An Open Letter to Bill McNabb, CEO of Vanguard Group

Dear Mr. McNabb,

We find your WSJ op-ed (Wednesday, May 6) misleading, short-sighted, self-serving, and very disappointing.

Vanguard has been in the forefront of providing low-cost, reliable access to U.S. and global capital markets to millions of customers, including ourselves. Following the financial crisis of 2007-2009, the firm naturally should be a leader in promoting a more resilient financial system. Your op-ed sadly goes in the opposite direction.

Let’s start with the most stunning example: your defense of money market mutual funds. MMMFs are simply banks masquerading as professionally managed investment products. Like banks, they engage in liquidity and maturity transformation. Like banks, they faced runs in 2008 that ended only when the federal government provided a guarantee that put taxpayers at risk. Even with that guarantee, the government still had to support many healthy U.S. corporations with household names that – having previously relied on MMMF purchases of their commercial paper – suddenly faced a severe credit crunch. And, to limit a fire sale amidst the crisis, the Federal Reserve had to provide special funding to buyers to help MMMFs unload their assets.

Unsurprisingly, fund sponsors and their clients – both creditors and borrowers – want to keep these opaque federal subsidies (especially the implicit guarantees that only become explicit and transparent in a crisis). Like them, you make the false, but popular claim that power-hungry regulators (who wish to limit the subsidies that make future crises more likely) are attacking (taxing!) Main Street instead of Wall Street.

In fact, the investment company industry captured its primary regulator long ago, and hasn’t let go.  The Securities and Exchange Commission’s 2014 “reform” of MMMFs is exhibit A.  It almost surely makes these funds more, not less, liable to runs (see here and here). And – what a surprise – Congress seems to find protecting U.S. taxpayers from contingent liabilities (like implicit financial guarantees to your industry) less attractive than the largesse of financial lobbyists. Even the voluminous Dodd-Frank Act didn’t address MMMFs!

While MMMFs are the most bank-like of mutual funds, they are not the only investment company vehicles that engage in bank-like activities that makes them vulnerable to runs and fire sales. Bond mutual funds are another example. Some hold illiquid securities like corporate, emerging market and municipal debt, promise to price the securities in their portfolios every day, and offer customers redemption on demand at those (questionable) daily values. What happens when the little market activity in these instruments that exists on a normal day dries up? We already know from painful experience: in 2007, it was the inability of some mutual funds to price their subprime debt holdings that compelled them to limit withdrawals and sent everyone in the global financial system scrambling for liquidity (and for government backstops when they couldn’t find it).

At the risk of overstating our case, these funds represent a significant fraction of the intermediation activity in the United States.  The sum total of assets in MMMFs, taxable bond funds and municipal bonds funds is now on the order of $6 trillion.  That’s nearly one half of deposits in U.S. banks and credit unions.

Following the global financial crisis, Congress charged the new U.S. Financial System Oversight Council with the job of preventing another such disaster. One key means of doing so is to impose on banks capital and liquidity requirements that are both high and binding (unlike those that were in place before). Yet, this also tilts the playing field in favor of competing intermediaries who offer bank-like services outside of the regulatory perimeter. If, instead of reducing systemic risk, capital requirements on banks merely shift it to run-prone nonbanks, the financial system will remain vulnerable. In such a world, fire sales and credit crunches would become nonbank, rather than bank, phenomena. And, the meager protection we have in place today would become useless to stop another conflagration.

As a protector of global financial stability, and an advocate for the small investor, you should be promoting regulation of the activities that threaten the financial system regardless of the legal form of those who undertake them. This should lead you to support our position, which is to regulate the activities that investment companies undertake, rather than naming one or two really big companies as systemically important financial intermediaries (SIFIs). This means that various forms of liquidity associated with mutual funds – like repo, securities lending and the like – should face tougher rules and penalties that make them more resistant to runs and fire sales, just like bank deposits.

If, for example, funds investing in illiquid assets face appropriate purchase and redemption fees, they would be making transparent to investors from the start that the magic promise of ever-present liquidity was never credible. Many bond funds (of the type that all mutual fund companies offer) fit this bill. Higher redemption fees, in particular, can help balance the interests of the buy-and-hold investors and those who wish to trade actively.

As others have rightly noted, such redemption fees pose a collective action problem: even if everyone were to miraculously impose fees voluntarily, they would quickly be eliminated by a competitive race to the bottom.  It is exactly for circumstances like this that we need regulation: the industry should be lobbying the authorities to force mutual funds and their asset managers to do something they know they should do, but can’t do on their own.

As the CEO of one of the largest mutual fund companies in the world that is dedicated to serving and protecting small investors, you should be in the vanguard of advocating reforms that enhance stability.

Instead of complaining about regulation under the guise of protecting Main Street, you should highlight the vulnerabilities in our financial system and make the case for efficient regulation that treats all activities equally. You should also promote investment vehicles that are likely to prove robust in a crisis, while warning about existing products that probably won’t be.

Only greater resilience in the system can make investors confident that capital markets here and elsewhere will remain strong. That is in Vanguard’s interest, too.

Sincerely,

Stephen G. Cecchetti and Kermit L. Schoenholtz