting Advantage of our setting f f i i � Implicit guarantees are central to this Implicit guarantees are central to this industry industry � Large and important industry ($ 3 trillion in 2008) Large and important industry ($ 3 trillion in 2008) � Assets under management about the size of equity mutual funds Assets under management about the size of equity mutual funds � Demand deposits provided similar to commercial banking sector Demand deposits provided similar to commercial banking sector � Can observe and measure risk Can observe and measure risk-taking decisions b b d d k k taking decisions k k d d � Weekly data on fund holdings, flows, and Weekly data on fund holdings, flows, and returns returns
E E Empirical Strategy Empirical Strategy i i i i l S l S � Unexpected Shock: � Unexpected Shock: Unexpected Shock: Sub Unexpected Shock: Sub Sub prime mortgage crisis (Aug 2007 Sub-prime mortgage crisis (Aug. 2007 prime mortgage crisis (Aug 2007 08) prime mortgage crisis (Aug. 2007-08) 08) 08) � � � Prior to 2007, most money market instruments had similar yields Prior to 2007, most money market instruments had similar yields � Large Large decline decline in collateral values of money market instruments in collateral values of money market instruments � Some instruments became riskier Some instruments became riskier (expansion in risk (expansion in risk- -taking opportunities) taking opportunities) � Strong incentives to take on more risk (“yield chasing”) Strong incentives to take on more risk (“yield chasing”)
E E Expansion in Risk-Taking Opportunities Expansion in Risk i i i i Ri k Ri k T ki Taking Opportunities T ki O O i i i i 1.4 Pre Post 1.2 suries (%) 1 ve to Treas R Repos 0.8 Deposits Obligation 0.6 read Relativ FRNS FRNS 0.4 CP ABCP 0.2 Spr 0 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 -0.2 M M M M S M S M N N 9
E E Empirical Strategy Empirical Strategy i i i i l S l S � Unexpected Shock: � Unexpected Shock: Unexpected Shock: Sub Unexpected Shock: Sub Sub-prime mortgage crisis (Aug. 2007 Sub prime mortgage crisis (Aug 2007 prime mortgage crisis (Aug 2007 08) prime mortgage crisis (Aug. 2007-08) 08) 08) � � � Use variation in “ability” to provide implicit guarantees Use variation in “ability” to provide implicit guarantees � � Guarantee after shock depends on sponsor’s capital Guarantee after shock depends on sponsor’s capital � Sponsor capital determined by mutual fund organization Sponsor capital determined by mutual fund organization � � All sponsors are part of larger mutual fund organization � All sponsors are part of larger mutual fund organization All sponsors are part of larger mutual fund organization All sponsors are part of larger mutual fund organization � Some mutual fund organizations are affiliated with banks Some mutual fund organizations are affiliated with banks
Results: The Tale of Two Funds Results: The Tale of Two Funds � Reserve � Reserve Reserve Primary Fund Reserve Primary Fund Primary Fund Primary Fund � Oldest fund in the money market fund industry Oldest fund in the money market fund industry � Known for Known for its safe approach to its safe approach to investing pp pp investing g � Sponsored by Reserve Funds Sponsored by Reserve Funds 11
Results: The Tale of Two Funds Results: The Tale of Two Funds � Reserve Primary Fund � Reserve Primary Fund Reserve Primary Fund Reserve Primary Fund � Oldest fund in the money market fund industry Oldest fund in the money market fund industry � Known for its safe approach to investing Known for its safe approach to investing pp pp g g � Sponsored by Sponsored by Reserve Funds Reserve Funds � Columbia Cash Reserves Fund Columbia Cash Reserves Fund � Large, well Large, well- -known fund known fund � Sponsored by Bank of America Sponsored by Bank of America 12
Results: The Tale of Two Funds Results: The Tale of Two Funds � Reserve Primary Fund � Reserve Primary Fund Reserve Primary Fund Reserve Primary Fund � Oldest fund in the money market fund industry Oldest fund in the money market fund industry � Known for its safe approach to investing Known for its safe approach to investing pp pp g g � Sponsored by Sponsored by Reserve Funds ( Reserve Funds ( little capital little capital ) � Columbia Cash Reserves Fund Columbia Cash Reserves Fund � Large, well Large, well- -known fund known fund � Sponsored by Bank of America ( Sponsored by Bank of America ( significant capital significant capital ) 13
R R Reserve Primary: Assets and Return Reserve Primary: Assets and Return P i P i A A d R d R 50 70 Pre Post 45 60 40 50 35 30 asispoints 40 $ billion 25 30 30 Ba 20 Assets Return 15 20 10 10 10 5 0 0
C l C l Columbia Cash Reserves: Assets and Return Columbia Cash Reserves: Assets and Return bi C bi C h R h R A A d R d R Pre Post 0 50 45 -5 40 -10 35 -15 $ Billion 30 Basis points -20 25 Assets 20 20 R Return B -25 15 -30 10 -35 35 5 -40 0
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