The United States Securities and Exchange Commission (SEC) recentlyrejected proposed rules aimed at making money-market funds safer in a financialcrisis – a rejection that has caused consternationamong observers and other regulators. Given the risks that money market fundscan pose to the global financial system, as shown by their destabilizing role in the 2008 financial crisis,it is not hard to see why they are worried.

Money-market funds take excess cash from investors and use it to purchaseshort-term IOUs from businesses, banks, and other financial institutions. They mimic bank accounts by allowing investors to writechecks and promise that their investment’s value will not fall.

In 2012, American “prime” money-market funds, which buy bank and corporatedebt, were worth nearly $1.5 trillion. The money flowing through these fundswent to many of the world’s largest banks, including not just the obvious USsuspects (JP Morgan Chase, Bank of America, and Citi), but also major Europeanand Japanese banks such as Barclays, Deutsche Bank, Bank of Tokyo, Sumitomo, CreditSuisse, and ING. These six international banks alone accounted for nearly 20%of the prime money-market funds’ value.

Many readers know how money-market funds work: An investor buys a $1.00share from the XYZ fund, which keeps each share’s value at a constant $1.00,allowing the investor to believe that the money – invested in a pool of safe,secure, but not always government-guaranteed assets – is on deposit. Even ifthe asset pool declines in value, the fund’s managers keep the value of eachshare at $1.00 by rounding upward the fund’sreal value. If the fund’s losses are big enough thatrounding off still leaves it short ofa stable $1.00 value, the fund “breaks the buck.”

That happened when Lehman Brothersfailed in September 2008. The Reserve Fund, a well-established money-marketfund with too many unpaid IOUs from Lehman, could not keep its value steady. Itbroke the buck.

All money-market funds then became suspect, and many investors fled –withdrawing one-third of a trillion dollars in a single week. Since much of themoney-market funds’ assets are IOUs from theworld’s biggest banks, the withdrawals weakened the already-shaky globalbanking system. The Federal Reserve, seeking to stem the growing panic andstabilize the American and international banking system, promptly guaranteed the value of all money-marketfunds.

The proposals that the SEC rejected were aimed at making money-marketfunds more robust by requiring that each fund maintain capital reserves or letits value “float” – and not be rounded up – to reflect its true, underlyingrisk. The proposal would also have required that money-market funds hold back a fraction of some redemptions, thereby making investors take somerisk that funds might not have complete transactional liquidity if theirinvestments weakened.

A majority of the commissioners turned down the proposals after substantial lobbying from the mutual-fundindustry. If money-market funds had to maintain capital reserves, industryrepresentatives argued, yields to investors would decline and the industry’sprofits would suffer. And, if retail investors saw their money-market funds’values declining from the amount that they had invested, and if they knew thatthey could not get all of their money back immediately, the funds would becomeless attractive. Investors might choose other places for their excess cash,like banks.

Banks are obliged to hold reserves,maintain capital, and pay deposit insurance to ensure that they can honor theirdeposits. The mutual-fund industry, one can assume, feared that the SEC’s ruleswould induce customers to redirect much of their cash directly into banks.

As a result of the SEC’s inaction, money-market funds will continue tooperate outside the scope of bank-style rules on capital and reserves, eventhough investors treat them like bank accounts. Unlike banks, though, they donot pay the government to insure their investors. But the 2008 financial crisisshowed that, when push comes to shove, thegovernment will backstop money-market fundsnonetheless.

The rejected proposals are thus good policy: money-market funds should bemade safer – via capital requirements and liquidity restrictions – because theyalready receive a de facto government guarantee. Their steady value makesthem appear safer to investors than they are to the world’s financial system.

The SEC’s rejection of the proposed rules demonstrates the power of concerted lobbying – and that concentrated interests often trump diffusebenefits. Typically, an interest group lobbies Congress, blandishing persuasive arguments, campaigncontributions, and other support; often enough members – or enough key members– come to see the merit of the group’s point of view (or at least vote asif they do). Meanwhile, ordinary citizens do not notice unless the issuereceives significant media attention. Often no one lobbies the other side ofthe issue.

One might think that banks wouldcounter-balance the mutual-fund industry’s lobbying efforts, because thelikely effect of forcing money-market funds to pay for more of their systemiccosts would be to expand funds flowing directly to banks. But inflows throughmoney-market funds are not so bad for banks, which get the cash without havingto set aside reserves or pay for depositinsurance. Some banks may even prefer these flows to direct deposits.

So the mutual-fund industry had the regulators allto itself. Its lobbyists told the SEC commissioners that current rulesalready did everything possible to ensure safety; that retail investors wantmoney-market funds’ steady value; thatchange would hurt all investors; and that the recent Dodd-Frankfinancial-reform legislation disrupts regulators’ ability to bail out money-market funds next time.

Other regulators were watching,  as were academics and journalists –and some regulators may now feel compelledto take over the money-market safety rules from the SEC or push the SEC backinto action. With no one having a direct financial interest in the outcomepressing an alternative view, the SEC’s initial decision was as predictable as it was bad.