Fast-growing money market funds linked to 'exuberant' equity markets and systemic risk

A new study published in the Journal of Banking & Finance reveals that rapidly growing money market funds (MMFs) linked to soaring equity markets may pose a systemic risk to the global financial system. Researchers analyzed data on 3,568 U.S. dollar-denominated MMFs from 2004 to 2022 and found that the potential risk of such funds is more dependent on their rate of growth than their size, particularly during periods of booming financial markets.

Professor Giovanni Urga, one of the co-authors from Bayes Business School in London, stated that regulators and policymakers should consider the characteristics and behavior of individual nonbank financial institutions, as they play a significant role in the buildup and spread of risk through the financial system. The study found that larger MMFs are typically associated with lower systemic risk during normal market conditions, but during equity market booms, rapid fund growth becomes associated with increased systemic risk.

A one-standard-deviation increase in fund-size growth is linked to a 5.7 basis points rise in systemic risk during these periods.

The research suggests that rapid expansion of nonbank financial institutions during asset-price booms should be seen as a red flag for potential vulnerabilities, prompting a more differentiated approach to supervision. Government MMFs and offshore U.S. dollar funds were found to pose lower systemic risk compared to prime MMFs, which primarily invest in commercial paper and certificates of deposit.

The authors emphasize the importance of examining the microeconomic drivers of systemic risk, rather than solely focusing on macroeconomic variables correlated with asset price bubbles.