The majority of federally insured savings and loans failed in the 1980s, wiping out the Federal Savings and Loan Insurance Corporation in 1989. The fiasco ultimately cost taxpayers around $150 billion to make savings depositors whole. Two years later, the failures of hundreds of commercial banks put the Federal Deposit Insurance Corporation in the red. (The FDIC got a bridge loan from the US Treasury, which it eventually repaid.) It became clear that deposit insurance had fostered immense moral hazard, enabling the growth of unsound S&Ls and commercial banks.
For many reformers these events raised the question of how the core services of banks (intermediation and payments) might be provided without the expense of tax-funded guarantees, and yet without the danger of runs that had prompted the creation of the FSLIC and FDIC. A number of economists (myself included) pointed to checkable money-market mutual funds (MMMFs) as an alternative to bank deposits that are not run-prone and therefore have no need for taxpayer-funded guarantees.
MMMFs, like other mutual funds and unlike banks, offer savers not debt claims promising specified dollar payouts on specified dates but rather equity claims (shares) in the dollar value of a portfolio. Like other mutual funds, a MMMF buys back shares on demand at the current “net asset value” or NAV. The modifier “money-market” means that a fund invests only in fixed-income securities with less than a year in remaining maturity, which means that present-value losses will be negligible from a rise in interest rates. A fund can keep default and liquidity risks low by maintaining a diversified portfolio of highly rated securities with active secondary markets.
In 1976 Merrill Lynch introduced a MMMF that allowed customers to write checks against their account balances, an innovation which was quickly copied by other funds. Money-market share accounts now combined the services of checking accounts with much higher returns, because they were not subject to the binding interest-rate ceiling (under the Fed’s Regulation Q) then constraining bank accounts. To make them seem more like bank accounts, fund providers adopted the convention of pegging the share redemption value or NAV at $1, and varying the number of shares in an account, rather than varying the share price to reflect changes in the value of portfolio assets. The popularity of MMMFs soared. MMMFs that hold only Treasury obligations are called “government” funds. Those that hold mostly commercial paper and jumbo bank CDs are called “prime” funds.