Abstract
This paper conducts an ethical analysis of the 2008 closure of a US money market fund entitled the reserve primary fund (RPF), which triggered the first run in the money market sector and a resultant liquidity crisis that harmed the entire US financial system. Although many academics and regulators have studied and written about RPF, the question whether the decision that caused the fund to collapse represented any ethical dilemma, has not been addressed to date. With this purpose in mind, the paper will examine the events that culminated in the closure of RPF according to Alasdair MacIntyre’s virtue ethics approach. In so doing, the paper aims to extend the applicability of MacIntyre’s concepts to the finance industry in general, and to provide a framework to predict and so potentially prevent crises like that exemplified by the RPF case.
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Notes
A rule that was impeding retail investors having access to market interest rates. The idea was simple: use a structure similar to that of the mutual fund (pooled investment vehicles, where investors became owners of fund shares) to invest in securities with high liquidity and short maturity that would give higher yields than banks or saving accounts.
See Baklanova (2012), Akay et al. (2015b), Swirsky (2008) for a full comprehension of Rule 2a-7 and its amendments. As explained below, one of the consequences of the financial turmoil of 2008 has been a new regulation of the money market funds, based on a distinction between institutional and retail funds.
The accounting techniques that since then have allowed for this type of evaluation are: (a) the valuation of assets at an amortized cost, a kind of book value in accordance with the International Accounting Standard (IAS) 39 that records the value of the securities at their purchasing price minus changes related to amortization; (b) the 'penny rounding' mechanism that makes it possible to keep a stable NAV at $1.00 as long as the changes in the market-based NAV (Floating NAV) range between $1005 and $0.995.
In times of market stress, an investor who anticipates changes in prices has an incentive to withdraw its shares and benefit from the stable NAV and consequently dilute the value of the fund for the remaining investors. This creates a risk for the remaining investors who now have a market-based NAV that is lower than what the exiting investor redeemed his shares at and which can be further reduced until below the threshold of $0,995, breaking the buck (Lyon 1984).
For a complete analysis on all the different types of MMFs seeing Baklanova (2012).
These conduits are shell companies set up by banks and financial companies essentially to transfer credit risk and increase their leverage (Acharya and Schnabl 2009).
MMFs can hold commercial paper that carries the highest or second-highest rating for short-term debt from at least two of the nationally recognized credit rating agencies. Furthermore, MMFs must not hold more than 5% of their assets in securities of any individual issuer with the highest rating and not more than 1% of their assets in securities of any individual issuer with the second-highest rating. Finally, total holdings with the second-highest rating must not exceed 5% of the fund’s assets.
Even if the lack of an explicit insurance program has been one of the most debated issues in the regulation following the crisis, money market funds are still deprived of it.
Institutions typically invest in riskier MMFs because they believe they can redeem their shares at a stable $1 NAV, before bearing any losses associated with this risk-taking (first mover advantage).
An event identified as a first harbinger of the crisis that followed (Acharya and Richardson 2009).
Akay et al. (2015a) use as benchmark for the spread the average yield on 30-day non-financial commercial paper since this rate is the rate least altered by the financial crisis.
In April of 2008, the US government, through the Federal Reserve Bank of New York, rescued Bear Stearns by lending $29 billion to JPMorgan Chase to buy the financially troubled firm.
For the aim of this paper the difference between the Reserve Management Company, Inc., and the Reserve Primary Fund is not relevant. Reserve Management Company, Inc. was the financial sponsor of the Reserve Primary Fund. Bruce Bent as Chairman of the Reserve Management Company, Inc. was eventually responsible for the investment decisions of the Reserve Primary Fund, of which he was Chairman, President, Treasurer and Trustee.
By cash management, or treasury management, we refer to an area of finance involving the collection, handling and usage of cash.
Against the critique of circularity often directed at virtue ethics (Moore 2017, p. 49).
Lehman Brothers was considered one of the major players in the financial industry. Its bankruptcy on September 15, 2008, marked the beginning of the public’s awareness of the financial crisis.
Through this settlement the investors received back more than 99% of their investment in RPF from 2008.
