Regulatory SWAT Team May Have to Move Slowly on Money Funds

A SWAT team of top regulators was formed after the financial crisis to swoop in and stamp out big risks lurking in the financial system. Should the mutual fund industry fear this team as it tries to protect one of its biggest products from further reform?

The Securities and Exchange Commission said on Wednesday that it would have to drop its proposed overhaul of the money market mutual fund industry after it was a clear that a majority of its commissioners would not support the reforms. Investors use money market funds like banks accounts, a theoretically safe place to park cash for short periods. But many investors fled the funds during the financial crisis in 2008. Regulators have therefore wanted to impose changes they think would prevent such runs.

After the S.E.C. defeat, regulators are contemplating pursuing money fund overhaul through the Financial Stability Oversight Council, essentially a supercommittee of financial regulators. It was set up by the Dodd-Frank legislation to identify systemic risks that individual regulators may not have a grip on — and then set in motion moves to remove those risks. The council, which is led by Treasury Secretary Timothy F. Geithner, has said that money funds are a concern, and backed the reforms scuttled at the S.E.C.

On paper, the council certainly has the freedom and power to take up money market funds, and then identify them as an area of risk.

“F.S.O.C. exists for this very circumstance,” said Dennis Kelleher, president of Better Markets, a lobbying group that has pushed for stronger financial regulation.

But the big question is whether the council has the resolve to go down untrodden paths and officially designate money funds as a risk, especially in the few months before the presidential election.

In some ways the council has to act. The Treasury Department and the Federal Reserve have both supported money fund reform, saying they remain vulnerable. Therefore, failure to use the council would mean they were resigned to letting a systemic risk remain.

Conversely, they may balk when they think through what they have to do.

One concern in Washington may be that if the council takes up money funds, it would damage the standing of the funds’ primary regulator, the S.E.C. Darrell Duffie, a professor of finance at Stanford University, says the council should act on money funds, but he adds, “there would be a weakening of the S.E.C.”

Even though the council has freedom to label money funds a risk, its two main options present serious challenges. One is to designate the whole money fund industry as a risk. But the Dodd-Frank legislation effectively says that if the council took that approach, the S.E.C., as the funds’ primary regulator, would ultimately have to sign off on the reforms. The S.E.C.’s current commissioners might not vote for the recommendations. But another set might.

Another option: The council might designate individual money funds, or the companies that manage them, as systemically important. Those funds would then end up regulated by the Fed, which could decide to impose new rules.

But the council’s members might worry that picking only some funds could create instability in the sector and create an unlevel playing field.

That would be something that the mutual fund companies would most likely emphasize.

“Designating one money market fund as a significantly important financial institution won’t accomplish much except destroy that one money market fund,” said Jay G. Baris, a lawyer at Morrison & Foerster, which has represented fund companies.

But Mr. Kelleher, who favors reforms, said the council could simply designate, say, the 100 largest funds as systemically important, which would mean regulation of most of the industry.

The opponents of the reforms acknowledge that the council has a lot of authority, but they say it will still need to present a thorough analysis of the costs and benefits of the reforms. The council “would not be able to operate arbitrarily without standards,” said Robert M. Kurucza, a partner at the law firm Goodwin Procter.

As a result, the council will most likely move slowly and carefully. Not only will it need to build a detailed case for designating money funds as a risky sector, it will also want to make doubly sure that it properly fulfills its own procedures.

In other words, don’t expect to see this SWAT team bursting into the money fund sector anytime soon – even if President Obama wins re-election.