It has been suggested in the media that the real reason why the Reserve Bank rescued African Bank is the exposure of money market funds to African Bank debt instruments.
The perceived risk was that losses on African Bank paper held by money market funds could cause them to “break the buck” (unit prices declining to below R1 per unit or par), and that a loss of confidence could then have caused a run on these funds.
This could develop into a systemic event creating difficulties for borrowers issuing commercial paper to finance operations, in turn affecting real economic activity negatively.
The question is whether this is a plausible argument.
Fears in this regard probably originate from the 2008 financial crisis when subsequent to the bankruptcy of Lehman Brothers, the Reserve Primary Fund, with total assets of $62 billion (R656bn), “broke the buck”.
The eventual losses to investors amounted to less than 1.5 percent, in spite of the severity of the subprime crisis.
The losses at the Reserve Primary Fund coincided with a switch in the amount of $500bn (14 percent of total money market assets) out of primary funds, with the bulk of the withdrawals reallocated to government money market funds with lower risk.
However, it is important to note that this was not a “run” on primary funds and the money remained within the system.
However, to avoid disruption in the market for commercial paper, the US government stepped in to temporarily extend deposit insurance to money market funds, while the Federal Reserve established a special liquidity facility to support the market for commercial paper.
According to the Financial Services Board (FSB), money market funds as a whole had an exposure of 1.3 percent of total assets to African Bank debt.
Leon Campher, the chief executive of the Association for Savings and Investment SA, which counts collective investment schemes among its members, has expressed the view that fund managers’ exposure to African Bank was not so high as to cause “meaningful losses”.
The exposure of individual money market funds to African Bank debt would have varied around the average of 1.3 percent mentioned by the FSB.
Funds will differ in the way they account for any losses, with many preserving the price of R1 per unit by cancelling an appropriate number of units.
Money market funds also differ in the degree to which they have warned investors about the possibility of capital losses.
Many funds were clear in spelling out the risks to investors, warning them of the possibility of capital losses that in the event would be borne by investors*.
To the extent that investors took these warnings to heart, the losses imposed by the failure of African Bank should not come as a shock, dampening any systemic risk.
Local industrial firms do not depend on the commercial paper market for short-term financial needs as in the US, which weakens the argument for intervention.
The attraction of money market funds is their ability to earn higher returns than those offered by bank deposits.
However, the basic investment principle that higher returns come with higher risk still applies.
A twist to this argument relates to banks’ compliance with the new net stable funding ratio under Basel 3.
The implication is that they should reduce dependence on wholesale funding (such as money market funds) and use more retail funding (account deposits) on the assumption that the latter is a more stable source of funding.
A greater awareness of the risk in money market funds should favour investment in bank deposits and help banks to comply with the net stable funding ratio.
So paradoxically the Reserve Bank should not try to dampen increased perceptions of risk in money market funds because of African Bank’s failure.
Reference: Alan S Blinder: After the Music Stopped. Penguin Press. New York. 2013.
* The fact sheet for the Sanlam Glacier Money Market Fund contains the warning: “The price of each unit is aimed at a constant value. The total return to the investor is primarily made up of interest received, but may also include any gains or loss made on any particular instrument. In most cases this will merely have the effect of increasing or decreasing the daily yield, but in an extreme case it can have the effect of reducing the capital value of the fund.”
Jac Laubscher is the group economist at Sanlam.