The event raised important questions about the nature of the money market mutual funds and their implicit promise of a stable NAV (Gordon and Gandia 2013; Witmer 2016). In 2014 the Securities and Exchange Commission (SEC 2014) adopted amendments to the rules that oversee money market funds to address this issue. The reform of 2014 addressed the risk of loss for some shareholders by defining the standard of excellence that serves the internal good of the money market funds. If the loss for the shareholders was a first vice as analyzed in this section, a worse problem that received the attention of the regulators came from another source, namely the run of the money market funds from the short-term market which froze the liquidity of the overall financial system. This issue will be take into account in the last section.
Furthermore, it is worthy to underline that the existence of the regulation, such as Rule 2a–7, was not sufficient to protect the goodness of the practice of the money market funds. This is because proper rule-following needs practical wisdom. Human beings are not all-knowing and are unable to establish perfect rules or foresee all circumstances, which implies that there will always be room for practical wisdom in the interpretation and implementation of rules (Sison and Hühn 2018).
A basis point is 1/100 of 1 percent or $10 on $100,000 invested for an entire year.
The expression gambling for resurrection was coined by Baldursson and Portes (2014) to describe a situation in which a manager facing bankruptcy decides to take on excessive risks hoping for a good outcome.
Most of the money market funds prefer to run from the asset-backed commercial paper since the first signals of the crisis, even if the yields of those instruments were particularly attractive.
The commercial papers market did not usually provide high returns and hence, it was unexpected that the funds ended up with the opportunity to earn cheap money by drawing large investors in.
According to the Financial Crisis Inquiry Report (National Commission on the Causes of the Financial and Economic Crisis in the United States 2011), Michael Luciano, a RPF manager, assumed that after the government-assisted rescue of Bear Stearns, the federal government would similarly save the day if Lehman or one of the other investment banks—which were much larger and posed greater apparent systemic risks—ran into trouble.
Most of the regulation reforms following the financial crisis of 2008 have had as a central aim to restore financial stability (Acharya and Richardson 2009). Financial Stability has been defined as a public good long before the financial crisis of 2008 (Kaul et al. 1999). Van De Ven (2011, p. 558), speaking of banking activity, refers to financial stability as one of the “societal goals and values which presupposes trust in other financial institutions.”
The US Government heavily intervened to stop the run in commercial paper and money market funds. There were four main interventions: (i) On September, 19, 2008, the US Department of the Treasury announced an explicit deposit insurance program covering all money fund investments made prior to the Lehman default; (ii) On September, 19, 2008, the Federal Reserved (FED) decided to provide a liquidity backstop to money market mutual funds through the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF); (iii) On October, 7, 2008 the FED announced the creation of the Commercial Paper Funding Facility (CPFF) in response to the freezing up of the commercial paper market. CPFF aims to provide a liquidity backstop purchasing three-months commercial papers issued by US entities; (iv) Finally on October, 21, 2008, FED launched another lending program—the Money Market Investor Funding Facility (MMIFF)—that was intended to complement the AMLF, by purchasing—through special purpose vehicles—short-term instruments other than asset-backed commercial paper (such as: certificate of deposits, bank notes, corporate and financial commercial paper). A full description of these programs´ functioning and cost is provided by a document published by the Congressional Budget Office (2010); Acharya and Sundaram (2009); Duygan-Bump et al. (2013); Kacperczyk and Schnabl (2013).
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Acknowledgements
We wish to thank the several financial practitioners and scholars for helpful and informative discussions of both ethical and technical aspects of our argument and in particular: Marco Sormani (Varenne Capital Partners), Marco Cipriani (Federal Reserve Bank of New York) and Gabriel García Daumen (Stelac Advisory Services LLC), Antonio Moreno Ibañez and Alejo J. Sison (University of Navarra), and the two anonymous referees. Andrea Roncella gratefully acknowledges the financial support of the MCE Research Centre at the Pontifical University of the Holy Cross and the Asociación de Amigos de la Universidad de Navarra.
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Roncella, A., Ferrero, I. A MacIntyrean Perspective on the Collapse of a Money Market Fund. J Bus Ethics 165, 29–43 (2020). https://doi.org/10.1007/s10551-018-4078-9
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DOI: https://doi.org/10.1007/s10551-018-4078-9