Boston Fed President Delivers Excellent Overview Of Potential For Credit Contagion Right Now

eric rosengren boston fed

Photo: YouTube

Boston Fed President Eric Rosengren emphasised the importance of maintaining short term credit stability by guarding the market for money market mutual funds in a speech he gave in Stockholm last week.Pointing out similarities to the collapse of short-term funding that escalated after the fall of Lehman Brothers in 2008, Rosengren argued that MMMFs are increasingly vulnerable as credit conditions tighten across the world.

The failure of one fund, he added, could result in a collapse in short-term credit in general. Not to mention that branches of foreign banks could get swept up by much the same problems.

His answer? Basel III will help foreign banks maintain more capital, but the U.S. should also consider more closely regulating the MMMF and foreign banking industry.

Pressure on dollar funding has magnified even though the Fed has increased the size of its balance sheet.

The widening spread between LIBOR and OIS rates suggests strains in interbank markets.

This shows the cost of using derivatives contracts to obtain dollars. Under positive economic conditions, it should be close to 0.

With $2.5 trillion under management, MMMFs play a huge role in short-term credit markets. When Lehman fell, the net asset value of one MMF dropped below $1, leading to a run on MMFs in general.

Credit-sensitive MMFs (prime money market funds) experienced the biggest shocks when Lehman fell, while less risky MMFs were hardly impacted.

MMFs have amped up liquidity in the last year, both because of new regulations and perceived liquidity risk.

With low returns on short-term investments right now, MMMF investors have been squeezed.

MMMFs have sharply decreased exposure to Europe, particularly in the troubled periphery. But the failure of even one MMF could be dangerous. More regulation could protect the industry.

Foreign branches are ineligible for much of the funding domestic U.S. banks rely on.

Foreign banks and branches are hugely dependent upon MMFs (and other wholesale funding), and so suffer some of the same problems as MMFs. The U.S. should consider addressing this.

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.