Study links fast-growing money market funds, “exuberant” equity markets and systemic risk

Money market funds (MMFs) that grow rapidly when equity markets are soaring pose systemic risk to global financial systems, new academic research reveals.

The study may amplify concerns around the scale and security of private debt amid mounting fears of a possible AI bubble in equity markets.

After analysing data on 3,568 US dollar-denominated MMFs between 2004 and 2022, the authors concluded that the potential systemic risk of such funds depends less on size than on how quickly they have grown – particularly when financial markets are booming.

Money market funds are an increasingly important part of the non-bank financial system and play a major role in providing short-term financing to governments, banks and companies. The paper has just been published in the Journal of Banking & Finance.

The authors conclude that MMFs should be incorporated more explicitly into systemic-risk monitoring frameworks, particularly during periods of asset-price exuberance when rapid fund growth can become destabilising.

Co-author Professor Giovanni Urga, Director of the Centre for Econometric Analysis at Bayes Business School in London (formerly Cass), said: “Our analysis suggests that regulators and other policymakers need to look beyond banks and broad macroeconomic indicators when assessing systemic risk. The results demonstrate that the characteristics and behaviour of individual non-bank financial institutions clearly influence how risk builds up and spreads through the financial system.”

Regulating the bubbles

The authors speculate that the heightened systemic risk of fast-growing MMFs during equities bubbles may reflect investors reaching for yield amid an equity boom.

Professor Urga said:

It is particularly striking that ‘bigger’ does not necessarily mean ‘riskier’: larger MMFs were generally associated with lower systemic risk in normal market conditions. However, that all changes dramatically during equity-market booms: suddenly, rapid fund growth is associated with higher systemic risk.

At such times, a one-standard-deviation increase in fund-size growth is associated with an increase in systemic risk of 5.7 basis points.

The same effect is not seen with real estate bubbles.

Professor Urga said: “Regulators and other policymakers should therefore see rapid expansion of non-bank financial institutions during asset-price booms as a red flag of possible emerging vulnerabilities.”

The authors call for a more differentiated approach to supervision based on differing risk profiles. Government MMFs, for example, were associated with lower systemic risk than prime MMFs (which invest primarily in commercial paper and certificates of deposit). Similarly, offshore US dollar funds do not appear to provide a significant buffer against stress originating in US markets.

The paper concluded: “Our findings [also] underscore the importance of examining the microeconomic drivers of systemic risk rather than focusing solely on macroeconomic variables correlated with asset price bubbles. In particular, we highlight the crucial role of non-bank intermediaries-whose contribution has been relatively underexplored in the literature-in amplifying systemic risk.”

* The paper, “Asset Price Bubbles and Systemic Risk in Money Market Funds”, was written by Matteo Aquilina (Bank for International Settlements and Macquarie University), Peter Cincinelli (University of Bergamo) and Giovanni Urga (Centre for Econometric Analysis, Bayes Business School, City St George’s, University of London).