In the decade surrounding the Great Depression, about 9,000 banks failed. Some of these institutions were undercapitalized, others made risky investments, and still more were just victims of the devastating economic turmoil. Regardless of the cause of the bank failures, the result was often the same – investors lost their life savings along with their faith in the banking system.
To prevent a similar catastrophe in the future, U.S. lawmakers created many new rules to ensure banks remained solvent, and to restore trust in the industry. While many of these provisions were both necessary and beneficial – like the establishment of the Federal Deposit Insurance Corporation [FDIC] – the major problems that one particular rule would create were not foreseen – and didn’t materialize for several decades.
1966-1970: Regulation Q Sets the Stage for Money Market Mutual Funds
Among other things, the Glass-Steagall Act of 1933 sought to prevent commercial banks from engaging in risky behaviors that had exacerbated bank failures during the Great Depression. ‘Regulation Q’ was one such provision in the act and it capped the interest that banks could offer on deposits.
From the introduction of Regulation Q through 1965, the cap on deposit rates exceeded prevailing market interest rates. This meant that bank customers received comparable rates of return from savings accounts and similar investments such as short-term Treasuries. During this time, the regulation worked as intended.
The following year, inflation pushed market interest rates above the Regulation Q rate cap1. As a result, banks were no longer able to compete on rates and customers began searching for an alternative that would provide a more competitive return. Some short-term bonds were able to offer rates closer to customer expectations, but they often lacked the accessibility and stable value investors had grown accustomed to with bank accounts.
Regulation Q kept deposit ceilings artificially low throughout the late 1960s and 1970s, creating the opportunity for Bruce Bend and Henry Brown to create a new investment option. This innovation would be called the money market mutual fund.
1971: The First Money Market Mutual Fund is Created
In 1969, there were options for wealthy investors to achieve higher rates of return than Regulation Q allowed for the average savings account. However, small investors didn’t have the capital necessary to participate in those markets. That year, Bend and Brown had the idea to create a mutual fund which would allow investors to pool their assets and buy short-term, high-quality investments, like commercial paper and repurchase agreements. By 1971, they had turned this idea into the Reserve Fund, the first money market mutual fund.
Mutual funds were not a new concept – the first modern mutual fund launched in 1924 – but Bend and Brown’s creation was different. Rather than stocks and bonds, which can have volatile prices, the Reserve Fund invested in assets that allowed the fund to maintain a stable, $1 per share value. Since the Reserve Fund was issued by an investment firm rather than a bank, it was not subject to the rate caps of Regulation Q. With this fund, investors could achieve a market rate of return, a stable value, and the liquidity they needed for their cash.
After some initial hesitation, investors flocked to the Reserve Fund and other money market mutual funds that emerged throughout the 1970s. By 1975, money market mutual funds held more than $3.6 billion in assets. Just five years later, that number had grown to more than $61 billion.
While money market mutual funds provided many of the benefits investors sought for their cash – liquidity, stability, and returns – they fell short in one key area. Funds invested in a money market mutual fund were not guaranteed or insured by the fund sponsor, the FDIC, or any government agency. This shortcoming would become startlingly apparent in just a few decades.
1979 – 1980: Tighter Policy Widened the Gap Between Deposit Rates and Market Interest Rates
The time between 1965 and 1982 is sometimes called The Great Inflation due to the massive surge in prices witnessed by consumers and businesses. In 1979, Paul Volcker took control of the Federal Reserve and began an all-out attack on inflation. His primary weapon in this battle was interest rates.
As the Fed raised rates aggressively, it widened the gap between the interest rate banks were allowed to offer and the rate investors required as incentive to part with their funds. In 1980, the cap on deposit rates was 5.25%, less than half of the 12% return investors could earn from short-term Treasuries. As such, it was unsurprising that investors flocked to deposit account alternatives, like money market mutual funds and short-term Treasuries.
While Regulation Q was implemented to prevent banks from becoming illiquid, that’s exactly what happened when they weren’t able to offer rates high enough to tempt depositors away from other alternatives. This was one of the factors that led to the Depository Institutions Deregulation and Monetary Control Act of 1980 which included a six-year phase out of the deposit rate caps set under Regulation Q.
1982: Money Market Deposit Accounts Emerge
The popularity of money market mutual funds in the 1970s and early 1980s highlighted a gap in bank offerings. While most banks at the time offered checking accounts for everyday transactions and savings accounts and Certificates of Deposit for longer-term purposes, they did not have anything in between.
