NERA experts published a paper titled “Money Market Mutual Funds: Stress Testing and the New Regulatory Requirements.”
The introduction to the paper provides a brief description of the failure of the Reserve Primary Fund, a money market fund that “broke the buck” following the failure of Lehman Brothers, which is regarded as one of the signal events in – and causing – the 2008 financial meltdown. The paper then provides a brief summary of the changes to the regulation of money market funds made under ICA Rule 2a-7 in response to the failure of Lehman.
Following that background, the bulk of the paper concerns the creation of an “econometric and data simulation framework” that aims to bring a money market fund into full compliance with the SEC’s stress testing requirements that become effective in 2016. The paper outlines three stress test scenarios: (i) an increase in short-term risk; (ii) a widening of spreads generally; and (iii) a significant downgrade in an issuer to which the fund has exposure.
The paper also provides seven stress-testing questions for firms to consider when assessing results of stress tests, including:
- Do the scenarios cover all SEC-mandated stress testing scenarios?
- Is fund management making full use of the testing framework by including other relevant scenarios of business interest?
- Are the parameters chosen for the stress testing scenarios realistic?
- How often are the parameters of the approach recalibrated to reflect changes in the portfolio?
- How effective is the internal validation of the methodology used?
- What is the margin of error (confidence interval) of the results presented?
- What is the best way to summarize and present the results of a set of stress tests?
Lofchie Comment: Bringing home the risk that directors of money market funds face if they do not institute – and follow – the procedures required by revised ICA Rule 2a-7, the authors also cite the SEC enforcement action against Ambassador Capital Management, a money market fund that took significant risks in order to boost returns, and whose directors were unaware of the degree of risks to which the fund was exposed. Directors should also be mindful of the various SEC enforcement actions that have been brought against funds and their affiliated persons for improper valuation procedures.