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|  |  | Home	 > Industry Analysis > Research & Analysis > FYI: An Update on Emerging Issues in Banking |  |
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|  | **FYI: An Update on Emerging Issues in Banking**FYI Home    Subscribe    Unsubscribe**Effects of Interest Rates on Money Market Mutual Funds**May 19,2004
**Overview**The prolonged low interest rate environment has pressured returns on money market mutual funds (MMMFs).   Although low rates are a boon to borrowers, the opposite, of course, is true for savers, and MMMF portfolios are earning the lowest returns on investments since the funds were established more than 30 years ago (see Chart 1).1  In this environment, there has been some concern about MMMFs "breaking the buck," a situation in which the net asset value (NAV) of a MMMF falls below $1 per share.  Breaking the buck can occur if some of the fund's investments experienced significant losses, or if the fund's investment income declined below operating expenses.   D
 Should the NAV of a MMMF break the buck, shareholders could lose money.  Unlike bank deposits, MMMFs are not FDIC-insured.  However, MMMFs are relatively low risk investments, and the expectation in the marketplace is that shareholders do not anticipate losing money.  If their fund breaks the buck, shareholders would be expected to withdraw their money, unless the company sponsoring the fund provides financial support to prop up the NAV.   A byproduct of the prolonged low rate environment could be increased risk taking by MMMF managers searching for higher yields.  Higher risk investments tend to be more volatile and would decline in value more quickly in a scenario of sharp interest rate increases.  Indeed, rapidly rising interest rates may be the more problematic scenario for MMMFs.  There has only been one instance of a MMMF breaking the buck and liquidating; this was due to losses associated with high-risk structured note investments that were incurred when rates spiked up sharply in 1994.2   While this is the only MMMF that failed, there are several examples where sponsoring companies have sustained faltering MMMFs, primarily by buying or otherwise supporting troubled fund assets, sometimes expending hundreds of millions of dollars to do so.3  These companies viewed the perception of safety as an overarching factor as to why investors have placed, in aggregate, some $2 trillion in MMMFs. Therefore for them, the reputation risk of allowing a fund in their family to fail far outweighed the cost of support.This report examines the effects of interest rate scenarios on MMMF yield and net asset value, discusses challenges facing MMMF managers in terms of asset selection, and addresses potential risks to FDIC-insured banks and their affiliates that sponsor MMMFs.  Currently, banks and bank affiliates sponsor approximately 33 percent of all MMMF assets.4   Like other firms, banks and bank affiliates that sponsor MMMFs are experiencing low asset returns, diminished income from the need to reduce fees, and are subject to the general reputation risk associated with operating a MMMF.  To alert banking organizations to potential risks and the legal framework for providing support to bank-advised funds, the FDIC and the other federal banking agencies released the *Interagency Policy on Banks/Thrifts Providing Financial Support to Funds Advised by the Banking Organization or its Affiliates*on January 6, 2004.5**What is a Money Market Mutual Fund?** |
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