The Garn-St Germain Depository Institutions Act of 1982 created a new type of account at banks – money market deposit accounts. These combined the interest-bearing features of savings accounts with some of the liquidity traditionally reserved for checking accounts.
Money market deposit accounts offered rates of return that were competitive with short-term Treasuries and money market mutual funds. And, unlike money market mutual funds, they are covered by FDIC insurance, up to the standard limit at each financial institution.
With the advent of money market deposit accounts, investors finally had an option that provided the return, liquidity, stability, and safety they needed. Only one obstacle remained – FDIC limits. But it would take a few more decades for a simple solution to that problem to emerge.
2008: Money Market Mutual Funds “Broke the Buck”
Over the next several decades, both money market mutual funds and money market deposit accounts thrived. Many investors thought that these investments were “as good as cash” since their principal values never wavered. That belief was put to the test in 2008. While money market deposit accounts held up under the pressures of the financial crisis, some money market mutual funds did not.
To understand how the problems with money market mutual funds during the financial crisis began, some background information is needed. There are two main types of money market mutual funds – government and prime. As the name suggests, government money market funds invest exclusively in short-term government securities. Prime funds, on the other hand, can also invest in short-term, high-quality corporate debt.
During the financial crisis, even companies that had excellent credit ratings, and therefore would have been considered “high-quality debt,” suffered. As stories of companies failing and being unable to pay their obligations flooded the newscasts, investors became skeptical of their corporate holdings, including those in their prime money market funds.
In September 2008, after the failure of Lehman Brothers and the AIG bailout, investors rushed to divest their prime money market funds. From September 2, 2008 to October 7, 2008, prime money market fund assets fell by $498 billion (24%).
The Reserve Primary Fund (the first money market mutual fund) lost substantially on Lehman Brothers’ commercial paper and these losses were compounded by the rush away from prime money market funds. As a result, the Reserve Primary Fund was unable to hold the $1 per share price it had maintained since its inception. For the first time ever, a money market mutual fund had “broken the buck,” and investors had lost some of the principal they had been certain was safe.
While investors only lost a small percentage of their holdings when the Reserve Primary Fund “broke the buck,” the psychological implications were significant. For decades, investors had been sure that the funds they placed in money market mutual funds were “as safe as cash.” Then, they were proven wrong.
How did money market deposit accounts react during the financial crisis?
During the financial crisis, corporations, individuals, investment firms, and banks suffered. While more than 500 banks failed from 2008 to 2015, the assets that investors kept in FDIC-insured banks were safe, up to the $250,000 limit.
Unlike investments with a brokerage firm, assets deposited with an FDIC insured bank are guaranteed by the full faith and credit of the United States’ government, up to the applicable limit. Since 1933, no depositor has lost a penny of FDIC insured funds – including 2008.
While the FDIC guaranteed the principal and accrued interest in accounts at member banks, that protection was limited. Businesses and individuals with more than the $250,000 limit risked losing a portion of their investments when banks collapsed. This risk prompted yet another innovation in money market investments.
AMMA™ by ADM – a New Type of Money Market
Throughout the history of money market investments, one thing has always been lacking – simple access to government protection beyond the $250,000 FDIC limit. Since the limit applies to each institution, individuals and businesses could open accounts at enough FDIC insured banks (or NCUA insured credit unions) to achieve protection for all their funds. But this process is labor intensive.
For example, a business with $10 million in cash would need accounts with 40 different financial institutions to achieve full protection. That means forty relationships to manage, account statements to reconcile, and interest rates to monitor. Increase that amount to $100 million, and it could take an entire team to manage a business’ deposits.
Marketplace Banking™ by the American Deposit Management Co. [ADM] was created to solve this problem. Through our American Money Market Account™ [AMMA™], businesses can access FDIC / NCUA insurance for all their funds, with one account and one monthly statement.
With AMMA™, businesses don’t have to sacrifice returns or liquidity to achieve extended safety. Through proprietary fintech, ADM spreads business cash across a nationwide network of financial institutions that compete for deposits. Then, a team of deposit consultants monitors rates to ensure each client continues to receive the most advantageous return available. Finally, AMMA™ features next-day liquidity.
Since the 1970s, money market investments have solved problems for investors by providing higher rates when regulations kept returns stagnant and increasing liquidity on interest-bearing deposit accounts, but protection remained a challenge. Now with AMMA™, companies can finally have it all – safety, liquidity, and return.
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1 “Requiem for Regulation Q: What It Did and Why It Passed Away” by R. Alton Gilbert, Published February 1986. Accessed from https://files.stlouisfed.org/files/htdocs/publications/review/86/02/Requiem_Feb1986.pdf